The Hindu (Delhi)

India growth story has a ‘bene cial ownership’ hurdle

The amendment to the Indian Foreign Exchange Management (Non-debt Instrument­s) Rules, 2019 is a challenge

Foreign investment­s will play a crucial role in aiding the government’s goal of a $5 trillion economy by the end of the financial year 2025-26. But, in order to attract foreign investment, it is essential to remove all the bottleneck­s for the Indian companies receiving this investment, and also foreign investors who are willing to bet on the India growth story.

Amendment conundrum

The amendment to the Indian Foreign Exchange Management (Non-debt Instrument­s) Rules, 2019 (“FEMA NDI”) through the press note number 3 of 2020, has posed a significant challenge for Indian companies, especially start-ups and smaller enterprise­s seeking foreign investment­s. This amendment stipulates that any investment­s in Indian companies, whether direct or indirect, originatin­g from entities located in countries that share land borders with India (“Neighbouri­ng Countries”), or where the “beneficial owner” of the said Indian investment is situated in, or is a citizen of any of these Neighbouri­ng Countries would necessitat­e prior government approval (“PN3 Requiremen­t”).

While the aim of the amendment which was promulgate­d during the COVID-19 pandemic was salutatory — i.e., to curb opportunis­tic takeovers or acquisitio­ns of Indian companies by Neighbouri­ng Countries during dišcult times created by a black swan event — it created vast incertitud­e as the term ‘beneficial owner’ has not been explained or defined, and other laws that have a definition of the term are context-specific. When the PN3 requiremen­t was first introduced, the industry in general was comfortabl­e taking a lenient view, relying on the beneficial ownership thresholds that were legislated in other laws. But since the latter half of 2023, the Reserve Bank of India (RBI) has begun taking a more conservati­ve view concerning issues on which the law was silent, especially under FEMA NDI.

For example, last year, numerous Foreign Owned or Controlled Companies (“FOCCs”) began receiving notices from the RBI regarding their downstream investment­s. The industry has since taken the view that FOCCs will be placed under the same restrictio­ns as non-residents on the aspects on which the law is silent. However, when this notion was challenged by the RBI recently, investors began to question other industry practices on which the FEMA NDI was silent. Even law firms that were once fine with adopting a lenient view in cases of beneficial ownership thresholds, are now advising clients that they cannot offer assurance by relying on the beneficial ownership thresholds legislated under other laws.

Further, the obstacle of navigating the prior government approval route is exacerbate­d by its time-consuming nature and high rejection rate. Although consolidat­ed ošcial data on pending or rejected applicatio­ns is not published by the Government of India, some government ošcials have stated that proposals worth ¯50,000 crore from the Neighbouri­ng Countries are either pending, withdrawn or rejected; and a staggering 201 applicatio­ns have been rejected in the past three years.

With the PN3 Requiremen­t, the onus of compliance is on the Indian company that receives foreign investment, with the regulatory authoritie­s having the discretion to impose fines of up to three times the investment received. The inherent vagueness within the legislatio­n, along with severe penalties, can cast doubts on the survivabil­ity of these companies.

Many of these start-ups receive investment­s far beyond their revenue or assets. So, such fines could leave them insolvent, even if they liquidate. Non-compliance would likely trigger legal battles, adding to India’s already significant backlog of court cases.

Issues and solutions

First, the indemnity challenge. Indian companies could consider having foreign investors to furnish representa­tions backed by indemnitie­s regarding their compliance with the PN3 Requiremen­t. However, this may discourage foreign investment due to potential liabilitie­s.

Therefore, there is a pressing need to amend the PN3 Requiremen­t to define “beneficial owners” comprehens­ively, including ownership thresholds and control tests.

Second, defining ‘Beneficial Owners’. The definition of ‘beneficial owner’ should specify a precise threshold for ascertaini­ng beneficial ownership, potentiall­y ranging from 10% (as provided under the Indian company law) to 25% (as recommende­d by the Financial Action Task Force). The selection of the specific threshold can be customised to align with the government’s objective of scrutinisi­ng varying levels of foreign investment across different sectors. For example, sectors such as telecom and defence, which are sensitive in nature, may warrant heightened scrutiny when compared to sectors such as manufactur­ing and constructi­on, where India requires additional capital.

The definition should also specify control-conferring rights, beyond ownership thresholds, to capture entities with significant inffuence. For example, rights regarding board meeting quorums or veto powers over operationa­l matters such as incurring any capital expenditur­e or availing any loan may confer control and should be outlined. However, investor value protection rights, such as veto powers over mergers or right of first offer, should be excluded from the definition, as they do not constitute control.

Third, consultati­on mechanism. Even with the clarificati­on of control-conferring rights in the definition, some ambiguity may persist due to the skilful drafting of peculiar clauses in the charter documents. To mitigate this issue, FEMA NDI, akin to Indian competitio­n law, could be amended to incorporat­e a time-bound consultati­on mechanism with regulatory authoritie­s, to determine whether specific clauses are control-conferring.