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What is Foreign Direct investment in India?

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May 12, 2021

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23 mins read

Foreign Direct Investment in India or FDI in India as it is commonly called, refers to investment in Indian companies by non-residents. Foreign Direct Investment (FDI) is considered as a major source of non-debt financial resource for economic development of a nation. There are various aspects involved in Foreign Direct Investment in India, and understanding what it is; its meaning and its nuances is a must for all non residents investing in India. This is particularly true, given that there are restrictions in various sectors where investment can be made, eligible persons / entities that can make investments, ownership limits for such investments, different available instruments for making such investment with different tax implications associated with each one of them and many other reasons.  FDI helps in providing long term sustainable capital in India which leads to technology transfer, development of strategic sectors, greater innovation, competition and employment creation amongst other benefits.

When a foreign company invests in India, they have to choose which instrument should be used to invest for the purpose of Foreign Direct Investment in India. It could be either shares (Equity, Preference, Convertible or Non Convertible), Debentures or Loans. Equity Shares are the most commonly used instrument by various foreign companies to invest into an Indian Company, or in case of acquisition of controlling stakes in existing companies. However, in the recent past, Compulsory Convertible Debentures, Compulsory / Non Convertible Preference shares have also found favour with the investors.

We would discuss certain key aspects of FDI in India in this note. For topics requiring detailed analysis/ evaluation, you can click on specific links to get more detailed and in-depth analysis.

Mode Route of FDI in India

Foreign investment, in eligible Indian entities, can be categorised broadly into   three  buckets :

Categories Permitted FDI Route
Category 1 100% Automatic Route – No approval is required from the Government. Once investment is done, certain filings are required .
Category 2 Up to 100% Government Route (Approval Route) – Prior approval has to be obtained from the Government, before investment can be made into such entities
Category 3 Up to 100% FDI permitted Automatic + Government Route – Investment upto certain level, do not require approval. Prior approval has to be obtained from the Government, above the permitted level

Automatic Route of FDI Investment

Under the Indian regulations, Foreign Direct Investment in India can be made either under the Automatic Route, or the Approval Route. The Automatic Route of FDI refers to the entry route in which investment by a person resident outside India does not require the prior approval of the Reserve Bank of India or the Central Government for investing in India. The list of activities/ sectors is provided in Regulation 16 of FEMA 20 (R).

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Government Route in FDI in India

There are certain sectors, investment in which is governed by the Central Government. This is because investment in such entities generally leads to transfer of ownership and/or control of Indian entities from resident Indian citizens to non-resident entities. The approval of the Government is granted through various Ministries / Departments. The procedure for applying for Government approval has been provided at http://fifp.gov.in/Forms/SOP.pdf

Regulators / Agencies regulating Foreign Direct Investment in India

There are various Regulators / Agencies regulating FDI in India. The prominent one amongst those are as under (depending on the sector and the quantum of investment, an investor may need to approach one or more of them):

  1. Government of India
  2. Department of Economic Affairs ;
  3. Ministry of Finance
  4. Reserve Bank of India
  5. Ministry of Commerce and Industry
  6. Department for Promotion of Industry and Internal Trade

Let’s take a look at the sectors and the quantum of investment that are covered under the Automatic and Approval Routes:

Permissible Sector for FDI in India – Automatic Route
Sectors Quantum of Investment
Medical Devices Up to 100% FDI
Thermal Power Up to 100% FDI
Services under Civil Aviation (Maintenance and Repair)
Insurance Up to 74% FDI
Ports and Shipping Up to 49% FDI
Railway Infrastructure
Pension Up to 49% FDI
Power Exchanges Up to 49% FDI
Petroleum Refining (By PSUs) Up to 49% FDI
Infrastructure Company in the Securities Market Up to 49% FDI

These are just a few sectors that fall under the Automatic Route. There are many others that include but not limited to:

