India: Foreign direct investment regulations (2024)

Introduction

Over the years, India has become one of the preferred destinations for foreign investments owing to favourable demographics as well as noticeable and consistent growth trajectory. During the financial year 2021-2022, India witnessed its highest ever foreign direct investment (FDI) inflow of approximately US$83.57 billion.^[2] Interestingly, this surge in FDI was observed despite the restrictions imposed by the Indian government on receiving FDI from countries sharing land borders with India, which is discussed later in this chapter.

The increasing number of FDI may be largely attributable to (1) various policy reforms introduced by the Indian government over time in order to liberalise the economy and enhance the ease of doing business in India; and (2) geopolitical considerations and global trade relations, pursuant to which investors are diverting their investments away from China.^[3]

This chapter lays down an overview of the regulations governing FDI in India, along with a brief description of the modalities and rules associated with making foreign investments in India.

Overview of regime

Legislative framework

The primary legislation governing the foreign exchange regime in India is:

• the Foreign Exchange Management Act, 1999 (as amended from time to time) (FEMA) along with the rules and regulations framed thereunder including the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules) and the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019; and
• the Consolidated Foreign Direct Investment Policy, 2020 issued by the Department of Promotion of Industry and International Trade (DPIIT) as amended from time to time by way of press notes issued by DPIIT.

We shall collectively refer to these as ‘the FEMA Regime’.

Key regulators and authorities

The key regulators of foreign investment in India are (1) the DPIIT (in the Ministry of Commerce and Industry, Indian government), along with other concerned governmental departments and ministries; and (2) the Reserve Bank of India (RBI), which has been empowered to administer the NDI Rules.

Modes of foreign investment

Foreign investment in India can be made through the following three modes: FDI, FVCI, and FPI, which are detailed below.

FDI

FDI, which is the focus of this chapter, is the most prevalent and preferred mode of investment in India. The attendant conditionalities, rules and restrictions in relation to investments under the FDI mode are discussed below.

The FEMA Regime defines FDI as ‘investment through equity instruments by a person resident outside in India in an unlisted Indian company; or 10% or more of the post issue paid-up equity capital on a fully diluted basis of a listed company.’

Routes of FDI

The FEMA Regime contemplates FDI into India via two routes: the automatic route and the government (approval) route. The available route of investment is dependent on the sector in which the business of the Indian investee entity falls and the quantum of the investment being made. Under the automatic route, FDI is permitted without any approval from the government or the RBI, up to 100 per cent or such other limit as may be prescribed for a sector. Some sectors that fall under the 100 per cent automatic route include manufacturing, telecom services, and other financial services.^[4]

Further, sectors or activities that are neither specifically listed under the FEMA Regime, nor provided under the prohibited sectors as listed below, fall under the 100 per cent automatic route and are not subject to any sectoral cap. Nevertheless, FDI in such sectors remains subject to the applicable regulations and rules.

Investments in sectors falling under the government route require the prior approval of the government or the RBI, or both, and any investment made under this route is subject to the conditions that may be stipulated by the government or RBI, or both, in its approval. Sectors that fall under the 100 per cent government route (i.e., where foreign investment is permitted up to 100 per cent with approval) include satellites (establishment and operation), mining and mineral separation of titanium bearing minerals and ores, and financial services (where any part of the financial services is not regulated by a financial services regulator). Further, investments that are considered to have an impact on the national security of India also fall under the government route, and the same are discussed in further detail below.

It is pertinent to note that in certain sectors FDI is permitted under the automatic route up to a specified threshold, and government approval is required for any investment beyond such threshold. For instance, sectors such as defence and brownfield pharmaceuticals both fall under the automatic route up to 74 per cent, and require government approval for any foreign investment beyond 74 per cent.

Sectoral caps

As indicated above, while over the years foreign investment has been liberalised considerably by the Indian government whereby 100 per cent FDI in the majority of sectors has been made permissible, for a few sectors that are considered imperative from a national security perspective, the FEMA Regime prescribes thresholds beyond which investments by non-residents are not permitted, either under the automatic route or the government route. For instance, an entity engaged in private sector banking can receive foreign investment only up to 74 per cent of its share capital, of which 49 per cent falls under the automatic route, and any investment beyond 49 per cent and up to 74 per cent requires government approval; and in the sector of print media, an entity engaged in the business of publishing of newspapers and periodicals dealing with news and current affairs is allowed to receive foreign investment only up to 26 per cent of its share capital, and such foreign investment can only be made under the government route.

