INTRODUCTION

The regulation of foreign investment in India is governed by the Foreign Exchange Management Act, 1999 ( the “FEMA”), the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (“NDI Rules”), the Consolidated FDI Policy issued by the Department for Promotion of Industry and Internal Trade (“DPIIT”), and the Reserve Bank of India's (“RBI”) Master Direction on Foreign Investment in India (“Master Direction”), as amended from time to time.

When a foreign investor directly acquires or subscribes to equity instruments or capital of an Indian entity, such acquisition or subscription constitutes foreign direct investment (FDI), subject to the conditions prescribed under these instruments as discussed below. A conceptually distinct but closely related mode of foreign investment is the indirect acquisition or subscription of equity or capital of an Indian entity through another Indian entity that is itself a recipient of FDI. This indirect mode is known as downstream investment and gives rise to what is termed indirect foreign investment (“IFI”) in the investee entity.

This article examines the regulatory framework governing downstream investments made by FOCCs(as defined below), the conditions for classifying an investment as IFI, the compliance obligations that arise therefrom, and the pricing, consideration, and reporting framework applicable to such transactions.

DOWNSTREAM INVESTMENT AND INDIRECT FOREIGN INVESTMENT

A. Definition of Downstream Investment

Under the NDI Rules, downstream investment is defined as an investment made by an Indian entity or an investment vehicle, having total foreign investment in it, in the equity instruments or the capital of another Indian entity. The term “total foreign investment” means the aggregate of direct foreign investment and indirect foreign investment in an entity, computed on a fully diluted basis.

For this purpose, an “investment vehicle” means an entity registered and regulated under regulations framed by the Securities and Exchange Board of India (“SEBI”) or any other designated authority, and includes Real Estate Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs), Alternative Investment Funds (AIFs), and mutual funds. The term “Indian entity” refers to an Indian company or a limited liability partnership (“LLP”).

B. Distinction between Downstream Investment and Indirect Foreign Investment

Although the terms “downstream investment” and “indirect foreign investment” are frequently used interchangeably, they are conceptually distinct. Downstream investment refers to the investment made by an Indian entity or an investment vehicle (that has received foreign investment) into another Indian entity. Whereas, the IFI is a downstream investment received by an Indian entity from another Indian entity which has received foreign investment and the Indian entity qualifies as an FOCC (as defined hereinbelow).

By way of illustration: where a foreign investor (Company A) invests in an Indian company (Company B) under the FDI route, and Company B thereafter invests in another Indian company (Company C), the investment by Company B into Company C is downstream investment from Company B's perspective. From Company C’s perspective, that same investment constitutes IFI, but only if Company B is an FOCC.

FOREIGN-OWNED AND CONTROLLED COMPANIES

A company owned or controlled by a non-resident is termed a Foreign Owned and/or Controlled Company (“FOCC”). The criteria for ownership and control differ as between Indian companies and LLPs.

A. In the Case of an Indian Company

Ownership: An Indian company is treated as “owned” by non-residents where more than 50% (fifty percent) of its paid-up capital is beneficially held by persons resident outside India.

Control: An Indian company is treated as “controlled” by non-residents where non-residents hold the right to appoint a majority of its directors or to control the management or policy decisions of the company, whether by virtue of shareholding, management rights, shareholders' agreements, voting agreements, or otherwise.

B. In the Case of an LLP

Ownership: An LLP is treated as owned by non-residents where non-residents contribute more than 50% (fifty percent) of its capital and hold a majority profit share.

Control: An LLP is treated as controlled by non-residents where non-residents hold the right to appoint the majority of its designated partners, and such designated partners (to the exclusion of others) exercise control over all the policies of the LLP.

CONDITIONS APPLICABLE TO DOWNSTREAM INVESTMENT AND INDIRECT FOREIGN INVESTMENT

A. General Conditions: Sectoral Compliance

Any downstream investment must strictly adhere to the entry route (automatic or government approval), sectoral caps, pricing guidelines, and all attendant conditions including reporting requirements applicable to FDI in the relevant sector. The rationale, enshrined in the NDI Rules, reflects the principle that what cannot be done directly by a foreign investor shall not be permitted to be done indirectly through an FOCC.

Two illustrative applications of this principle are as follows:

B. Restriction on FOCC-LLPs

Where the investing FOCC is constituted as an LLP, it may make downstream investment only in companies or LLPs operating in sectors where foreign investment up to 100% (hundred percent) is permitted under the automatic route and no FDI-linked performance conditions are prescribed.

