Navigating the New Era: Comprehensive Guide to India’s Amended Foreign Exchange Management Rules

Foreign Exchange

The renewed Foreign Exchange Management rules, directions, and regulations represent a significant overhaul of the legal aspects governing overseas investments by Indian entities. Before this, such investments were regulated by the Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004, and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015. With the amended legislation launched on August 24, 2022, the regulatory landscape for overseas investments is now governed by three key frameworks-

  1. Foreign Exchange Management (Overseas Investment) Rules, 2022
  2. Foreign Exchange Management (Overseas Investment) Regulations, 2022
  3. Foreign Exchange Management (Overseas Investment)  Directions, 2022

The new directives supersede the previous regulations, aiming to streamline and simplify the procedures related to overseas investments. They encompass various aspects, including acquiring gifts outside India and opening subsidiaries overseas, ensuring a cohesive system for managing foreign exchange in the context of overseas investments.

Prominent Changes Brought Forth Under the New Regime of Foreign Exchange Management 

The revised guidelines represent a liberal architecture of self-regulation, addressing the evolving needs of Indian businesses looking to expand globally. By simplifying processes and introducing clear definitions, these directions are designed to facilitate smoother and more efficient international investment activities.

  1. Replacement of the Concepts of “Joint Venture & Wholly Owned Subsidiary”

The past concepts in the Foreign Exchange Management framework related to “Joint Venture” (JV) and “Wholly Owned Subsidiary” (WOS) have been replaced with the concept of “Foreign entity.” A foreign entity is any entity formed, registered, or incorporated outside India, including an IFSC. These foreign entities under the new OI regime must have limited liability and can be registered as a limited liability company or partnership. This restriction does not apply to entities engaged in strategic sectors like energy, natural resources, or startups, which the Central Government identifies as crucial areas.

https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12381&Mode=0

  1. Indian Entity vs. Indian Party

The erstwhile OI Regulations defined the term ‘Indian Party’ to collectively refer to all Indian investors in a foreign entity. However, the amended regulations replaced this with the concept of an ‘Indian entity’. Now, each investor from India will be recognized individually as an Indian entity rather than being grouped together as an Indian Party.

https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12381&Mode=0

  1. Redefined Meanings of Overseas Direct Investment (ODI) and Overseas Portfolio Investment (OPI)

The definition of Overseas Direct Investment (ODI) now includes the following-

  • Acquisition of unlisted equity capital of a foreign entity.
  • Subscription as part of the memorandum of association of a foreign entity.
  • Investment in 10% or more of the paid-up equity capital of a listed foreign entity.
  • Investment with control where the investment is less than 10% of the paid-up equity capital of a listed foreign entity.

This redefinition ensures that Overseas Direct Investments continue to be classified as an ODI even if the investments falls below 10% of the paid-up equity capital or if the investor loses control over the foreign entity.

Overseas Portfolio Investment (OPI)” generally represents investments in foreign securities that are not classified as Overseas Direct Investment (ODI). However, as per the new foreign exchange management regime, the following stipulations apply to OPI:

  1. a) OPI is not permitted in:
  • Any unlisted debt instruments;
  • Any security issued by a person resident in India who is not in an International Financial Services Centre (IFSC);
  • Any derivatives unless explicitly allowed by the Reserve Bank;
  • Any commodities, including Bullion Depository Receipts (BDRs).
  1. b) OPI made by a person resident in India in the listed equity capital of a listed entity will continue to be treated as OPI even after the entity is delisted. However, any further investment in the equity capital of the foreign entity post-delisting will be classified as ODI.

https://rbidocs.rbi.org.in/rdocs/notification/PDFs/APDIRCIRCULAR0983259ED23DD84EC0BC5D9864789C84CD.PDF

Furthermore, quite recently in June 2024, the Reserve Bank of India has again amended Para 1(ix)(e) and Paragraph 24(1)] Foreign Exchange Management [Overseas investment] Directions, 2022. As per these amendments, Overseas Portfolio Investments (OPI) also cover investments made by listed Indian Companies, Resident Individuals or Unlisted Indian Entities into regulated Investment funds abroad in the forms of units or other similar instruments. This classification is for jurisdictions other than International Financial Services Centres (IFSCs)

According to the revisions, investments made by listed Indian companies, resident individuals, and unlisted Indian entities in units or similar instruments issued by regulated investment funds abroad are classified as Overseas Portfolio Investments. This classification applies to jurisdictions outside International Financial Services Centres (IFSCs).

