The legal, economic and financial reforms undertaken by the Indian government since the early 1990’s have resulted in substantial and rapid growth of the Indian economy and led to the integration of India into the global economy. While reform efforts stalled somewhat during the weak coalition governments of the mid-1990’s, following the 1999 parliamentary elections, the Bharatiya Janata Party-led government launched a second round of economic reforms, which included major privatization, deregulation and tariff reduction initiatives. Annual foreign direct investment in India rose from approximately $100 million in 1990 to an estimated $5.5 billion in 20031, and while some barriers continue to restrict foreign investment in India, momentum toward liberalization of the Indian economy seems to be irreversible.
As a result of its efforts to attract foreign investment, the Indian government has established a regulatory framework for three separate investment avenues: foreign direct investment; investment by foreign institutional investors; and investment by foreign venture capital investors. While these investment alternatives have created clear avenues for foreign investment in India, they remain subject to many conditions and restrictions which continue to hamper foreign investment in India. Each of these alternatives, together with the restrictions and limitations applicable thereto, is discussed below.2
I. Regulatory Framework.
Foreign investment in India is regulated principally by the Industrial Policy of the Indian government, which is formulated by the Secretariat of Industrial Assistance (the "SIA"), an arm of the Ministry of Finance, press notes issued by the Ministry of Commerce and Industry, the Foreign Exchange Management Act, 1999 ("FEMA"), and the regulations and notifications issued by the Reserve Bank of India (the "Reserve Bank") under FEMA and the Securities Exchange Board of India ("SEBI"), the regulator of the Indian securities market. The investment policies formulated by the SIA lay down the broad policy applicable to foreign investment in India. The administration and implementation thereof, however, is largely handled by the Reserve Bank, which is responsible for overseeing India’s exchange controls, the Foreign Investment Promotion Board ("FIPB"), which is responsible for reviewing all foreign investments in Indian companies which require prior governmental approval and SEBI in its capacity as the regulatory of the Indian capital markets.
II. Foreign Direct Investment.
Foreign direct investment in India is now permitted in most sectors of the Indian economy without the need to obtain prior governmental authorization (commonly, referred to as the "automatic route"). Foreign Direct Investment, or FDI, within the meaning of the regulations, means the purchase by a person outside of India of newly issued equity shares, preference shares, fully convertible or partly convertible bonds, American Depository Receipts or Global Depository Receipts. FDI, however, even under the automatic route, where no governmental authorization is required, is subject to a number of important conditions. These conditions include the following:
- The investment must not be within the sectors in which industrial licensing is required;3
- The investment must be within the prescribed sectoral equity caps;
- The investment must not exceed 24% of the equity share capital of an Indian company manufacturing items reserved for small scale industry;4
- The price at which the investment is made must comply with the formula prescribed by the FDI regulations; and
- The investment must not be in a sector (exclusive of the IT sector) in which the investor (other than a financial investor) has a prior joint venture arrangement with an Indian partner.
A. Sectoral Prohibitions and Limitations.
While foreign investment restrictions have gradually been relaxed, foreign direct investment remains prohibited in certain sectors, including gambling, lottery business, railway and postal service, retail trading, atomic energy, most agricultural sectors and real estate (although limitations in this sector are increasingly becoming subject to carve outs)5. In addition, investment limitations (i.e., percentage ownership limitations) apply in several other important business sectors, including media, airlines, defense, operation of satellites, insurance, infrastructure services, mining, telecommunications and banking.
These sectoral prohibitions and limitations are a vestige of past Indian protectionist governments which feared, among other things, that allowing foreign ownership of Indian enterprises would lead to capital flight. With India’s foreign currency reserves having grown significantly as market reforms have been adopted, however, the sectoral investment prohibitions have gradually eroded, and the sectoral ownership limitations in various business segments either have been raised or eliminated altogether. Investment restrictions in retail trading, however continue to present substantial limitations on the Indian economy and limitations on investment in real estate, although recently liberalized, continue to hamper the development of India’s infrastructure.
