RESEARCH PAPER SUBMITTED IN FULFILMENT OF THE COURSE TITLED

CORPORATE LAW – II AND FOR OBTAINING THE DEGREE B.B.A., LL.B.(HONS.)

DURING THE ACADEMIC YEAR – 2020 – 2021.

DOWNSTREAM INVESTEMENT IN INDIA

SUBMITTED TO:- Ms. NANDITA S. JHA

FACULTY - CORPORATE LAW

SUBMITTED BY – RAHUL RAJ

ROLL NO – 1845
B.B.A., LL.B.(HONS.)

APRIL 2021.
CHANAKYA NATIONAL LAW UNIVERSITY NYAYA
NAGAR, MITHAPUR, PATNA.
 AKNOWLEDGEMENT
Writing a project is one of the most significant academic challenges I have ever faced.
Though this project has been presented by me but there are many people who remained
in veil, who gave their all support and helped me to complete this project.

First of all, I am very grateful to my subject teacher MRS. NANDITA JHA without
the kind support of whom and help the completion of the project would have been a
Herculean task for me. He donated his valuable time from his busy schedule to help me
to complete this project and suggested me from where and how to collect data.

I am very thankful to the librarian who provided me several books on this topic which
proved beneficial in completing this project.

I acknowledge my friends who gave their valuable and meticulous advice which was
very useful and could not be ignored in writing the project.

RAHUL RAJ

ROLL- 1845 4TH YEAR

B.B.A. LLB. (HONS.)

2017-2022
 CONTENTS

1. INTRODUCTION
• HISTORICAL BACKGROUND
• DEFINITION OF IFI OR DOWNSTREAM INVESTMENT
• CATEGORIES OF INVESTMENT

2. MEANING OF INDIRECT FOREIGN INVESTMENT

• POLICY OF INDIRECT INVESTMENT
• CONDITIONS FOR DOWNSTREAM INVESTMENT
• METHODOLOGY FOR CALCULATING INDIRECT FOREIGN
INVESTMENT
• RULES AND REGULATIONS RELATED TO IFI
➢ Press Note 3 (2020)

3. IMPLICATIONS OF INDIRECT FOREIGN INVESTMEMNT

• FOREIGN EXCHANGE MANAGEMENT ACT – FEMA

4. CONCLUSION AND SUGGESTIONS

 OBJECTIVES OF STUDY

Thr ough this study the researcher wants to find out:

• the meaning of downstream investment

• implications of downstream investment
• the need of fema to regulate IFI.

RESEARCH METHODOLOGY

The researcher has adopted Doctrinal method of research to complete the project.
Doctrinal Methods refer to Library research or research done upon texts writings
or Documents, legal propositions and Doctrines, Articles, Books as well as Online
Research and Journals relating to the subject.

HYPOTHESIS

The researcher believes that the latest press note regarding the indirect foreign
investment is ambiguous in nature which needs to be clarified.

SOURCES OF STUDY

• Primary sources: Case Law, Companies Act, 2013, FEMA, 1999.

• Secondary Sources: Newspapers, journals, periodicals, etc.

LIMITATIONS OF THE STUDY

There are various hindrances which can be faced by the researcher during the
formation of this project such as scarcity of time, expensive legal materials for
various research works, research done by an individual.
 LITREATURE REVIEW

Foreign Direct Investment and Globalisation 2014 Edition by Ramni Taneja

Foreign Direct Investment (FDI) is a subject of great importance to India. Ms Ramni

Taneja presents an overall study of FDI in all its aspects. The author has presented a
comprehensive and authoritative analysis of the background, legality, advantages and
disadvantages of FDI. Additionally, the book provides the judicial interpretation given to
FDI policy in India and its impact on various laws including taxation.
 INTRODUCTION

Foreign investment comprises of both direct foreign investment from non-residents and
indirect investments through resident Indian entities. Downstream investment means
indirect foreign investment by one Indian company into another Indian company by
way of subscription or acquisition of shares1.

Foreign Direct Investment (FDI) has been welcomed in India since 1991. Investment
by foreigner (non-resident) in an Indian entity is considered as Direct Foreign
Investment. Investment by an Indian company (which is owned or controlled by
foreigners) into another Indian entity is considered as Indirect Foreign Investment (IFI).
It is also known as downstream investment.

