Navigating Deferred Consideration for Foreign Owned and Controlled Companies (FOCCs) in India – Legal Perspective

Deferred Consideration Dilemma for FOCCs

Introduction

In India, foreign direct investment (FDI) is governed by the Foreign Exchange Management Act, 1999 (FEMA), and regulated by the Reserve Bank of India (RBI). Over the past few years, India has emerged as a leading destination for corporate investments, largely due to an established FEMA framework and clear directions from the RBI. Despite this success, there are gaps and ambiguities in the FEMA framework, particularly regarding whether a Foreign Owned or Controlled Company (FOCC) in India should be treated as a resident or a non-resident. This ambiguity has resulted in a dilemma regarding downstream investments by FOCCs, especially in the context of deferred consideration.

Dichotomy of FOCC

Investments by FOCCs into other Indian companies are known as ‘downstream investments’ or ‘indirect foreign investments.’ Rule 23(1) of the FEMA (Non-debt Instruments) Rules, 2019 (NDI Rules), requires that an Indian entity receiving indirect foreign investment comply with the entry routes, sectoral caps, pricing guidelines, and other attendant conditions for foreign investment. This implies that FOCCs should be treated as non-residents.

However, the definition of “person resident in India” under Section 2(v) of FEMA and the NDI Rules, which define Indian companies as companies incorporated in India, suggests that FOCCs should be treated as residents. Despite these definitions, the NDI Rules treat FOCCs as both residents and non-residents. This dual treatment is evident when reading Rule 23(5) in conjunction with Rule 21(2) of the NDI Rules. Rule 23(5) imposes pricing guidelines on FOCC transactions with persons residing in India but remains silent on whether these guidelines apply in cases of transfers between FOCCs and persons residing outside India. Consequently, a FOCC is treated as a resident when dealing with non-residents and as a non-resident when dealing with residents.

Deferred Consideration

The general rule for deferred payment stipulates that any deferred consideration for a transaction must be paid within 18 months and cannot exceed 25% of the total consideration of the transaction (the “18/25 Rule”). Rule 9(6) of the NDI Rules specifies that the 18/25 Rule applies to the transfer of equity instruments from a resident to a non-resident but does not explicitly apply this rule to FOCCs. This ambiguity is further compounded by the dual treatment of FOCCs as both residents and non-residents.

This gap has led to various interpretations for deferred payments by FOCCs. One interpretation is that there can be no deferred consideration in transactions undertaken by FOCCs. Another interpretation suggests that deferred considerations are permissible for FOCCs but must adhere to the 18/25 Rule. A more conservative view posits that the 18/25 Rule need not be followed by FOCCs.

The RBI appears to hold the view that no deferred consideration is allowed in FOCC transactions. This inference comes from the RBI’s rejection of forms filed to report downstream investments through FOCCs with elements of deferred consideration since early 2022. Additionally, the RBI has issued notices to FOCCs for structuring share purchases in Indian companies through deferred (holdback) consideration constructs. This conservative stance is due to the fact that Form DI, which is filed for downstream investments, does not include a field to disclose deferred consideration amounts.

However, the prohibition of deferred payments is impractical as it prevents benefits for both buyers and sellers, such as providing security for post-closing price adjustments and earnouts for sellers, practices common globally.

Middle Ground Approach

A resolution could be for the RBI to adopt a middle ground that allows deferred payments, subject to the 18/25 Rule. This approach is supported by the fact that FOCCs fall under the definition of residents per FEMA and the NDI Rules. Therefore, Rule 9(6) should apply to FOCC transactions with non-residents. By this logic, the 18/25 Rule would not apply to transactions between FOCCs and residents, as Rule 9(6) only contemplates transactions between residents and non-residents.

This view aligns with “other attendant conditions for foreign investment” that FOCCs must follow per Rule 23 of the NDI Rules. It is consistent with the objectives of FEMA to promote external trade and ensure the orderly development of the foreign exchange market in India. Moreover, it aligns with India’s FDI policy to attract and promote foreign capital inflows.

Conclusion

Downstream investments are an attractive avenue for non-residents to invest in Indian equity. However, amendments to the NDI Rules are necessary to align regulatory safeguards with economic expansion. Despite being incorporated in India, FOCCs are owned and controlled by foreign entities, necessitating heightened scrutiny for investments in India. To enhance India’s appeal as a destination for foreign investments, the Indian government must avoid micromanaging contractual relationships between parties and allow businesses to make autonomous decisions. The RBI should consider making exceptions and extending indemnity periods for breaches related to fundamental issues, environmental matters, tax, and employment claims.

The ambiguity surrounding deferred payments in FOCC transactions needs to be clarified. The RBI’s conservative stance on this issue has not been officially articulated, leading to conjecture by authorized dealer banks. The view that the 18/25 Rule applies to FOCC transactions with non-residents, but not with residents, is supported by statutory definitions and legislative intent.

Failure to provide clear regulatory guidelines will necessitate unnecessary circumventions, significantly hindering the deal-making process for investors in India. The regulatory framework for downstream investment hinges on the treatment of FOCC investments. This fundamental differentiation complicates transactions involving FOCCs. The absence of a clear regulatory framework addressing key issues impacts foreign investor sentiment and impedes the ease of doing business in India. Therefore, it is imperative for regulators to issue necessary clarifications promptly to instill confidence in foreign investors regarding their current and future investments.

Contributed by – Krishnan Sreekumar

King Stubb & Kasiva,
Advocates & Attorneys

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