Introduction

In the past year, India has seen an influx of foreign investment surpassing its otherwise preferred neighbour China as a recipient of foreign investment.[1] To accommodate this steady inflow, Indian legislators have made significant modifications to the various laws that govern routes of foreign investment that a foreign investor can access when investing in India.

The question that arises is – which route for foreign investment to choose? The intent of this article is to provide a snapshot of the investment routes available to foreign investors desirous of investing in India and the key considerations to bear in mind.

Entry Routes for Foreign Investment in India

There are broadly three entry routes available for foreign investment in India: (a) foreign portfolio investor (“FPI”); (b) foreign venture capital investor (“FVCI”); and (c) foreign direct investment (“FDI”).

FPI

What is the on-boarding process for a FPI?

SEBI registered designated depository participants (“DDPs”) are authorised to on-board foreign investors as FPIs into one of the three categories after ensuring that the proposed FPI meets the eligibility criteria, as well, amongst other things, as applicable know-your-customer, anti-money laundering and combating financing of terrorism guidelines.

The three categories of FPIs and which category a foreign investor will fall under depends on the type of foreign entity making the FPI application. For example, sovereign wealth funds, government agencies, banks, and multilateral organizations would be classified as a Category I FPI. Appropriately regulated broad based funds[2] such as mutual funds, investment trusts, and insurance/reinsurance companies would be classified as Category II FPIs and Category III FPI is the residuary category.

One of the key developments in the on-boarding process for a FPI is the requirement on the FPI to provide details of their ultimate beneficial owner, i.e., natural persons who ultimately own or control an FPI. This disclosure is subject to materiality thresholds prescribed by SEBI. This requirement however does not apply to a Category I FPI.

What investments are permissible for a FPI?

FPIs are permitted to invest in shares, debentures (compulsorily convertible to equity) and warrants of companies,listed or to be listed on a recognized stock exchange in India, through primary and secondary markets. Such investment is subject to the total holding by each FPI or an investor group being less than 10% of the total paid-up equity capital (on a fully diluted basis) or less than 10% of the paid-up value of each series of (compulsorily convertible) debentures or preference shares or warrants issued by an Indian company.In case the total holding of the FPI increases to 10% or more of the paid-up share capital (on a fully diluted basis) or the paid-up value of each series of (compulsorily convertible) debentures or preference shares or warrants issued by an Indian company, the total investments of the FPI are required to be re-classified as FDI subject to conditions as specified by SEBI and RBI.

FPIs are also permitted to invest in listed or proposed to be listed debentures or bonds, subject to conditions, security receipts issued by asset reconstruction companies, securitised debt instruments, units of schemes floated by domestic mutual funds (whether listed on a recognised stock exchange or not), collective investment scheme, listed and unlisted non-convertible debentures/bonds issued by an Indian company in the infrastructure sector, unlisted non-convertible debentures/ bonds issued by an Indian company subject to the guidelines. It should be noted that FPIs are permitted to invest in unlisted non-convertible debentures/ bonds subject to end-use restrictions on investment in real estate business,capital market and purchase of land.

The FPI route is considered attractive for debt investments given debt investments by FPIs are not classified as external commercial borrowings,which is far more regulated. It is however pertinent to note that more recently, concentration norms have been prescribed for FPI investment in debt securities pursuant to which FPIs (including related FPIs[3]) are not permitted to invest in more than 50% of any single issue of corporate bonds (which limit is not applicable to security receipts).

In order to provide a boost to the Indian debt market, RBI has recently introduced the voluntary retention route (“VRR”). VRR exempts FPIs from the restrictions in relation to the minimum residual maturity period (which is one year for the general FPI route), and concentration limits as above. However, VRR imposes a minimum retention period of three years and the requirement to invest 25% of the committed portfolio size within one month and the remaining amount within three months from the date of allotment of the committed portfolio size to the FPI under the VRR.

SEBI has also permitted FPIs to invest in units of real estate investment trusts (“REITs”), infrastructure investment trusts (“InvITs”) and category III alternative investment funds. However, FPIs cannot hold more than 25% stake in units of category III alternative investment funds. While investors prefer to invest in alternative investment funds (“AIFs”) under the FDI route, the FPI route is commonly utilised for making investments in REITs and InvITs given there is no restriction on the percentage stake.

Significant tax benefit for FPIs are that securities held by FPIs are deemed to be capital assets under Indian tax laws and therefore, income would be generally regarded as interest income or capital gains but not business income (which is subject to higher rate of tax). Further, there is no withholding tax on capital gains on securities. Interest income received on debt instruments is subject to withholding tax in the range of 5% to 20%.