B. Pricing Requirements.
Foreign direct investment in India is also subject to certain pricing requirements established under applicable FDI regulations. The issuance of fresh equity on a preferential allotment basis by an Indian company whose securities are listed on a recognized stock exchange, for example, must satisfy the pricing regulations prescribed by the Securities Exchange Board of India. These pricing regulations require that any issuance by a publicly traded Indian company must be equal to or greater than the higher of (i) the average weekly high and low closing prices of the related shares on its principal stock exchange during the six months preceding the date which is thirty (30) days prior to the date on which the shareholders meeting is held to consider the proposed issuance (the "Measurement Date") or (ii) the average weekly high and low of the closing prices of the related shares on its principal stock exchange during the two weeks preceding the Measurement Date. Since the foregoing pricing requirements apply only to a preferential allotment of shares, they would not apply if a foreign investor acquired shares in a public offering of shares by the Indian company. If, on the other hand, a proposed investment is for shares of an unlisted company, the price paid for the shares must meet certain pricing guidelines established by the former Controller of Capital Issues. These guidelines apply different pricing formulae depending on the particular nature and size of the proposed investment and the availability of objective valuation criteria.
C. Approval Criteria for Investment Not Qualifying Under the Automatic Route.
Approval of FIPB is required for all investments which do not qualify for the automatic route6. Such approval is granted on a case by case basis based on the merits of the proposed investment. Criteria used by FIPB in assessing the merits of a proposed investment include: the amount of the investment; the effects of the investment on employment; the availability of new technology; the level of exports proposed to be generated as a result of the investment; and other benefits to India resulting from the investment. The approval process is normally completed within 4-6 weeks. If FIPB approval is obtained, no separate approval is required from the Reserve Bank, although certain notice requirements would nonetheless apply.
D. Purchase of Shares from Third Parties.
Until recently, a person resident outside India could not acquire securities of an Indian company from an Indian resident under the automatic route. However, the automatic approval route was recently extended to apply to the purchase of shares or convertible debentures of an Indian company (other than securities of a financial services company) by foreign investors from a person resident in India subject to the following conditions:
- The foreign investment must be of the type that would qualify under the automatic route if the purchase were made directly from the Indian company;
- The purchase would not result in the violation of any of the prescribed ceilings for non-resident shareholdings; and
- The price paid for the shares must satisfy the minimum pricing requires established by SEBI with respect to foreign direct investment.
A person resident outside India may also transfer shares or convertible debentures of an Indian company to another non-resident without governmental approval; provided that the transferee does not have a previous joint venture interest in an Indian company within the same field. Under these circumstances, the buyer and seller of the shares are free to effect the transaction at a negotiated price, the rationale being that there are no exchange control implications to a non-resident-to-non-resident transfer. If, however, the transferee has a pre-existing joint venture with any Indian company within the same field as the company, the shares of which are being transferred, the prior approval of FIPB would be required.
III. Foreign Institutional Investors.
Special regulations have been adopted which allow foreign institutional investors ("FIIs") to make portfolio investments in India through the Portfolio Investment Scheme.7 A FII is defined as an institution organized outside of India for the purpose of making investments into the Indian market under the regulations prescribed by SEBI. FIIs may be comprised of foreign pension funds, mutual funds, investment trusts, asset management companies, nominee companies, incorporated/institutional portfolio managers, endowments, foundations, charitable trusts and other similar entities. FIIs are required to register with SEBI in order to benefit from the Portfolio Investment Scheme, and must comply with certain exchange control regulations adopted by the Reserve Bank which are specific to FIIs.
A. Scope of Investments Under the Portfolio Investment Scheme.
FIIs, under the Portfolio Investment Scheme, are permitted to make both primary and secondary investments in the India capital markets. Unlike an investor which relies solely on FDI regulations, a foreign investor which registers as a FII would be allowed to buy and sell securities over Indian stock exchanges. In addition, FIIs are entitled to effect transactions in a broader category of securities than an investor relying on FDI regulations alone. FIIs are permitted to purchase equity securities (both listed and unlisted), units of schemes floated by the Unit Trust of India and other domestic municipal funds, warrants, debentures, bonds, governmental securities and derivative instruments which are traded on a recognized stock exchange. There is no limit on the amount that FIIs may invest in the Indian market, and no lock-up periods apply to investments made by FIIs.