Prohibited sectors

FDI is prohibited in entities engaged in following sectors:

• lottery business;
• gambling and betting including casinos, etc.;
• chit funds;
• nidhi companies;
• trading in transferable development rights;
• real estate business or construction of farm houses;^[5]
• manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or tobacco substitutes;
• activities or sectors not open to private sector investment, for example, atomic energy, railway operations (other than as specifically permitted under the FEMA Regime); and
• foreign technology collaborations in any form including licensing for franchise, trademark, brand name and management contract are also prohibited for lottery business and gambling and betting activities.

Entities eligible to receive FDI

In the context of eligible investees, the FEMA Regime originally defined an Indian entity to mean an Indian company or a limited liability partnership (LLP). FDI is permitted in LLPs engaged in sectors where 100 per cent FDI is allowed under the automatic route and there are no foreign investment linked performance conditions.

Earlier this year, the DPIIT issued Press Note No. 1 of 2022 Series, dated 14 March 2022 to widen the ambit of an Indian company to include ‘a body corporate established or constituted by or under a central or state act, which is incorporated in India.’ The intent of this change was to introduce the ‘corporation’ as an Indian entity to pave the way for foreign investment in the Life Insurance Corporation (LIC) of India, the largest public sector insurance company in India, which was established as a ‘corporation’ under the Life Insurance Corporation Act, 1956. With effect from April 2022, FDI in LIC has been permitted up to 20 per cent under the automatic route.

It is pertinent to note that the FEMA Regime explicitly clarifies that societies, trusts and any other excluded entities do not fall under the ambit of an Indian company and, consequently, are not eligible investee entities under the FEMA Regime.

Types of securities

Under the FEMA Regime, with respect to the FDI mode, a non-resident can invest in the following equity instruments of an Indian company:

• equity shares, including partly paid shares;
• fully paid and mandatorily convertible preference shares;
• fully paid and mandatorily convertible debentures; and
• share warrants.

The FEMA Regime also permits optionality clauses in equity instruments, which are subject to a minimum lock-in period of one year or as prescribed in the conditionalities for the specific sector. Upon expiry of the lock-in period, the non-resident is eligible to exit without any assured return.

Further, non-residents can invest in capital contribution of LLPs.

Convertible notes

In addition to the equity instruments as set out above, the FEMA Regime permits foreign investment by way of convertible notes. The key features of convertible notes are as follows:

• they can be issued only by start-up companies^[6] for an amount of 2.5 million rupees or more in a single tranche;
• they are a hybrid instrument with the features of both debt and equity. The instrument is initially acknowledged as a debt, which at the option of the holder of the convertible note is either repayable or convertible into equity of the start-up company within 10 years from the issuance of the convertible note;^[7] and
• issuance and transfer of convertible notes to non-residents are subject to adherence to the pricing guidelines, entry routes and sectoral conditions as prescribed under the FEMA Regime.

Pricing guidelines

For acquisition and transfer of equity instruments under the FDI mode, the FEMA Regime prescribes certain pricing guidelines, which are as follows.

Issuance and transfer of equity instruments from residents to non-residents

• Pricing of equity instruments of a listed Indian company to be issued or transferred to a non-resident is not to be less than the price as determined in accordance with the relevant guidelines issued by the Securities Exchange Board of India (SEBI).
• For issuance or transfer of equity instruments of an unlisted Indian company, the pricing of equity instruments is not to be less than the fair value as determined by a SEBI registered merchant banker, chartered accountant or practising cost accountant, in accordance with an internationally accepted pricing methodology, on an arm’s-length basis (‘fair value’).

Transfer of equity instruments from non-residents to residents

Transfer of equity instruments of a listed Indian company from a non-resident to a resident cannot be undertaken at a price that is higher than the prevailing market price. In the case of equity instruments in an unlisted Indian company, the pricing cannot exceed the fair value.

The guiding principle for pricing guidelines is to ensure that a non-resident investor takes the equity risk and is not guaranteed any assured exit price at the time of its investment. This also assists in keeping a check on the outflow of foreign exchange from India.

