India growth story has a ‘beneficial ownership’ hurdle

Relevance: GS Paper III

Why in News?

The amendment to the Indian Foreign Exchange Management (Non-debt Instruments) Rules, 2019 is a challenge.

More About News:

• Foreign investments will play a crucial role in aiding the government’s goal of a $5 trillion economy by the end of the financial year 2025-26. 
• In order to attract foreign investment, it is essential to remove all the bottlenecks for the Indian companies receiving this investment, and also foreign investors who are willing to bet on the India growth story.

Amendment conundrum:

• The amendment to the Indian Foreign Exchange Management (Non-debt Instruments) Rules, 2019 ("FEMA NDI") through the press note number 3 of 2020, has posed a significant challenge for Indian companies, especially start-ups and smaller enterprises seeking foreign investments. 
• This amendment stipulates that any investments in Indian companies, whether direct or indirect, originating from entities located in countries that share land borders with India ("Neighbouring Countries"), or where the "beneficial owner" of the said Indian investment is situated in, or is a citizen of any of these Neighbouring Countries would necessitate prior government approval ("PN3 Requirement").

Challenges and Complexities

• Regulatory Uncertainty and RBI's Conservative Stance

• • The amendment aimed to prevent opportunistic takeovers of Indian companies by neighboring countries during the COVID-19 pandemic. 
  • However, it created significant uncertainty because the term "beneficial owner" is not clearly defined, and existing definitions in other laws are context-specific.
  • When the PN3 requirement was introduced, the industry initially took a lenient view, using beneficial ownership thresholds from other laws. However, since late 2023, the Reserve Bank of India (RBI) has adopted a more conservative stance, particularly on issues where the law is silent, especially under FEMA NDI.
  • Foreign Owned or Controlled Companies (FOCCs) received RBI notices regarding their downstream investments. The industry assumed FOCCs would face the same restrictions as non-residents where the law is silent. However, when the RBI challenged this recently, investors began questioning other practices not addressed by FEMA NDI.
  • Even law firms that were once fine with adopting a lenient view in cases of beneficial ownership thresholds, are now advising clients that they cannot offer assurance by relying on the beneficial ownership thresholds legislated under other laws.

• Approval Route Challenges
  • The prior government approval route is time-consuming and has a high rejection rate. While the Government of India does not publish consolidated data on pending or rejected applications, some officials have revealed that proposals worth ₹50,000 crore from neighboring countries are either pending, withdrawn, or rejected, with 201 applications rejected in the past three years.
• Penalties and Survivability Concerns

• The PN3 Requirement, the onus of compliance is on the Indian company that receives foreign investment, with the regulatory authorities having the discretion to impose fines of up to three times the investment received. 
• The inherent vagueness within the legislation, along with severe penalties, can cast doubts on the survivability of these companies.
• Many of these start-ups receive investments far beyond their revenue or assets. So, such fines could leave them insolvent, even if they liquidate. Non-compliance would likely trigger legal battles, adding to India's already significant backlog of court cases.

Solution to address challenges:

• Foreign Investor Representations and Indemnities: 
• Indian companies could consider having foreign investors to furnish representations backed by indemnities regarding their compliance with the PN3 Requirement. However, this may discourage foreign investment due to potential liabilities.
• Therefore, there is a pressing need to amend the PN3 Requirement to define "beneficial owners" comprehensively, including ownership thresholds and control tests.
• Comprehensive Definition of "Beneficial Owner": 
• The definition of 'beneficial owner' should specify a precise threshold for ascertaining beneficial ownership, potentially ranging from 10% (as provided under the Indian company law) to 25% (as recommended by the Financial Action Task Force). 
• The selection of the specific threshold can be customised to align with the government's objective of scrutinising varying levels of foreign investment across different sectors. For example, sectors such as telecom and defence, which are sensitive in nature, may warrant heightened scrutiny when compared to sectors such as manufacturing and construction, where India requires additional capital.
• The definition should also specify control-conferring rights, beyond ownership thresholds, to capture entities with significant influence. For example, rights regarding board meeting quorums or veto powers over operational matters such as incurring any capital expenditure or availing any loan may confer control and should be outlined. 
• However, investor value protection rights, such as veto powers over mergers or right of first offer, should be excluded from the definition, as they do not constitute control.
• Consultation Mechanism: 
• Even with the clarification of control-conferring rights in the definition, some ambiguity may persist due to the skilful drafting of peculiar clauses in the charter documents. 
• To mitigate this issue, FEMA NDI, akin to Indian competition law, could be amended to incorporate a time-bound consultation mechanism with regulatory authorities, to determine whether specific clauses are control-conferring.

Conclusion :

• Addressing the 'beneficial ownership' hurdle is crucial for India to sustain its growth momentum while safeguarding national interests. The key lies in providing a clear regulatory framework defining 'beneficial ownership', control rights and sector-specific thresholds. 
• A consultative approach allowing timely clarifications, streamlined approval process, capacity building and transparent implementation are also essential. By striking the right balance between security concerns and investor-friendliness, India can overcome this challenge, unlock its true potential and cement its position as a global economic powerhouse.