Applicability of Downstream Filing in Case of Downstream Investment: Covering Caps, Routes and FAQs

Downstream investments are a cornerstone of corporate structuring in India, particularly in multi-tiered corporate setups. Governed by the Foreign Exchange Management Act (FEMA) and specific rules set by the Reserve Bank of India (RBI), understanding downstream filing requirements is essential for compliance. This article delves into the nuances of downstream investments, regulatory frameworks, caps, routes, and FAQs.

Understanding Downstream Investments

Definition: Downstream investment refers to indirect foreign investment in Indian companies. It occurs when a foreign entity or a foreign-controlled Indian entity invests in another Indian company through an intermediary entity.

Example:

• Foreign Company A invests in Indian Company B (a foreign-controlled company).
• Indian Company B then invests in another Indian company, Company C.
• This qualifies as a downstream investment since Company A indirectly owns a stake in Company C through Company B.

Scope:

• Downstream investments can be made into various entities, including private and public limited companies, as well as Limited Liability Partnerships (LLPs).
• Such investments must comply with India's FDI policy, sectoral caps, and relevant regulatory norms.
• All downstream investments must be reported to the RBI within 30 days via Form DI.

Regulatory Framework: Laws and Sections

The regulatory framework surrounding downstream investments is governed by several provisions in Indian law, particularly under the Foreign Exchange Management Act (FEMA), 1999, and Foreign Direct Investment (FDI) Policy:

Foreign Exchange Management Act (FEMA):

• Section 6: Enables foreign investments in Indian entities under prescribed guidelines.
• Section 2(1)(m): Defines "foreign exchange" and related transactions.
• Rule 23 - FEMA 20(R) Regulations: Details specific rules for downstream investment reporting.

FDI Policy:

• Stipulates sectoral caps and delineates automatic and government approval routes for foreign investments

What is Indirect Foreign Investment?

Indirect foreign investment (IFI) refers to investments made by foreign investors in an Indian company through another foreign-owned company. In other words, an investment is termed "indirect" if the foreign investor owns shares of a company, and this company, in turn, makes investments in another Indian company.

For example, a foreign investor might own 100% of a foreign company, and that company might make investments in an Indian entity. The ultimate ownership of the Indian company (through the foreign company) qualifies as an indirect foreign investment.

Sectoral Caps and Routes for Downstream Investment

Downstream investment is subject to sectoral caps and FDI routes, which are critical in determining whether a foreign investor must apply for government approval or if the investment can proceed through the automatic route.

Automatic Route:

• No prior government approval required.
• Common in sectors like e-commerce, IT and software development, automobile and single-brand retail.
• Downstream investments in these sectors are also permissible under the automatic route, provided the sectoral caps are not breached.

1. Government Route:

• Applicable for sensitive sectors such as defense, news media, and multi-brand retail, banking.
• Requires approval via the Foreign Investment Facilitation Portal (FIFP).

1. Sectoral Caps:

• 100% FDI: Sectors like IT, e-commerce, and software development.
• 49% FDI: Sectors such as defense and insurance (with conditions).
• 26% FDI: News media and broadcasting.
• 51% FDI: Multi-brand retail (requires government approval).

Instruments for Downstream Investment

1. Equity Shares: Direct shareholding in the intermediary company.
2. Preference Shares: Priority in dividends or liquidation.
3. Convertible Instruments: Convertible debentures or preference shares.
4. Non-Cash Instruments: Intellectual property or technology transfers.

Cash vs. Non-Cash Investments

• Cash-Based Investments: Involve direct capital infusion into the intermediary or Indian company.
• Non-Cash Investments: Include technology, intellectual property, or other non-monetary contributions.

Rule 23(4)(b) of the NDI Rules permits use of funds received from abroad or internal accruals for making downstream investment. Considering this specific requirement, downstream investment by the Foreign owned or controlled entity (FOCC) for consideration other than cash may not be permitted under automatic route and should require prior RBI's approval.

Reporting Downstream Investments

Downstream investments must be reported to the RBI via Form DI within 30 days of the investment. The reporting ensures adherence to FEMA and FDI policies.