Transfer of equity instruments from non-residents to non-residents

Transfers of equity instruments among non-residents do not attract pricing guidelines.

Reporting obligations

Foreign investments in equity instruments or capital of eligible investee entities are required to be reported to the RBI within prescribed time periods. The regulatory filings for the purpose of reporting of foreign investments are to be made on a unified online RBI portal referred to as the Foreign Investment Reporting and Management System (FIRMS). Transactions among non-residents are exempt from these reporting obligations.

Additionally, every Indian company that has received FDI is required to file an annual return with the RBI by 15 July each year.

Downstream investment

Indirect foreign investment in an Indian investee entity is known as downstream investment, which is an investment (primary or secondary) made by a foreign owned^[8] and controlled^[9] Indian entity into another Indian investee entity. Downstream investment for the investee entity is subject to: (1) prior approval of the board of directors of the investee entity; and (2) the entity making the downstream investment bringing in requisite funds from abroad or making the downstream investment out of its internal accruals. It is important to note that funds borrowed from the domestic markets cannot be utilised for making the downstream investments. Further, depending on the nature of the transaction, the rules and regulations in relation to FDI such as the pricing guidelines and reporting requirements are applicable in the case of a downstream investment, as well.

Downstream investment by a foreign owned and controlled LLP in an Indian company is permitted if the investee company is operating in sectors where foreign investment is permitted under the 100 per cent automatic route and there are no additional conditions applicable.

FVCI

An FVCI is a foreign venture capital investor incorporated and established outside India, which is required to be registered with SEBI. An FVCI is permitted to invest in unlisted securities of Indian companies engaged in the following sectors:

• biotechnology;
• IT related to hardware and software development;
• nanotechnology;
• seed research and development;
• research and development of new chemical entities in the pharmaceutical sector;
• the dairy industry;
• the poultry industry;
• production of biofuels;
• hotels and convention centres with a seating capacity of more than 3,000; and
• the infrastructure sector.^[10]

FVCIs can also invest in securities of listed Indian companies, subject to compliance with the applicable SEBI regulations.

Opting for the FVCI mode of investment provides an investor the following benefits: (1) FVCIs are exempt from pricing restrictions as applicable to FDI investments; and (2) shares held by an FVCI are not subject to the statutory post-initial public offering lock-in period of one year provided that the FVCI has held the concerned shares for at least six months from the date of acquisition.

Separately, FVCIs registered with SEBI can also opt to invest under the FDI mode. However, the investment would be subject to the conditions and rules in relation to FDI as discussed above.

FPI

A foreign portfolio investor (FPI) is a person registered under the relevant SEBI regulations. FPIs are classified into two categories – Category I and Category II, where Category I includes government and government-related investors such as sovereign wealth funds and central banks, while Category II includes corporate bodies, charitable organisations and unregulated funds.

FPIs can make investments in listed Indian companies or companies to be listed. The FEMA Regime defines foreign portfolio investment as follows:

Any investment made by an FPI through equity instruments where such investment is less than 10% of the post issue paid-up share capital on a fully diluted basis of a listed Indian company or less than 10% of the paid-up value of each series of equity instrument of a listed Indian company.

If the investment made by an FPI or its investor group breaches the prescribed 10 per cent threshold, the FPI has the option to divest such holding within five trading days. Alternatively, the investment is (1) classified as FDI and the FPI or its investor group would be prohibited from making any further portfolio investment in such investee company; and (2) required to comply with all conditions and rules associated with FDI, such as the pricing guidelines and reporting obligations.

In addition to the above, the cap for aggregate holdings of all FPIs collectively in a particular Indian investee company has been recently increased up to the sectoral caps applicable to the Indian investee company. However, for sectors where FDI is prohibited the aggregate cap for FPI stands at 24 per cent.

The pricing of equity instruments for foreign portfolio investments is determined as follows: (1) in the case of a public offer, the price of the equity instruments is required to be not less than the price offered to the residents of India; and (2) in the case of private placement, the pricing either has to be in accordance with the guidelines prescribed by SEBI or the fair value.

Where an FPI holds equity shares in an unlisted company and continues to hold such shares after such company lists its shares, the FPI’s holdings are subject to lock-in for the same period as is applicable to shares held by an FDI investor placed in a similar position according to the extant applicable laws.

