For professionals working on corporate transactions involving acquisitions, investments and involving non-residents, situations arise where one needs to determine if a particular transaction structure is permissible under the Foreign Exchange Management Act, 1999 and the regulations, rules, circulars, notifications and directions thereunder ("FEMA").
It is understandable that the law cannot possibly provide for every such situation. FEMA has classified the transactions into two broad categories, i.e. capital account and current account transactions.
Capital account and current account transactions constitute the fundamental concept of FEMA. Every transaction involving a non-resident and resident can be classified either as a capital account or a current account transaction.
The fundamental rule is that if it is a current account transaction, it is permitted unless prohibited or specifically regulated by FEMA. For capital account transactions, the rule is that unless it is specifically permitted, it is prohibited by FEMA.
While this seems easy enough and simple to understand, challenges arise in interpreting the subjective definitions of these two concepts as provided in the FEMA:
For ready reference, please refer to the FEMA definitions as follows:
(e) "capital account transaction" means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India, and includes transactions referred to in sub-section (3) of Section 6;
(j) "current account transaction" means a transaction other than a capital account transaction and without prejudice to the generality of the foregoing such transaction includes, —
(i) payments due in connection with foreign trade, other current business, services, and short-term banking and credit facilities in the ordinary course of business,
(ii) payments due as interest on loans and as net income from investments,
(iii) remittances for living expenses of parents, spouse and children residing abroad, and
(iv) expenses in connection with foreign travel, education and medical care of parents, spouse and children;
The definition of current account transaction refers to a transaction "other than a capital account transaction". However, the definition of capital account transaction is itself very subjective and involves any transactions which alters the "assets" or "liabilities" including "contingent liabilities" of residents outside India and non-residents in India. Sub-section (3) of Section 6, provides for the regulated capital account transactions such as transfer or issue of foreign security by an Indian resident, transfer or issue of any Indian security by a non-resident, borrowing or lending, etc.
It is also important to note that since the terms, "assets", "liabilities" and "contingent liabilities are not defined in the FEMA, it makes it difficult to determine whether a transaction, in fact, constitutes a capital account transaction. An immediate reaction would be to refer to the meanings provided in the accountancy practice. However, the Reserve Bank of India ("RBI") has not provided any guidance one way or the other if this would be the right approach to follow.
While there may be many situations or transactions that would fall under the "grey" area of permissibility under FEMA, some of the instances are given below. In all these cases, one will need to determine whether it is a capital or a current account transaction.
(a) Exclusivity fee:
- Exclusivity fee in relation to a corporate transaction of acquisition or an investment transaction is not very common. Such exclusivity fee is paid to ensure that the party to whom it is paid is restricted from negotiating the same transaction with any other person for a fixed period.
- FEMA does not provide for payment of exclusivity fee between residents and non-residents. As the exclusivity fee is linked to a transaction involving the equity instruments of an Indian company, which is a capital account transaction, such payment of exclusivity fee may be treated as a capital account transaction which should have been specifically permitted under FEMA.
- The exclusivity fee can also be used to set off against the purchase consideration payable by the purchaser. In such a situation, it would be treated as a capital account transaction. If, however, the exclusivity fee is not set-off as the purchase consideration, such payment may still be categorised as a capital account transaction.
(b) Non-compete fee:
- Payment of non-compete fee or consideration has also not been common in the recent times, particularly, after the changes in regulations involving listed company transactions. Non-compete fee is paid to the seller to restrict the seller from competing with the purchaser or the target company for a particular period.
- As the non-compete fee is linked to the purchase and sale of shares, it could also be treated as a capital account transaction and not covered under the general permission of the RBI.
(c) Damages and indemnities:
- Foreign Exchange Management (Non-debt Instruments) Rules, 2019 provide that in case of transfer of equity instruments between a resident and a non-resident, an amount not exceeding 25% of the total consideration may be paid as by the seller to the buyer on account of indemnity within a period not exceeding 18 months from the date of the payment of the full consideration, if the total consideration has been paid by the buyer to the seller
- Apart from the foregoing, for a share acquisition or subscription transaction, FEMA does not expressly allow or disallow payment on account of indemnity or as damages in a transaction involving sale and purchase of, or subscription of equity instruments.
- If the payment of damages can be considered as a current account transaction, such a payment between residents and non-residents would be permitted, as payment of damages has not been expressly prohibited.
- The Hon'ble Delhi High Court in the case of NTT Docomo vs Tata Sons Ltd., had considered the permissibility of payment of damages by a resident to a non-resident for breach of a contractual provision. The High Court upheld the arbitration award and permitted NTT Docomo to recover damages from Tata Sons Ltd pursuant to the arbitral award ("Tata-Docomo Case").
- The arbitral tribunal had held that payment of the amount by Tata Sons to NTT Docomo was on account of damages for breach of a contractual provision and not share purchase consideration and there was no restriction in FEMA for payment of damages for such a breach.
- In the Tata-Docomo Case, the Hon'ble Delhi High Court did not analyse whether payment of damages would be catergorised as a current account transaction. The High Court upheld the arbitration award. The High Court also observed that the RBI, in its application, did not mention any provision in FEMA which prohibited the payment of damages to NTT Docomo.
- As the Tata-Docomo Case had not been ultimately decided by the Supreme Court, the applicability of the decision as a precedent cannot be certain.
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