B. Exchange Controls.
FIIs are required to open up one or more bank accounts with certain designated banks and must also appoint a domestic custodian for custody of investment made by the FII. Through the designated accounts, FIIs are authorized to freely transfer funds from foreign currency accounts to Rupee accounts and vice versa; make Rupee denominated investments in Indian companies; freely transfer after-tax proceeds from Rupee accounts to foreign currency accounts, and repatriate capital, capital gain, dividends interest income and other gains, subject to deduction for applicable withholding taxes.
So long as FIIs execute purchases and sales on a recognized Indian stock exchange, they are not required to obtain transaction specific approval from the Reserve Bank. FIIs are also entitled to effect transactions using their own proprietary funds, or the funds of their subaccounts.8
C. Investment Restrictions.
Certain limitations apply to investments by FIIs into India. First, FIIs’ and their subaccounts’ investment in an Indian company can not exceed ten percent (10%) of the total issued share capital of the Indian company (five percent if the subaccount is a foreign corporation or individual). In addition, the aggregate investment of all FIIs in an Indian company may not exceed twenty four percent (24%) of its total issued share capital, without the express approval of its board of directors and shareholders. Even with board of director and shareholder approval, the same sectoral limits which apply to foreign direct investment would continue to apply.
FIIs may register with SEBI as a debt fund or an equity fund. FIIs which are registered as equity funds, are required to invest at least seventy percent (70%) of their funds in equity and equity-related securities. A FII registered as a debt fund, on the other hand, must invest one hundred percent (100%) of its funds in debt instruments. Foreign corporations and individuals are not eligible subaccounts of a FII that is registered as a debt fund.
FIIs are not permitted to engage in short selling, other than in respect of derivative securities traded over a recognized exchange, and must effect transactions through a registered stock broker. Sector investment prohibitions and caps which apply to foreign direct investment also apply to investments by FIIs, and FII investments must also comply with the pricing requirements applicable to foreign direct investment. In addition, FIIs are not permitted to invest in print media.
D. Qualification Criteria.
Certain criteria must be satisfied in order to qualify for registration as a FII. FIIs, among other things, must be able to demonstrate a good track record, professional competence, financial soundness, and must have a reputation for fairness and integrity. They must also be registered with a competent foreign regulatory authority. SEBI also will consider whether the grant of registration for a FII will be in the interest of the development of the Indian securities market. FIIs must also register each of their subaccounts with SEBI.
Registration as a FII may fall into two separate categories. The first applies to institutional investors such as insurance companies, pension funds, mutual funds, investment trusts and other charitable or endowment funds that are authorized to make investments on their own behalf. The second applies to foreign asset management companies, banks, investment advisors, institutional portfolio managers or similar entities that are authorized to invest on their own behalf and on behalf of their subaccounts.
In order to be eligible as a subaccount of a FII, a collective investment fund must be broad-based, that is to say, it must have at lease 20 individual investors, and no single investor may hold more than a 10% stake in the fund. This 10% requirement is often difficult to comply with for new funds, since seed money investors often hold more than 10% of a fund, at least in the early stages. If, however, the broad-based fund has one or more institutional investors, it is not required to have 20 investors. If the institutional investor holds more than 10% of the fund, however, the institutional investor must itself satisfy the broad-based criteria.
IV. Venture Capital Funds.
As an alternative to making foreign direct investments in India, a foreign investor may seek to register with SEBI as a foreign venture capital investor ("FVCI") under the SEBI (Foreign Venture Capital Investor) Regulations 2000. Under this option, a foreign investor, following registration, may (i) invest in existing domestic venture capital funds in India or (ii) invest directly in qualifying Indian companies.9 If the FVCI elects to invest in existing domestic venture capital funds, it may invest its entire funds in one venture capital fund or in as many venture capital funds as it deems appropriate. If, on the other hand, it elects to invest directly in qualifying Indian companies, it must do so subject to the limitations specified under the FVCI regulations.
