I. Introduction

The Foreign Exchange Management Act, 1999 (the “FEMA”), along with the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (the “NDI Rules”), constitutes the primary legal framework governing foreign equity investments (both direct and indirect) in India. Additionally, instructions issued on foreign investment in India and its related aspects under the FEMA in the ‘Master Directions on Foreign Investment in India’ (the “Master Directions”), issued by the Reserve Bank of India (the “RBI”) lay down the modalities as to how the foreign exchange business has to be conducted with a view to implementing the NDI Rules. The FEMA read with the NDI Rules, and the Master Directions, collectively forms the comprehensive “FDI Regime” for foreign investments in India.

In the past years, both the Master Directions and the NDI Rules have undergone changes to attract foreign investment in India and ease out the processes of regulatory clearances, with emphasis on making India a hotspot for ease of doing business.

II. Downstream Investment

A downstream investment means investment by an Indian company which is either owned or controlled by a person resident outside India (an “FOCC”). It is an indirect foreign investment into equity instruments of Indian companies also conventionally termed as ‘downstre3am investment’. A downstream investment by an FOCC has always been governed by the underlying principle that “what cannot be done directly, shall not be done indirectly” (the “Guiding Principle”). Accordingly, the legislative intent of the FDI Regime is to prevent foreign investors from making investments indirectly through an Indian entity that would otherwise not be allowed under the FDI Regime directly.

Accordingly, any downstream investment made has to be in compliance with entry routes, sectoral caps, pricing guidelines, and other attendant conditions as applicable for foreign investment. However, historically, there has been certain regulatory ambiguity due to the lack of explicit clarification regarding the scope of the Guiding Principles under the FDI Regime. For instance, overseas entities have been expressly permitted, to undertake foreign direct investments (“FDI”) through swap of equity instruments, as well as make deferred consideration payments for the transfer of equity instruments to a person resident outside India (a “PROI”) and a person resident in India (with certain conditionalities). At the same time, ambiguity persists as to, whether this flexibility for swap transactions or deferred considerations (as allowed for FDIs) can be extended to FOCCs.

On January 20, 2025, the RBI updated the Master Directions (the “Updated Master Directions”), which provided clarifications on certain key aspects in relation to (i) downstream investment through swap of equity instruments, and (ii) deferred consideration in downstream investments, as detailed below.

III. Key Updates Regarding Downstream Investments

(a)Swap of Equity Instruments

In a share swap transaction, generally, consideration is discharged through the issuance or transfer of securities by the acquiring company. This approach alleviates liquidity constraints and enables more effective allocation of resources towards operational needs of the business.

Rule 6, and Rule 9A read with Schedule I of the NDI Rules, expressly allows a swap transaction, whereby equity instruments can be issued or secondary shares can be transferred to a PROI in exchange for equity instruments of another Indian company or equity capital of a foreign company, under the automatic route (wherever the sector of the relevant business allows it), subject to other conditionalities that may be applicable basis such sector of the business.

Historically, owing to the Guiding Principle, it should have been implied that if a swap of equity instruments is allowed for FDI, it would also be allowed for downstream investments.

However, in light of recent scrutiny by the RBI regarding specific swap transactions, several authorized dealer banks (“AD Banks”) had adopted a conservative approach. As per this approach, FOCCs utilizing the swap mechanism for downstream investment would be subject to the government approval route rather than the automatic route.

This view seems to have stemmed from Rule 23(4)(b) of the NDI Rules, which states that “for the purpose of downstream investment, the Indian entity making the downstream investment shall bring in requisite funds from abroad and not use funds borrowed in the domestic markets. The downstream investments may be made through internal accruals, and for this purpose, internal accruals shall mean profits transferred to the reserve account after payment of taxes”. The above provision, combined with the RBI’s extensive scrutiny of swaps in downstream investments, seemed to have led to a conservative approach that the consideration for downstream investment should be solely in cash.

Following the Updated Master Directions, this conflict has been sought to be resolved. It has now been expressly clarified under paragraph 9 of the Updated Master Directions that investment by way of swap of equity instruments is also allowed for downstream investment, provided that the transaction does not circumvent other provisions of NDI Rules in relation to downstream investment.

III. Investment Limits on Deferred Consideration and the FOCC Dilemma

Under the NDI Rules, deferred consideration is allowed for FDI under Rule 9(6) of the NDI Rules, which also stipulates that the deferment cannot exceed 18 months from the execution of the principal transaction documents. Furthermore, a PROI can defer, hold back, or place in escrow1 only up to 25% of the total consideration, for matters such as post-closing adjustments, earnouts2, or specific indemnity items under the principal transaction documents. Provided that the consideration paid as a final amount is required to be in adherence to the ‘fair value’ computed as per the pricing guidelines under the NDI Rules.

