All you need to know about Foreign Investment

Varun Hariharan

29 Mar, 2023

Any form of investment in India from any foreign company is considered as foreign investment. The entity has to either be a company or a Non- Resident Indian. Apart from this, foreign investment can be from a person who is resident outside India. Foreign investment (FI) must be in the form of any subscription in the capital structure of the company. When a foreign company subscribes in the capital instruments of the company, the company has to provide capital instruments such as equity shares, debentures, preference shares or some form of convertible notes. This article is going to analyse how foreign investment in India works.

What are the routes for receiving foreign investment in India?

Different countries have various patterns of receiving FI. In India, FI is received through routes. The Government has specifically made these routes of India in consultation with the RBI.

The following are the routes for foreign investment in India:

• Automatic Route- Under the automatic route, there is no prior approval required from the Government of India to carry out an investment activity. For example, if a foreign company wants to invest in the floricultural sector of a domestic company, the foreign company is free to carry out this form of investment. No form of prior approval is required from the government of India. Under this route, an investment can either be in the form of 100% investment through the automatic route. For example, some sectors such as insurance consider 74% under the automatic route. Therefore, 74 % of foreign investment can be got through the automatic route for insurance. The amount of investment cap has been recently amended in 2020.
• Government Route- The government route is also known as the approval route for FI in the country. When a foreign company is planning to invest through the approval route, then government approval would be necessary. If the foreign investor has not taken the requisite approval, then the investment would not be allowed. For example, investment from countries such as Pakistan and Bangladesh required prior approval from the government. The recent amendment in April 2020 brought about changes in the requirement of approval from neighbouring states that share borders with India. Under this amendment, the meaning of beneficial owner is also considered. Hence, further investments from countries that share land borders with India would require approval from the government.

What are Capital Instruments?

Capital Instruments are specific instruments such as shares and securities, which are freely transferable from one person to another. Capital instruments can also be transferred between companies. The government has permitted foreign companies and entities to invest in capital instruments of companies.

Foreign investment is allowed through capital instruments which are issued through Indian Companies. The type of capital instruments which can be issued by Indian Companies include:

• Equity Shares- Under the Companies Act, 2013^[1], equity shares which are issued to foreign investors or foreign companies would have the same meaning under any form of securities law. Any form of equity shares would be included in the definition of equity shares issued by the company. Such shares issued by the company would include partly paid equity shares which are issued after 08 July 2014.

• Warrants which are considered as Shares- These would include any form of warrants which are issued after the day of 08 July 2014.

• Debentures– Any form of instrument that acknowledges the form of debt which can be issued by the company to be converted to any other form of security. The definition of debenture means an instrument which evidences any form of debt under the Companies Act, 2013. Debentures will include convertible debentures, fully convertible debentures and partially convertible debentures.

• Preference Shares- Preference shares are the capital instruments which are issued first to preference shareholders or existing shareholders. Under the companies act, 2013, the meaning of preference shares would include any form of preferential rights, which comes with the instruments such as the payment of dividends and during the process of winding up. Preference shares can also be issued as capital instruments. Partially convertible preference shares, fully convertible preference shares and normal preference shares are included under the definition of preference shares which are issued as capital instruments.

Apart from this, any form of preference shares which are considered optionally convertible or partially convertible and if these shares have been issued up to 30 April 2007, then the same will be allowed to be compliant with the rules of FI.

• Convertible Notes- Due to the regulation of start-ups, the government has come out with convertible notes which can be issued by a start-up company to a foreign investor. The minimum amount of investment in a convertible note is up to 25 lakh rupees which can be received by the start-up company in a Single Tranche of investment.  On the maturity of the convertible note has to be returned to the start-up company in India. This has been brought recently by the government of India.

How is Foreign Exchange Law regulated for Foreign Investment in India?

Foreign exchange laws were present in India since the 1960s. The government of India first brought out the foreign exchange regulation act, 1973 (FERA). There were many restrictions for foreign investment in the country as a result of the FERA. Hence the government brought out economic liberalisation in 1991, opening the doors to different forms of FI. Along with this, the government of India and RBI brought out the FEMA regulation. The Foreign Exchange Management Act, 1999 was different from the FERA.

Under the FEMA, foreign investment in India was promoted rather than restricted. With the introduction of FEMA, the government brought out laws and regulations for NBFCs, Foreign Direct Investment, and Foreign Portfolio Investment. Even for the transfer of security to an individual outside India, there is a regulation. This regulation is the Foreign Exchange Management (Transfer or Issue of Security to a Person outside India) Regulations, 2017.

