[Mahi is a student at Hidayatullah National Law University.]
In a move aimed at boosting India’s foreign investment climate, on 11 November 2024, the Reserve Bank of India (RBI) introduced a framework that allows foreign portfolio investments (FPI) to reclassify as foreign direct investments (FDI) when they cross a specific ownership threshold. This change is particularly relevant to FPIs that unintentionally exceed the 10% ownership cap, as it enables them to avoid forced divestment while still complying with Indian regulations. Below, we analyze this development, focusing on the rationale behind it and the potential impacts.
Why Reclassification Matters: Background and Context
Historically, India’s financial regulations distinguished sharply between FPI and FDI. FPIs typically represent passive investments—such as equity stakes by foreign investors in Indian markets—whereas FDIs indicate a longer-term commitment, often involving greater control over the company. However, if FPIs exceed a 10% stake, they’re legally considered as FDIs, a status that requires different regulatory compliance, sectoral approvals, and restrictions.
To add clarity to the abovementioned framework, consider this scenario. Say a foreign hedge fund holds an 8% share in an Indian tech company, with the FPI designation. However, due to strong company performance, the fund gradually increases its stake to 10.5%, crossing the FPI threshold. Under the previous regulations, the fund would have had to sell a portion of its holdings to stay under 10%, which could disrupt its investment plans. The new framework allows this hedge fund to reclassify its holding as FDI, letting it retain its investment without forced divestment, provided it complies with sectoral and regulatory guidelines.
Key Elements of the New Framework: Steps for FPI-to-FDI Reclassification
The RBI’s new framework includes specific provisions that make this reclassification process structured and clear:
Eligibility for reclassification
Only FPIs breaching the 10% threshold can opt to reclassify. This eligibility criterion aims to reduce abrupt divestment due to minor breaches, facilitating smoother compliance for investors who meet the framework’s conditions. For instance, a foreign pension fund holding shares in an Indian pharmaceutical company sees its ownership percentage increase to 11% due to market gains. Previously, the fund would have been forced to sell the excess shares. Now, it can reclassify its shares to FDI and continue its investment, as long as it meets FDI sectoral rules.
Approval requirements
FPIs opting for reclassification must obtain necessary government approvals. This is especially critical for investments originating from countries bordering India, where FDI is subject to additional scrutiny.
Reporting protocol
Both the FPI and the Indian company must report the reclassification through specific forms—Form FC-TRS for the FPI and Form FC-GPR for the company. Once completed, the reclassified shares are transferred to a designated FDI demat account, formalizing the change.
Sectoral compliance
The framework only allows reclassification in sectors open to FDI and within sectoral caps. This ensures that reclassified investments align with India’s investment priorities and sectoral policy. For instance, an FPI holding a 12% share in an Indian telecom company can only reclassify as FDI if the telecom sector permits such foreign ownership and doesn’t breach its FDI limits. If it does, the FPI would still have to reduce its stake to remain compliant.
Custodian’s role
During the reclassification process, custodians must freeze FPI transactions, preventing any non-compliant activity until reclassification is complete. This step ensures accuracy and regulatory compliance.
Impact of the Framework: A Structural Shift in Investment Policy
The RBI’s decision to introduce a reclassification option for FPIs signals a shift toward a more flexible, investor-friendly approach. Previously, FPIs exceeding the ownership limit had to offload shares, often at a loss, to comply with the cap. By offering an alternative to divestment, this framework reduces disruptions, helps avoid compliance costs, and gives investors a more predictable regulatory environment. Moreover, allowing FPIs to reclassify as FDIs provides a stable pathway for continued investment. This continuity is essential for investors focused on long-term growth in India and reduces the need for sudden exits due to regulatory limits.
The new framework complements India’s broader objective to attract stable foreign capital by simplifying regulatory requirements. By accommodating the needs of both FPIs and FDIs, India is more likely to position itself as a top destination for long-term foreign investment. Large pension funds and sovereign wealth funds, which prefer predictable and long-term investments, will find India more appealing with these revised rules, as they can grow their stakes with fewer regulatory risks.
The Way Forward
RBI’s reclassification framework is not just a procedural update; it is a policy statement that India is evolving toward a more balanced approach to foreign investment. While the framework already offers much-needed flexibility, using blockchain technology to support it can be the next step towards the radical improvement of the process itself as well as its safety. Specifically, a blockchain-based system would maintain a decentralized, tamper-proof ledger to track every step of the reclassification process, from threshold breaches to approvals. Moreover, smart contracts could also assist in compliance as they can initiate filings on their own, freeze nondomestic transactions that are in violation of certain standard, and even finalize transitions to FDI accounts as soon as approvals are received. This approach would remove the current paper-based approaches to the FPIs’ operations, communication, and reporting, with the FPIs, custodians, and regulators essentially working hand in hand, leaving major inefficiencies out of sync.
The RBI could begin with a pilot program for key sectors to refine the system, eventually scaling it nationwide. As global investors increasingly look to India, such reforms will be instrumental in sustaining foreign capital inflows and supporting India’s growth ambitions. Through initiatives like these, the RBI demonstrates its commitment to making India’s investment landscape adaptive and resilient qualities that are essential for an economy aspiring to be a global investment hub.