FEMA Rule 23 Guidelines

1. Entities Required to Report:
   • The Indian entity receiving foreign investment.
   • The intermediary entity making downstream investments.
2. Compliance:
   • Investments must align with sectoral caps and prescribed FDI routes.
3. Form DI Details:
   • Information about the parent company.
   • Details of the downstream investment and the Indian entity involved.
   • Nature and purpose of the investment.

Filing Steps on the Firms Portal

1. Register: Visit the RBI Firms Portal and create an account using the Corporate Identification Number (CIN).
2. Log in: Access the portal with your credentials.
3. Complete Form DI:

• Fill in details about:
  • Parent company.
  • Downstream entity.
  • Investment type and sector.
• Attach Documents:
  • Foreign Inward Remittance Certificate (FIRC).
  • Board Resolution or Investment Agreement.
  • Any additional supporting documents.

1. Submit: Review for accuracy and submit.
2. Acknowledge: Receive an acknowledgment receipt for tracking.

Annual Compliance: File the FLA Return by July 15 annually to report foreign liabilities and assets, including downstream investments.

Frequently Asked Questions (FAQs)

1. Are all downstream investments subject to filing requirements?

Yes, all downstream investments must be reported to the RBI as per FEMA regulations.

2. Can borrowed funds be used for downstream investments?

No, downstream investments must be funded through internal accruals or approved foreign inflows.

3. What happens if filing requirements are not met?

Non-compliance may lead to penalties under FEMA, including fines and restrictions on further investments.

4. Can Downstream Investment be made through LLP?

Yes, downstream investment can be made through an LLP. A Foreign-Owned and Controlled LLP (FOCC-LLP) is permitted to make downstream investments by subscribing to the equity instruments or capital of another Indian entity, such as a company or LLP. However, this is subject to the condition that the receiving entity operates in sectors where foreign investment up to 100% is allowed under the automatic route, and there are no FDI-linked performance conditions

5. How to Determine the FMV of Equity Instruments/Capital for Undertaking Downstream Investment?

The pricing guidelines under the Non-Debt Instruments (NDI) Rules, which apply to Foreign Direct Investment (FDI), also extend to downstream investment transactions. Therefore, the Fair Market Value (FMV) of the equity instruments or capital of the Indian Investee Company or LLP should be determined using internationally accepted pricing methodologies for share valuation on an arm's length basis. This valuation must be certified by a SEBI-registered Merchant Banker, a Chartered Accountant, or a practicing Cost Accountant.

6. What are the consequences if the valuation of equity instruments or capital is not conducted at arm's length for downstream investment?

If the valuation of equity instruments or capital is not done at arm's length, it can lead to non-compliance with the pricing guidelines set out under the NDI Rules. This could result in penalties or the rejection of the downstream investment transaction. To ensure compliance, the FMV must be determined using internationally accepted pricing methodologies, and the valuation must be certified by an authorized professional.

7. What happens if a downstream investment is made in violation of FDI-linked performance conditions?

If a downstream investment is made in violation of FDI-linked performance conditions, the transaction may be deemed non-compliant with FDI regulations. This could result in penalties, the reversal of the investment, or other legal and financial consequences for the investor and the investee entity. It is important to ensure that all performance conditions, if applicable, are met to avoid regulatory issues.

8. Can downstream investments be made in entities that are already partly foreign-owned?

Yes, downstream investments can be made in entities that are already partly foreign-owned, as long as the foreign ownership does not exceed the sectoral limits under the automatic route, and there are no violations of FDI-linked performance conditions. The FMV of the equity instruments or capital must be determined, and the investment must meet all regulatory requirements for FDI.

Conclusion

Downstream investments offer strategic advantages for corporate structuring but require strict adherence to regulatory guidelines. Understanding sectoral caps, selecting the appropriate FDI route, and fulfilling filing requirements such as Form DI are crucial for compliance. Companies must also maintain annual reporting practices to ensure alignment with FEMA and the RBI's regulations.