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Total Number of Subscribers: 1626 |
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Date:10th July 2010 |
Compiled by: M Sathya Kumar |
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The Ministry of Commerce and Industry has issued a ‘Consolidated FDI Policy’ effective from 1st
April, 2010. (Circular 1 of 2010) The policy has consolidated into one document the entire
policy on foreign direct investment spread over various Press Notes. The past
Press Notes are rescinded. A fresh consolidated policy will be issued every
six months. Though it states that there are no new measures in the
policy, there are a few provisions which did not exist earlier. In this
article I have mainly covered those issues which were not discussed earlier,
and those where there is additional or more clarity. I have covered the basic
policy provisions very briefly. 2. Basic FDI policy : The basic policy for FDI is that foreign investment is
freely permitted in all sectors in If the investment is not under the automatic route, an
approval from FIPB or SIA is required. Non-residents are required to invest
at a price which is at least equal to the value as per erstwhile CCI
guidelines. Transfer of shares is also under automatic route —
subject to compliance of the conditions laid down. 3. Legal background : In the past, the foreign investment policy was issued as
a part of Industrial Policy. The Industrial Policy dealt with licensing and
other issues. Over a period by 2003, the Government titled the document as
Foreign Investment Policy, etc. In actual practice, ‘Industrial Policy’,
‘Foreign Direct Investment Policy’, ‘Foreign Investment Policy’ have been
used interchangeably. There has never been a ‘Foreign Direct Investment
Policy’ as such. 3.1 The Consolidated FDI policy has not been issued
under any law. It is a policy issued by the Department of Industrial Policy
and Promotion (DIPP) which is under the Ministry of Commerce and Industry. DIPP issues Press Notes for amendments to the policy.
The legal framework is the Foreign Exchange Management Act and the
regulations issued under it. FEMA regulations lay down the law, and
procedures. For Foreign Direct Investment, FEMA Notification 20 is
applicable. Generally the RBI issues Notifications to amend the regulations
in line with the Press Notes issued by DIPP. However where the RBI has some
differences or requires some clarifications, FEMA regulations does not get
amended. On a few issues, there are differences between the FDI
policy and FEMA regulations. 3.2 Clause 1.1.9 of the Consolidated FDI policy states
that “The Circular consolidates FDI policy framework, the legal edifice is built on Notifications issued by the
RBI under FEMA. Therefore, any changes notified by the RBI from
time to time would have to be complied with and where there is a need/scope
of interpretation, the relevant FEMA notification will prevail.” This is for the first time that a document states that
it is FEMA regulations which have the legal binding force. This is a clear
provision which is good. Where the Press Note (or Consolidated FDI policy)
liberalises any provision till the FEMA notification is amended, the
liberalisation will not have any effect. In such situation, one can approach
the RBI with an application. Generally the RBI would grant an approval,
unless it has some differences with DIPP on the liberalisation measures. 3.3 Clause 1.1.4 states that “the regulatory framework
over a period of time thus consists of Acts, Regulations, Press Notes, Press
Releases, Clarifications, etc.”. Thus according to DIPP, all communication
from the DIPP are a part of regulatory framework ! At times, there are
clarifications given by Ministers, or by DIPP on its website. Would they be a
part of legal framework ? It will be interesting to read the decision of
Federation of Associations of Manufacturers referred to in paragraph 6. The
Delhi High Court has said in case of policy matters, the Government is free
to decide the meaning it wants to adopt for various terms. In that case, the
Government had adopted a modern meaning of wholesale trading compared to the
traditional meaning. That time the meaning was not in the public domain. The
Government gave its view by way of an affidavit to the Court. The issue is
that the Government can be more upfront in providing its view. 3.4 FEMA Notification No. 20, states the following in
Schedule I, clause 2(1) : “An Indian company, not engaged in any activity/sector
mentioned in Annex A to this schedule, may issue shares or convertible
debentures to a person resident outside India, subject to the limits
prescribed in Annex B to this schedule, in accordance with the Entry
Routes specified therein and the provisions
of Foreign Direct Investment Policy, as notified by the Ministry
of Commerce and Industry, Government of India, from time to time.” As mentioned above, there has never been any Foreign
Direct Investment Policy as such. There has been an ‘Industrial policy’.