In the case of IFSCs, the updated regulations widen the ambit of eligible investors to cover unlisted Indian entities, listed Indian companies, and resident individuals. Such entities are now permitted to invest in units or similar instruments issued by investment funds or vehicles, as specified in Schedule V of the Overseas Investment Rules, subject to applicable limits.

The modification of Paragraph 24(1) specifies that Indian entities or resident individuals may invest in units or instruments issued by investment funds or vehicles established within other IFSCs. This amendment broadens the categories of entities eligible to engage in Overseas Portfolio Investments within IFSCs, aligning with regulatory frameworks designed to facilitate and regulate foreign investments by Indian entities.

  1. Amendment to the Concept of Control

Control is now defined as the right to appoint the majority of directors or to control management or policy decisions, either directly or indirectly, through shareholding, management rights, or agreements that confer 10% or more of voting rights or other forms of influence.

  1. Revision of the Net-Worth Definition

The preceding definition of net worth under the erstwhile ODI Regulations, which included paid-up capital and free reserves, was ambiguous and did not address how losses, deferred expenditures, and similar items had to be treated. The new OI Rules have now changed the definition of net worth to align with the one provided in the Companies Act, 2013. Additionally, the OI Rules clarify how to determine net worth for partnerships and LLPs, including specific guidelines for reducing accumulated losses when calculating net worth.

  1. Gifting Foreign Securities

The Overseas Investment Rules allow a resident individual to acquire foreign securities through inheritance from someone in India (who complied with the Foreign Exchange Management Act, 1999 (FEMA)) or from someone outside India.

Resident individuals can also receive foreign securities as a gift from a relative in India, as long as those securities comply with FEMA.

A key change in the amended rules concerns acquiring foreign securities from someone outside India. According to the new regulations, a resident individual can acquire foreign securities from a person outside India, but this must comply with the Foreign Contribution (Regulation) Act, 2010 (FCRA). The FCRA governs the acceptance and use of foreign contributions by certain individuals and entities. This means that a resident individual receiving foreign securities from a foreign source might need FCRA registration.

However, suppose a resident individual receives foreign securities valued at less than Rs. 10 lakhs from a relative who is a foreign citizen. In that case, they do not need special approval from the Ministry of Home Affairs. If the foreign securities gifted are worth more than Rs. 10 lakhs, the recipient must notify the Central Government by submitting Form FC-1 within three months of receiving the contribution.

  1. Control in Subsidiary or Step-Down Subsidiary (SDS)

The Revised Framework connotes a “subsidiary” or “step-down subsidiary” (SDS) of a foreign entity as an entity controlled by the foreign entity. As per the OI Rules meaning of “control”, it can be exercised by an individual or group acting together, directly or indirectly. This control can be based on shareholding, management rights, shareholders’ agreements, or voting agreements that provide 10% or more of the voting rights, or any other manner of control within the entity. Hence, the Revised Framework sets a significantly reduced threshold of 10% voting rights to identify an entity as a subsidiary, in contrast to the Companies Act, 2013.

  1. Financial Commitment by Indian Entities via Debt

Indian entities can remit funds towards loans or issue bank guarantees to a foreign entity only if they have made an ODI and have control over the foreign entity. Interest rates must be at arm’s length.

  1. Disallowance of Borrowed Funds for Start-ups

ODI in foreign start-ups must be funded from the Indian entity’s internal accruals, not borrowed funds. Resident individuals can only use personal funds.

  1. Opening New Avenues for Overseas Investment

  • International Financial Services Sector (IFSC): The definition of a foreign entity includes entities in IFSCs. Indian entities not engaged in financial services can invest in foreign entities engaged in financial services, except banking or insurance, without meeting the net profit condition.
  • Non-financial Indian Entities Investing in Financial Services: Indian entities in non-financial sectors can now invest in foreign entities engaged in financial services, except banking or insurance.
  1. Operational Changes

Form FC has replaced Form ODI, and a new Form OPI has been introduced for non-individual residents making Overseas Portfolio Investments. Delays in reporting compliance, including the Annual Performance Report, will now attract Late Submission Fees (LSF). The LSF option is available for delayed reporting under earlier regulations for up to three years from the notification date of the OI Regulations. 

