NEW ODI REGIME | EFFECT ON CROSS BORDER STRUCTURING

NEW ODI REGIME | EFFECT ON CROSS BORDER STRUCTURING

Following the overhaul of the foreign investment regime through introduction of the non-debt instrument rules, Ministry of Finance also attempted to overhaul the overseas investment regime. On August 22, 2022, Ministry of Finance notified: (a) Foreign Exchange Management (Overseas Investment) Rules, 2022 (“OI Rules”) in supersession of the earlier regime, i.e. (i) the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004; and (ii) the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015 (together “Old ODI Regime”).

Immediately thereafter, the Reserve Bank of India (“RBI”) also notified Foreign Exchange Management (Overseas Investment) Regulations, 2022 and Foreign Exchange Management (Overseas Investment) Directions, 2022. (collectively, and along with OI Rules, “New ODI Regime”).

While the New ODI Regime brought about significant changes, the most critical revision for the new age Indian businesses has been legitimisation of round tripping transactions and permitting cross border corporate structuring.

Restrictions under Old ODI Regime

Among the new age Indian businesses, while likes of Flipkart and PhonePe pioneered cross-border holding structures through flipping their existing mature structures and re-establishing their holding companies in Singapore, new set of start-ups are exploring foreign holding company structures from the get-go.

Although tax concerns are one of the primary motivations for setting up a base abroad, access to global markets and a deeper funding pool also play significant role in motivating Indian businesses to explore cross border corporate structures1.

Under the Old ODI Regime, an Indian company was not permitted to re-structure its operations and establish a foreign holding structure if the resultant foreign entity becomes the holding company and the existing Indian company, or any other Indian entity becomes subsidiary of such foreign holding company2.

This, basically, was the ‘round-tripping prohibition’ under the Old ODI Regime. Essentially, round tripping involves a structure in which an Indian entity invests in an offshore entity which further invests, or already has investments, in India.

Round tripping restrictions were further clarified by RBI through a response to the set of frequently asked questions, which was released by RBI in 2019. The response clarified that the Old ODI Regime does not permit an Indian entity to set up subsidiary(ies) through its foreign wholly-owned subsidiary (WOS) or joint venture (JV) nor does the Old ODI Regime permit an Indian entity to acquire a WOS or invest in a JV abroad that already has direct or indirect investment in India. However, in such cases, Indian entities were permitted to approach the RBI for prior approval through their Authorised Dealer Banks which was to be considered on a case-to-case basis, depending on the merits of the case3.

Although the intent of RBI while formulating the round tripping restriction was to avoid tax leakage, it ended up affecting legitimate cross border transactions. For instance, if any foreign investor already had obtained funds or equity investments from Indian entities, such investor could not make legitimate investments, in any form or manner, in Indian entities, without requiring prior approval from RBI. Similarly, Indian entities considering outbound investments required prior RBI approval if the foreign based target entity had any existing investment in India.

Relaxations under New ODI Regime

Keeping the legitimate business interests in mind, the authorities have, through the New ODI Regime, directly addressed the round tripping concern. Under the New ODI Regime, Indian entities and individuals are permitted to undertake financial commitment in a foreign entity that has invested or at any time, thereafter, will invest in India, whether directly or indirectly; provided the resultant structure does not have more than 2 (two) layers of subsidiaries (“Two Layer Limit”)4

New ODI Regime defines subsidiary only in relation to a foreign entity. As per OI Rules5, subsidiary of a foreign entity means an entity in which the foreign entity has control. Additionally, control has been defined to mean6: “the right to appoint majority of the directors or to control management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements that entitle them to ten per cent. or more of voting rights or in any other manner in the entity.”

Effect on Cross Border Structures

Introduction of the Two Layer Limit has legitimised flip structures being undertaken by several new age businesses. Under the New ODI Regime, Indian entities and persons connected to such Indian entities will be able to invest in a foreign entity. This will include investments that result in the relevant foreign entity (that has received investments from India) becoming the holding company and the Indian entity, its subsidiary. Additionally, the said Indian entity will still be permitted to create another layer of subsidiary in India or elsewhere if it business so requires. However, in light of the Two Layer Limit, any further step-down subsidiaries will not be permitted.

Notwithstanding the Two Layer Limit, recognition of round tripping structures will allow globally focussed Indian businesses the option to structure their organisation to meet their business requirements.

While recently several companies such as PhonePe and Razorpay have reversed their cross border structures in light of better valuation prospects on Indian stock exchanges7, considering significant and continued benefits associated with global structures (including mature funding ecosystem and bigger market access), we expect the current preference for cross border holding structures to not only continue but gain steam.

Impact on other legitimate structures

Considering the definition of subsidiary and control, lack of clarity in relation to the Two Layer Limit may impact legitimate transactions of foreign entities involving multiple jurisdictions. For instance, any foreign entity that has received financial commitment from an Indian entity, even if the said commitment consists of minimal amounts, will be covered by the New ODI Regime, for all its global operations. This may impact the investments or business the relevant foreign entity may intend to make as holding even as low as 10% voting stake in any entity or retaining any reserved matter rights (whether in entities based in India or otherwise) could be hit by the Two Layer Limit test.

Conclusion

While relaxation, including in the form of recognising cross border structures and legitimising round tripping transactions is a welcome move, certain clarifications will be further required from RBI to ensure legitimate interests of foreign entities that are not established for cross border structure purpose, is not impacted by the Two Layer Limit under the New ODI Regime, merely because it retains or seeks Indian investments. In this regard, limiting the extent of definition of subsidiary to mean only Indian entities, may also be explored.

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1. https://www.entrepreneur.com/en-in/news-and-trends/why-many-indian-startups-are-headquartered-overseas/429862#:~:text=However%2C%20the%20number%20of%20startups,MindTickle%2C%20among%20a%20few%20others
2. Order from Reserve Bank of India in the matter of Binani Industries Limited, dated June 03, 2016
3. Frequently Asked Questions on Overseas Direct Investments, updated on September 19, 2019
4. Rule 19(3) of OI Rules
5. Rule 2(y) of OI Rules
6. Rule 2(c) of OI Rules
7. https://www.bqprime.com/business/after-phonepe-razorpay-kicks-off-reverse-flipping-process