Impact of covid-19

Despite the economic turmoil and slowdown caused by the covid-19 pandemic, deal activity in India witnessed a substantial increase compared to the pre-covid period. The most significant impact of the pandemic on Indian foreign investment has been the changes introduced under Press Note 3 (2020 Series) (PN#3) issued by the DPIIT on 17 April 2020.

Introduced with the intent of ‘curbing opportunist takeovers/acquisitions of Indian companies due to the current COVID-19 pandemic,’^[11] the PN#3 was issued promptly after the announcement of the People’s Bank of China raising its stake in HDFC Bank Limited, one of the largest private Indian banks, from 0.8 per cent to 1.01 per cent, between January 2020 and March 2020, at a time when the value of these shares was sliding on account of the covid-19 pandemic.^[12]

Pursuant to the PN#3, any investment by an entity of a country sharing its land border with India (i.e., Afghanistan, Bangladesh, Bhutan, China (including Hong Kong), Myanmar, Nepal and Pakistan) (‘neighbour countries’) or where the beneficial owner of an investment into India is situated in or is a citizen of any neighbour country may be made only with prior approval of the Indian government.^[13]

The requirement to obtain prior government approval is regardless of the sector or activity of the Indian investee company. Further, the term ‘beneficial owner’ has not been defined under the PN#3 and as such, at present there is no formal guidance on the quantum of shareholding that would qualify as beneficial ownership under the PN#3.

The approval process is extensive and entails a security clearance of the investor entity by the Indian government. Consequently, the approval process has been time-consuming and as such, even after over two years since the issuance of the PN#3, as at 29 June 2022, the Indian government had approved only 80 proposals out of the total of 382 applications received by it.^[14]

Similar changes in other statutes

Subsequent to the issuance of the PN#3, the Indian government has introduced similar amendments in other statutes:

• The Ministry of Finance, Department of Expenditure, Public Procurement Division, under its order dated 23 July 2020 imposed certain restrictions on entities from the neighbour countries participating in public procurement contracts in India, pursuant to which they are, inter alia, required to obtain prior registration with the registration committee constituted by the DPIIT.
• The Ministry of Corporate Affairs has also introduced a few amendments to the Indian company law and the rules thereunder, which, inter alia, require:
  • nationals of the neighbour countries to obtain security clearance from the Ministry of Home Affairs (MHA) prior to being appointed directors of an Indian company;
  • every transferee and first directors as well as subscribers of the charter documents is to provide a declaration in the securities transfer form (Form SH–4 and Form INC-9 respectively) that they do not require the prior approval of the Indian government for such investment, and if they do, a copy of such approval is required to be annexed to the relevant form; and
  • the Indian investee company is not to make an offer or invitation of securities by way of private placement to any body corporate incorporated in, or to any national of, neighbour countries, in the absence of an approval obtained by such investor from the Indian government.

Review process

All proposals for FDI in sectors or activities falling under the government route are required to be filed online, along with the requisite supporting documents, on the Foreign Investment Facilitation Portal (FIFP), which is a single point interface of the Indian government for investors that is administered by the DPIIT.

With the intent of simplifying the approval process for FDI, the Ministry of Commerce and Industry, DPIIT, issued a standard operating procedure, dated 9 November 2020 (SOP) setting out the guiding principles with respect to the procedure, steps and timelines for the approval process. The SOP recognises the relevant administrative ministries and departments for the respective sectors in which FDI is proposed (‘competent authority’).

Once the application is filed by the applicant with the FIFP, the DPIIT identifies and transfers the application to the relevant competent authority, depending on the sector. For instance, applications for FDI in the mining sector would be transferred to the Ministry of Mines and in the broadcasting, print media and digital media sector would be transferred to the Ministry of Information and Broadcasting. However, investments attracting the PN#3 would be transferred to the competent authority, as may be identified by the DPIIT.

In addition to the competent authority, the application is also sent by the DPIIT to the RBI, for its comments from the perspective of the FEMA Regime, and the Ministry of External Affairs (MEA) for its information and comments, if any. Further, certain proposals that are considered critical from the perspective of national security also require security clearance from the MHA; these include investments in broadcasting, telecommunication, satellites (establishment and operations), private security agencies, defence, civil aviation and applications arising out of the PN#3.

