In this article, Meet Chandresh Kachhy who is currently pursuing M.A. IN BUSINESS LAWS, from NUJS, Kolkata, discusses What structuring advice will you give to an Indian entrepreneur who wants to receive foreign direct investment.

What is Foreign Direct Investment (FDI)

• Businesses need capital to grow, and capital needs to be put to its most optimal use for it to grow, generate returns and create value in the society. It is a simple supply-demand situation where excess capital finds its way to businesses which are in need of capital.
• The situation today is such that a lot of innovation and growth is happening in economies and regions which are deprived of capital, whereas a lot of capital is waiting to be deployed in developed regions where the scope for growth isn’t as much.
• When this surplus capital is invested in business across geographical borders, it is referred to as Foreign Investment in the recipient country. One of the forms of this investment is FDI. Hence, FDI is just another form of investment into growing businesses, albeit coming from outside the country, and hence it is governed by certain rules and regulations.

Foreign investment can come into a country in various forms, but the three predominant forms are as below:

1. Foreign Portfolio Investment (FPI)
   • Refers to any foreign entity which invests in the financial assets of an Indian company, such as stocks, bonds, mutual funds, etc
   • Typically, a FPI investor is not interested in having any operational or management control in the company, but only interested to the extent of making a financial return on its investment
   • As a benchmark, the amount up to which point an investment is considered a FPI is a 10% stake in the investee company
   • This is considered a short term investment, typically done in liquid assets for a purely financial return
2. Foreign Institutional Investment (FII), which is another class of FPI but is done only by institutions registered with SEBI
3. Foreign Direct Investment (FDI)
   • Refers to any investment by a foreign individual or entity into creating or building a business in India, via obtaining a controlling (operating or management) stake in an Indian business
   • It typically refers to an equity stake of more than 10% in the domestic investee company, and could involve setting up a business or investing in assets such as manufacturing facilities, plant & machinery, technology transfer, organizational skills, participating in a joint venture or a merger, re-investment of profits in host country, etc.
   • It has the connotation of a lasting interest in the domestic business, and not just a passing financial investment
   • This is the subject of interest in the present case.

FDI in India

As per the economic survey of 2016-17, India has become of the leading recipients of Foreign Direct Investment, running currently at an annual rate of USD 75 billion, very similar to the kind of amounts China was receiving about a decade ago.

The FDI limits for some key sectors is as follows:

Eligible investee entities

1. Any Indian company can accept FDI and issue capital against it

2. Partnership Firm or Proprietorship

A Non-Resident Indian (NRI) or a Person of Indian Origin (PIO) resident outside India can invest in the capital of a firm or a proprietary concern in India on non-repatriation basis provided

• Amount is invested by inward remittance or out of NRE/FCNR(B)/NRO account maintained with Authorized Dealers/Authorized banks.
• The firm or proprietary concern is not engaged in any agricultural/plantation or real estate business or print media sector.
• Amount invested shall not be eligible for repatriation outside India.

Investments with repatriation option:

• NRIs/PIO may seek prior permission of Reserve Bank for investment in sole proprietorship concerns/partnership firms with repatriation option.
• The application will be decided in consultation with the Government of India.

Investment by non-residents other than NRIs/PIO:

• A person resident outside India other than NRIs/PIO may make an application and seek prior approval of Reserve Bank for making investment in the capital of a firm or a proprietorship concern or any association of persons in India.
• The application will be decided in consultation with the Government of India.

Restrictions: An NRI or PIO is not allowed to invest in a firm or proprietorship concern engaged in any agricultural/plantation activity or real estate business or print media.

3. Trusts

• FDI is not permitted in Trusts other than in ‘VCF’, registered and regulated by SEBI and ‘Investment vehicle’.

4. Limited Liability Partnerships (LLPs)

FDI in LLPs is permitted subject to the following conditions:

• FDI is permitted under the automatic route in Limited Liability Partnership (LLPs) operating in sectors/activities where 100% FDI is allowed, through the automatic route and there are no FDI-linked performance conditions.
• An Indian company or an LLP, having foreign investment, is also permitted to make downstream investment in another company or LLP in sectors in which 100% FDI is allowed under the automatic route and there are no FDI-linked performance conditions.
• FDI in LLP is subject to the compliance of the conditions of LLP Act, 2008.

5. Investment Vehicle

   1. An entity being ‘investment vehicle’ registered and regulated under relevant regulations framed by SEBI or any other authority designated for the purpose including Real Estate Investment Trusts (REITs) governed by the SEBI (REITs) Regulations, 2014, Infrastructure Investment Trusts (InvIts) governed by the SEBI (InvIts) Regulations, 2014, Alternative Investment Funds (AIFs) governed by the SEBI (AIFs) Regulations, 2012 and notified under Schedule 11 of Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 is permitted to receive foreign investment from a person resident outside India (other than an individual who is citizen of or any other entity which is registered / incorporated in Pakistan or Bangladesh), including an Registered Foreign Portfolio Investor (RFPI) or a non-resident Indian (NRI).

