Authors: Amrut Joshi,

Foreign direct investments regulating laws in India

The regulatory regime which governs foreign direct investments in India includes: (i) the Consolidated Foreign Direct Investment Policy of 2017 (“FDI Policy”); (ii) the Foreign Exchange Management Act, 1999 (“FEMA”); and (iii) Foreign Exchange Management (Transfer/Issue of Security by a Person Resident outside India) Regulations, 2000 (“FI Regulations”).

The Reserve Bank of India (“RBI”) is tasked with: (i) administering various provisions of FEMA, FDI Policy and the FI Regulations; and (ii) regulating the inflow and outflow of foreign exchange to/from India.

Entitled persons for foreign direct investments in Indian companies

Registered Foreign Institutional Investor (“FII”), Foreign Portfolio Investors (“FPI”), and non-resident companies, trusts, and partnerships can invest in Indian companies. The entities to which investment can be made include: (i) Indian companies; (ii) partnership or proprietary firms; (iii) trusts; (iv) Limited Liability Partnerships (“LLP”); (v) startup companies; and (vi) Securities Exchange Board of India (“SEBI”) registered investment vehicles like real estate investment trusts, infrastructure investment trusts and alternative investment funds.

Routes through which foreign direct investments can be made in Indian entities

Indian entities can receive foreign direct investment through two routes:

  1. Automatic Route: Under this route, foreign investors can invest in permitted sectors without obtaining any prior approval from the Government of India or the Foreign Investment Promotion Board (“FIPB”). The investors are allowed to invest via the automatic route only in permitted sectors and up to a sectoral cap as prescribed in the FDI Policy.
  2. Government Route: Under this route, prior Government and FIPB approval will be required to be obtained by the foreign investor before making its investment in the permitted sectors. Examples of sectors requiring Government approval include mining, defence, telecommunication, broadcasting, etc. The Government route is considered for foreign investments being made in an Indian entity wherein: (i) the Indian entity is established with foreign investments and the same is not owned or controlled by a resident entity; and (ii) when the control or ownership of an existing Indian entity which is owned or controlled by resident Indian citizens or Indian companies are being transferred to a non-resident entity through mergers, acquisitions or amalgamations etc.

Following are some examples which specify sectoral caps and the routes through which foreign investment can be made in Indian companies:

Sector Activity Sectoral Cap Entry Route
Cash and Carry Wholesale Trading/Wholesale Trading (including sources from MSEs) 100% Automatic
(a) B2B Commerce Activities
(b) Market Place Model of E-Commerce
100% Automatic
Manufacturing 100% Automatic
Multi Brand Retail Trading 51% Government
(a) Insurance Company
(b) Insurance Brokers
(c) Third Party Administrators
(d) Other Insurance Intermediaries
49% Automatic

A detailed list of: (i) the sector/activities in which foreign direct investments can be made; (ii) the applicable sectoral caps; and (iii) the routes through which foreign investments can be made are provided in the FDI Policy.

Instruments for making investments 

The three instruments that can be allotted for receiving foreign investments in India are: a) Equity shares, b) Compulsorily Convertible Preferential Shares (“CCPS”), and c) Compulsorily Convertible Debentures (“CCDS”).

Equity shares are high-risk instruments with no obligation to declare dividends. There is no limit on the declared dividends as the returns are risk-based. Equity shareholders can vote on all matters affecting the company as they participate in the governance of the company.

CCPS are medium risk instruments which are preferred instrument compared to equity shares. The shareholders possess a preferential right to receive dividends. The voting rights of preferential shareholders shall be stipulated contractually (on an as if converted basis).

CCD are low risk, low return instruments which are essentially debt instruments with an assured rate of interest. The voting rights of debenture holders shall be stipulated contractually (on an as if converted basis).

FDI policy and the issuance of convertible notes 

As per the RBI Notification dated January 10, 2017, a person resident outside India may purchase convertible notes issued by an Indian ‘startup company’ for an amount of INR 25,00,000 or more in a single tranche.

As per the RBI notification, a ‘convertible note’ is an instrument issued by a startup evidencing receipt of money initially as debt, which is convertible into equity shares within a period of five years from the date of issue.

The term ‘startup company’ or ‘startup’ is defined by the Department for Promotion of Industry and Internal Trade (“DPIIT”) as highlighted earlier.

