This article on FDI is written by Lalrinngheti Sangsiama, pursuing M.A. in business law from NUJS, Kolkata.
What is FDI?
In recent years FDI has become a major source of transfer of money between countries both developed and developing. FDI stands for Foreign Direct Investment. This is when an investor (a company or an individual) invests in a foreign business by “establishing business operations or acquiring business assets, such as ownership or controlling interest in a foreign company.” The growth of FDI has been due to the good investment climate in most developing countries, high corporate profits, rising stock market valuations, ownership rules being liberalised around the world, low-interest rates and so on. FDI has been proven to withstand economic crisis while continuing to boost national savings which is why most countries seek to increase their FDI. The benefits of FDI are improved quality of goods, provide employment and increase in investments in market supply chains.
FDIs are different from portfolio investments which is where an investor merely buys the foreign company’s equities. FDIs, on the other hand, are marked by the investor’s control or substantial influence over the foreign company. Important to note is also the difference between foreign direct investment and an indirect foreign investment. FDI is the physical investment made over a foreign company, its factories, equipments, etc in contrast to an indirect investment which is the investment on foreign stock exchange.
FDIs occur in open economies where the workforce is skilled and the investor has good prospects of growth so FDIs are unlikely to flourish in tightly regulated economies. FDIs commonly take horizontal, vertical and conglomerate forms. A horizontal FDI is when the investor operate the same kind of operation in the foreign country as it does in its home country, for example, a UK based clothing company opening its stores in India. A vertical FDI is when the investor establishes or acquires a related business in a foreign country, for example, a US tire company acquiring an interest over a rubber company in India to supply its raw materials. A conglomerate FDI occurs when an investment is made on a foreign company that has no relation to the investor’s existing business. This kind of investment usually takes the form of a joint venture since the investor lacks experience in the field.
There are two types of FDI: inward FDI and outward FDI which represents the flow of money. Inward FDI happens when foreign capital is invested in local resources. This results in tax breaks and low-interest rates. Outward FDI is the opposite flow of inward FDI and is also called “direct investment abroad”. This net inflow is also called the “stock of foreign direct investment” and it represents he cumulative number for a given period. FDI does not include the purchase of shares, it is an of international factor movements.
Advantages and Disadvantages
In the matter of FDIs, the advantage or disadvantage depends on perspective. Ideally, the investment should be beneficial to both investor and foreign country. For the investor, (a firm that participates in FDI becomes a Multinational Corporations (MNCs) or Multinational enterprises (MNEs)), advantages include access to markets, access to resources reduces cost in production. Disadvantages include outsourcing of jobs to foreign countries which meant that the investor’s home country does not reap the benefits. Regardless, businesses have a competitive advantage because investors consistently look to create profit with the least risk thereby decreasing the effects of politics, bribery and cronyism.
Advantages for foreign countries are that FDI offers a source of external capital and increased revenue which can lead to economic development. It creates an increase in jobs which may lead to the creation of even more jobs and businesses as foreign money is being pumped into the country. Moreover, tax revenue is generated from the products and activities of the factory which the country can use to create and improve its economic infrastructure. On the other hand, countries create closed economies for fear of economic imperialism and undue influence from other countries. The way that some countries like USA deal with this is to have an open economy for most industries but a closed one for strategically important industries. The other disadvantage can be that investors can sell the unprofitable parts of the company to local, less savvy investors and use the collateral of the business to get loans that are local and low cost.
Tracking FDI Statistics
All countries and relevant businesses keep track of FDI statistics but the most important reports are from
- The Global Investment Trends Monitor which is published by the United Nations Conference on Trade and Development (UNCTAD)
- The Organization for Economic Cooperation and Development (OECD) releases the inflows and outflows of developed countries
- The IMF publishes the Worldwide Survey of Foreign Direct Investment Positions
The “data on FDI flows are presented on net bases (capital transactions’ credits less debits between direct investors and their foreign affiliates). Net decreases in assets or net increases in liabilities are recorded as credits, while net increases in assets or net decreases in liabilities are recorded as debits. Hence, FDI flows with a negative sign indicate that at least one of the components of FDI is negative and not offset by positive amounts of the remaining components. These are instances of reverse investment or disinvestment.”
The Organization for Economic Cooperation and Development (OECD) established a minimum threshold of 10% ownership to form a controlling interest over a foreign company. However, this threshold only applies to the 34 member countries of the OECD. India has a different threshold for different industries.
FDI in India
India is ranked the top 10 countries for attractive investments making it one of the fastest growing economies in the world. As quoted from the Economic Times on 4th December 2016, “India crossed the $300 billion foreign direct investment (FDI) milestone between April 2000 and September 2016, firmly establishing its credentials as a safe investment destination in the world.” The Commerce and Industry Minister, Nirmala Sitharaman reported that FDI inflows to remain robust in 2017 as well. The highest FDI in India was in February 2008 of $5670 million (USD) and its lowest in February 2014 of $ -60 million (USD).