6. FDI in other Entities FDI in resident entities other than those mentioned above is not permitted.

Sectoral Rules for FDI

Foreign Direct Investment into an Indian entity can be done by individuals and/or entities. As far the FDI policy is concerned, it treats individuals and body corporate/partnerships the same with regards to the FDI policy. Any foreign investment in an Indian entity will be governed by the latest FDI policy circular (http://dipp.nic.in/English/Policies/FDI_Circular_2016.pdf). The said circular defines in very clear terms the amount of foreign shareholding allowed, the mode of investment, and the definition of a non-resident investor.

1. Amount of foreign shareholding allowed
   • The government of India has defined the maximum thresholds of the foreign shareholding allowed in various sectors of industry.
   • For example, the government allows 100% FDI in ‘non-news and current affairs’ television channels, but only 49% in ‘news and current affairs’ television channels.
2. Mode of investment: There are two approved modes of FDI into an Indian company
   • Automatic route: Under the automatic route, the investor doesn’t require any approval from the government for its investment. It is possible that a particular sector could have automatic approval up to a certain level of investment, beyond which government approval is required. For example, investment up to 49% stake in any defence undertaking is covered under the automatic route, but government approval is required for investment above 49%
   • Government route: Under the government route, prior approval of the government is required for the investment to go ahead. This approval is provided by a body called the Foreign Investment Promotion Board (FIPB), which comprises of secretaries from ministries of finance, commerce & industries and external affairs.
3. Definition of foreign investment
   • Foreign investment into an Indian company includes both direct and indirect foreign investment.
   • Direct investment means investment which has come from a non-resident entity directly into the target resident entity
   • Indirect foreign investment means that investment which has come from a non-resident entity into a resident entity, which then further invests into the target resident entity.
     • If the investing resident entity is such that even after the non-resident investment, it is still owned and controlled by an Indian person/entity, then downstream investment into the Opco will not be considered as a foreign investment

So any decision about the proposed structure of the entity accepting the FDI will first have to be filtered through the above-described FDI rules and regulations.

What is the optimal structure to attract FDI?

FDI into LLP Structure

An LLP structure could be a very attractive option for the entrepreneur and the investor, as long as it would operate within the constraints described above with respect to FDI into LLPs

FDI into a Company

In light of the above rules governing FDI into an Indian company, there are various options to structure the business depending on the level of FDI planned for and the kind of business the company is in. Below we look at some of the options and discuss their suitability for different kinds of businesses.

Let us define two entities first, Hold-Co (Holding Company), and Op-Co (Operating Company).

1. FDI into the main operating company

   • The FDI comes into the entity which is conducting the underlying business, also known as the Op-co or the Operating Company
   • This means that the underlying business of the Op-Co should be such that it is eligible to receive FDI in the first place, as the respective sectoral & modal restrictions will apply
   • This structure will work best when the underlying business of the Op-Co is one where the extant FDI policy allows up to 100% FDI under the automatic route.
   • The promoter must note that once the FDI crosses 50%, the company becomes classified as a foreign company, and hence will be liable to pay taxes at a higher rate of 40%, and any downstream investment by the company will be considered FDI
   • From an operational perspective, this structure will have a lot of compliances as any FDI coming in at this level will be governed by the extant FDI regulations as well as all the required RBI filings

2. FDI into an operating Hold-co, with Op-co as a subsidiary of the Hold-Co

   • The FDI comes into a holding company, or Hold-Co, which holds the Op-co as a subsidiary. It is critical that the Hold-Co has some business operations and is not a pure investment vehicle Hold-Co
   • This is one of the most flexible structures as the Hold-Co can have FDI upto 49% while continuing to be classified as a domestic entity. This allows the Hold-Co to invest downstream as a domestic entity, without any restrictions
   • In such a structure, the underlying business of the venture can be split into a regulated portion, and an unregulated portion which would sit in the Hold-Co
   • Once the Hold-Co receives FDI under the automatic route, as long as the FDI at Hold-Co level remains < 49%, it will be able to make any investment downstream like a domestic company.
   • This structure only makes sense where parts of the underlying business can be separated, and are treated differently under the extant FDI regulations
   • For example, if a company has a news broadcasting-cum-website business, then the website / digital business can be taken into the Hold-Co, which would have a subsidiary housing the news broadcasting business
     • Digital and website businesses do not have any restrictions on FDI limits or mode of approval, essentially allowing up to 100% under automatic route, while news uplinking businesses have an FDI limit of 49%, which also requires government approval
     • As long as the FDI in Hold-Co remains < 50%, the Hold-Co continues to be classified as a domestic company. This allows the Hold-Co to attract FDI at the parent level, and then invest downstream into the new uplinking businesses, as a domestic parent, without any restrictions.
   • Operationally, this structure provides the most flexibility as once FDI has come into the company, and as long as it remains < 50%, there is complete flexibility on usage of funds downstream, without any regulatory requirements
   • Once the FDI in Hold-Co > 50%, then the Hold-Co is classified as a foreign entity, and any downstream investment by the Hold-Co will be treated as FDI
   • A drawback of this structure is that any FDI will have to come at Hold-Co level, thus making it difficult for potential investor to make targeted investments into specific subsidiary businesses