C. Conditions for Classification as Indirect Foreign Investment

An investment received by an Indian investee entity from an FOCC will be treated as IFI upon satisfaction of the following conditions: (a) the downstream investment must be approved by the board of directors of the investing Indian entity (i.e., the FOCC). Where a shareholders' agreement exists, such agreement must also sanction the proposed downstream investment; and (b) for the purposes of making downstream investment, the FOCC must bring in requisite funds from abroad and shall not utilise funds borrowed in the domestic market. Downstream investment may, however, be made through internal accruals, which for this purpose means profits transferred to a reserve account after payment of taxes. Where debt is raised and utilised for any related purpose, such raising and utilisation must be in compliance with FEMA and the rules and regulations made thereunder.

TREATMENT OF FOCCS: DEEMED FOREIGN INVESTMENT AND REGULATORY SYMMETRY

Once an entity is classified as an FOCC, any investment made by it in the equity instruments or capital of another Indian entity is treated as 100% (hundred percent) foreign investment, regardless of the actual proportion of foreign ownership in the FOCC.

Further, the NDI Rules read with the Master Direction, establishes a dual treatment for FOCCs: (a) for the purposes of pricing guidelines, an FOCC is treated at par with a person resident outside India; and (b) for the purposes of reporting requirements, an FOCC is treated at par with a person resident in India. While this dual treatment is intended to balance regulatory oversight with investor facilitation, it gives rise to certain interpretive inconsistencies that are discussed below.

PRICING FRAMEWORK

A. General Principles for Pricing under the NDI Rules

The NDI Rules prescribes the following pricing norms for transfers of equity instruments: (a) a floor price not less than fair market value (“FMV”) applies to transfers from residents to non-residents; and (b) a ceiling price not more than FMV applies to transfers from non-residents to residents. FMV must be determined in accordance with arm length basis and internationally accepted pricing methodologies and certified by a SEBI-registered Merchant Banker, Chartered Accountant, or Cost Accountant.

B. Pricing Norms for FOCC Transactions - Secondary Sales by FOCC

The NDI Rules prescribes pricing norms applicable where an FOCC is the seller in a secondary transfer of equity instruments of another Indian entity. Where the transferee is a non-resident, or another FOCC, pricing norms do not apply and the parties are at liberty to agree on any consideration. Where, however, the transferee is a resident, pricing norms are attracted and the sale price must not exceed FMV.

C. Pricing Norms for FOCC Transactions - Acquisitions by FOCC

The NDI Rules do not expressly address the applicability of pricing norms where an FOCC is the acquirer in a secondary transaction. In the absence of explicit statutory guidance, market participants have relied on interpretations developed through authorised dealer banks (“AD Banks”), informed by informal consultations with the RBI.

Historically, AD Banks generally treated FOCCs as equivalent to non-residents for pricing purposes, with the consequence that pricing norms applied when an FOCC acquired from a resident but not when acquiring from a non-resident. In recent years, the RBI has clarified that pricing norms must apply even where a FOCC acquires equity from a non-resident, with a view to preventing unregulated outflow of domestic funds.

D. Pricing Matrix for FOCC Transactions

The pricing guidelines applicable to transactions involving a FOCC can be understood more clearly when broken down based on the nature of the transaction and the counterparty involved.

In the case of a primary investment, where the FOCC is subscribing to equity instruments or contributing to capital, the subscription price must be at or above the FMV. Similarly, where the FOCC acquires shares from a resident shareholder, the purchase price is required to be at or above FMV. On the other hand, where the FOCC acquires shares from a non-resident shareholder, the purchase price must be at or below FMV. This creates a contrasting requirement depending on the residency status of the seller.

In a disinvestment scenario, where the FOCC sells shares to a resident, the sale price must be at or below FMV. However, if the sale is made to a non-resident, there are no prescribed pricing restrictions, and the parties are free to agree upon any mutually acceptable consideration.

Further, in transactions involving transfers between two FOCCs, the pricing guidelines do not apply, and the parties may negotiate and agree upon any price without being bound by FMV constraints.

E. Complexity in Multi-Seller Transactions

The pricing guidelines become particularly complex in transactions involving multiple categories of sellers, such as a 100% (hundred percent) acquisition where the target company’s shareholders include both residents and non-residents. In such situations, different pricing rules apply depending on the status of the seller.

For transfers by resident shareholders to a FOCC, the consideration must be not less than the FMVfloor. For transfers by non-resident shareholders to the FOCC, the consideration must be not exceeding the FMV.

As a result of these pricing constraints, the parties are effectively constrained to transact at the FMV. This significantly limits the ability to negotiate different prices with different sellers and reduces overall commercial flexibility. Accordingly, this becomes an important practical consideration when structuring a 100% (hundred percent) acquisition transaction involving both resident and non-resident shareholders.

CONSIDERATION STRUCTURE: SHARE SWAPS AND SETTLEMENT OF DOWNSTREAM INVESTMENT

A. Share Swaps

The NDI Rules permits an Indian company to issue equity instruments to non-residents against, inter alia, a swap of equity instruments, under the automatic route. On a principled reading, an FOCC being treated at par with a non-resident for pricing purposes should be able to undertake downstream investments through share swaps.

