This article is written by Soumi Ghose who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

Introduction to Foreign Direct Investment and External Commercial Borrowings

Foreign Direct Investment

Since the economic crisis in 1991, India started experiencing economic liberation and Foreign Direct Investment (“FDI”) gained its momentum in the  Indian economy, thereby improved the investment climate in the country. The Government of India for attracting FDI extended incentives in various forms like that of the tax holiday, depreciation allowances, investment tax allowances etc. As a result at present, FDI forms an integral part of India’s economic development as well as considered to be an important monetary source for the country’s economy. In other words, with time, FDI has gained the position of a major driver for Indian economic growth.

Further, in the recent past, the Government of India has also been instrumental in streamlining various laws, rules and regulations in a manner to make India as a country which is undoubtedly considered for “ease of doing business”. The measures undertaken in this regard have resulted in a significant enhancement of FDI inflows in India. Besides being a vital engine of economic growth, FDI is also a major source of non-debt financial capital for India’s economic development. With the changes made in several regulations, FDI is now allowed up to 100% in most of the sectors, however, it stands prohibited in the following sectors even now:

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  • Lottery Business including Government/private lottery, online lotteries, etc.
  • Gambling and Betting including casinos etc.
  • Chit funds.
  • Nidhi company.
  • Trading in Transferable Development Rights (TDRs).
  • Real Estate Business or Construction of Farm Houses.
  • Manufacturing of Cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes.
  • Activities/sectors not open to private sector investment e.g. (I) Atomic energy and (II) Railway operations (other than permitted activities mentioned in entry 18 of Annex B).

It is also worthy to note that in addition to the above, for Lottery Business and Gambling and Betting activities, any form of “foreign technology collaboration” including licensing for franchise, trademark, brand name, management contract is also prohibited. 

External Commercial Borrowings

On the other hand, External Commercial Borrowings (“ECB”), which is a comparatively newer concept in India is regulated by the Reserve Bank of India (“RBI”). In January 2019, the RBI had systematically liberalized the ECB framework in the light of the increase in demand for funds in India and a simplified process of raising debt. ECB is the loan, debt or borrowings by an eligible entity in India for commercial purposes from any recognized entity outside India, shall be in conformance with Reserve bank of India’s (RBI) requirements in terms of certain parameters like:- minimum maturity, permitted and non-permitted end-uses, maximum all-in-cost ceiling. In other words, ECB is such  foreign funding which are in the form of loans, financial lease, Foreign Currency Convertible Bonds (FCCB), Foreign Currency Exchangeable Bonds (FCEB). 

There are various recognised lenders eligible to lend through INR denominated ECB:

(i) International Banks,

(ii) International Capital Markets,

(iii) Multilateral Financial Institutions (such as IFC, ABC etc.)/regional financial institutions and Government-owned (either wholly or partially) financial institutions,

(iv) export credit agencies,

(v) suppliers of equipment,

(vi) foreign equity holders,

(vii) overseas long term investors like – prudentially regulated financial entities, pension funds, insurance companies, sovereign wealth funds, financial institutions located in International Financial Services Centres in India,

(viii) In case of NBFCs – MFI, other eligible MFIs, NPO and NGO, ECB can be availed from overseas organizations and individuals subject to the applicable conditions. Interest on these ECBs shall be taxable in India for the non-resident lenders and the rate of computing tax shall be determined.

Two major regulations which governed these “borrowing” and “lending” between a resident Indian and an external entity i.e the entity outside the jurisdiction of India are as follows:

  1. Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000 (FEMA notification No.- 3/2000-RB).
  2. Foreign Exchange Management (Borrowing and Lending in Rupees) Regulations, 2000 (FEMA notification No.- 4/2000-RB).

On December 17, 2018, RBI, vide its notification, had consolidated both the above Regulations as Foreign Exchange Management (Borrowing and Lending) Regulations, 2018.