3. FDI into a pure Hold-co, with Op-co as a subsidiary of the Hold-Co

   • The FDI comes into a Hold-Co, which is essentially a pure investment vehicle Hold-Co
   • In such a structure, the Hold-Co is classified as an NBFC, in which FDI is allowed up to 100%, but only via government approval
   • Also, any downstream investment will be treated as an indirect FDI, and hence any sectoral FDI restrictions applicable to the subsidiary will be triggered, regardless of the extent of FDI at the Hold-Co. Hence, there is no flexibility at the Hold-Co level with regards to usage of funds downstream
   • Additionally, since the Hold-Co will be classified as a NBFC/CIC, it will need to get a NBFC CoR and all the NBFC compliances and restrictions will apply as well
   • The only benefit of this structure is that it allows a single platform for any investor to come in, especially when the business of the company can be split into multiple subsidiaries, and investors are interested in different parts of the businesses
     • For example, if a company has a news broadcast businesses, a news website and a newspaper, then any investor who is interested only within one or two of these businesses, will prefer a structure where a pure Hold-Co has 3 subsidiaries each housing a different businesses, and each investor can pick and choose which subsidiary to invest in
   • Operationally, this can be a challenging structure as each time FDI comes in, the Hold-Co will have to clearly specify the exact downstream investment use, and seek relevant approvals depending on the sectoral rules applicable to the downstream investment

4. Foreign investment into a pure investment company

   • Foreign investment into a company engaged only in the activity of investing other Indian business entities, will require prior Government approval for any amount of investment
   • These companies, which are classified as CICs under the RBI, will have to follow all relevant RBI compliances
   • For undertaking activities which are under automatic route and without foreign investment linked performance conditions, Indian company which does not have any operations and also does not have any downstream investments, will be permitted to have infusion of foreign investment under automatic route
   • However, approval of the Government will be required for such companies for infusion of foreign investment for undertaking activities which are under Government route, regardless of the amount or extent of foreign investment.
   • Whenever such a company decides to make downstream investments, it will have to comply with the relevant sectoral conditions

Which structure is best suited from a Returns perspective?

One of the main reasons for new businesses to be formed, and invested into, is that the promoters and investors are looking to make outsized returns from betting big at an early stage into what they believe would be successful businesses of the future. While promoters can often start a venture out of passion for the underlying business, and could even continue doing the same for many years, non-promoter investors are always investing from the perspective of generating returns, either for themselves or for their clients whose money they are managing.

Hence, one of the key points of discussion & negotiation in any such deal is the exit strategy of the business, and the various exit options available to the investors. These options and rights can be materially impacted by the corporate structure of the business. Below, we examine the question at hand and how it will impact the return of capital to the investors:

1. Dividends

   • Once the operating business has paid its income taxes, and subject to the rules governing dividend distribution under the Companies Act 2013, it is free to pay dividends to the Holdco after withholding the dividend distribution tax
   • The above rule is applicable regardless of whether the parent (Holdco) is domiciled in India or abroad
   • In terms of the 3 options applicable to a company, the best option for the investor is option 1 as the other two options (with Hold-Co/Opco structures) will lead to tax leakage on account of dividends being taxed at two company levels

2. Exit via sale/listing of shares

   • This is the primary mode of exit as well as the primary motivation for investors to invest into a business
   • In any exit scenario, having a pure Hold-co structure at the top invariably leads to a valuation discount due the tax leakage inherent in such a structure, so long as the exit is being done at the Hold-co level
     • All the value is created in the underlying subsidiaries, and any return of such value to the ultimate investor will be taxed at two levels (operating company, and Hold-Co)
   • If the intention is to spin-off/exit subsidiaries independent of each other, then the pure Hold-co structure would be more beneficial as it could provide for a clean exit