Please note that the issue of equity shares against convertible notes should be in compliance with the entry route, sectoral caps, pricing guidelines and other conditions that are prescribed under the FDI for foreign investment.

Pricing guidelines for issuance of securities 

The price of the securities issued by an Indian company shall not be less than the valuation calculated as per any internationally accepted pricing methodology on an arm’s length basis, and the same is duly certified by a Chartered Accountant or a SEBI registered Merchant Banker or a practicing Cost Accountant. As regards convertible instruments, the price / conversion formula of the instrument should be determined upfront at the time of issuance.

Initiating and completing the investment process for a foreign investor 

Once the investor confirms the route through which the foreign investment will be made and is privy to the sectoral caps that may be applicable for making the investment in the Indian entity, the investor may:

  1. Draw out a term sheet outlining: (i) the structure of the investment i.e., the capital that is infused by the investor in the company, allotment of securities by the company against the investment made by the investor; (ii) investor rights; and (iii) exit options that granted to the investor.
  2. Conduct a commercial, technical, financial, and legal due diligence of the investee company, along with a background check on the promoters of the company.
  3. Outline the conditions precedent to closing and conditions subsequent to closing action items in the form of a due diligence report.
  4. Execution of the definitive agreements between the investor and the investee company based on the final term sheet agreed between the investor and the promoters of the company.
  5. Ensuring that the conditions percent to closing action items (based on the due diligence exercise) are completed prior to making the investment.
  6. Subject to the completion of the conditions precedent action items, the investor will make the investment in the investee company.
  7. Ensuring that the conditions subsequent to closing action items (based on the due diligence exercise) are completed within the stipulated timelines after making the investment.

Provisions provided for in a Share Subscription Agreement and in a Shareholders’ Agreement

Typically, a share subscription agreement includes: (i) details regarding the current and post investment shareholding pattern of the investee company; (ii) the representations and warranties made by the promoters and the investee company to the investor about the company’s affairs and business; (iii) the conditions precedent action items (based on the due diligence exercise conducted by the investor); (iv) the conditions to be satisfied by the company on the day of closing; (v) the conditions subsequent action items (based on the due diligence exercise conducted by the investor); (vi) list of reserved matters for which the investor’s consent will be required; and (vii) specific indemnity provided to the investors by the promoters and the company, in the event the promoter and/or the company is in breach of its representation and warranties.

A shareholders’ agreement outlines the rights that are granted to the investor. Typically, the rights granted to an investor shall include: (i) Pre-emption rights; (ii) Right of first refusal; (iii) Anti-dilution right; (iv) Management rights (i.e., investor being entitled to appoint an investor nominee director); (v) Information rights; (vi) Tag- along right; (vii) exit options – strategic sale or IPO; (viii) liquidation preference; (ix) Drag-along right and such other rights as may be mutually discussed and agreed between the promoters of the investee company and the investor.

Reporting requirements 

(a)  Advance Remittance Form (“ARF”): The receipt of foreign investment should be reported by the Indian investee company to the RBI through the ARF. The ARF reporting must be done within 30 days of receipt of investment from the foreign investor. This form should contain details pertaining to: (i) Name and address of the foreign investors; (ii) Date of receipt of funds and their INR equivalent; (iii) Name and address of the authorised dealer through whom the funds have been received; and (iv) Details of the Government approval, if any.

(b)  Form Foreign Currency – Gross Provisional Return (“FC-GPR”): The investee company will be required to submit Form FC-GPR to the RBI to report the issuance of securities to the foreign investor. The investee company should file from FC-GPR form within 30 days of allotment of securities to the investor.

(c) Annual Return on Foreign Liabilities and Assets (“FLA”): Annual return on Foreign Liabilities and Assets should be submitted by all Indian companies which have received foreign direct investment July 15th of every year.

(d) Form Foreign Currency – Transfer of Shares (“FC-TRS”): This form should be submitted by the Indian entity to the RBI in the event there has been a transfer of securities between an Indian resident to a non-resident, or vice versa.

Please note that the RBI has issued a circular dated June 07, 2018 through which it has introduced the Single Master Form (“SMF”) for reporting foreign investment in India. In order to effectively implement this measure, the RBI has provided an interface to Indian entities for inputting the data on total foreign investment in a specific format. The SMF intends to integrate the foreign direct investment reporting system.