Further, an Indian company may either issue its shares or transfer shares held by it (in India or overseas) against a swap of shares of an Indian or foreign company, subject to compliance with the applicable sectoral caps, FDI-linked conditionalities, the Overseas Investment Rules, 2022, and pricing guidelines.

B. Divergent Interpretations and Practical Considerations

Notwithstanding the above, divergent interpretations have emerged in practice. Certain AD Banks have taken the view that share swap transactions by FOCCs may fall under the government approval route, which requires downstream investments to be funded through either funds remitted from abroad or internal accruals. This has been interpreted by some as implying a preference for cash consideration, notwithstanding the absence of an express statutory prohibition on share swaps.

In practice, a distinction is sometimes drawn between: (a) pure swap transactions which are viewed conservatively by certain AD Banks as requiring government approval; and (b) hybrid transactions involving part cash and part securities, which may be permissible under the automatic route. A further constraint is that an FOCC that lacks adequate foreign currency reserves or retained earnings may not, in such circumstances, be permitted to settle consideration by way of a share swap.

The absence of uniform regulatory interpretation continues to introduce deal uncertainty and the requires the early and engagement with the relevant AD Bank at the transaction planning stage, for seeking clarity.

DEFERRED CONSIDERATION, ESCROW ARRANGEMENTS AND INDEMNIFICATION

The NDI Rules provides that, upon the transfer of equity instruments between a resident and a non-resident, up to 25% (twenty-five percent) of the total consideration may be: (a) deferred; (b) placed in an escrow arrangement; or (c) structured as an indemnity by the seller for a maximum period of 18(eighteen) months from the date of transfer or payment.

This provision was previously applicable only to direct foreign investment and was silent on its applicability to downstream investments by FOCCs. The RBI has now clarified that the deferred consideration framework applicable to foreign investment extends equally to downstream investments made by FOCCs in other Indian entities.

Scope of the Indemnity Limitation

A significant interpretive question arises as to whether the 25% (twenty-five percent) cap and 18(eighteen) month limitation apply exclusively to deferred consideration, or whether they also govern any indemnity provided by the parties in the transaction such as business indemnities, tax indemnities, warranty claims, and the like.

A careful reading of the NDI Rules suggest that indemnities arising from third-party claims, breaches of representation or warranty, or contractual obligations (including business and tax claims) may fall outside the scope of “consideration” as contemplated by the provision. Such indemnification obligations, being contractual in nature and arising from the conduct or representations of the parties, may not constitute consideration for the transfer of equity instruments. However, the applicability of such limitations would ultimately depend on the specific drafting of the indemnity provisions, including the scope of covered claims, trigger events, payment mechanics, and the overall transaction structure. Accordingly, indemnity provisions should be carefully structured to avoid any ambiguity regarding their nature and enforceability.

COMPLIANCE AND REPORTING OBLIGATIONS

Downstream investments by FOCCs give rise to a series of compliance and reporting obligations. Since IFI is treated as foreign investment for all regulatory purposes, the investee entity must comply with the full FDI regulatory framework, including the two-stage compliance mechanism prescribed by the RBI:

iii. Form FC-TRS: Where a non-resident acquires equity from an FOCC, Form FC-TRS is required to be filed by the FOCC.

It is pertinent to note that while the RBI has amended its regulations to permit deferred consideration and share swaps in the context of downstream investments by FOCCs, the corresponding instructions and operational guidelines for the filing of Form DI through the RBI's firms portal are, at the time of writing, yet to be published.

RIGHTS ISSUES OF SHARES

The NDI Rules provides for the issuance of shares to non-resident shareholders of Indian companies that have received FDI, by way of a rights issue. The NDI Rules do not prescribe specific pricing guidelines for such issuances, requiring only that the value of such shares not be less than the price offered to residents.

However, where an FOCC proposes to subscribe to a rights issue of shares in another Indian investee entity, the position is that the pricing guidelines applicable to downstream investments apply, and no exception has been carved out in this regard. Accordingly, the price at which an FOCC subscribes to such rights shares must comply with the FMV-based pricing norms applicable to downstream investments.

PRACTICAL IMPLICATIONS FOR TRANSACTION STRUCTURING

The regulatory framework governing downstream investments by FOCCs, while comprehensive, is attended by a number of interpretive ambiguities that have material consequences for transaction structuring:

iii. Documentation Requirements: Transaction documents in particular, share purchase agreements must carefully account for differential pricing obligations, regulatory conditions, indemnity structures, and reporting timelines. Generic contractual provisions may give rise to inadvertent FEMA violations.

Authors:

Shramona Sarkar – Principal Associate

Jaydeep Saha - Associate