Overseas Direct Investment


Outbound investments in India have witnessed a significant decline from its peak in the golden period of 2005-08. As per the data collated by the Reserve Bank of India (“RBI”), in July 2011, the total outbound financial commitment was at USD 5,478.15 million. This figure has declined over the decade to USD 2,047.79 million in December 2021.

While the onslaught of the Covid-19 pandemic has resulted in a 13% decline in ODI in FY 2020-21, countries such as Singapore, USA, Mauritius, and UK continue to be the most popular destinations for Overseas Direct Investment (“ODI”), together accounting for around 73% of total ODI.[1] The ticket size of ODI has declined. Preferred sectors for overseas investments[2] were (a) financial, insurance and business services; (b) manufacturing; and (c) wholesale, retail trade, restaurants, and hotels[3].

While the limit of the total financial commitment that an Indian entity can make remains 400% of the net worth of such company[4], in an effort to further liberalise the regulatory framework, to promote ease of doing business and also to plug certain loop-holes, in August 2021, the RBI proposed significant changes to the ODI regulatory architecture in India.

On August 9, 2021, the RBI notified the Draft Foreign Exchange Management (Non-debt Instruments – Overseas Investment) Rules, 2021 (“Draft Rules”) and the Draft Foreign Exchange Management (Overseas Investment) Regulations, 2021 (“Draft Regulations” and collectively, “Proposed Framework”), for stakeholder comments.

Currently, outbound investments in India are governed by the Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004 (“FEMA 120”) and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations 2015 (“Existing Framework”).

Similar to the regulatory architecture for inbound investments, outbound investments, after the notification of the Proposed Framework will be segregated into, (i) the Draft Rules, which propose to deal with overseas equity investments (i.e. investment by way of non-debt instruments) and acquisition and transfer of immovable property outside India; and (ii) the Draft Regulations, which propose to deal with investments by way of debt instruments, such as guarantee, pledge, charge, etc.

This blog examines the implications of the Proposed Framework on outbound investments in foreign entities.

Potential challenges under the Proposed Framework

  1. Interpretation of ‘foreign entity’

In the Existing Framework, subject to the conditions prescribed, an Indian party may make an investment in a joint venture (“JV”) or a wholly owned subsidiary (“WOS”) outside India. The terms ‘JV’ and ‘WOS’, which find themselves in the Existing Framework have been dropped from the Draft Rules. Instead, the Draft Rules uses the term ‘foreign entity’, which is defined as:

(a) “an entity incorporated and registered outside India under the laws of the host country; or

(b) an unincorporated entity engaged in a strategic sector and formed under the laws of the host country”

Broadening the scope of the Existing Framework from investments to all entities incorporated and registered outside India, or unincorporated entities, is likely to have a positive impact on an Indian entity’s ability to make outbound investments.

In practice though, the inclusion of the words ‘and’ in ‘incorporated and registered’ to some extent limits the applicability of the Proposed Framework. There may be a situation where certain Limited Liability Partnerships (or similar entities) are formed and registered, but not “incorporated” in the strict sense. For instance, in USA, Limited Liability Companies are ‘formed’ and ‘registered’, but not ‘incorporated’ in the strict sense.

In essence, the inclusion of the word ‘and’ may to some extent limit the type of foreign entities that would be eligible to receive investments from India, and therefore hinder the RBI’s objective of simplifying the ODI regime.

  1. Definition of ‘overseas direct investment’ and ‘overseas portfolio investment’

The Draft Rules provides that “ODI” means investment (a) by way of acquisition of equity capital of an unlisted foreign entity; or (b) subscription to the Memorandum of Association of a foreign entity; or (c) investment in 10% or more of the paid-up equity capital of a listed foreign entity; or (e) where the person resident in India making such investment has or acquires control, directly or indirectly, in the foreign entity.[5]

As per the Draft Rules, any investment other than an ODI, in foreign securities, including units of exchange-traded funds and depository receipts, which are listed, unless stated otherwise, on a recognised stock exchange outside India, but not in any securities issued by a person resident in India (outside an IFSC), will be considered overseas portfolio investment (“OPI”).

It is important to note that for investments in listed companies to count towards ODI, a numerical limit of 10% has been introduced. On the other hand, for unlisted companies, the threshold requirement for triggering the Draft Rules has been made stricter.

A reading of the definition of ODI and OPI indicates that any and all amounts of investment in an unlisted foreign entity would fall under the regulatory ambit of the Draft Rules. Accordingly, it should be noted that even small investments made inter alia under RBI’s Liberalised Remittance Scheme (“LRS”) will trigger compliance with the Draft Rules.

  1. Round tripping

The Existing Framework does not specifically define or deal with “round tripping”. The FAQs on overseas direct investment issued and updated by RBI from time to time, which are meant to only be clarificatory in nature, surprisingly lays down a substantive piece of the law and addresses a crucial question on the round tripping front.