FVCI

Investors resident outside India can make investments under the FVCI route pursuant to registration with SEBI under SEBI (Foreign Venture Capital Investors) Regulations, 2000 (“FVCI Regulations”).

What are the permissible investments for a FVCI?

A FVCI is required to invest at least two-third of its investible funds[4] in equity or equity linked instruments (which also includes optionally convertible debentures) of venture capital undertakings[5], provided that the remaining one-third of investible funds can be invested, inter alia, in debt or debt instruments of a venture capital undertaking in which the FVCI already has equity investment.

The RBI has restricted investment by FVCIs to investment in: (a) Indian companies engaged in ten permitted sectors (including infrastructure, biotechnology and IT related to hardware and software); (b) start- ups irrespective of the sectors; and (c) units of a venture capital fund or category I alternative investment funds. Investments by FVCIs in capital instruments are subject to sectoral caps on foreign investment in India and attendant conditions.

Why choose the FVCI route?

The key benefits that the FVCI route provides are exemptions from: (a) the pricing guidelines stipulated under the FEMA Regulations, and (b) pre-issue capital lock-in requirements prescribed under the regulations governing issue of securities. Therefore, foreign investors seeking to make investments in the ten permitted sectors can consider making investment under the FVCI route.

From a tax perspective, it is pertinent to note that there is no clarity on whether income will be characterized as capital gains and such income may be characterised as business income, subject to fact-specific determination.

FDI

What is FDI?

FDI is defined as investments through capital instruments by a non-resident in: (a) an unlisted Indian company; or (b) 10% or more of the paid up equity capital (on a fully diluted basis) of a listed Indian company.

Unlike FPI and FVCI routes, the FDI route does not require registration and any eligible investor is permitted to make investments through this route. There are, however, certain cases where under the FDI route, a specific approval from the Government of India may be required to be taken to make an investment.

What are the permissible investments under the FDI route?

FDI is permitted in equity shares; fully, compulsorily, and mandatorily convertible debentures; fully, compulsorily, and mandatorily convertible preference shares, and share warrants; and in any sector except those sectors that are prohibited. FDI route cannot be utilized to make debt investments.

Investments under the FDI route are subject to entry routes, sectoral caps, pricing guidelines, and attendant conditionalities.

Investments in Alternative Assets

Foreign investments in REITs, InvITs and AIFs (“Investment Vehicles”) have been permitted under the FDI route subject to attendant conditions. It is pertinent to note that RBI has clarified that the extent of foreign investment in the corpus of the Investment Vehicle would not be a factor in determining as to whether downstream investment by the Investment Vehicle is foreign investment or not. However, RBI has further clarified that investments by Investment Vehicles into an Indian investee entity would be reckoned as indirect foreign investment for such entity if the sponsor or the manager to the Investment Vehicle is not owned and controlled by resident Indian citizens, or is owned or controlled by persons resident outside India. Such investments would have to conform to the sectoral caps and attendant conditions including pricing guidelines, if any, as applicable to the investee Indian investee entity in which the downstream investment is proposed to be made.

Conclusion

Given the choice of entry routes available to foreign investors, foreign investors are often faced with the dilemma of electing the most appropriate entry route in order to attain as closely as possible their investment objectives. More often than not, a foreign investor may have to use a combination of routes to access the Indian securities market. A careful analysis of the investment strategy, nature of investment, and commercial reason to use a particular route will need to be undertaken before deciding which entry route should be adopted to make investments in India.

[1]https://economictimes.indiatimes.com/news/economy/indicators/india-pips-china-in-fdi-inflows-for-the-first-time-in-20-years/articleshow/67281263.cms
[2]Broad based fund is defined as a fund established outside India, with at least 20 investors and no single investor holding more than 49% interest in the fund and this criteria can be fulfilled on a look-through basis if an institutional investor is holding more than 49% interest in the fund.
[3]Multiple entities having common ownership, directly or indirectly, of more than 51% or common control would be considered as related FPIs
[4] Funds committed for investments in India net of expenditure for administration and management of the fund.
[5]A domestic company whose shares are not listed on a recognised stock exchange in India, and which is engaged in the business of providing services, production or manufacture of articles or things excluding the negative list (which includes non-banking financial services, gold financing).

Authors:

Pallabi Ghosal, Partner
Ananya Sonthalia, Senior Associate