Prior to 2009, there were no clear rules on Indirect Foreign Investment. There were
some rules for Telecom, broadcasting, insurance and infrastructure service sectors.
DIPP issued press notes in February 2009 bringing in the concept of IFI. These
guidelines were notified by RBI only in June 2013. The delay was due to differences
between RBI and Government of India. There have been some amendments after June
2013. In 2015-16, several notifications under FEMA have been issued which have
brought in a lot of clarity.

The basic policy behind IFI rules is - What can be done directly can be done indirectly.
What cannot be done directly cannot be done indirectly.

HISTORICAL BACKGROUND

Foreign Direct Investment (FDI) has been welcomed in India since 1991. Investment
by foreigner (non-resident) in an Indian entity is considered as Direct Foreign
Investment. Investment by an Indian company (which is owned or controlled by
foreigners) into another Indian entity is considered as Indirect Foreign Investment

1
The term ‘Downstream Investment’, although widely used, was not specifically defined. It is now defined
under Press Note 4 [2009 Series] issued by the Department of Industrial Policy & Promotion, Government of
India [DIPP] as indirect foreign investment by one Indian company into another Indian company by way of
subscription or acquisition in terms of Press Note 2 of 2009
 (IFI). It is also known as downstream investment.
Prior to 2009, there were no clear rules on Indirect Foreign Investment. There were
some rules for Telecom, broadcasting, insurance and infrastructure service sectors.
DIPP issued press notes in February 2009 bringing in the concept of IFI. These
guidelines were notified by RBI only in June 2013. The delay was due to differences
between RBI and Government of India. There have been some amendments after
June 2013. In 2015-16, several notifications under FEMA have been issued which
have brought in a lot of clarity.2
Guidelines for calculation of total foreign investment i.e. direct and indirect foreign
investment in Indian companies is primarily governed by Press Note No 2 (2009
Series) issued by Ministry of Commerce & Industry, Department of Industrial Policy
& Promotion, Government of India.

Meaning of Foreign Direct Investment (FDI)

In Indian perspective, FDI in simply words means Investment by foreign entity or

enterprise into an Indian entity or enterprise with a view to create long business
relations. FDI may be made in an Indian entity or enterprise by way of purchasing
equity shares.
In other words, any non-resident investment in an Indian company is foreign direct
investment.

Meaning of Indirect Foreign Direct Investment (Indirect FDI)

Investment in Indian companies can be made both by non-resident (Foreign Entities)

as well as resident Indian entities. Investment by resident Indian entities could again
comprise of both resident and non-resident investment. Thus, such an Indian
company would have indirect foreign investment if the Indian investing company has
foreign investment in it.

2
Foreign Direct Investment and Globalisation 2014 Edition by Ramni Taneja
 Example: XYZ Limited (resident Indian entities) is having Foreign Direct
Investment made by Fidelity fund Mauritius (non-resident). ABC Limited is
subsidiary of XYZ Limited in India having investment of XYZ Limited. Here XYZ
Limited comprise of both resident and non-resident investment. Accordingly ABC
Limited said to have indirect foreign investment as XYZ Limited (Indian investing
company) has foreign investment in it For the purpose of computation of indirect
Foreign investment, Foreign Investment in Indian company shall include all types of
foreign investments i.e. FDI, investment by FIIs (holding as on March 31), NRIs,
ADRs, GDRs, Foreign Currency Convertible Bonds (FCCB) and convertible
preference shares, convertible Currency Debentures regardless of whether the said
investments have been made under Schedule 1, 2, 3 and 6 of FEMA (Transfer or
Issue of Security by Persons Resident Outside India) Regulations.