A. Investment Restrictions.
In accordance with these regulations, a FVCI must invest at least 66.67% of its funds in unlisted equity shares or equity-linked shares. Up to 33.33% of the funds of a FVCI may be invested in (i) the purchase of shares of a qualifying company in an initial public offering; (ii) debt instruments of a domestic qualifying company in which an FVCI has already made an equity investment; (iii) preferential allotment of equity shares of a listed company so long as the shares are subject to a one-year holding period, (iv) equity shares (or equity-linked shares) of a listed company that is financially distressed; and (v) certain special purpose entities created for the purpose of promoting investment by foreign investors under the FVCI regulations.
The limitation on FVCI investment in listed companies, other than through an initial public offering, is a significant restriction on FVCIs investment activities. To date, the number of foreign investors registering as FVCIs has been limited. This restriction and the resultant lack of investment flexibility is often sited as a factor that makes registration as a FVCI unattractive to many private equity funds.
FVCI also may not invest in most types of non-bank finance companies, print media companies, companies engaged in gold financing or any other companies in which foreign investment is not permitted under India’s Industrial Policy. In addition, FVCIs may not invest more than 25% of their funds in any qualifying Indian company.
B. Benefits of Registration.
Registration as a FVCI allows a foreign investor to avoid the approval requirements of the Reserve Bank with respect to individual purchases and sales of securities of Indian companies, and also provides a foreign investor an exemption from the pricing requirements which are applicable to investments made under the foreign direct investment alternative.10 Thus, once registered, a FVCI is free to purchase and sell securities at a negotiated price. In addition, shares acquired by a FVCI in an unlisted company are not subject to a one-year lock-up period at the completion of the company’s initial public offering as is generally the case for other pre-IPO shares. Shares acquired by a FVCI in an initial public offering, however, are subject to the one-year lock-up. In addition, FVCIs are treated as qualified institutional buyers and are, accordingly, eligible to subscribe to the securities in an initial public offering undertaken under India’s book-building offering process. Finally, India’s Takeover Code does not apply to shares transferred from a FVCI to promoters of the company or to the company itself if effected in accordance with a pre-existing agreement between the FVCI and the promoters or the company. 11 This ensures that if the promoters have to buy back the shares from FVCIs, they will not be required to comply with the public offering requirements of the Takeover Code which would otherwise require that an offer be made to the other shareholders of the company for up to twenty percent (20%) of the outstanding share capital.
C. Qualifications Criteria.
Criteria for qualifications as a FVCI are similar to those applicable to foreign institutional investors. A proposed FVCI must be able to demonstrate a good tack record, professional competence, financial soundness, experience, and whether the foreign investor is regulated by a competent foreign regulatory authority or is an income tax payer. Qualifying investors include pension funds, mutual funds, investment trusts, investment partnerships, asset management companies, endowment funds, university funds, charitable institutions or other investment vehicles incorporated outside of India.
D. Compliance Matters.
FVCIs are required to satisfy certain record keeping requirements for a period of eight years. FVCIs must also appoint a custodian to act on its behalf in connection with purchases and sales of securities. The custodian is required to monitor the investments made by the FVCI to ensure compliance with applicable rules and to furnish periodic reports to SEBI on the FVCI and its activities. Also, like a FII, a FVCI is required to designate a bank approved by the Reserve Bank with which it is required to maintain foreign currency accounts or special non-resident Rupee accounts.
V. ADRs and GDRs.
Foreign investors may also invest in Indian companies through the purchase of American Depositary Receipts ("ADRs") and Global Depository Receipts ("GDRs"). Depository receipts, whether ADRs or GDRs, are basically negotiable instruments denominated in U.S. dollars or another currency representing a publicly-traded issuer’s local currency equity shares. They are created when the local currency shares of an Indian company, for example, are delivered to a depository bank’s domestic custodian bank, against which the depository issues a depository receipt in U.S. dollars or another currency. Each depository receipt can represent one or more of the underlying shares. Indian companies are very familiar with the issuance of these instruments and have tapped the ADR/GDR market frequently to raise foreign capital. Because ADRs/GDRs represent the underlying shares of the issuing company, their value fluctuates along with the value of the underlying shares.
