Introduction
'Indirect foreign investment' or 'downstream investment' commonly refers to investments received by an Indian entity from another Indian entity ("FOCC") which has received foreign investment and which is not owned and not controlled by resident Indian citizens or is owned or controlled by persons resident outside India. Accordingly, apart from investing directly through the foreign direct investment ("FDI") route, foreign investors can also invest in India through an FOCC.
The guiding principle of the downstream investment guidelines in India has been that "what cannot be done directly, shall not be done indirectly". Accordingly, similar to FDI norms, downstream investments are also subject to the entry routes, sectoral caps, pricing guidelines and the attendant conditionalities as laid down under the Foreign Exchange Management Act, 1999 ("FEMA") and the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 ("NDI Rules").
However, despite the above guiding principle, over the years, there have been ambiguities on certain aspects pertaining to downstream investments including the aspects as to whether FOCCs can make downstream investments by share swap arrangements or by adopting deferred consideration payment structures. It is noteworthy that, subject to prescribed conditions, such arrangements are expressly permitted to foreign entities making FDI.
The Reserve Bank of India ("RBI"), on January 20, 2025 updated the Master Direction on Foreign Investment in India ("Master Direction") and provided clarifications on various grey areas under the foreign investment regulations of India including on the ambiguities pertaining to downstream investments specified above. This article highlights the ambiguities that were persistent in the regulations dealing with downstream investments and how such ambiguities were addressed by way of the updated Master Direction.
The Ambiguity of Deferred Consideration Arrangements in Downstream Investments
Rule 9(6) of the NDI Rules, inter-alia, provides that in case of transfer of equity instruments between a person resident in India and a person resident outside India, an amount not exceeding twenty five per cent of the total consideration: (i) may be paid by the buyer on a deferred basis within a period not exceeding eighteen months from the date of the transfer agreement; or (ii) may be settled through an escrow arrangement between the buyer and the seller for a period not exceeding eighteen months from the date of the transfer agreement; or (iii) may be indemnified by the seller for a period not exceeding eighteen months from the date of the payment of the full consideration, if the total consideration has been paid by the buyer to the seller.
While it is apparent from the above provision that deferred consideration arrangements are permitted for foreign entities undertaking FDI into India, FOCCs were not explicitly covered under the scope of the said provision. Based on the guiding principle of the downstream investment guidelines, a plausible interpretation of the provision would convey that if deferred consideration arrangements are allowed for FDI, they should also be permitted for downstream investments. However, in recent times, there have been news reports that the RBI has issued notices to various FOCCs which adopted deferred consideration arrangements for their downstream investments in India citing non-compliance with the foreign investment regulations of India. This regulatory scrutiny created an apprehension among FOCCs and the AD banks, leading them to adopt an overly conservative approach that deferred consideration arrangements are not automatically permitted in case of downstream investments and require prior RBI approval.
The Ambiguity of Share Swap Arrangements in Downstream Investments
The NDI Rules expressly permit share swap transactions under which an Indian company may issue its equity instruments or transfer shares of another company held by it to a person resident outside India in exchange for equity instruments of another Indian company or foreign company under the automatic route (subject to sectoral requirements and other conditionalities).
While the above contemplates share swap transactions between a person resident in India and a person resident outside India, there was ambiguity as to whether FOCCs can make downstream investments by utilizing share swap arrangements. Again, basis the guiding principle of the downstream investment guidelines, a plausible interpretation would convey that if share swap arrangements are allowed for FDI, they should also be permitted for downstream investments. However, in this regard, the AD banks have been adopting a conservative approach that FOCCs employing share swap arrangements for making downstream investments would not fall under the automatic route and accordingly require prior RBI approval. This approach appears to be arising from Rule 23(4)(b) of the NDI Rules which requires that downstream investments be funded through requisite funds from abroad or internal accruals, thereby indirectly implying that non-cash transactions such as share swaps would not be permissible for downstream investments.
RBI Resolving the Regulatory Ambiguities
As may be noted from the above, the conservative approach adopted by the regulators created a regulatory paradox as well as a conflict with the guiding principle of the downstream investment guidelines in India wherein FOCCs, despite ultimately being Indian entities, were subjected to stricter restrictions than non-resident entities. In effect, while foreign entities could use share swap arrangements or adopt deferred consideration payment structures in the course of FDI transactions, such arrangements and structures could not be utilized by FOCCs in their downstream investments.
In order to resolve the above conflict, by way of the updated Master Direction, the RBI has expressly clarified that based on the guiding principle of the downstream investment guidelines, the arrangements which are available for FDI under the NDI Rules such as investment by way of swap of equity instruments/equity capital and deferred payment arrangements/mechanism shall also be available for the purpose of downstream investment provided that the transaction does not circumvent the provisions contained in Rule 23 of the NDI Rules, including the restrictions on use of borrowed funds for downstream investment.
Conclusion
The updated Master Direction represents a welcome step by providing much-needed clarity and flexibility to downstream investment transactions. The clarifications go a long way towards aligning the framework for downstream investments with the FDI regime already in place and are expected to boost investor confidence and promote a robust and investor-friendly market.
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