FDI is important for India in order to fund its infrastructure growth. It is estimated that around $1 trillion worth of investments in needed so the liberalisation of policy framework has been a huge help through programmes such as Make in India, Digital India and Skill India. In the process, India has opened up many sectors for FDI and simplified its conditions for FDI to make it easier for investing businesses. FDI in India is however, not permitted in the arms and ammunition sector, atomic energy sector, railway transport sector, the coal and lignite sector and a few others. Much of India’s outbound FDI flow is because of the scarcity of resources in India, for example, Tata Steel has coal assets in Indonesia.
Briefly, the economic reform in India has been known to be seen in three phases. The first phase was between 1985-1990 consisting of reforms introduced by Prime Minister Mr. Rajiv Gandhi in 1985 who wanted to improve productivity, absorb modern technology and utilise capacity fully. These goals, however, were not reached with his approach and the balance of trade deficit narrowed down instead of increasing.The second phase came with the Congress Government, on June 21, 1991, which adopted a number of stabilization measures that were designed to restore internal and external confidence. The Government put policies with a strategy to reduce fiscal imbalance. During this time, Finance Minister Dr. Manmohan Singh introduced Liberalisation, Globalization and Privatization (LPG) model of development which was highly successful in introducing domestic changes. The third phase is now with the liberalisation of the market under the Foreign Exchange Management Act 1999(FEMA). The economic reform in India is also commonly divided into two parts: the Pre-liberalisation period and the Post-liberalisation period.
The Foreign Exchange Regulation Act of 1973 (FERA) once dictated the terms of FDI in India and was very controversial throughout its 27 years of use as many Indian corporations were found breaching the law by the Enforcement Directorate (ED). Any FERA offence was criminal offence liable to imprisonment. The Indian government policy towards foreign capital was very selective. under FERA. Foreign investment was normally allowed only in high technology industries in priority areas and in export-oriented areas. So the inflow of FDI before 1990’s was very low. FERA’s draconian rules gave India a rather closed economy and it became incompatible with India’s pro-liberalisation policies so it was replaced by the Foreign Exchange Management Act 1999(FEMA). FEMA’s new management regime is consistent with the World Trade Organisation (WTO) framework. The main difference between FERA and FEMA is that under FERA, the old law, “nothing was permitted unless specifically permitted”. During the pre-liberalisation period under FERA, there was a lack of adequate infrastructure in India, stringent labour laws, corruption, lack of decision making authority with the state governments, high corporate tax rates, indecisive government and political instability. All these factors that reduced FDI chances for India are being dealt with as the country matures by stabilising policies, building basic infrastructure and so on.
Recent Policy Measures
Some of the key policy changes that have impacted India’s investment flows:
- Reserve Bank of India Notification No. FEMA.40/2001RB; 2 March 2001
a) The three years profitability condition requirement has been removed for Indian companies making overseas investments under the automatic route
b) Overseas investments are opened to registered partnership firms and companies that provide professional services. The minimum net worth of Rs. 150 million for Indian companies engaged in financial sector activities in India has been removed for investment abroad in financial sector
- Reserve Bank of India Notification No. FEMA.49/2002RB; 2 March 2001
a) An Indian party which has exhausted the limit of $100 million in a year may apply to the Reserve Bank of India for a block allocation of foreign exchange subject to such terms and conditions as may be necessary
- Reserve Bank of India Notification No. FEMA.49/2002RB; 19 January 2002
a) Indian companies in Special Economic Zones can freely make overseas investment up to any amount without the restriction of the $100 million ceiling under the automatic route, provided the funding is done out of the Exchange
Earners Foreign Currency Account balances
- Reserve Bank of India Notification No. FEMA.53/2002RB; 1 March 2002 and FEMA.79/2002RB;10 December 2002
a) The annual limit on overseas investment has been raised to $100 million
- Reserve Bank of India Notification No. 83/RB 2003; 1 March 2003
a) Indian companies can make overseas investments by market purchases of foreign exchange without prior approval of the Reserve Bank of India up to 100% of their net worth; up from the previous limit of 50%
- In the fiscal year 2003-2004
a) Indian firms are allowed to undertake agricultural activities, which was previously restricted, either directly or through an overseas branch
- In 2005, banks were permitted to lend money to Indian companies for acquisition of equity in overseas joint ventures, wholly owned subsidiaries or in other overseas companies as strategic investment.
- In 2006, the automatic route of disinvestments was further liberalized. Indian companies are now permitted to disinvest without prior approval of the RBI in select categories.
- In 2007, the ceiling of investment by Indian entities was revised from 100 per cent of the net worth to 200 per cent of the net worth of the investing company under the automatic route of overseas investment.
- The aggregate ceiling for overseas investment by mutual funds, registered with SEBI, was enhanced from US$ 4 billion to US$ 5 billion in September 2007.
- Registered Trusts and Societies which have set up hospital(s) in India have been allowed in August 2008 to make investment in the same sector(s) in a JV/WOS outside India, with the prior approval of the Reserve Bank.