Practically, the document published by the Ministry of Commerce and
Industries has been referred to as the FDI policy. 3.5 The Consolidated FDI policy states that in cases of
interpretation, FEMA Notification will prevail. FEMA notification states that
investment will be permitted as per the limits stated in the schedule and the
FDI policy. Which prevails — FEMA regulations or FDI policy ? Take an example : Chapter 4 of the Consolidated FDI policy lays down the
policy for deciding whether an Indian company is controlled and owned by
Indian residents and citizens. (Earlier the policy was laid down in Press
Notes 2, 3 and 4 of 2009. These Press Notes now stand rescinded.) It states
that if the Indian company in which there is foreign investment is owned or
controlled by non-residents to the extent of 50% or more, it will be
considered as foreign investment. Any investment by such a company in another
Indian company will be considered as foreign investment. Sectoral caps will
apply. Vice-versa, if the Indian company is owned and controlled
by persons who are Indian residents and citizens to the extent of more than
50%, it will be considered as Indian investment. Investment by such a company
in another Indian company will not be considered for counting foreign
investment. A chart is given below to illustrate the issue : Thus the Foreign Co. (F) owns directly and indirectly
[through the JV Co. – (J)] total capital Rs.6,226 (3,626 + 2,600) of 62.26%
in Defense production company (D). In defence sector, foreign investment cannot exceed 26%.
With the above structure, the investment can exceed 26%, although the control
will be with the Indian Co. – I. Is this permitted ? A plain reading of FDI policy gives an impression that
it is permitted. Investment in the above manner can take places in several
sectors where there is a restriction or a sectoral cap. However these provisions have not been enacted in FEMA
regulations. This is a situation where FDI
policy is more liberal than the FEMA regulations. The Consolidated FDI policy states that if there is any
interpretation issue, FEMA will prevail. As such a provision is not there in
FEMA, the investment cannot be made. Under FEMA, it states that the investment is subject to
provisions of the FDI policy. Can we say that the investment can be made ? In my view, as the Consolidated FDI policy clearly
states that FEMA will prevail, the investment cannot be made. (Also see
paragraph 3.11.) 3.6 Take a situation where FEMA
is more liberal than the FDI policy. All sectors where there is no restriction, foreign
investment can be made freely. Services sector is under automatic route under
FEMA. Under the erstwhile FDI policy before 31-3-2010 also,
services sector was under automatic route. The Consolidated FDI policy now
states under clause 5.20 that FDI is allowed in specified ‘Business
services’. Does this mean that other services are now no longer under
automatic route ? (See paragraph 9.1 also for more discussion.) 3.7 Is it possible to take a view that only if the
Consolidated FDI policy and FEMA regulations both permit, then only
investment can be made ? My personal view is as under : Where FEMA permits an investment on automatic basis, a
non-resident can make the investment. Where the FDI policy permits an
investment, but FEMA does not permit it, then one needs to take an approval
from the RBI/FIPB before making the investment. 3.8 Consider a situation where the non-resident wants to
invest in ‘Cash and carry/Wholesale trading’.It is an activity which is
permitted on automatic basis. There were however controversies on the meaning of ‘Cash
and carry/Wholesale’. One of the controversies was that whether goods sold on
credit will be in line with ‘Cash and carry’. FEMA regulations do not explain
the meaning of ‘cash and carry’. The Consolidated FDI policy now explains the
meaning of this term. It states that normal credit terms can be given to the
customers. Thus investment can be made in this sector and normal credit can
be extended to the customers. (See paragraph 6 for more discussion.) Thus where FEMA is ‘silent’ on the meaning of any term,
one should be able to rely on the FDI policy. In the case of Federation of
Associations of Manufacturers, the Delhi High Court has stated that such
issue is a policy matter. The Government is within its rights to formulate
policy matters. If the Government decides to adopt a particular meaning of
any business phrase, it can do so. If the Government has considered that
normal credit terms are permissible, then the same are permissible. 3.9 Therefore in a situation where there is a clear
conflict between FDI policy and FEMA, FEMA will prevail. Where it is an issue
of understanding of particular terms, the clarification given by DIPP or FEMA
will prevail. 3.10 One may appreciate that Consolidated FDI policy by
DIPP is a policy level document, whereas
FEMA is the legal document. Both
have different objectives. The Consolidated FDI policy can be considered as
the intention of the Government, whereas FEMA lays down the detailed rules.
