Introduction

The Reserve Bank of India (“RBI”), vide circular dated 11th November 2024 has placed an elaborate operational framework for reclassifying Foreign Portfolio Investment (“FPI”) to Foreign Direct Investment (“FDI”). This is an important clarification for Authorised Dealer (“AD”) Category-I banks and foreign investors, thereby giving much-required guidance on the procedural aspects of such reclassification.

Legal Basis and Background

The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (“Rules”), in particular Schedule II, serve as the foundation for the current framework. As per the Rules, holding by an investor group, including other investors, in FPIs should not exceed 10% of the total paid-up equity capital on a fully diluted basis. This would leave the foreign portfolio investor with an option to either divest the excess holding, or it could reclassify the same as FDI. It addresses the latter one specifically and moves on systematically to follow this reclassification exercise.

Key Components of the Framework

The current operational framework outlines several critical requirements that deserve careful consideration. First, the framework emphatically curbs reclassification in sectors in which FDI is not allowed. This essentially sets a definitive boundary for such conversions, qualifying it as a sensitive boundary for sectors of the Indian economy.

The framework mandates necessary governmental approvals, particularly if the countries where investments are undertaken share a land border with India. This sits well with the recent policy changes that the Indian government has executed regarding investments that are coming in from neighbouring countries. There is also a requirement for the concurrence of the investee company, such that the reclassification satisfies sector-specific caps and other applicable conditions under Schedule I of the Rules.

Procedural Requirements and Timeline

One of the most notable aspects of this framework is the making of explicit requirements for documentation and reporting. The FPI needs to document its intention to reclassify its investments with the necessary approval of its custodian. The Custodian freezes the purchase transactions until the reclassification is complete. Thus, the reclassification process is always regulated, and no interim transactions are allowed to be made there that might create hurdles for the reclassification process. 

The reporting requirements are extra stringent, with certain forms prescribed depending on the nature of the investment. For fresh issuances, the Indian company has to report on Form FC-GPR, whereas, in the case of secondary market acquisition, the FPI has to report on Form FC-TRS. The framework requires that AD banks report the reclassified foreign portfolio investment as divestment under LEC (FII) reporting.

Impact and Implications

This framework is one step in the right direction towards the much-required clarity in the reclassification process of FPI to FDI. This subsumes several practical difficulties that investors and custodians previously faced with respect to similar conversions. However, the strict five-trading-day timeline from the date of settlement of the trades that caused a breach may pose operational challenges when multiple approvals are required.

Perhaps the most significant aspect of such treatment is in relation to reclassified investments. Once an investment is reclassified as FDI, all the investment continues to be so regarded even if, subsequently, the limit has fallen below 10%. Such a provision would establish regulatory consistency and prevent frequent switching between FPI and FDI.