On April 17, 2020, the Department for Promotion of Industry and Internal Trade (“DPIIT”) issued the Press Note No. 3 (2020 Series) (“PN3”) with the primary objective of “curbing opportunistic takeovers and acquisitions of Indian companies due to the COVID-19 pandemic”. PN3 amended the Consolidated Foreign Direct Investment Policy of India, 2017 (“FDI Policy”) and made government approval a mandatory requirement for foreign direct investments (“FDI”) originating from countries sharing land border with India. This marked a significant deviation from India’s previous FDI policy and came against the backdrop of the economic and political challenges posed by the COVID-19 outbreak and the border conflict with China in 2020. However, as things stand today, there is a need to reflect on PN3’s impact on India’s FDI landscape and consider whether this framework needs modifications.
Key Amendments
Paragraph 3.1.1 of the FDI Policy was amended pursuant to PN3 to mandate prior government approval for (i) investments made by entities incorporated in countries sharing land border with India; or (ii) where the “beneficial owner” of the investment in India is situated in or is a citizen of such country. Further, it was mandated that a direct or indirect transfer of ownership of existing or future FDI resulting in the beneficial ownership falling under the above restrictions will also require prior Government approval. For the purpose of PN3, India recognizes Pakistan, Afghanistan, Nepal, Bhutan, China (including Hong Kong), Bangladesh and Myanmar as countries sharing land border with India (“Bordering Countries”).
In 2022, the Ministry of Corporate Affairs (“MCA”) introduced certain amendments pursuant to PN3:
- Incorporation: The Companies (Incorporation) Second Amendment Rules, 2022 introduced a revised format for the declaration made by the subscribers and first directors of companies in the Form INC-9 (Declaration by Subscribers and First Directors). Such persons need to confirm applicability of the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019, as amended (“NDI Rules”) in Form INC-9 and obtain prior government approval, if applicable, under the NDI Rules before subscribing to the shares of the company.
- Transfer of shares: The Companies (Share Capital and Debentures) Amendment Rules, 2022 introduced a new declaration regarding applicability of the NDI Rules and FDI approval in the Form SH-4 (Securities Transfer Form). Accordingly, an investing entity from the Bordering Countries needs to obtain prior government approval for acquiring shares of an Indian company and submit such approval along with the Form SH-4.
- Allotment of securities: The Companies (Prospectus and Allotment of Securities) Amendment Rules, 2022 mandated prior government approval under the NDI Rules for allotment of securities to citizens or legal entities from the Bordering Countries. Further, a new declaration regarding applicability of the NDI Rules has been added in the Form PAS-4 (Private Placement Offer cum Application Letter) and the government approval is required to be submitted along with the Form PAS-4.
- Appointment of directors: Pursuant to the Companies (Appointment and Qualification of Directors) Amendment Rules, 2022, the nationals of any of the Bordering Countries seeking appointment as a director of an Indian company or applying for a director identification number in India, are required to obtain necessary security clearance from the Ministry of Home Affairs. Further, additional declarations regarding applicability of national security clearance have been included in the relevant consent letters and application forms to be submitted therein.
- Merger or Amalgamations: The Companies (Compromises, Arrangements and Amalgamations) Amendment Rules, 2022 introduced a new Form CAA-16 for submitting the declaration regarding applicability of the NDI Rules and FDI approval in case of a compromise or an arrangement or merger or demerger being undertaken between an Indian company and a company or body corporate which has been incorporated in a country sharing land border with India.
In 2023, the DPIIT revised the standard operating procedure for processing FDI approval applications in India (“SOP”). The SOP seeks extensive information in the applications regarding beneficial ownership from the Bordering Countries, which inter alia includes: (i) entity wise details of the existing shareholders, investors, directors, key managerial personnel, etc., of all upstream entities until the ultimate beneficial owner, and (ii) details of shareholders belonging to or having beneficial ownership in the Bordering Countries, along with the ownership structure, place of incorporation or citizenship details of such entities and individuals. For the non-PN3 proposals, a broad declaration is required to be submitted confirming that none of investors or shareholders of the Indian investee company and the foreign investor, including their respective beneficial owners (regardless of their shareholding), belong to the Bordering Counties.
Key Shortcomings
Procedural aspects
While the DPIIT prescribes an indicative timeline of up to 12 weeks in the SOP, decisions on PN3 proposals have generally taken far longer. In many cases, PN3 proposals have remained pending without a decision for several years.
For example, in April 2024, media reports quoting an anonymous source noted that out of a total 526 proposals received under PN3 since its introduction, 124 proposals were approved, and 201 proposals were rejected. The remaining 200 proposals remained pending, in some cases for several years.
One key procedural shortcoming has been that there is no regular public data on PN3 proposals, or indeed any FDI proposals. Data in the public domain on PN3 applications has largely been based on responses to questions in Parliament or media reports quoting anonymous sources.