The Department of Industrial Policy and Promotion Ministry of Commerce and Industry published the “Consolidated FDI Policy” which is effective from June 2016 which lists out sectors that requires Government approval such as defence, print media, air transport service, etc.
The Consolidated FDI Policy also lists out sectors that are under automatic route such as agriculture, plantation sector, duty-free shops, etc.
Types of Investors
There are three main types of investors in India: an individual, a company or foreign institutional investors. Individuals may consist of FVCI (Foreign Venture Capital Investors), pension/provident fund and financial institutions. Companies can be in the form of foreign trust, Sovereign Wealth Funds or NRIs (Non-Resident Indians)/ PIOs (Persons of Indian Origin). And finally, Foreign Institutional Investors may be through Private Equity Fund, Partnership / Proprietorship Firm and Others.
Bodies constituted for FDI
- Foreign Investment Promotion Board (FIPB)
- Foreign Investment Promotion Council (FIPC)
- Foreign Investment Implementation Authority (FIIA)
- Secretariat for Industrial Assistance (SIA)
Methods of FDI
The three routes for FDI in India is through automatic approval by the RBI, through the FIPB route and finally, through the CCFI Route.
There are many entry structures in which Foreign Direct Investments can be made in India:
- Incorporate a company in India: private or public limited company/ wholly owned & joint ventures
- Limited liability partnerships: For sectors that have 100% FDI automatic route
- Sole proprietorship/partnership firm: Subject to RBI approval.
- Extension of foreign entity: Liaison office, Branch office (BO) or Project Office (PO) subject to RBI approval
- Other structures such as Not for Profit companies, etc.
The steps involved in investment as neatly summarised by Make in India website are:
- Identification of structure
- Central Government approval if required
- Setting up or incorporating the structure
- Inflow of funds via eligible instruments and following pricing guidelines
- Meeting reporting requirements of RBI and respective Act
- Registrations/obtaining key documents like PAN etc.
- Project approval at State/UT level
- Finding ideal space for business activity based on various parameters like incentives, cost, availability of manpower etc.
- Manufacturing projects are required to file Industrial Entrepreneur’s Memorandum (IEM), some of the industries may also require industrial license.
- Construction/renovation of unit.
- Hiring of manpower.
- Obtaining licenses if any.
- Other state & central level registrations.
- Meeting annual requirements of a structure, paying taxes etc.
As mentioned earlier in the disadvantages and advantages section above both investor and the foreign country, in this case India, have to be wary of where the benefits are going. Repatriation is the process of ‘taking profits back home’ is subject to the laws and regulations of India for breach of which will incur penalties on the investor. India has policies on Repatriation of Dividends, Capital and interest. Dividends are freely repatriable without any restrictions (net after tax deduction at source or Dividend Distribution Tax and Interest on fully, mandatorily & compulsorily convertible debentures is also freely repatriable without any restrictions (net of applicable taxes). For repatriation of capital, an “Authorized Dealer(AD) Category-I bank can allow the remittance of sale proceeds of a security (net of applicable taxes) to the seller of shares resident outside India, provided the security has been held on repatriation basis, the sale of security has been made in accordance with the prescribed guidelines and NOC / tax clearance certificate from the Income Tax Department has been produced. Investments are subject to lock-in period of 3 years in case of construction development sector.”
Investors have to pay tax on their net income in India. The rates of taxes depends on the structure of investment.
For an incorporated company in India, a 30% tax+surcharge+education cess on net income earned is required along with a deduction on profits distributed @15.5%+surcharge+education cess.
A Branch office/ Project office/ Liaison office or permanent establishment has to pay 40%+surcharge+education cess but there is no tax on profits distributed.
Limited Liability Partnerships (LLPs) have to pay tax @30%+surcharge+education cess with no tax on profits distributed.
Indian tax law requires a Minimum Alternate Tax (MAT) of 18.5%+surcharge+education cess where the tax payable according to the regular tax provisions is less than 18.5% of their book profits. However MAT credit (MAT-actual tax) can be carried forward in next 10 years for set-off against regular tax payable during the subsequent years subject to certain conditions.
To draw investors to India, the Central Government provides various incentives such as exports incentives like duty drawback, duty exemption/remission schemes, focus products & market schemes etc and sector specific incentives like Modified Special Incentive Package Scheme(M-SIPS) in electronics. In the same way, each State Governments have their own incentives such as stamp duty exemption for land acquisition, refund or exemption of value added tax, exemption from payment of electricity duty etc.
Incentives also depends on India’s tax treaties with certain countries. For example, 33% of FDI comes through Mauritius because of India’s double taxation avoidance treaty with Mauritius. The other big investors in India are from Singapore, US, UK and the Netherlands.
For more information
Investment related queries can be registered in www.investindia.gov.in and more on FDI can be found on the Department of Industrial Policy and Promotion website (http://dipp.nic.in/English/Investor/FDI_Policies/FDI_policy.aspx) and the Make in India Website (http://www.makeinindia.com/home)