  • Agriculture and Animal Husbandry
  • Airports (Greenfield and Brownfield)
  • Capital goods
  • Roads and Highways
  • Textiles and Garments
  • Pharmaceuticals
  • Tourism and Hospitality
  • Healthcare
Approval Route
Sectors Quantum of Investment
Food Products Retail Trading Up to 100% FDI
Core Investment Company Up to 100% FDI
Mining and minerals (separation of titanium bearing minerals and ores) Up to 100% FDI
Print Media (Scientific and technical journals, speciality journals, etc.) Up to 100% FDI
Satellite (Establishment and Operations) Up to 100% FDI
Multi-Brand Retail Trading Up to 51% FDI
Broadcasting Content Services Up to 49% FDI
Print Media (Periodicals, newspapers, etc.) Up to 26% FDI
Banking and Public Sector Up to 20% FDI

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Prohibited Sectors under FDI in India

Non- Residents are prohibited to invest in India for the following sectors:

  1. Lottery business (Government and private)
  2. Gambling, betting (inclusive of casinos)
    Note: Foreign Technology collaboration in the form for franchise, trademark, brand name, etc. for gambling and betting is also prohibited
  3. Chit Funds (Excluding investments made by NRIs and OCIs on a non-repatriation basis)
  4. Nidhi Company (Mutual Funds Companies)
  5. Trading in TDRs
  6. Real Estate Business or Construction of Farm Houses
  7. Manufacturing of cigars, cigarettes, tobacco and its substitutes (Retail trading will be governed under the Automatic Route)
  8. Industries which have not been privatized- Atomic Energy and Railways.[1]

Types of Instruments for Foreign Direct Investment in India

A non-resident can invest through various financial instruments for the purpose of making FDI in India. Some of the most commonly used investment instruments are as under:

  1. Equity shares;
  2. Fully, compulsorily and mandatorily convertible debentures;
  3. Fully, compulsorily and mandatorily convertible preference shares;
  4. Share warrants.

Note: These are subject to pricing guidelines/valuation norms prescribed under FEMA Regulations

In respect of convertible instruments (shares or debentures), the price/conversion formula of convertible capital instruments is required to be determined upfront at the time of issue of the instruments. As per the FEMA rules/regulations, once such determination is made, the price at the time of conversion should not in any case be lower than the fair value worked out, when such instruments are being issued. In case of unlisted companies, the price determination must be according to internationally accepted pricing methodology on an arm’s length basis. However, in respect of listed companies, valuation has to be carried out in terms of SEBI (ICDR) Regulations.

Benefits of FDI

Advantages of bringing foreign investment into India are as follows:

  1. Inflow of financial resources
  2. Inflow of new technologies, skills, knowledge, etc.
  3. Generation of employment opportunities
  4. Creates a more competitive business environment in the economy; resultantly quality of products and services will also improve.

Disadvantages of FDI

  1. Domestic investments and domestic companies will be impacted adversely.
  2. Small companies will be affected massively as it will not be able to compete with the large MNCs.
  3. Exchange rates of foreign currencies are bound to get effected.

What can the Government do to increase FDI in India?

The Government can take the following measures to increase the inflow of FDI in India:

  1. Production Linked Incentives (PLIs) have to be properly implemented; it is a major source of attracting foreign investment.
  2. Government schemes like PM Gati Shakti National Master Plan, single clearance window and GIS- mapped land bank have provided a push to the inflow of FDIs in the economy.
  3. Providing financial and infrastructural support to start-ups, have made India a lucrative economy for foreign investment.
  4. The Central Government has further relaxed FDI norms in coal mining, defence production, single-brand retail trading and contract manufacturing.

FDI Guidelines on issue of Equity shares:

Under the existing FDI Policy in India, the price at which fresh shares are issued by the Indian Company to a non-resident, should not be less than the price determined as per any internationally accepted pricing methodology for valuation of shares. Generally, discounted cash flow method is the most commonly used method for arriving at the fair value of shares.

However, in case of issue of equity shares on rights basis , the above pricing guidelines are not applicable, but the law provides that the price at which the shares are issued to the non resident, should not be less than the price at which the same shares are issued to the resident.