It is imperative that decisions are issued one way or another on PN3 rather than keeping them pending. Pending proposals without any decision leads to lack of clarity on the objectives sought to be achieved. It is also critical that the rationale for decisions on PN3 proposals be made public so that this can inform future applications under PN3.
As a broader point (not limited to PN3 proposals), the authors recommend:
- time-bound decision making in respect of FDI proposals where the SOP is followed in letter and spirit; and
- a process for periodic public dissemination of decisions on FDI proposals, including any key points emerging from such decisions.
Substantive aspects
PN3 covers investments where the “beneficial owner” is situated in or is a citizen of one of the Bordering Countries. The term “beneficial owner” has not been defined under PN3 and has different meanings under different laws in India. For example, the Companies Act, 2013, as amended, defines a “significant beneficial owner” as someone with a direct or indirect shareholding of 10% or more in the investing entity whereas the Prevention of Money Laundering Act, 2002 (“PMLA”) defines “beneficial owner” as the owner or holder of ultimate control over the investing entity. The rules framed under the PMLA earlier referred to a 25% threshold for ascertaining “control” – this threshold was revised to 10% in March 2023. The absence of any formal guidance under PN3 for ascertaining “beneficial ownership” has resulted in the authorized dealers bank adopting an inconsistent approach while identifying restricted investments under PN3. This significantly impacts foreign investors, private equity or venture funds and listed entities, where entities or individuals from the Bordering Countries might have miniscule or passive participation and still attract the restrictions of PN3 as a technical matter.
The authors recommend that it be clarified that any investment of less than 10% in an investing entity from a person or entity in a Bordering Country will not be considered relevant from a PN3 perspective.
Existing investors from the Bordering Countries may also have call or put options over shares of Indian investee companies or may seek to participate in bonus or rights issue of such companies to maintain their existing shareholding. However, pursuant to PN3, these would trigger prior government approval and any additional investments made by such investors in their existing wholly owned subsidiaries in India would also trigger such approval requirement.
The authors recommend an exception for (i) investments by persons or entities from Bordering Countries in existing wholly owned subsidiaries in India, and (ii) participation by such persons or entities in bonus or rights issuances to maintain existing shareholding in Indian companies.
The Economic Survey
While the stated objective of PN3 was to prevent opportunistic takeovers by investors from Bordering Countries (specifically China) due to the COVID-19 pandemic, the result has been that investments from China accounted for 0.37% of the total FDI inflow reported in India between April 2000 and March 2024. It is undeniable that national security concerns in relation to China have not abated; however other circumstances that prompted introduction of PN3 have changed significantly as the COVID-19 pandemic has abated and Indian companies have overcome the uncertainty brought by the global pandemic.
In this backdrop, recently the Economic Survey for 2023-2024 (“Economic Survey”) has proposed a contrasting approach to the government’s current stance on FDI investments from China. The Economic Survey, which is an annually published by the Ministry of Finance and prepared under the guidance of the chief economic advisor to the Government, has advocated for softening the stance on FDI inflows from China. It highlights India’s two choices to benefit from the China plus one strategy being pursued by many international companies: integrating into China's supply chain or promoting FDI from China.
The Economic Survey favors choosing FDI as a strategy to benefit from the China plus one approach rather than relying on trade. The Economic Survey notes that China is India's largest import partner, and the trade deficit with China has been rising. Further, with the western markets shifting their immediate sourcing away from China, it is more effective to have Chinese companies invest in India and then export products to the western markets. This is in contrast with India’s current practice of importing from China, adding minimal value, and then re-exporting such products.
Way Forward
The authors submit that there is a strong case to take a nuanced approach towards Chinese FDI, particularly in sectors in which such FDI could potentially assist in growth of Indian industry.
It has been suggested that the Government consider notifying a list of sectors and industries where it may permit Chinese investment without prior approval. Such a list would focus on sectors that would help indigenize manufacturing and not undermine national security concerns. Investment in these sectors would be permitted without scrutiny under PN3.
Other commentators have suggested that while a prior approval requirement be retained in all cases of investments from China, however consideration of PN3 proposals be substantially expedited and approvals be issued as a matter of course for investments in sectors which do not raise national security concerns – this approach could achieve a similar result.
Irrespective of the approach that is followed (or indeed a combination of such approaches), it is evident that a recalibration of the PN3 restrictions is imperative to help diversify supply chains and encourage domestic industry without, in any way, undermining or compromising national security concerns.
This insight has been authored by Rajat Sethi and Oshika Nayak from S&R Associates. They can be reached at [email protected] and [email protected], respectively, for any questions. This insight is intended only as a general discussion of issues and is not intended for any solicitation of work. It should not be regarded as legal advice and no legal or business decision should be based on its content.