In FAQ No. 64, RBI states that the provisions of the FEMA 120 “do not permit an Indian party to set up Indian subsidiary(ies) through its foreign WOS or JV nor do the provisions permit an Indian party to acquire a WOS or invest in JV that already has direct/indirect investment in India under the automatic route. However, in such cases, Indian parties can approach the Reserve Bank for prior approval through their Authorised Dealer Banks, which will be considered on a case to case basis, depending on the merits of the case.”

While RBI has been criticised for dealing with important issues such as round tripping through the insertion of an FAQ, market practice requires the regulator’s nod for such transactions in which the Indian entity ends up indirectly acquiring a stake in another Indian entity.

As a result of this, certain bona fide transactions which may result in a situation where an Indian company eventually ends up indirectly holding a stake in another Indian company through its holding in a foreign entity as a by-product, would also be under the regulator’s radar.

Accordingly, an Indian entity merging with a foreign entity, which holds certain stake in another Indian company would not be permitted, and would need RBI approval. Additionally, transactions through a special purpose acquisition company (SPAC) as well would have to be cleared since they would fall under the ambit of FEMA.

Regulation 6(3) of the Draft Rules contemplates a change in the aforesaid situation. As per Regulation 6(3), any investment in a foreign entity that has a stake in India is prohibited only if it is done for the purposes of tax evasion/avoidance. Therefore, if it can be established that the transaction is being undertaken for a bona fide commercial reason, and not with the objective of obtaining any tax benefits, it will not require prior RBI approval.

However, it is important that some clarity is provided on what constitutes tax avoidance/ evasion, and whether this determination would be made by the Income Tax Department, or RBI.

  1. NOC Requirement

As per Rule 4 of the Draft Rules, any person resident in India, undertaking any kind of financial commitment and has an account appearing as a Special Mention Account – Category 1/ Special Mention Account – Category 2/ Non-Performing Asset/ wilful defaulter, as per the information available with a Credit Information Company or is “under investigation” by a regulatory body, including SEBI, IRDA, National Housing Bank, or an investigative agency such as ED, CBI, SFIO shall be required to obtain a no objection certificate (“NOC”) from the lender bank(s)/ regulatory body/ investigative agency concerned before making such financial commitment or undertaking disinvestment of such financial commitment.

While all in all, the requirement to obtain an NOC is a positive one, one of the conditions when such NOC needs to be obtained is when the person is ‘under investigation’. A practical aspect which may cause a level of ambiguity is the absence of the definition of ‘under investigation’ in the Draft Rules, as the meaning of ‘under investigation’ may vary across different statutes.

  1. The dilemma of the energy sector

The Draft Rules define ‘strategic sectors’ as follows:

“Strategic Sector” shall include energy and natural resources sectors such as Oil, Gas, Coal and Mineral Ores or any other sector that may be advised by the Central Government subject to conditions as may be laid down under these rules by the Central Government.

According to the definition of ODI, any acquisition outside India of a ‘participating interest/ right’ in the energy sector or investment made outside India in agricultural operations as provided under the Proposed Framework shall also be treated as ODI.

Difficulties arise because the definition of ODI singles out the words “energy sector” and does not use the expression “strategic sector”, which is specifically defined.

With “energy” and “natural resources” being closely associated with one another, the practical implications of this distinction is likely to cause confusion on which entities will fall under the ambit of “energy” and which will fall under the ambit of “natural resources”. Additionally, the lack of a definition of ‘participating interest/ rights’ is also likely to cause ambiguity.

Concluding thoughts

In India, the large corporate groups have had mixed experiences with outbound investments. Over the years, the quantum of ‘big-bang’ outbound investments by Indian companies has also witnessed a steady decline, and the Covid-19 pandemic has only accelerated this downfall.

It is important for the regulator to achieve a fine balance between ease of doing business on the one hand, and simultaneously ensuring that the ODI route is not used for round tripping or tax evasion. The RBI’s proposals serve as a good starting point towards achieving these twin objectives, and the proposed changes will facilitate ODI by Indian companies.

There are certain drafting lacunae and grey areas which need to be clarified, and the RBI would be well-advised to iron out these creases before notifying the new framework. It is also important that all the important provisions relating to the ODI legal architecture are specified in the text of the Rules/ Regulations, and not surreptitiously added later in the form of FAQs.

[1] As per the RBI Annual Report for FY 2020-21. Please note that in certain cases these jurisdictions may only be the intermediate jurisdiction through which investments are being undertaken, the final destinations of such investments have not been specified in the RBI Annual Report.

[2] As per the ODI Factsheet for the month of November 2021 released by the Department of Economic Affairs for the period of April 2019 to November 2021.

[3] At 36.8%, 25.5% and 17.1% of the total ODI, respectively.

[4] Please note that (a) Financial commitment made by “Maharatna” PSUs or “Navratna” PSUs or subsidiaries of such PSUs in foreign entities outside India engaged in strategic sectors; (b) investment made out of the balances held in its EEFC account; (c) utilisation of amount raised by issue of ADR/ GDR; (d) utilisation of ECB for making financial commitment are exempt from such limit.

[5] Rule 2 (xvii) of the Draft Rules.