However, in recent years, reports emerged in the media that notices were issued by the RBI for various downstream investments, as regards utilizing deferred consideration in transactions involving transfer of equity instruments, highlighting that such practices were in contravention of legal design of FDI Regime.

Due to the regulatory ambiguity and the RBI’s practical approach, a conservative market view emerged, with the belief that FOCCs were prohibited from utilizing deferred consideration for structuring remittances for the purpose of transferring equity instruments.

However, the inclusion of paragraph 9 of the Updated Master Directions, in line with the Guiding Principle, has expressly clarified that FOCCs can utilise deferred consideration for transfer of equity instruments. However, it must be noted that any utilisation of deferred consideration arrangement in relation to transfers requires to be explicitly provided under the transaction documents in relation to foreign investments (whether direct or indirect). Additionally, such arrangements should not circumvent the other provisions of NDI Rules in relation to downstream investment.

IV. Issues Pending Clarity in Relation to FOCCs

(a) Applicability of pricing guidelines and reporting requirements

In relation to a transfer of equity instruments by a FOCC, the NDI Rules solely provide clarity on the scenarios where the FOCC is a transferor of equity instruments. In such cases, (i) when the transfer is made to a PROI, compliance with the reporting requirements is mandated and compliance with pricing guidelines is not mandated, (ii) when the transfer is made to a person resident in India, compliance with the pricing guidelines is mandated (that is, the consideration to be paid must not be above a ‘fair value’ computed as per accepted pricing methodology), and the compliance with reporting requirements is not mandated.

However, the FDI Regime does not provide clarity for scenarios where an FOCC is a transferee of equity instruments of an Indian entity and lacks the necessary legislative clarity to address this scenario comprehensively. At present, FDI Regime is unclear on: (i) whether for a transfer of equity instruments by a PROI to an FOCC, only reporting requirements are applicable or whether any specific requirements in relation to fair value  exist owing to the pricing guidelines; and (ii) whether for transfer of equity instruments by a person resident in India to an FOCC if reporting requirements are applicable, or if such transaction is solely governed by the pricing guidelines apply (as there is no clear directive on whether the price per equity instrument must meet or exceed the fair value ). Therefore, such transactions are currently evaluated on case-to-case basis by each AD Bank.

(b)Practicalities relating to swap of equity instruments through secondary transfers

Previously under FDI Regime any swap of equity instruments required an Indian company to undertake ‘fresh issuance of equity instruments’ to a PROI in lieu purchase of equity instruments of another Indian company.

A recent clarification3 added to the NDI Rules under Rule 9-A allows for a transfer of equity instruments of an Indian company, through swap transactions (involving equity instruments of an Indian company, or equity capital of a foreign company), subject to other applicable conditions.  Therefore now, in secondary transactions, the consideration for a secondary purchase of shares can be discharged by utilising shares of another entity (whether Indian or foreign). While there is no legislative ambiguity under NDI Rules, since this is a recent change, the manner of implementation and practical challenges around this are yet to be seen.

Paragraph 9 of the Updated Master Direction clarifies that the swap of equity instruments as a method for concluding secondary transfers is also available for downstream investments, subject to the FDI regime. Since the Updated Master Directions have just been released, the modalities of implementation remain to be seen.

V. Conclusion

The Updated Master Directions provide much-needed clarity to the regulatory landscape governing downstream investments in India, specifically addressing certain key areas of ambiguity. While some ambiguities as mentioned above subsist, clarifications by the Updated Master Directions have resolved critical uncertainties by confirming that swap transactions can be used by an FOCC, as long as they comply with the FDI Regime. Similarly, the clarification on deferred consideration gives more flexibility to FOCCs, allowing them to structure transfer of equity instruments basis the said mechanism on deferment of consideration, again, provided they comply with the FDI Regime.

This aligns the downstream investment framework with practices already allowed for FDI, making it easier for FOCCs to structure deals with a greater degree of certainty around the regulatory framework governing such investments.

Overall, these updates enhance the foreign investment landscape by reducing ambiguity and providing a more predictable framework for downstream investments. This aligns with India’s broader goal of becoming a leading destination for foreign investment and compliments its ambition to become a $5 trillion economy.

This paper has been written by Anindya Ghosh, Anantha Krishnan Iyer (Partners), Jaidrath Zaveri (Principal Associate) and Shubham Tiwary (Associate).

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1Holdbacks or escrows: To account for potential price adjustments post-closing, investors often defer part of the purchase price by holding it back or placing it in escrow, with any reduction in purchase price deducted from this amount once the final valuation is determined.

2Earnouts: Deferred consideration, often structured as an earnout tied to milestones, aligns the interests of investors and founders, while being more tax-efficient for founders as it is taxed at a lower capital gains rate compared to a cash bonus.

3 Rule 9-A was introduced to the NDI Rules vide Foreign Exchange Management (Non-debt Instruments) (Fourth Amendment) Rules, 2024 (August 16, 2024).

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