Navigating Disinvestment Under FEM (Overseas Investment) Rules 2022: Unraveling The Grey Area

Introductionx

In recent years, India has seen a significant evolution in its policies governing overseas investments including overseas direct investment (“ODI”). The Ministry of Finance on 22nd August 2022 notified the Foreign Exchange Management (Overseas Investment) Rules, 2022 (“OI Rules”) for regulating the overseas investments by persons resident in India, in supersession of the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015 (“erstwhile OI regime”). The OI Rules were followed by the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (“OI Regulations”) and the Foreign Exchange Management (Overseas Investment) Directions, 2022 (“OI Directions”), both issued by the Reserve Bank of India. The OI Rules, OI Regulations and OI Directions are hereinafter referred to as the new OI Regime.

The Regulatory Framework: OI Rules

The OI Rules are designed to streamline and regulate Indian investments abroad and impose certain obligations on Indian entities regarding the acquisition and disposal of overseas assets.

Defining the Disinvestment Period

Rule 17(4)¹ of OI Rules provides that the where the disinvestment² by a person resident in India (“PRI”) pertains to ODI, such PRI “must have stayed invested for at least one year from the date of making ODI”, which would typically be interpreted as “from the date of remitting the funds”.

Definition of ODI as per the Rule 2(q)³ of the OI Rules provides that ODI means inter alia investment by way of acquisition of unlisted equity capital of a foreign entity, or subscription as a part of the memorandum of association of a foreign entity.

A careful interpretation of Rule 17(4) in conjunction with Rule 2(q) of the OI Rules suggests that Overseas Direct Investment (ODI) is deemed to commence from the date of remittance (i.e., making payments outside India). Therefore, the one-year duration should also be reckoned from the date when this remittance was effectively transferred from India through an Authorized Dealer (AD Bank).

Where does the grey area arise from?

The grey area arises from another provision in the new OI regime that allows deferred payment of consideration by a PRI for acquiring shares of the overseas entity.

The erstwhile OI Regime

The erstwhile OI regime did not have the provisions for making deferred payment under automatic route, that is, it required prior RBI approval. Hence, there did not arise much scope of ambiguity for calculation of the disinvestment period. There are several orders passed by the RBI pursuant to compounding⁴ applications filed by PRIs under the erstwhile OI regime, wherein the PRI, be it individuals or entities, as the case may be, have disinvested before the expiry of one year and the RBI has allowed for compounding of the contravention. A perusal of these orders clearly demonstrates that the RBI had considered the one-year period to be calculated from the date of remittance of funds.

The new OI Regime

In the new OI regime, Regulation 7 of the OI Regulations elaborates on provisions regarding the acquisition or transfer of equity capital through deferred payment. It allows a resident in India to acquire equity capital through subscription or transfer, with the option to defer payment of the consideration for a specified period, subject to the prescribed terms and conditions.

Consequently, the PRI can acquire shares through subscription to the memorandum of association of the overseas entity, or through allotment or transfer, with the option to make payment at a later time.

The challenge lies in determining the starting point for calculating the one-year period to determine when the PRI can divest their shareholding in the overseas entity—whether it begins from the date the shares are allotted in the PRI's name or from the date of making the remittance.

While practical experience with the new OI regime remains limited at present, entities are currently adhering to the interpretation that the one-year period starts from the date of funds remittance, pending any further clarification or guidance from the RBI.

Another practical challenge faced by PRIs is that even though remittance can be deferred and the one-year disinvestment period is to be calculated from the date of remittance, PRIs who acquire shares on a deferred payment basis cannot divest their shareholding from the time they acquire the shares in the overseas entity until the date of remittance. Consequently, PRIs are effectively required to retain their shareholding for a period exceeding one year — specifically, from one year after the date of remittance of funds to the actual date of disinvestment, in addition to the period during which the shares were allotted without remittance of funds.

In essence, if a PRI acquires shares in an overseas entity in January 2024 and remits the funds in June 2024, the PRI cannot disinvest until June 2025. This results in a minimum holding period of 18 months.

The question at hand is whether the PRI can divest their shares after allotment but before remitting the funds, without considering the one-year vesting period. This remains a concern awaiting clarification from the RBI.

Challenges and Implications

Calculation of disinvestment is an important aspect to be considered in case of ODI to ensure that the PRI is aware of the time when he/she/it can disinvest his/her funds from the overseas entity. The grey areas in disinvestment period calculation pose several challenges:

• Compliance Risks: Misinterpretation or miscalculation of the disinvestment period can result in non-compliance penalties, impacting the financial health and reputation of the investing entity.

• Operational Burden: Managing disinvestment timelines requires meticulous record-keeping and continuous monitoring, placing additional operational burden on entities with overseas investments.

• Strategic Decision-Making: Uncertainty regarding disinvestment timelines can influence strategic decisions concerning acquisitions, expansions, or divestitures, potentially affecting growth trajectories and market positioning.

Navigating Uncertainty: Best Practices and Recommendations

To navigate the grey areas effectively and until there is more clarity in this regard by the RBI, Indian entities investing overseas should consider remaining in constant touch with their AD banks for clarification on ambiguous provisions and seek guidance on compliance strategies. This would ensure that none of the PRI inadvertently commits any non-compliance specifically w.r.t the provisions of the FEMA, which provides for heavy penalties in case of contravention.

Conclusion

As India continues to integrate into the global economy, the regulation of overseas investments becomes increasingly crucial. While the OI Rules provide a structured framework, the grey area surrounding disinvestment period necessitate careful attention and proactive compliance measures from Indian investors. By understanding these challenges and adopting best practices, entities can navigate the complexities effectively, ensuring both regulatory adherence and strategic growth in their international ventures.

Disclaimer: This article was first published in the S&A Law Offices - 'Indian Legal Impetus' newsletter in June 2024.