CATEGORIES OF INVESTMENTS IN INDIA

Under the Foreign Direct Investments (FDI) Scheme, investments can be made in
shares, mandatorily and fully convertible debentures and mandatorily and fully
convertible preference shares of an Indian company by non-residents through two
routes:
a. Automatic Route:
Under the Automatic Route, the foreign investor or the Indian company does not
require any approval from the Reserve Bank or Government of India for the
investment.
b. Government Route:
Under the Government Route, the foreign investor or the Indian company should
obtain prior approval of the Government of India (Foreign Investment Promotion
Board (FIPB), Department of Economic Affairs (DEA), Ministry of Finance or
Department of Industrial Policy & Promotion, as the case may be) for the investment.
 CONDITIONS FOR DOWNSTREAM INVESTMENT

1. The Downstream Investments should have the approval of the Board of

Directors as also a Shareholders' Agreement, if any.
2. Downstream investments may be made within foreign equity levels permitted
for different activities under the automatic route.
3. The Downstream Investment involving setting up of an Export Oriented
Units (EOU)/Software Technology Parks (STP) /Electronic Hardware
Technology Parks (EHTP) project or items involving compulsory licensing,
SSI reserved items, acquisition of existing stake in an Indian company by way
of transfer/ as also buyback shall not be eligible for automatic approval and
shall require prior approval of Foreign Investment Promotion Board
(FIPB)/Government.
4. Issue/transfer/pricing/valuation of shares shall be in accordance with
SEBI/RBI guidelines
5. 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. These guidelines were first issued
by DIPP in 2009 vide their Press Note 4 and was thereafter incorporated by
RBI in FDI Regulations.
6. Downstream investments can be made through internal accruals. Internal
accruals mean profits transferred to reserve account after payment of taxes.
DIPP issued these guidelines vide Press Note 12 of 2009 and was thereafter
incorporated by RBI in FDI Regulations.
7. Further, raising of debt and its utilisation shall be in compliance with FEMA
Act, rules or regulations made thereunder.
8. Capital instrument of an Indian company held by another Indian company
which has received foreign investment and is not owned and not controlled
by resident Indian citizens, or is owned or controlled by persons resident
outside India may be transferred to:

• A person resident outside India, subject to reporting requirements in

Form FC-TRS
 • A person resident in India subject to adherence to pricing guidelines
• An Indian company which has received foreign investment and is not
owned and not controlled by resident Indian citizens or owned or
controlled by persons resident outside India

9. The first level Indian company making downstream investment shall be

responsible for ensuring compliance with the provisions of these regulations
for the downstream investment made by it at second level and so on and so
forth.
10. The first level company shall obtain a Certificate to this effect from its
Statutory Auditor on an annual basis and compliance of these regulations
shall be mentioned in the Director's Report in the Annual Report of the Indian
company. In case statutory auditor has given a qualified report, the same shall
be immediately brought to the notice of the Regional Office (RO) of the
Reserve Bank in whose jurisdiction the Registered Office of the company is
located and shall also obtain acknowledgement from the RO3.
11. Pursuant to the Press Note 3 of 2020, government approval will also be
required for any Downstream Investment made by an FOCC Entity that has
received FDI from a Restricted Investor. This will apply even if the Indian
entity receiving the Downstream Investment operates in a sector covered
under the automatic route.4
.

METHODOLOGY FOR CALCULATING INDIRECT FOREIGN

INVESTMENT

The method of calculation of total foreign investment in an Indian company

including indirect foreign investment through other Indian companies has been
detailed out in entry 10 of Press Note 2(2000), Press Note 1(2006), Press Note
3(2007) and entry 24 of Press Note 7 (2008). The methodology for some sectors is
also separately contained in either sectoral regulations or rules and regulations under

3
https://www.sbsandco.com/blog/downstream-investment-under-fema accessed on 28th march,2021.
4
https://dipp.gov.in/whats-new/press-note-3-2020 accessed on 9th april,2021.
 specific statutes.5

Essentially the present FDI guidelines provide for three different regimes for
calculation of Indirect Foreign Equity.

a. Telecom/ Broadcasting sectors: Proportionate method is used in Telecom/

Broadcasting sectors through Press Note 5 of 2005, Press Note 1 of 2006 and Press
Note 3 of 2007.
b. Insurance: Outlined in IRDA regulations (IRDA (Registration of Indian Insurance
Companies) Regulations, 2000) and
c. Other Sectors: In all other sectors, for an investing company in the infrastructure
/ service sector attracting equity caps, indirect equity is calculated as was given in
Press Note 2 of 2000: Investing companies in infrastructure/service sectors (entry no.
10). This policy was reiterated by Press Note 4 of 2006(Entry no.18) which was
modified by a Press release dated November 13, 2006 and Press Note 7(2008) (entry
24). According to this, foreign investment in an investing company will not be set
off against this cap where the foreign equity in the investing company does not
exceed 49% and the Management of the investing company is with Indian owners.
FIPB approval is required by Investing Companies for downstream investment.

