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FDI Policy on downstream investment - A blessing in disguise?

By Rahul Dhawan

Foreign investment in India is regulated by the Foreign Direct Investment Policy (“FDI Policy”) as amended from time to time by the Department of Industrial Policy and Promotion (DIPP), Ministry of Commerce and Industry. Barring a few prohibited sectors such as real estate, retail trading (except single brand product retailing), gambling and betting, lottery business, manufacturing of cigars & cigarettes, atomic energy and railway transport and the like, FDI is permitted in almost all industrial sectors, and it has been the constant endeavour of the Government of India to further relax the FDI Policy as a consequence of which an increasing number of industrial sectors continue to be liberalized from the regulated / prohibited category.    

Entry routes: The FDI Policy envisages the foreign investments in India to be made directly as well as indirectly, under two entry routes, viz, the automatic route, in terms of which, there is no requirement of seeking a prior approval from the Government, and the only obligation is to notify the Reserve Bank of India (RBI) in the prescribed manner about the receipt of inward remittances of funds and subsequent issuance of securities to foreign investors; and the approval route, which is subject to prior Government approval. Proposals for FDI under the approval route are considered by the Government on a case-to-case basis.    

Sectoral Caps: In accordance with the FDI Policy, foreign investment in an Indian company is subject to certain equity caps varying at the levels of 26% in sectors such as defence and insurance; 49% in asset reconstruction companies and credit information companies;  74% in telecom service, ground handling service and scheduled air transport service in the aviation sector; and 100%  in sectors including manufacturing, agriculture, mining, power, oil & gas, construction, non-banking finance companies, wholesale trading, single brand retail trading, etc. The sectoral caps signify the extent of ‘ownership’ and ‘control’ that a foreign investor is permitted to have, or exercise, in an Indian company.      

Downstream Investment: Downstream investment is an indirect mechanism of FDI, whereby an Indian company having FDI (‘investing company’), which is owned or controlled by ‘foreign persons / entities’, invests in the shares of another Indian company (‘subject company’). It has been further provided under the FDI Policy that the investment through the investing company would not be considered for calculation of foreign investment (as downstream investment), in the event, such investment is made by an Indian company which is ‘owned’ and ‘controlled’ by resident Indian citizens and/or Indian companies (which in turn are owned and controlled by resident Indian citizens).    

A company is said to be owned by Indian citizens / Indian companies if more than 50% of the capital in it is beneficially owned by resident Indian citizens and/or Indian companies; and a company is considered as ‘controlled’ by resident Indian citizens and/or Indian companies if the resident Indian citizens / Indian companies have the power to appoint a majority of directors in that company. In case of proposals falling under the approval route, any inter-se agreement between/amongst shareholders which has an effect on the appointment of the directors or on the exercise of voting rights or of creating voting rights disproportionate to shareholding or any incidental matter thereof, will have to be informed to the Government.    

Downstream investment was first allowed without the Government approval by Press Notes 2 and 4 of 2009 Series issued by the DIPP. Under the prevailing FDI Policy, downstream investment by an investing company which is ‘owned and controlled’ by ‘foreign persons / entities’ has to be in compliance with the sectoral caps and the conditions attached to it, if any. However what raises a question mark on the applicability of the sectoral caps to downstream investment is the removal of a provision contained in Paragraph 4.6.1 of the earlier consolidated FDI Policy, effective from 1st October, 2010. The said paragraph stated that “the ‘guiding principle’ is that downstream investment by companies ‘owned’ or ‘controlled’ by non-resident entities would require to follow the same norms as a direct foreign investment i.e. only as much can be done by way of indirect foreign investment through downstream investment..... as can be done through direct foreign investment and what can be done directly can be done indirectly under same norms”. This requirement of having to do indirectly, only what could have been done directly, was omitted from the Consolidated FDI Policy, effective from 1st April, 2011, and continues to be omitted in the Consolidated FDI Policy, effective from 1st October, 2011.
Consequently, downstream investment by entities owned and controlled by resident Indian citizens may not be counted for ascertaining indirect foreign investments which are subject to the restrictions imposed under the FDI Policy. In other words, the downstream investment of an Indian investing company, in which more than 50% of the beneficial equity, as well as the right to appoint majority of the Board of Directors, are with resident Indian citizens, may be treated as domestic investment. This may eventually lead to the contention that investing companies with no foreign ownership or control are permitted to further invest in any sector, notwithstanding the sectoral caps. This arrangement of combining the direct and indirect foreign investments to overcome the sectoral restrictions, has been taken note of by the DIPP in its discussion paper, although no formal step has been initiated by the Government to either recognise it or explicitly invalidate it, thus giving way to a bigger question as to whether ‘what cannot be done directly, can be done indirectly?’

[The author is Principal Associate, Corporate Division, Lakshmikumaran & Sridharan, New Delhi]
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