[Rachit and Sujatro are students at Rajiv Gandhi National University of Law.]
The Finance Minister, while presenting the Budget 2024, stated that "the rules and regulations for foreign direct investment and overseas investments will be simplified to facilitate foreign direct investments, nudge prioritization, and promote opportunities for using Indian Rupee as a currency for overseas investments" in order to relax FDI regulations to boost inwards foreign investments. In line with this, on 16 August 2024, the Ministry of Finance notified certain amendments to the Foreign Exchange Management (Non-Debt Instrument) Rules 2019 (NDI Rules). The amendments to the NDI Rules introduce significant changes, including revised approval norms, regulations on cross-border share swap, and a redefined concept of 'control' in equity transactions. The most significant change pertains to regulating share swaps as a form of non-debt, equity-based foreign investment and redefining the threshold for a controlling interest. This was a much-awaited change to address the ambiguity surrounding share swap transactions and broaden the limited scope of allowable swap transactions under the erstwhile NDI Rules. This marks a pivotal shift in the regulation of foreign investment, promising a liberal FDI policy, thus necessitating a detailed analysis of the amended rules.
Through this article, the authors provide a comprehensive analysis of the recently amended NDI Rules, highlighting the key differences between existing and proposed share swap regulations, along with their pros and cons.
Tracing the Stance of FEMA on Share Swaps
Share swap transactions refer to a share swap arrangement that signifies the issuance of a share in exchange for a share rather than the remittance of cash consideration. Prior to 2015, share swap transactions were permissible only after obtaining prior approval from the government as per Rule 3(c) of Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2000. However, this position was altered under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2017. According to the 2017 regulations, issuing shares in a share swap did not require government approval if the transaction qualified under the 'automatic route'. Through the 'automatic route', cases below a certain threshold were not required to acquire government approval for such investment. In contrast, the 'government route' stipulated that a share swap was permissible only with prior government approval. This position was retained under the NDI Rules and the Foreign Exchange Management (Overseas Investment) Regulations 2022 (ODI Regulations).
Further, the scope of share transactions under the erstwhile NDI Rules and ODI Regulations limited it to 'primary transfer'. Moreover, share swaps, as per Schedule 1(1)(d)(i) of NDI Rules, only took into purview 'equity instruments' of Indian companies. As defined by the NDI Rules, equity instruments are limited to equity shares, convertible debentures, preference shares, and share warrants issued by an Indian company, thus, excluding share swap transactions of foreign companies from the scope of permissible swap transactions under the existing foreign exchange management rules.
Dissecting the New Position of Law
Inclusion of secondary transfers
Erstwhile NDI Rules permitted share swap only as a primary transfer, i.e., the issuance of new equity instruments, against a share swap transaction with a person resident outside India (PROI). However, the recent notification amends the previously existing rules to add Rule 9A, where even secondary transfer in the form of a share swap has been recognised and permitted. In a secondary transfer, the pre-existing equity instruments may be swapped between a person resident in India (PRI) and PROI. Although Regulation 8 (iii) of the ODI Regulations had, in practice, previously allowed secondary transfers in the form of share swaps, it merely acknowledged this as a mode of payment in transactions between PRI and PROI. However, the amended NDI Rules have expressly recognised secondary transfer in the form of share swap as a valid/permitted mode of transfer, thereby removing any ambiguity and doubts regarding its legality. Thus, in effect, this addition clarifies the provisions of share swaps as a mode of cross-border transfer concerning non-debt instruments.
Enabling the swap of equity shares of foreign companies
The scope of permissible share swap transactions under the NDI Rules has also been revised. Previously, only the equity of Indian companies was allowed to be swapped as an 'equity instrument' comprised only of instruments of an Indian company. Thus, only equity of an Indian company was allowed to be issued to a PROI in a swap transaction. Due to the inclusion of the term 'equity capital' under Rule 9A (3) and Schedule 1 (1)(d)(iv) of the NDI Rules, any transaction by way of swap of equity has been modified to include equity of a foreign company as well.
Owing to these changes, the restriction on the exchange of equity of foreign entities has been lifted, and Indian Companies are now permitted to issue or transfer their shares against a swap of shares/compulsorily convertible debenture (CCDs) of a foreign company. Thus, shares/CCDs of an Indian Company may be transferred between a PRI and PROI through a swap of shares of an Indian company or a foreign company. This marks a significant improvement in the foreign exchange management framework by relieving any ambiguity in the regulations and boosts reliability by reducing the persisted entry barriers and making the Indian investment landscape easier to navigate (by broadening the overall scope of allowable share swap transactions).
Dilution of approval routes
Per the foreign exchange management rules and regulations framework, there are two routes for gaining approval for different investments or transactions. The government route requires all investments to obtain prior government approval for each transaction in government approval sectors. The recent amendment has omitted the terms 'automatic route' and 'government route' from Schedule 1(1)(d)(i) of the NDI Rules. This means that there is no difference in the treatment of a share swap transaction from the automatic and government approval routes, except in cases where specific government approval is explicitly required. These instances include investments from countries which share land borders with India. Notably, the dilution of the approval routes system concerning share swaps would increase the ease of investment into the country, especially for growth-stage companies.
However, this proposed change would introduce considerable ambiguity in discerning which transactions are exempt from approval and which are not, potentially imposing an additional regulatory burden for the government to delineate the same without any express clarification and significant compliance burdens and ambiguity for the investors.
Redefining 'control'
Previously, under foreign exchange management framework, for NDI Rules, control of a company could arise from shareholding, management rights, shareholders' agreements, or voting agreements that granted 10% or more voting rights or through any other means. This framework implied that a person could be said to have control over a company only if they held at least 10% of the voting rights, which enabled them to appoint the majority of the directors or control the management or policy decisions. However, the recent notification amending the NDI Rules has removed the 10% quantitative threshold from the definition of control. The new definition has been standardized based on the definition used under the Companies Act 2013. Due to this elimination of the quantitative threshold, investors now have more flexibility to acquire equity in a company without necessarily being deemed to gain control, which would otherwise trigger various foreign exchange management compliances.
Eliminating the quantitative threshold for defining control introduces significant ambiguity, as it now relies solely on qualitative factors. This shift makes it harder to determine if an investor has acquired a controlling interest, making it more challenging for investors to confidently do a preliminary assessment of their investment. Furthermore, the unequivocal definition of control under FEMA is now clouded with the same ambiguity surrounding the concept of control under the Companies Act 2013. Consequently, without an express clarification, this standardization risks opening a Pandora's box of uncertainties, posing significant risks for the investors.
Conclusion
The recent amendments to the NDI Rules aim to clarify the long-standing ambiguities pertaining to share swap transactions and ease regulatory compliances. That being said, the onset of explicit secondary transfers for share swaps and inclusion of equity of foreign companies with no scope of obscurity is commendable. This aligns with the government's agenda to make India FDI attractive. However, the dilution of approval routes raises concerns. The amendments create ambiguity regarding when specific government approval is required by removing the distinction between the 'automatic' and 'government' routes for share swaps. This lack of clarity could complicate compliance for investors, as the criteria for determining exempt transactions still need to be clarified. Additionally, the re-definition of 'control' without a quantitative threshold adds further uncertainty, making it challenging to assess when regulatory obligations are triggered.
While the reforms are a positive step toward creating a more investor-friendly environment, the approval routes and control issues could undermine the intended benefits, necessitating further regulatory clarification. However, despite all the concerns raised, the broadening of the scope of permissible swap transactions, and providing absolute clarity on provisions regulating swap transactions, the government has solidified a platform encouraging M&A transactions in India.
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