In addition to the above, proposals involving FDI in excess of 50 billion rupees also require clearance of the Cabinet Committee of Economic Affairs.

With respect to approximate timeline for the approval process, while the SOP prescribes an indicative timeline of eight to 12 weeks from the date of submission of the application, the effective time taken for disposal of the application is generally longer and could take approximately six to nine months. This is primarily attributable to the level of scrutiny involved and the interplay between several departments and ministries in the decision-making process. Furthermore, the indicative timeline does not factor in the time spent seeking and receiving responses to clarifications or requests for additional documents from the applicant by the relevant competent authority.

Conditions

To enable the RBI to effectively administer foreign investment in India, the elaborate legislative framework curated under the FEMA Regime, at the outset, prescribes several obligations and requirements on all parties involved such as the investor or transferee, transferor and the issuer or investee company. These include:

• Reporting obligations: as explained above, every FDI related transaction is required to be reported to the RBI within the prescribed timelines, and every Indian company that has received FDI is required to file an annual return with the RBI.
• Pricing guidelines: as indicated above, the pricing guidelines ensure that a non-resident does not acquire equity instruments at a price that is lower than their fair value; or sell or transfer equity instruments to a resident at a price above the fair value.
• Geographical restrictions: in addition to the PN#3 foreign nationals from neighbour countries are required to obtain security clearance for being appointed as a director of an Indian company; Indian company law also requires at least one director of an Indian company to be an Indian resident.^[15] Appointment of key designations such as managing director, manager or full-time director needs to be approved by the Indian government if the position is not being held by an Indian resident.^[16]
• Attendant conditions: the FEMA Regime prescribes certain set conditions required to be fulfilled for FDI in identified sectors. Examples of such sectors and the associated conditions are provided below.

Defence

While FDI up to 100 per cent is permitted in the defence sector, only 74 per cent is permitted under the automatic route for companies seeking a new industrial licence. Consequently, investments beyond 74 per cent require the prior approval of the Indian government. Several conditions have been prescribed with respect to investments in this sector, which include:

• the application for grant of a licence to be reviewed by DPIIT, the Ministry of Commerce and Industry in consultation with the Ministry of Defence and the MEA;
• investments in this sector is subject to security clearance by the MHA; and
• the investee company receiving the FDI is to be structured to be self-reliant in terms of designing and development of the products. The investee company or the joint venture, as the case may be, is also to provide for maintenance and life cycle support facility for the products manufactured or developed by it in India.

Insurance

The sectoral cap for FDI in the insurance sector is 74 per cent, which falls under the automatic route. However, the conditions required to be fulfilled for FDI in this sector, inter alia, include:

• investment in this sector is subject to compliance with the provisions of the Insurance Act, 1938, and the investee company needs to obtain the necessary licence or approval from the Insurance Regulatory and Development Authority of India (IRDAI) for undertaking insurance and related activities;
• an Indian insurance company receiving foreign investment requires (1) at least one among the chairperson of its board, its managing director and its chief executive officer, (2) the majority of its key management persons; and (3) the majority of its directors, to be resident Indian citizens; and
• an Indian insurance company receiving foreign investment must comply with the provisions of the Indian Insurance Companies (Foreign Investment) Rules, 2015 (as amended from time to time) and applicable rules and regulations notified by the Department of Financial Services or the IRDAI from time to time.

Pharmaceuticals

FDI up to 100 per cent under the automatic route is permitted in greenfield projects, while under brownfield projects, FDI is permitted only up to 74 per cent under the automatic route, with investments beyond 74 per cent falling under the government route. FDI in the pharmaceutical sector is subject to certain conditions such as (1) non-compete provisions not being allowed (except under exceptional circ*mstances with government approval); and (2) the non-resident and the investee brownfield pharmaceutical company to furnish a certificate setting out the inter se agreements between them.

The other sectors and activities in relation to which such specific conditions have been prescribed include mining, broadcasting, print media, civil aviation, construction and development of townships, housing, built-up infrastructure, cash and carry wholesale trading, e-commerce, multi-brand retail trading, railway infrastructure, asset reconstruction companies, banking and credit information companies.