The above-mentioned Regulations towards ECB became effective from 16th January 2019. However, as specifically mentioned under Master Direction, ECB can’t be used for the following:

  1. Real estate activities;
  2. Investment in the capital market;
  3. Equity investment;
  4. Working capital purposes, with the permissible exceptions;
  5. General corporate purposes, with the permissible exceptions;
  6. Repayment of Rupee loans,  with the permissible exceptions;
  7. On-lending to entities for the above activities, except in case of ECB raised by NBFCs as given under the Master Direction. 

Under its January 2020 bulletin, RBI confirmed that ECBs are one of the reasons ffor rise in external debt of India in 2018-2019 and first half of 2019- 2020. 

Tax impact on FDI and ECB in India

Like several other countries across the world, India has also revisited its corporate tax rates with a view to bring these tax rates at a competitive edge with other foreign countries and more specifically with the ASEAN region. Indian government continually balanced its desire of offering a competitive tax environment for FDI, with the check to ensure that an appropriate share of domestic tax is collected from multinationals.

Section – 94B was introduced in the Income Tax Act in the Financial Year-2018 with Action Plan 4 of OECD’s Base Erosion and Profit Shifting Project. This provision restricts deduction in respect of expenditure by interest or of similar nature, paid to non-resident associated entities to 30 percent of EBITDA. The provisions do not apply to a banking company and for others, the threshold limit is Rs. 1 crore. Further, interest over 30 percent limit can be carried forward for set-off up to 8 subsequent years.  Any Indian corporate which avails foreign currency loans from related parties are needed to be mindful of the above provisions and properly plan their debt-equity structure in order to avoid any disallowance of excess interest.

As per the recent changes, if any loan is raised in foreign currency from the foreign lender, before July 1, 2020, then the interest payable on such loan shall be at a reduced tax rate of 5 percent and this percentage shall be calculated in addition to the surcharge and education cess, as applicable from time to time as per the provisions of Section 194LC of the Income Tax Act. In the light of this ECB liberalisation, it can be expected that the government is likely to extend the time limit of 2020 also in order to boost the foreign inflows. 

Further, lenders who are the tax residents of those countries with which, India has executed the Double Taxation Avoidance Agreement (“DTAA”), should claim the lower rate of tax on interest income as per the terms and conditions of DTAA and the tax rate is generally ranging between 0-15 percent, if it is derived and beneficially owned by tax resident of respective country.

The regulations in relation to ECB clearly indicates the maximum interest that can be charged. Currently, the limit provided under the ECB framework is the benchmark rate plus a 450 basis point spread. The benchmark rate in the case of foreign currency refers to a 6-month London Inter-Bank Offered Rate (“LIBOR”) rate of applicable borrowing currency and for rupee loans, it refers to the prevailing rate of Government of India securities. While the maximum rate.
is provided under the regulations, the interest rate for related-party loans must be at an arm’s length interest rate, from the transfer pricing perspective. Therefore, it is advisable for the corporate entities that they shall perform an interest rate benchmarking study to save themselves from protracted litigation with the tax authorities.


It is expected that the ECB flows shall enhance in India due to the recent introduction of tax SOPs in conjunction with the relaxation on LLPs raising ECBs, bucket of eligible lenders and the purpose for which ECBs can be raised. It is evident from the economic growth and development in India that FDI has helped to raise the output, productivity and employment in certain sectors especially in service sector resulting in generation of employment opportunity. Additionally, service sectors like banking and insurance are helping in strengthening Indian’s economic condition and developing the health of the foreign exchange system in country. 

With the advent of global companies, the government revenues enhanced, however, these companies are likely to be more sensitive to tax incentives because they are better able to enjoy the best of the benefits by transferring their activities from one country to another. It is often witnessed that tax incentives have international impact resulting to tax competition amongst countries. There are several studies which concluded that developing countries do not need to offer tax incentives to attract Foreign Direct Investment (FDI) as the decision to invest in a developing country depends upon the respective country’s overall investment climate and not merely on the tax aspect. It was earlier found that despite increase in the flow of FDI in India during the post-liberalization period, still the global share of FDI in India was very less in compared to other developing countries like Malaysia and Thailand. So, as per the need of the hour, the Government of India is more focused at present on legislating flexible laws and innovating policies. 

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