Detailed Narrative:

The Indian economy has witnessed a surge in foreign investment, with many domestic companies being owned or controlled by foreign entities, known as Foreign-Owned or Controlled Companies (FOCCs). When these FOCCs invest in other Indian companies or contribute to their capital, it is termed a “downstream investment.” The Foreign Exchange Management Act, 1999 (FEMA), and its accompanying rules, particularly Rule 23 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules), provide the regulatory framework for such downstream investments.

While the NDI Rules outline certain conditions for downstream investments, ambiguities persist regarding the treatment of FOCCs. One such ambiguity arises from Rule 23(5) of the NDI Rules, which mandates pricing guidelines and reporting requirements when an FOCC transfers capital instruments to an Indian resident. However, the rules remain silent on the requirements to be followed when an FOCC purchases equity instruments of an Indian entity.

1. Pricing Conundrum:

A plain reading of Rule 23(5) suggests that FOCCs are treated as Non-Residents (NRs) from a pricing perspective and as Indian residents from a reporting standpoint. Consequently, FOCCs should be treated as NRs when purchasing equity instruments, adhering to the pricing guidelines applicable to NRs. However, in some instances, Authorized Dealer (AD) banks have applied the pricing guidelines for transactions between NRs and FOCCs, which is counterintuitive as there is no outflow of domestic funds from the country in such transactions.

Furthermore, the NDI Rules do not address the pricing guidelines for scenarios where an FOCC simultaneously acquires shares of an Indian company from both residents and NRs. AD Banks have adopted a view that in such cases, FOCCs should purchase shares from NRs at or below the Fair Market Value (FMV) but from residents at or above the FMV. This leads to an absurd situation where the FOCC is treated as a resident when buying from NRs but as an NR when buying from residents.

2. Reporting Ambiguities:

Similar to the pricing issue, the NDI Rules do not specifically provide for filing requirements when FOCCs acquire equity instruments from residents or NRs. AD banks may require the filing of Form FC-TRS in addition to Form DI (used to report downstream investments). For transfers between FOCCs, as the NDI Rules are silent, no reporting may be required, although the acquiring FOCC may have to file Form DI.

3. Optionally Convertible Instruments:

Optionally Convertible Preference Shares (OCPS) and Optionally Convertible Debentures (OCDs) offer flexibility to parties in structuring their transactions. The investor can choose at a later point whether to convert their investment into equity shares and participate in profits and capital appreciation or redeem the instrument to protect their capital. The Reserve Bank of India (RBI) has clarified that investments in instruments other than capital instruments would not be treated as downstream investments. However, upon conversion of OCPS or OCDs into equity shares, it would be considered a downstream investment.

4. “Other Attendant Conditions”:

Downstream investments are obligated to comply with the designated entry route, sectoral caps, pricing guidelines, and additional conditions relevant to foreign investment. The term “other attendant conditions” refers to the generic conditions applicable in the context of foreign investment regulations, in addition to the FDI-linked performance conditions. It is recommended that the scope of “other attendant conditions” be construed restrictively to avoid rendering regulations governing downstream investments as burdensome as those governing Foreign Direct Investment (FDI).

FAQs:

Q1. What is the significance of the pricing guidelines for downstream investments by FOCCs?

A1. The pricing guidelines ensure that downstream investments by FOCCs are conducted at fair market value, preventing potential overvaluation or undervaluation of the target company’s shares. However, the ambiguity in the treatment of FOCCs as residents or non-residents for pricing purposes creates confusion and inconsistencies.

Q2. Why is the reporting requirement for downstream investments by FOCCs important?

A2. Reporting requirements, such as filing Form DI and potentially Form FC-TRS, enable regulatory authorities to monitor and track downstream investments by FOCCs. This helps maintain transparency and ensures compliance with foreign investment regulations.

Q3. How are investments in Optionally Convertible Instruments treated under the NDI Rules?

A3. Investments by FOCCs in Optionally Convertible Preference Shares (OCPS) or Optionally Convertible Debentures (OCDs) are not initially treated as downstream investments. However, upon conversion of these instruments into equity shares, they are considered downstream investments and subject to the relevant regulations.

Q4. What is the significance of the term “other attendant conditions” in the context of downstream investments?

A4. “Other attendant conditions” refer to the generic conditions applicable to foreign investment regulations, in addition to the FDI-linked performance conditions. It is recommended that these conditions be interpreted restrictively for downstream investments to avoid imposing the same stringent requirements as those governing Foreign Direct Investment (FDI).

Q5. What are the potential solutions to address the regulatory hurdles faced by FOCCs in downstream investments?

A5. To streamline the process and provide clarity, the relevant authorities should consider revising the NDI Rules to address the ambiguities surrounding pricing guidelines, reporting requirements, and the treatment of investments in optionally convertible instruments. Additionally, a uniform approach to the treatment of FOCCs, either as residents or non-residents, would simplify compliance and reduce regulatory burdens.