Foreign investors who wish to have their investment in an Indian company represented by a U.S. dollar denominated instrument can purchase ADRs/GDRs of the Indian issuer. ADRs/GRDs can be privately issued or issued in a public offering in the U.S. (in the case of ADRs) or elsewhere (in the case of GDRs).
Issuances of ADRs/GDRs by Indian companies is governed by the Issue of Foreign Currency Convertible Bonds and Ordinary Share (Through Depository Mechanism) Scheme, 1993 as well as guidelines issued by the Ministry of Finance and various notifications of the Reserve Bank. ADR/GDR issuances, as well as the conversion thereof into the underlying securities, are permitted by Indian companies without the need for governmental approval so long as the issuance would not result in an exceedance of a sectoral cap and other aspects of the regulations related to foreign direct investment are met.
Issuance of ADRs/GDRs may be used in connection with the issuance of new equity by an Indian issuer, and more recently, as a method of sale of outstanding shares of the issuer held by a third party, subject to compliance with applicable conditions. ADR/GDR issuances must also comply with the various restrictions on foreign direct investment, including applicable pricing requirements.
VI. Capital Gains Tax Considerations.
While many countries (including India and the U.S.) impose capital gains tax on domestic investors, India is relatively unique in also imposing capital gains on foreign investors. In most countries, foreign investors, either by statute or treaty, are exempt from capital gains tax. Most of the tax treaties between India and other jurisdictions, however, including the United States, do not provide a capital gains tax exemption for foreign investors. A notable exception is the tax treaty between India and Mauritius. The absence of a capital gains exemption for most foreign investors creates a serious disincentive to investment in Indian securities. It is for this reason that much foreign investment in India is structured through indirect holding companies formed in Mauritius. For regulatory reasons, however, not all foreign investors are able to take advantage of the Mauritius structure, and if available, establishing the intermediate holding company creates additional costs to investing in India.
1. Congressional Research Service Issue Brief for Congress, India – U.S. Relations (Updated November 4, 2004).
2. Separate avenues for investment in India have been established for non-resident Indians and Overseas Corporate Bodies (companies which are owned at least 60% by non-resident Indians). These investment alternatives are not discussed herein.
3. Industrial licenses are required for manufacturing activities in (i) certain industries reserved for the public sector, and (ii) certain industries of strategic, social or environmental concern (i.e., distillation and brewing of alcohol, tobacco products, electronic aerospace and defense equipment, industrial explosives, hazardous chemicals and certain drugs and pharmaceuticals).
4. Small scale undertakings are defined as business enterprises having investments in fixed assets in plant and machinery of not more than Indian Rupees 10 million.
5. For example, foreign investment in real estate within the housing, commercial, hotel, resort, hospital, education and recreational sectors was recently authorized without the need for government approval (other than local governmental approvals related to development of a project), subject to compliance with certain minimum capitalization criteria and to certain minimum size requirements for individual real estate development projects (land area; minimum of 10 hectares for housing projects, and 50,000 square meters in the case of construction/development projects).
6. If a proposed investment would exceed Indian Rupees 6 billion, the approval of the Cabinet Committee on Foreign Investment is technically required, although FIPB would continue to interface with the foreign investor and would nonetheless issue the approval letter.
7. Securities and Exchange Board of India (Foreign Institutional Investors) Regulation 1995.
8. Subaccounts may include collective investment funds and institutions, proprietary funds, and foreign corporations and individuals.
9. A qualifying Indian company, or venture capital undertaking, is defined as "a domestic company whose shares are not listed on a recognized stock exchange in India, and which is engaged in the business of providing services, production or manufacture of articles or things, but does not include such activities and sectors which are specified in the negative list by the Board, with approval of Central Government, by notification in the Official Gazette on this behalf." SEBI (Venture Capital Funds) Regulations, 1996.
10. Reserve Bank of India; Notification No. FEMA 32/2000-RB dated December 26, 2000.
11. SEBI (Substantial Acquisitions of Shares and Takeover) Regulations, 1997.
Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.
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