The primary regulatory authority for foreign exchange transactions in India is the RBI. Under section 11 of the FEMA, the Reserve Bank of India has authorised specific banks to deal with foreign exchange transactions. These banks are known as authorised banks. If FI transaction has to occur, then prior approval of the authorised bank, as well as the RBI, is required.

What is the difference between foreign investment, foreign direct investment and foreign portfolio investment?

Foreign Investment- Foreign invest is understood as a form of investment by a foreign entity either in the capital instruments of the Indian company.  This investment can be either made by a foreign company or a person who is resident outside India. Such an investment can be made by an NRI also. Such an investment would be usually made on a repatriable basis. The meaning of repatriable includes when the investment can be sent back to the home country of the foreign investor. When an investment is repatriable, usually it is not subjected to any form of tax.

Foreign Direct Investment (FDI) – Foreign Direct Investment more commonly known as FDI is a form of direct investment which is made by a person resident outside India or a foreign company in the capital instruments of an Indian company. This investment is made through the purchase or acquisition of capital instruments of the Indian company.

Foreign direct investment is made through the following for FDI:

• FDI can be made directly on the capital instruments of an unlisted company
• 10% or more FDI on the paid-up capital of a listed company. A listed company would include any form of company that has its shares listed in a stock exchange.

Foreign Portfolio Investment- A portfolio can be understood as a composition of a different form of securities having values. Hence foreign portfolio investment is a type of foreign investment from foreign investors in the portfolio. Foreign portfolio investment must be differentiated from FI and foreign direct investment.

To be applicable for investing in foreign portfolio investment, the following conditions have to be satisfied:

• The investment by a foreign company has to be less than 10% of the paid-up capital of an Indian Listed company.
• The investment by a foreign company has to be less than 10% on the equity shares or such other capital instruments of the Indian listed company.

One main differentiation between foreign direct investment and foreign portfolio investment is the amount of investment that is made by the foreign company in the Indian company. If the percentage of investment is more than 10% on the paid-up value of the capital which is held by the company, then such form of investment is understood as Foreign Direct Investment. If the investment is less than 10% on the paid-up capital of the company or the equity shares of the company, then such form of investment is understood as foreign portfolio investment or FPI.

Another main difference between FDI and FPI is the company in which the investment is made. For example, if the investment is made in an unlisted company and if such investment adds up to more than 10%, then it would be a foreign direct investment. Whereas, a portfolio would comprise of a different form of securities which are issued by the company.

For issuing securities to the public, the company has to be registered with a stock exchange. Hence, foreign portfolio investment would only comprise listed companies which can raise investment from a foreign company.

Meaning of Valuation

Valuation of instruments means assessing the fair market value of a particular instrument based on internationally accepted standards.  For example, securities which are freely transferable between companies can be independently valued. Similarly, valuation occurs when securities are transferred from an Indian company to a resident outside India.

A valuation can also occur when there is a buyback of securities or redemption of preference shares by the company. Valuation has to be carried out by the company following certain international standards of valuation.

Both listed companies, as well as unlisted companies, can value their shares and capital instruments.

The following would be applicable to valuation for securities which are issued by an Indian company to a non-resident Indian or a person resident outside India:

• The price for valuation of this form of security should not be lesser than, the prices which are as per the guidelines for Securities Exchange Board of India (SEBI).

For an unlisted company, the following principles and guidelines of valuation would be applicable to the securities or capital instruments:

• The securities or capital instruments have to be valued as per the fair market value method. Under this method, international standards are prescribed for the valuation process. This process uses the arm’s length price or arm’s length mechanism for carrying out the aspects of valuation.  This is normally carried out by a certified SEBI registered merchant banker or a chartered account who is registered as per the rules under the accounting standards.

Valuation principles for the transfer of shares from a resident outside India to an Indian company

• The price at which the securities have to be transferred for a listed Indian company does not have to be more than the price which is accepted as per the standards of the SEBI for valuation.
• For an unlisted company, the international standards of valuation is used which considers the use age of the arms length price of understanding the valuation. Through this method a SEBI registered merchant banker or a chartered account is utilized for this process.

Hence the principles of valuation would include that instruments for FI must be valuation carried out as per the standards which are accepted by SEBI for Listed companies. When it comes to valuing instruments for unlisted companies then the international standards such as the arms length methods for valuation must be considered.

Conclusion

Read our article:A Complete Overview of Foreign Direct Investment Compliance under FEMA