Unless a policy is enacted as a statute, it does not have the force of law. 3.11 With the FDI policy, a press release has also been
issued. One of the paragraphs in the press release states that — “There
are a number of issues related to FDI policy that are currently under
discussion in the Government, such as foreign investment in Limited Liability
Partnerships (LLPs), policy on issuance of partly paid shares/warrants,
rescinding Schedule IV of FEMA, clarifications on issues related to Press
Notes 2, 3 & 4 of 2009 and on Press Note 2 of 2005, as also certain
definitional issues, etc. When a decision on these is taken, the Government
decision would be announced and thereafter incorporated into the Consolidated
Press Note subsequently.” Thus there is recognition that there are some issues on
which the Government thinking has still not been finalised. In my view, Press Notes 2, 3 and 4 of 2009 are not
operational as far as the automatic route is concerned. One can approach FIPB
for a specific approval. The Government is considering to scrap nonrepatriable
category of investment for NRIs. One will have to wait for the announcement. Investment in an LLP is desirable. There will be issues
of partners’ investment in capital, withdrawal of the same, payment of
interest, etc. Let us consider some specific issues dealt with by the
FDI policy which have not been dealt with earlier. 4. Investee entity : A non-resident can invest in an Indian company (on
automatic basis). An NRI can invest in an Indian company on repatriable basis
and non-repatriable basis. An NRI can invest in a partnership firm or a
proprietory concern on non-repatriable basis. This policy continues under the
Consolidated FDI policy. Investment in other entities was not permitted. Now the
Consolidated FDI policy is more specific. 4.1 Investment in partnership firm on
repatriable basis : Normally investment in partnership/proprietory concern
is not permitted on repatriable basis. The only sector where there is a
reference of investment in a firm is the defence sector (Press Note 2 dated
4-1-2002 and entry 5.9 of Consolidated FDI policy). The RBI had issued a
Circular No. AP 39, dated 3-12-2003. As per the Circular, NRIs could invest
in a partnership firm or a proprietory concern on repatriable basis after
obtaining an approval from Secretariat of Industrial Approvals/RBI. The
Circular also provides that persons of Non-Indian origin can invest in a
partnership firm or a proprietory concern after obtaining an approval from
the RBI. In actual practice, the RBI is not granting any approval
for repatriable investment in a partnership firm and proprietory concern. The Consolidated FDI policy now provides that NRIs and
persons other than NRIs can apply to the RBI [para 3.2.2]. The application
will be decided in consultation with the Government of India. This is the
first time that the FDI policy provides for a foreigner to invest in a
partnership firm/proprietory concern. The criteria however has not been
specified. One will have to wait and see whether the RBI/Government permits
investment in a firm/proprietory concern and on what terms and conditions. 4.2 Trusts : 4.2.1 Can an NRI or an FII invest in mutual funds which
are formed as trusts ? So far they have been permitted to invest (Schedule
5 of FEMA Notification 20). 4.2.2 An NRI wants to set up a private trust in Can such a trust be settled ? Will such a settlement be
considered as an ‘investment’ ? At the outset one may observe that ‘settlement’ cannot
be considered as ‘investment’. However there will be a transfer of assets to
the Indian trust where a non-resident will have an interest. It requires an
approval from the RBI. Now with a specific bar under the FDI policy, will it
be possible to have an Indian trust with non-residents as beneficiary ? Will
the RBI consider an application at all ? One will have to wait and watch. The above situation is different from a situation where
a non-resident wants to invest in the Indian economy through a trust.