• General approval conditions: in addition to the conditions prescribed under the FEMA Regime, the RBI or competent authority tend to impose certain common conditions on granting an approval under the government route. These may include conditions in relation to:
  • tax: any form of tax relief claimed by foreign investors under the Indian tax laws or the relevant double taxation avoidance agreements is to be subject to a separate examination by the relevant tax authorities;
  • environment: adequate anti-pollution measures are to be adopted including adoption of measures to monitor effluent and emissions in accordance with applicable standards;
  • compliance with other laws: depending on the sector of the investee entity, the proposed investment must be in compliance with applicable laws including those related to anti-money laundering, central or state environmental laws including local zoning, land use laws and import policy; and
  • board composition: it has also been observed that the government provides a conditional approval directing the non-resident investor who acquired a minority stake in the investee company not to control the majority of the board composition. The actual control of the board must be retained by the resident promoters or shareholders.
• Sectoral regulation: in addition to the stipulations prescribed under the FEMA Regime as illustrated above, the relevant sectoral regulators may impose additional conditions. For instance, in transactions involving investment in the insurance sector requiring approval of IRDAI, conditions such as a lock-in for a period ranging up to five years on the investor’s investment are common.

Penalties and rectification measures

For any contravention under the FEMA Regime or approvals granted by the RBI, the contravener may, upon adjudication, be liable to a penalty of up to three times the amount involved in the contravention. Where the amount involved is not quantifiable, the penalty may extend up to 200,000 rupees. Separately, for any contravention that continues beyond the first day, an additional penalty of 5,000 rupees for each day of delay may also be payable by the contravener.

However, in order to mitigate transaction costs, and rectify contraventions in a time-effective manner, a contravener could opt for a process known as compounding in lieu of the aforementioned adjudication process. Compounding is a voluntary process in which an individual or a corporate seeks remediation of an admitted contravention by payment of the requisite penalty as determined by the Director of Enforcement, RBI. A compounding process can be undertaken only after all the necessary administrative action has been completed, by way of obtaining post facto approvals or unwinding the transactions, where such transactions are not permissible. The FEMA Regime requires the compounding process to be completed within 180 days from the date of receipt of the compounding application by the authority. A contravention that has been compounded cannot be the subject matter of any separate or future adjudication by the RBI.

In relation to contraventions associated with a delay in adhering to the reporting obligations, the contravener has the option to make the relevant filings by payment of a late submission fee computed on the basis of the calculation matrix set out under the FEMA Regime. All other contraventions under the FEMA Regime would have to be compounded or adjudicated, as set out above.

Practical insights

India has in place a fairly extensive framework for regulating foreign investments, with guidelines ranging from pricing to sector-specific caps and conditions. Building on this framework, the Indian government has taken multiple steps to streamline and liberalise the process of foreign investment, which includes allowing 100 per cent investments in the majority of sectors and introducing a unified portal for reporting of foreign investment transactions.

Investors should understand and carefully analyse the relevant provisions as well as several other factors before making any investment in India. These factors include the growth potential in the relevant sector, degree of regulatory supervision and communication with regulators in conducting of business, state-specific incentives for establishing businesses in particular locations and the requirement to obtain approval for foreign investment from the RBI or the Indian government. In light of this, a single window clearance system has been established by certain states wherein an investment facilitation centre is available to assist investors with their foreign investment process in these states.

Approval requirements and communication between regulators is an important aspect to consider in the context of transaction timelines and needs to be appropriately factored into the structure and design of documentation for any transaction. For example, foreign investment transactions under the government route that contemplate a merger, demerger or amalgamation involve an additional layer of approval from the National Company Law Tribunal or relevant authority under the applicable statute, prior to obtaining an FDI approval under the FEMA Regime. Similarly, in the case of transactions that are required to be notified to the Competition Commission of India, the notification process is required to be completed prior to obtaining the FDI approval, since failure to notify the transaction may attract significant penalties.

It is also pertinent to note that FDI approvals are discretionary. Information in relation to previous approvals or rejections is not freely available in the public domain, which results in a lack of information and a degree of uncertainty which prospective investors should be mindful of in their comprehensive risk assessment of the transaction.

Therefore, a clear understanding of the applicable framework and assessment of the aforementioned factors is integral prior to making foreign investment in India.

Notes