Round Tripping: Permissible Overseas Investment Structures Under the New Regime

ROUND TRIPPING: PERMISSIBLE OVERSEAS INVESTMENT STRUCTURES UNDER THE NEW REGIME

The New Odi Framework Is a Step in The Right Direction as It Provides Much Needed Clarity On the Kind of Structures That Are Permissible from an Overseas Investment Standpoint

Let us start with the basics. What does the term ‘round-tripping’ mean from a regulatory standpoint? The Indian regulatory regime does not offer a definition. The glossary of the 4th Edition of the OECD Benchmark Definition of Foreign Direct Investment defines it as “channelling abroad by direct investors of local funds and the subsequent return of these funds to the local economy in the form of direct investment”¹.

The Reserve Bank of India (“RBI”) had issued a clarification in 2019 and this was often used as the guiding principle for evaluating such round-trip structures. The RBI’s response has been reproduced verbatim below²:

“Q. Can an Indian Party (IP) set up a step-down subsidiary/joint venture in India through its foreign entity (WOS/JV), directly or indirectly through step-down subsidiary of the foreign entity?

Ans. No, the provisions of Notification No. FEMA 120/RB-2004 dated July 7, 2004, as amended from time to time, dealing with transfer and issue of any foreign security to Residents do not permit an IP to set up Indian subsidiary(ies) through its foreign WOS or JV nor do the provisions permit an IP to acquire a WOS or invest in JV that already has direct/indirect investment in India under the automatic route. However, in such cases, IPs can approach the Reserve Bank for prior approval through their Authorised Dealer Banks which will be considered on a case-to-case basis, depending on the merits of the case.”

It is interesting to note from the above that the RBI did not specifically use the expression ‘round-tripping’ to describe the above fund flow, but the question pre-supposes a fund flow from an overseas entity which has investment from an Indian party back to India. It is also interesting that such structures were not outrightly prohibited by the RBI; instead, an approval could be obtained on a case-to-case basis. Also, the RBI uses the expression ‘Indian Party’ which is a defined term. This expression excluded ‘resident’ individuals and therefore investment by individuals were out of bounds even under the approval route. In this regard, Paragraph 6 of Schedule V of the Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004 is relevant. It states:

“The JV or WOS, to be acquired/set up by a resident individual under this Schedule, shall be an operating entity only and no step-down subsidiary is allowed to be acquired or set up by the JV or WOS.”

The new ‘overseas investment’ regime

A new overseas investment regime was notified by the Government of India on August 22, 2022, in the form of Foreign Exchange Management (Overseas Investment) Rules, 2022 (“OI Rules”). The RBI consolidated the instructions in Foreign Exchange Management (Overseas Investment) Directions, 2022 (“OI Directions”, together with the OI Rules, “New ODI Framework”).

The New ODI Framework supersedes the ODI Regulations, 2004, the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015 and the Master Direction – Direct Investment by Residents in Joint Venture / Wholly Owned Subsidiary Abroad dated January 1, 2016 (collectively referred to as the “Erstwhile ODI Framework”) and subsumes all other existing rules and regulations governing outbound investment.

Permissible ‘round-trip’ structures resulting from the New ODI Framework

The New ODI Framework has considerably liberalized round-trip structures. Round-trip structures are now allowed with a caveat that the investment being routed back into India from the overseas structure should not be beyond two layers of subsidiaries. The exact language of Rule 19(3) from the OI Rules is reproduced below:

“No person resident in India shall make financial commitment in a foreign entity that has invested or invests into India, at the time of making such financial commitment or at any time thereafter, resulting in a structure with more than two layers of subsidiaries.”

The proviso states that the above restriction on two layers will not apply to banking companies, NBFCs, insurance companies and Government companies.

The expressions “financial commitment” and “subsidiaries”, used in Rule 19(3) requires some discussion. These terms, along with the key definition of ‘control’ are examined below:

• Financial commitment: It refers to the aggregate amount of investment made by a person resident in India by way of overseas direct investment, debt instruments (other than overseas portfolio investment) and non-fund-based facilities.

• “Subsidiary” or “step down subsidiary (SDS)”: It refers to an entity in which the foreign entity has control and the structure of such subsidiary/SDS shall comply with the structural requirements of a foreign entity, i.e., such subsidiary/SDS shall also have limited liability where the foreign entity’s core activity is not in strategic sector. The investee entities of the foreign entity where such foreign entity does not have control (as defined above) shall not be treated as SDSs.

• Control: The right to appoint majority of the directors or to control management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements that entitle them to 10% or more of voting rights or in any other manner in the entity.

As regards the manner of calculating the step-down subsidiaries created by the Indian party, Paragraph 15 of the instructions to fill Form FC under the Master Direction – Reporting under Foreign Exchange Management Act, 1999 (Updated as on May 12, 2023) (“Master Direction”) issued by the RBI provides:

The level of step-down subsidiary (SDS) shall be calculated treating the foreign entity as the parent. So, an SDS directly under the direct foreign entity should be treated as first level SDS. Accordingly, an SDS under the first level SDS would be treated as second level SDS, so on and so forth.

We can explain this as follows:

To explain the above, Foreign Company 1 serves as the parent entity. Foreign Company 2 and Foreign Company 3 are its subsidiaries, with Foreign Company 2 being the first level subsidiary, and Foreign Company 3 being the second level subsidiary.

The above explanation in the Master Direction serves as a useful clarification for the purpose of Rule 19(3) of the OI Rules. It provides an important reference point for such calculation.

Concluding remarks

The New ODI Framework is a step in the right direction as it provides much needed clarity on the kind of structures that are permissible from an overseas investment standpoint. It also ends the ambiguity with respect to the manner in which such layers shall be calculated.

Exempting banking companies and insurance companies from the requirement is a pragmatic measure given the special nature of these industries. The good news is that the blanket restriction on round-trip structures is now replaced with a more permissible and liberalized structure which will help the industry.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.