Another pivotal aspect revolves around Point 10 of the Foreign Exchange Management (Overseas Investment) Directions, 2022. It specifies the following-

  • If the remittance for acquiring equity capital is to be made after subscribing to the Memorandum of Association, the timeline for such remittance must be specified in the agreement/documents/applicable laws; otherwise, the remittance must be made by the acquisition or establishment of the foreign entity.
  • Any deferred payment by a person resident in India will be treated as a non-fund-based financial commitment and reported accordingly. Subsequent payments towards deferred consideration must be reported in Form FC as the conversion of non-fund-based financial commitment to equity, with valuation done upfront as per pricing guidelines.

Clarifications for Initial Reporting Before Incorporation of Foreign Entity-

  • Prior to the foreign entity’s incorporation, we must report the intention to acquire equity as a non-fund-based financial commitment in Form FC, accompanied by a Deferred Consideration Agreement detailing terms, deferment period, upfront payment, and other relevant details.
  • Failure to report this initial commitment can lead to LSF levy.
  • Before proceeding with the investment, it is essential to ensure the Indian entity and its bank account are set up correctly.

Subsequent Reporting Payments-

  • Once the foreign entity and its bank account are established, payments can be made according to the Deferred Consideration Agreement timeline.
  • Upon payment, we must report in Form FC, converting the initial non-fund-based financial commitment into actual equity ownership in the foreign entity. This second reporting will follow the standard ODI application process.

While these steps provide a compliance framework, additional consequences or concerns may arise with the first application submitted to the bank.

  1. Permitting Investment in Immovable Property

The amended regulations empower Indian residents to directly invest in overseas immovable property using income or proceeds from assets acquired abroad, excluding Overseas Direct Investment (ODI) as per FEMA guidelines. This means residents can now utilize proceeds from property sales, rental income, profits from Overseas Portfolio Investments (OPI), and related earnings to procure new immovable assets abroad, a significant departure from previous regulations. Residents can now remit funds up to the Liberalized Remittance Scheme (LRS) limit (US$2.5 lakh) to jointly acquire immovable property with an NRI relative, adhering to definitions outlined in the Companies Act.

  1. Round Tripping Regulations

The term “round tripping” is generally used to describe a structure where an Indian individual or entity invests in an offshore entity, which subsequently invests or already has investments in India. Historically, the RBI imposed strict regulations on such transactions involving Indian funds remitted abroad to create assets in India. The updated Overseas Investment Rules now relax these restrictions, allowing financial commitments in foreign entities. However, no resident of India may make financial commitments in a foreign entity that invests or has invested in India, directly or indirectly, resulting in a structure with more than two layers of subsidiaries at any time. Exceptions to this rule apply to banking and select non-banking financial companies.

  1. Acquisition under ESOP or EBS

Under the OI Framework, if a resident individual gets shares through an Employee Stock Ownership Plan (ESOP) or Employee Benefits Scheme (EBS) and holds less than 10% of the equity in a foreign company (whether listed or unlisted) without control, it is considered an Overseas Portfolio Investment.

The OI Rules allow resident individuals, who are employees or directors of an Indian office, branch, or subsidiary of an overseas company or an Indian company in which the overseas company has shares, to acquire unlimited shares under ESOP or EBS. However, the shares must be issued uniformly to all eligible employees worldwide.

There’s a rule stating that the value of these shares counts towards an individual’s Liberalized Remittance Scheme (LRS) limit of US$250,000. For example, if an individual remits US$500,000 for ESOP or EBS in a financial year, the LRS limit is fully used up, preventing any further remittance under LRS for that year.

Non-Compliance Repercussions

Penalties for non-compliance with the new Overseas Direct Investment (ODI) and Overseas Portfolio Investment (OPI) regulations include:

  • A late submission fee of Rs 7,500 for delays in reporting Form ODI Part-II, Annual Performance Reports (APR), Foreign Liabilities and Assets (FLA) Returns, Form OPI, evidence of investment, or any other required returns.
  • For delays in submitting Form ODI Part I, Form ODI Part III, Form FC, or any other necessary returns, an additional penalty of Rs 7,500 plus 0.025% of the amount involved in delayed reporting, multiplied by the number of years of delay rounded up to the nearest month and expressed up to two decimal points, is levied.

The new regime in foreign exchange management brings about crucial changes aimed at simplifying and clarifying the process of overseas investments for Indian entities. By introducing new definitions, expanding investment avenues, and emphasizing self-regulation, these directions facilitate a more seamless setting for international business activities.