Consider a situation where an NRI settles funds in an Indian trust. The trust
will have an NRI as a beneficiary. The trust will undertake portfolio
investment/business activities. This is not permitted. 4.2.3 The personal status of the trust (whether it is a
person), and its residential status are existing issues under FEMA. These are
however beyond the scope of this article. 4.3 Other entities : FDI is not permitted in other entities. Thus investment
in Association of Persons is not possible. A non-resident and an Indian resident have to jointly
bid for a contract. The bidding may be done jointly. They may be even awarded
the contract jointly. This is clearly permitted. Under the Income-tax Act, it
may become an AOP. That is a different matter. As long as there is no ‘investment’ to be made in the
AOP, there is no restriction. In this kind of AOP, the parties only carry out
the work jointly. The finances are independently managed by the investors.
This is clearly permitted. As far as the non-resident is concerned, he may
have to comply with the ‘project office’ rules. If however the non-resident wants to ‘invest’ in the
AOP, then it is prohibited. 5. Securities in which the non-resident can
invest in : 5.1 Convertible debentures and
preference shares : 5.1.1 Prior to 1-5-2007, Indian companies could issue debentures
and preference shares to non-residents which were partly or fully convertible
into equity shares. There were different views on how much of the face value
could be converted into equity shares. Different offices of the RBI had given
varying views on the amount which had to be converted into equity shares
(ranging from 10 to 25% of the face value). However DIPP had a different
view. According to DIPP, even if 1% of the face value was converted into
equity shares, it was acceptable. With such an instrument, it was possible
for a non-resident to invest in partly convertible debentures (PCDs) or
partly convertible preference shares (PCPs). By having an option to convert
only 1% of the face value, the investor could participate in the debt in Only fully convertible debentures (FCDs) and fully
convertible preference shares (FCPs) are now permitted. 5.1.2 There is however an issue of the price at which
the FCDs and FCPs can be converted. The basic policy is that Non-residents are required to
invest at a price which is at least equal to the value as per erstwhile CCI
guidelines (referred to as the ‘minimum price’). Therefore at what price the
convertible debentures/preference shares should be converted. (This was an issue
even when PCDs or PCPs could be issued.) Broadly, there can be different alternatives for the
price at which the instruments can be converted. These can be as under : (i) The price of
conversion could be the ‘minimum price’ of equity shares at the time of issue
of FCDs/FCPs. It could be at face value in case of a new company or at
a ‘minimum price’ in case of an existing company. This is the minimum price
at which the non-resident has to invest. (ii) The price of conversion could be decided at the time
of conversion. (iii) The third alternative is a variation of the second
alternative. The basis of the price could be decided upfront depending
on the profits which the company earns. The conversion period could also be a
range of dates. It need not be a fixed date. The actual price could be worked
out later. As in the second alternative, the ‘minimum price’ of conversion
would be decided at the time of conversion. 5.1.3 The RBI held a view that the price could not be
determined at the time of issue. It had to be determined at the time of
conversion. Their argument was that if at the time of issue the prescribed
price was Rs.10, and at the time of conversion after 3 years, the price was
Rs.20, the non-resident must get the shares at Rs.20. Recently at a conference, we were told that the price
was to be decided upfront at the time of issue. This was the understanding
from 2007 when PCDs and PCPs were banned ! In my view, when PCDs and PCPs
were banned, there was nothing in the press releases and Circulars on the
pricing issue. 5.1.4 The FDI policy states in clause 3.2.1 that the
pricing of the capital instruments should be decided/determined upfront at
the time of issue of the instruments. Does this have any significance? Does the ‘minimum price’ have to be determined at
the time of issue ? Or only the basis for the ‘minimum price’ has to
be determined ? Does it have to be an exact amount, or can it be
determined with reference to a basis like price to earnings ratio ? The FDI policy states that the ‘pricing’ shall be
decided/determined at the time of issue. ‘Pricing’ is a broader term. It is
different from the term ‘price’. Pricing means basis of the price and
not a certain number. Therefore if the basis of the price is determined, but
the actual price is determined later, the condition should be considered as
complied with. However the RBI does not appear to have this view. Let
us consider an example below. 5.1.5 The ‘minimum price’ could be as under : At the time of issue Rs. 10 At the time of conversion into equity Rs. 20 From investors’ point of view, there could be bona
