India Growth Story Has a Beneficial Ownership Hurdle

Why in News?

• India's ambition to achieve a $5 trillion economy by the end of the financial year 2025-26 heavily relies on foreign investments.
• However, attracting foreign investments necessitates the removal of significant bottlenecks facing Indian companies and foreign investors.
• The Indian Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (FEMA NDI) while intended to protect Indian companies during the COVID-19 pandemic, has introduced considerable challenges that needs to be addressed to develop a conducive environment for foreign investment.

The Indian Foreign Exchange Management (Non-debt Instruments) Amendment Rules, 2020

• This amendment stipulates that any investments in Indian companies, whether direct or indirect, originating from entities located in countries that share land borders with India, or where the “beneficial owner” of the said Indian investment is situated in, or is a citizen of any of these Neighbouring Countries would necessitate prior government approval (“PN3 Requirement”).
• The amendment to the 2019 Rules (FEMA NDI) has posed a significant challenge for Indian companies, especially start-ups and smaller enterprises seeking foreign investments.

Amendment Conundrum: Challenges and Complexities Due to the Amendment

• Intent and Implications of the Amendment
  • The PN3 Requirement mandates prior government approval for any foreign investments originating from countries that share land borders with India, or where the beneficial owner of the investment is situated in these neighbouring countries.
  • This stipulation emerged as a protective measure against hostile takeovers during a period of unprecedented economic instability.
  • The rationale was to safeguard strategic assets and businesses from being acquired at undervalued prices by entities from neighbouring countries, potentially capitalising on India's temporary economic downturn.
  • However, the amendment's implementation has led to considerable uncertainty due to the lack of a clear definition for the term ‘beneficial owner’.
  • This term is crucial as it determines the necessity of obtaining prior government approval.
  • Various Indian laws provide context-specific definitions of beneficial ownership, but none are universally applicable to the PN3 Requirement, causing interpretative inconsistencies.
• Initial Industry Response
  • When the PN3 Requirement was first introduced, the industry generally adopted a lenient view.
  • Companies and legal advisors relied on beneficial ownership thresholds defined in other laws, such as the Companies Act, 2013, and the Prevention of Money Laundering Act, 2002.
  • These thresholds often varied between 10% and 25%, and the industry used these figures to guide compliance efforts.
  • However, the regulatory landscape began to shift in the latter half of 2023.
  • The Reserve Bank of India (RBI), responsible for overseeing compliance with FEMA NDI, adopted a more conservative interpretation of the law.
  • This shift was particularly evident in the RBI's scrutiny of Foreign Owned or Controlled Companies (FOCCs) and their downstream investments.
  • Many FOCCs received notices from the RBI questioning their compliance, leading to a re-evaluation of industry practices.
• Subsequent Regulatory Stance and its Effect
  • The RBI's conservative stance suggested that FOCCs might be subject to the same restrictions as non-resident entities regarding aspects of the law that were previously ambiguous.
  • This interpretation prompted investors to reassess their strategies and caused legal firms to advise clients against relying on beneficial ownership thresholds from other laws.
  • This shift in regulatory interpretation created a ripple effect of uncertainty and cautiousness among foreign investors and Indian companies alike.
• Challenges in Compliance and Approval Process
  • The requirement for prior government approval, as stipulated by the PN3 Requirement, poses significant challenges.
  • The approval process is not only time-consuming but also marked by a high rejection rate.
  • Although consolidated official data on pending or rejected applications is not publicly available, statements from government officials indicate a substantial backlog.
  • Proposals worth ₹50,000 crore are either pending, withdrawn, or rejected, and 201 applications have been turned down in the past three years.
  • This complex approval process creates a bottleneck for companies seeking foreign investment.
  • The uncertainty and delays associated with obtaining approval can deter potential investors, particularly those looking to invest in fast-growing start-ups and smaller enterprises that need timely capital infusions to sustain their growth trajectories.
• Legal and Financial Uncertainties
  • The PN3 Requirement places the onus of compliance squarely on the Indian companies receiving foreign investments.
  • The regulatory authorities have the discretion to impose severe penalties for non-compliance, including fines of up to three times the investment received.
  • This stringent penalty structure, combined with the inherent vagueness of the legislation, can create significant legal and financial risks for companies.
  • Many start-ups, which often operate with investments far exceeding their current revenues or assets, face the risk of insolvency if subjected to such fines.
  • Non-compliance could also trigger prolonged legal battles, adding to India's already substantial backlog of court cases.
  • This legal uncertainty further complicates the investment landscape, making it less attractive for foreign investors.

Proposed Solutions to Address the Challenges

• Clear Definition of Beneficial Owners
  • Indian companies might consider requiring foreign investors to provide indemnities ensuring compliance with the PN3 Requirement.
  • However, this approach could deter investors due to potential liabilities.
  • Therefore, a more practical solution involves amending the PN3 Requirement to include a comprehensive definition of ‘beneficial owners’, covering ownership thresholds and control tests.
  • The definition should specify a clear threshold for beneficial ownership, ranging from 10% (as per Indian company law) to 25% (as recommended by the Financial Action Task Force).
  • This threshold can be adjusted to align with the government's objective of scrutinising varying levels of foreign investment across different sectors.
  • Sensitive sectors like telecom and defence might warrant stricter scrutiny compared to sectors like manufacturing and construction, which require more foreign capital.
  • The definition should also outline control-conferring rights beyond ownership thresholds, encompassing significant influence indicators such as board meeting quorums or veto powers over operational decisions.
  • However, investor value protection rights, like veto powers over mergers or right of first offer, should be excluded as they do not constitute control.
• Employment of Time Bound Consultation Mechanism
  • To address lingering ambiguities even after defining control-conferring rights, a time-bound consultation mechanism with regulatory authorities could be instituted.
  • This would allow for a determination of whether specific clauses in charter documents confer control, like mechanisms in Indian competition law.
  • Such a system would ensure clarity and reduce legal uncertainties.

Conclusion

• For India to attract the necessary foreign investments to reach its $5 trillion economy goal, it is crucial to address the bottlenecks posed by the current regulatory framework.
• Amendments to the PN3 Requirement, specifically defining beneficial ownership and establishing a clear consultation mechanism, will provide clarity and confidence to foreign investors.

By refining these regulations, India can create a more favourable investment climate, encouraging the influx of foreign capital essential for its economic growth and development.

Q) What are the main drivers of India's recent economic growth?

India's recent economic growth has been propelled by several key factors. Foremost among them is the expansion of the service sector, particularly in information technology (IT) and IT-enabled services, which has significantly contributed to the country's GDP. Additionally, India's demographic dividend, characterised by a young and growing workforce, has enhanced productivity and innovation. Foreign Direct Investment (FDI) has also played a crucial role, bringing in much-needed capital, technology, and expertise across various sectors.

Q) What challenges does India face in sustaining its economic growth?

Despite its robust growth, India faces several challenges in sustaining its economic momentum. One significant issue is income inequality, which poses a threat to social stability and economic inclusivity. Additionally, while the economy has grown, creating enough quality jobs to match the expanding labour force remains a persistent challenge. The rural-urban divide also needs to be addressed to ensure balanced and equitable development across the country. Furthermore, although there have been strides in infrastructure development, continued investment is required to bridge existing gaps, especially in rural areas.

Source:The Hindu