Tax implications associated with Equity shares : –

  • Tax Deduction of Dividend in computing taxable income – Dividend paid by the Indian Company is not allowed as a tax deduction in computing taxable income of the Indian company. On the contrary, such dividend is liable to Dividend Distribution Tax (“DDT”) at an effective tax rate of 20.36 percent of the amount of dividend.
  • Taxation of dividend income in the hands of the non-resident investor in India : –Dividend income , on which the Indian company has paid Dividend Distribution Tax, is not taxable in the hands of the non-resident investor in India. However such dividends may be taxable in the country of residence of the non-resident investor, depending on the local tax laws of those countries. In many cases, it has been observed that where such a dividend is taxable in the country of residence, the credit for DDT paid by an Indian entity may or may not be available.
  • Cost of acquisition of equity shares acquired on Conversion of CCD /Preference Shares – Where equity shares were acquired by the non resident, on conversion of CCD /Preference Shares, the cost of acquisition of such shares for the purpose of calculating capital gains, shall be considered as the proportionate cost of respective CCD /Preference Shares.
  • Tax on Conversion of CCD into equity shares : – Conversion of compulsorily convertible debentures into equity shares is not liable to tax in India , under the Indian domestic tax law provision.
  • Tax on Sale of Equity Shares

Transfer of Equity Shares, is liable to Capital Gains tax in India. There is a special mechanism for taxation of shares of an Indian company, which are subscribed to in foreign currency by non- resident, whereby the effect of foreign currency fluctuation on capital gains is eliminated, but no benefit is provided in respect of indexation of cost of acquisition of such shares.

Given that the provisions relating to capital gain in various Tax Treaties may be different for transfer of shares and debentures, one should evaluate whether any additional benefit in terms of capital gains would be available post conversion of debentures into shares, and act accordingly.

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  • Gift of shares/ Transfer between two foreign companies under Corporate reorganization

Where shares of an Indian company are transferred by way of gift under a corporate reorganization of the MNC group, or transferred at less than fair value (specified under the IT Act), it may trigger tax implications under the Indian domestic law in certain specified circumstances in the hands of the recipient. Further, any transfer of shares under a merger of one foreign company into another/demerger of an undertaking of one foreign company into another, may be tax neutral, provided certain specified conditions are satisfied.

For any queries, please write them in the Comment Section or the author can be reached at contact@sortingtax.com

FAQs on FDI in India

Question: Define the following terms in the context of foreign Direct Investment in India : –

  • Foreign Investment
  • Foreign Direct Investment
  • Foreign Portfolio Investment
  • Foreign Venture Capital Investor

Answer: The terms have been defined below:

  • Foreign Investment- Investment made by a non-resident in capital instruments of an Indian company or LLP on a repatriable basis.
  • Foreign Direct Investment- Investment made by a non –resident in
    • An unlisted company or;
    • 10% or more post issue paid up equity share capital on a fully diluted basis in a listed Indian company.
  • Foreign Portfolio Investment- Investment made by a non –resident in
    • Less than 10% in the paid up equity value of capital instruments of a listed Indian company or;
    • Less than 10% in the post issue paid up equity share capital on a fully diluted basis in a listed Indian company.

Note: If on the basis of an increase in the total shareholding of a foreign resident in an Indian entity becomes 10% or exceeds it i.e. an FPI converts into an FDI, then if such shareholding drops below 10%, it shall still remain an FDI.

  • Foreign Venture Capital Investor- Investor incorporated and established outside India and registered under the SEBI (FVCI) Regulation, 2000. Investment by an FVCI is regulated by Schedule 7 of FEMA 20(R).

Question: If a sector has been shifted from the Automatic Route to Approval Route, does the non-resident, who has invested in that sector, require approval?

Answer: If the foreign investment remains the same and there no corporate action that is being brought under the purview of that sector under the Approval Route, no approval is to be obtained.

Question: What is the meaning of FDI linked performance conditions?

Answer: Sector specific conditions mentioned in Regulation 16 of FEMA 20(R) are guidelines that need to be followed by the companies that receive foreign investment.

Arinjay Jain

Bio of author

Arinjay is a Chartered Accountant with more than 20 years of post-qualification experience. He worked as Director, in the M&A Tax Division at KPMG in India. Presently, he is advising several MNCs in UAE on Economic Substance Regulations and impact of the UAE Corporate Tax Law on their business and clients across globe on International Tax issues . He is a well recognised Trainer of International Tax and UAE Corporate Tax. The areas of service include the following : - Advise and Compliance relating to International Tax Issues; Advise relating to UAE Corporate Tax Issues; Advise and Compliance relating to UAE Economic Substance Regulations; Advise and Compliance relating to Indian Income Tax Issues; Other connected matters from a Regulatory perspective.

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