fide reasons for conversion at a ‘minimum price’ on the date of issue
of FCDs/FCPs. They would consider their appreciation from the date of
investment. If the ‘minimum price’ is decided at the time of issue,
then the investor will benefit. Consider further that the investor may
receive interest on FCDs till the same are converted. In this situation, the
investor will get interest, as well as the benefit of conversion at a lower
price. From issuer’s (investee company’s) point of view, there
could be bona fide reasons for conversion at a ‘minimum price’ on the date of
conversion of FCDs/FCPs. If the ‘minimum price’ is higher at the time of
conversion, the Indian company would not like to give away the shares at a
lower price. This issue has become a grey area. It requires more
clarification from the RBI/Government. In the share purchase agreements, it is advisable to
provide that the price at which the FCDs/FCPs will be converted will be on a
particular basis; however it will not be less than the price prescribed as
per regulations under FEMA. 5.2 Prohibitions : Apart from the FCDs and FCPs, no other instrument can be
issued. It has been specifically stated that warrants and party paid shares
cannot be issued. 6. Trading : 6.1 FDI in trading activities is primarily prohibited.
However trading for exports, Cash and Carry trading/ Wholesale trading (WT),
single brand retail trading is permitted. (Press Note 4, dated
10-2-2006/clause 5.39 of Consolidated FDI policy.) 6.2 It will be interesting to note the meaning of ‘Cash
and Carry’ as understood internationally. The business format of cash and
carry includes the following characteristics : — The seller sells on cash. — Seller does not provide delivery services. The
purchaser takes the goods himself. This is a major distinction between normal
wholesale trading and cash and carry wholesale trading. — The volume of trade is not relevant. What is relevant
is type of customer — whether he uses the goods for business, or for personal
consumption. The customer should use the goods for business. 6.3 This understanding was never explained by the
Government in the past. Initially there were several issues on which there
was no clarity. Over time however some issues were clarified on the website
of DIPP, or by way of clarification from DIPP on a specific request. The meaning of WT as understood by DIPP is : — The sale should be to a person who has sales tax
number/VAT registration. Say a hospital wants to buy medical sutures on
wholesale basis. The hospital has registration numbers, under various
Government authorities. Yet it is the ultimate consumer. Whether this was
permitted or not was not clear. — — Subsequently, the Federation of Associations of
Manufacturers had filed a writ petition in the Delhi High Court. In that
case, the Government has given its understanding on the meaning of the term
‘Wholesale Cash and Carry trading’. The writ petition was filed mainly
because the Government had permitted non-resident investment in B2B
e-commerce. The Delhi High Court had said that this is a policy matter. If
the Government in its wisdom adopts a modern meaning of ‘wholesale trading’
against a traditional meaning, then it is right in doing so. 6.4 The Consolidated FDI policy now explains this issue
elaborately in clause 5.39.1.1. The important clarifications which the policy
provides are as under : — The sale cannot be for personal consumption of the
retail buyer. Can sale take place to an individual Chartered
Accountant in practice who will purchase, say, one box of papers for printing
in his office ? Clearly this is permitted. The policy clarifies that — “The
yardstick to determine whether the sale is wholesale or not would be the type of customers to whom the
sale is made and not the size and volume of the
sale.” Thus essentially sale to end user for personal
consumption is not permitted. Is a sale to a charitable trust or a hospital or an
educational institution permitted ? Again the answer is that as these
organisations will purchase for consumption during the course of their
activities, the sale can be undertaken. — The policy provides for guidelines as under : (a) All necessary approvals from Central/ State/local
Government should be obtained by the wholesaler. (b) (i) The buyer holds sales tax/VAT registration/service
tax/excise duty registration; or (ii) The buyer holds trade licences i.e., a
licence/registration certificate/membership certificate/registration under
the Shops and Establishment Act, reflecting that the buyer is itself engaged
in a business involving commercial activity; or (iii) The buyer holds permits/licence, etc. for
undertaking retail trade (like tehbazari and similar licence for hawkers); or (iv) The buyer is an institution having certificate of
incorporation or registration as a society or registration as public trust
for its self consumption. (c) Full records of the purchasers including their
registration/licence/permit, etc. should be maintained on a day-to-day basis. (d) WT of goods is permitted among group companies.
