In a quiet mid-October surprise, nearly four and a half years after the passage of the Finance Act 2015 (20 of 2015), the Government notified the effective date for implementation of the clauses that amended Section 6 of the Foreign Exchange Management Act, 1999 (FEMA). The notification defining debt and non-debt instruments followed suit and then of course the Non Debt Instrument Rules (NDI Rules) under FEMA, which superseded the extant FEMA 20R and 21R.
How Have Things Changed?
What would appear to be simply a new name for the old FEMA 20 R has in fact some changed parameters that need to be understood and recognised. There are also small “changes” that can technically be ascribed to the phenomenon of ‘lost in translation’ – recent changes made by the Department for Promotion of Industry and Internal Change (DPIIT) and which had not yet found a place in FEMA 20 R. These are the liberalisations announced vide PN 4 of 2019, pertaining to the coal-mining sector, contract manufacturing, single-brand retail trading and digital media. The latest notification from the Department of Financial Services, which set a 100% cap for insurance intermediaries also does not find a place. It is certain that suitable amendments incorporating these will come through within the next few days.
On the more substantive changes, the first big change to be noted is in Schedule II, which kicks in from 1 April, 2020.The first change is in the opening paragraph of Schedule II (1) (a) (i) itself. The extant 24% aggregate limit for Foreign Portfolio Investments (FPIs), which used to be exclusive to FPIs in FEMA 20R, is now redefined to include “any other direct and indirect foreign investment in the Indian company permitted under these rules”.
This is a restriction for companies having FPI levels at the default 24% as extant (and may be in the future too) and would also appear to be difficult to operationalise. This insertion, it is felt, would require some cleaning up. Going further, though earlier, the default aggregate FPI limit was 24%, which could be raised up to the sectoral cap by an appropriate board resolution and general body special resolution and intimation to the Reserve Bank of India (RBI); the regime now is being reversed. The default aggregate FPI limit beginning next fiscal year is being fixed at the sectoral cap, which, before the onset of the revised system can be reduced to 24/49/74%, as deemed fit, through the procedure of resolutions as extant. This aggregate limit once fixed can be upped to a higher threshold but can’t be reduced. It is not clear if it can be pegged at an odd figure or it must move in steps as indicated, but the real gap emerging here is what is to be done in the twilight zone – i.e. for the rest of this year till the next fiscal year because the earlier clause upping the limit from 24% is no longer there. So an enabling provision for allowing the status quo in the interregnum should have been there.
On the broader issue of this change itself, it will be viewed as a market-friendly move. But disallowing the reduction of the level effectively restricts the flexibility of options for a company, which may possibly, considering its future plans, want to secure long-term investment or evaluate various fundraising alternatives including by way of Foreign Direct Investment (FDI). Also if the sectoral cap is partly on the automatic route and partly on the approval route (Pharma / private sector banking / telecom, for instance) it could create an anomaly beyond the automatic route level and would end up discouraging FDI in favour of the portfolio route. Another aspect is that in some sectors, is relevant for determining the ‘control ’ issue: it is not clear as to which entity or entities and how exactly and at which stage will it be determined whether in a company, the FPIs are acting in concert, or there is common ownership of FPIs/ Governments. This may be something that would require elaboration and intervention at some stage.
Apart from Schedule II, there are changes in the definition clause itself – for example, the regime now changes from the earlier “capital instruments” to “equity instruments”, which inter alia includes warrants. But the Explanation under section 2 (k) seems to ignore that the same can also be issued by unlisted companies in accordance with the Companies Act 2013. The wording used in the NDI Rules itself in the case of Employee Stock Ownership Plans (ESOPs)/sweat equity, which encompass both listed and unlisted companies may need to be replicated mutatis mutandis in the case of warrants too. Despite the changed nomenclature, the NDI Rules still continue to use the term “capital instruments” in at least at five or six places. The term “hybrid securities” is defined in Section 2 (x) but one is left wondering as to its applicability as the term has not been used anywhere in the NDI rules at all. The definition of “listed Indian Company” has been changed and now includes any company that has listed “any equity instruments or debt instruments “ This expands the ambit considerably and brings under these rules even companies that have only pure debt listings and which earlier were excluded .
FDI Policy as announced in 2017 (and currently valid) specifically disallows FDI in trusts except Venture Capital Funds (VCFs) and ‘investment vehicles’, though this did not actually find a place in the extant FEMA 20R. In the NDI Rules however, it has been defined in Sec 2 (ai) that the non-debt instruments include contribution to trusts and that is a major change. Incidentally, the Foreign Contribution (Regulation) Act 2010 (FCRA) governs foreign contribution received by trusts, and as this Act is administered by the Ministry of Home Affairs, some element of overlap /control is bound to happen, which needs to be managed. Now it would appear that the only entities that cannot receive foreign funds directly would be societies. While on trusts, especially those that are “charitable”, there is a case for a separate treatment of the “not-for–profit” companies (Section 8 of Companies Act) because by their very nature these are not in the same mould as the rest of the corporate world or other entities formed as trusts and therefore opportunities for inter-regulation arbitrage are now possible.
While including Trusts in the definition of non-debt instruments, in the notification of non-debt instruments itself (Notification dated 16th October 2019 preceding the NDI Rules) it is stated to include “investment in units of mutual funds and Exchange-Traded Funds (ETFs), which invest more than 50 percent in equity”. These funds therefore have to conform to the NDI Rules in respect of entry route caps and conditions laid down therein for their investments. It has been reported in the media that the mutual funds affected are raising the issue with the regulator. Clearly where the “sponsors” and “managers” or investment managers” of such funds are owned or controlled by persons resident outside India, the downstream investment would get counted as indirect foreign investment under the NDI Rules, which could have implications for their portfolios and investment strategy
In sum, the NDI Rules are the result of changes affected in FEMA through the Finance Act 2015. At the first cut, these appear to be a quick job ticking off the to-do list, but they have brought about some deep changes, the impact of which will play out in time. However the multiplicity of control of the FDI Regime with the DPIIT still remains as the subject remains with them as per the allocation of business Rules . Of course, as hitherto, the RBI remains the operational regulator of FEMA and entities need to continue to report on various matters. The opportunity could have been availed to clean up a lot of regulations that are cumbersome, but instead, regulations appear to have simply moved one level up to the Rules under the Ministry of Finance. This is a good start, the advantage being that a unified view is now possible on the various kinds of foreign investment flows into various entities because all the financial sector regulators ultimately come under the Ministry of Finance, which is also the administering ministry for FEMA.
However, the dire need to make the whole regime simple and welcoming for foreign investors is, in my view, still a work-in-progress.