However, there are further conditions : — such WT to group companies taken together should not
exceed 25% of the total turnover of the wholesale venture. — the wholesale made to the group companies should be
for their internal use only. However, say, for example, if the wholesaler proposes to
sell the goods to a group company which is a retailer. Can it be done ? This
is clearly a permitted transaction. It cannot be a situation that the
wholesaler can sell goods to a 3rd party retailer, but not to its own group
company which is a retailer. It is only if the sale to group company is for
internal consumption that there is a restriction. However the manner in which
the restriction has been provided, it seems that sale to group company is
permitted only for self-consumption. (e) WT can be done as per normal business practice.
Credit facilities as per normal business practice can be given, subject to
applicable regulations. (f) A Wholesale/Cash & carry trader cannot open
retail shops to sell to the consumer directly. 7. NBFC activities : NBFC activities are permitted under automatic route.
There are capitalisation norms for such companies. For fund-based activities,
in case the non-resident investor wants to invest up to 100% of the equity
capital, the minimum capital required to be brought in is US$ 50 mn. For non-fund-based activities the capitalisation is US$
0.5 mn. The Consolidated FDI policy now has stated that the following
activities will be considered as non-fund based activities : (a) Investment Advisory Services. (b) Financial Consultancy. (c) Forex Trading. (d) Money Changing Business. (e) Credit Rating Agencies. 8. Transfer of shares : Transfer of shares from an Indian resident to a
non-resident is generally under automatic basis. [AP Circular 16, dated 4th
October 2004 read with other Circulars]. However if the Indian company is
engaged in financial services, and the transfer is from an Indian resident to
a non-resident, automatic route is not available. 8.1 DIPP had issued a Press Note No. 4, dated 10-2-2006
stating that transfer of shares of an Indian company engaged in financial
services sector will be on automatic basis. However the RBI had not agreed to that issue. Therefore
when the RBI issued the Notification No. 179, dated 22-8-2008 (with effect
from 10-2-2006 — the date of DIPP Press Note No. 4), it still provided that
automatic route is not available if the Indian company is engaged in
financial sector. Now the FDI policy again states that if the Indian
company is engaged in financial services sector, automatic route will not be
available. 8.2 The RBI has issued the Notification No. 131, dated
17-3-2005. It has defined ‘financial services’ as ‘service rendered by
banking and non-banking companies regulated by the Reserve Bank, insurance,
companies regulated by Insurance Regulatory and Development Authority (IRDA)
and other companies regulated by any other
financial regulator as the case may be.’ The Notification (No.
131) was issued with effect from 16-10-2004 (the date of issue of AP Circular
16, dated 16-10-2004). Thus if the company is regulated by a financial
regulator, automatic route will not be available. 9. Business services : Clause 5.20 provides that FDI up to 100% is permitted
for business services under automatic route. However it states that FDI is
allowed in “Data processing, software development and computer consultancy
services; Software supply services; Business and management consultancy
services, Market research services, Technical testing & Analysis
services.” Does this mean that FDI is not allowed in other business
services ? This kind of a clarification was not provided in FDI
policy earlier. It is also not provided in FEMA Notification. This cannot be the intention. Any sector where there is
no restriction, is freely permitted (clause 5.41 of FDI policy). FDI in
service sector has been permitted on automatic basis except in the areas
where there is a sectoral cap (like courier services, ground handling
services at airports, telecom services, etc.). In any case, FEMA prevails in case of interpretation
issue. Therefore in my view, FDI is freely permitted in ‘services sector’. See paragraph 2 on the basic FDI policy. 10. In a nutshell it is a good attempt to provide the
entire policy in one document. To refer to various Press Notes spread over a
few years is difficult. Some issues will always remain. Over time, these
should be sorted out. Article by Naresh Ajwani, Chartered Accountant |
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