Guidelines for calculation of total foreign investment i.e., direct and indirect
foreign investment in an Indian company

a. Counting the Direct Foreign Investment: All investment directly by a non-

resident entity into the Indian company would be counted towards foreign
investment.
b. Counting of indirect foreign Investment: Methods for counting of indirect
foreign Investment may be divided into 2 parts which are mentioned below:

Method No. 1

5
https://rbi.org.in
The foreign investment through the investing Indian company would not be
considered for calculation of the indirect foreign investment in case of Indian
companies which are ‘owned and controlled’ by resident Indian citizens and/or
Indian Companies which are owned and controlled by resident Indian citizens. For
this purpose, an Indian company may be taken as being:
• “owned” by resident Indian citizens and Indian companies, which are owned and
controlled by resident Indian citizens, if more than 50% of the equity interest in it is
beneficially owned by resident Indian citizens and Indian companies, which are
owned and controlled ultimately by resident Indian citizens; and
• “controlled” by resident Indian citizens and Indian companies, which are owned
and controlled by resident Indian citizens, if the resident Indian citizens and Indian
companies, which are owned and controlled by resident Indian citizens, have the
power to appoint a majority of its directors.
Example: Suppose the indirect foreign investment is being calculated for Company
ABC Limited which has investment through an investing company XYZ Limited
having foreign investment by Fidelity Fund Mauritius, the following would be the
method of calculation:
(i) where Company XYZ Limited has foreign investment less than 50%-
Company ABC Limited would not be taken as having any indirect foreign
investment through Company XYZ Limited.

Method No. 2

Method 2 applied where method 1 above is not satisfied or if the investing company
is owned or controlled by ‘non-resident entities’, the entire investment by the
investing company into the subject Indian Company would be considered as indirect
foreign investment.
Example: Suppose the indirect foreign investment is being calculated for Company
ABC Limited which has investment through an investing company XYZ Limited
having foreign investment by Fidelity Fund Mauritius, the following would be the
method of calculation:
(ii) where Company XYZ Limited has foreign investment of say 65% and:
a. invests 34% in Company ABC Limited, the entire 34% investment by Company
XYZ Limited would be treated as indirect foreign investment in Company ABC
Limited;
b. Invests 90% in Company ABC Limited, the indirect foreign investment in
Company ABC Limited would be taken as 90%.

Exception
There is one exception created for Method No. 2. As an exception, the indirect
foreign investment in 100% owned subsidiaries of operating-cum-
investing/investing companies will be limited to the foreign investment in the
operating-cum-investing/ investing company. For the purposes of explanation, it is
clarified that this exception is being made since the downstream investment of a
100% owned subsidiary of the holding company is akin to investment made by the
holding company and the downstream investment should be a mirror image of the
holding company. For the above purpose, an Indian company may be taken as being:
• “owned” by ‘non-resident entities’, if more than 50% of the equity interest in it is
beneficially owned by non-residents.
• “controlled” by ‘non-resident entities’, if non-residents have the power to appoint
a majority of its directors
Example: Suppose the indirect foreign investment is being calculated for Company
ABC Limited which has investment through an investing company XYZ Limited
having foreign investment by Fidelity Fund Mauritius, the following would be the
method of calculation:
(ii) where Company ABC Limited is a wholly owned subsidiary of Company
XYZ Limited (i.e., Company XYZ Limited owns 100% shares of Company
ABC Limited) and Company XYZ Limited has foreign investment of 65%,
then only 65% would be treated as indirect foreign equity and the balance
35% would be treated as resident held equity. The indirect foreign equity in
Company ABC Limited would be computed in the ratio of 65: 35 in the total
investment of Company XYZ Limited in Company ABC Limited. The total
foreign investment would be the sum total of direct and indirect foreign
investment. The above methodology of calculation would apply at every
stage of investment in Indian Companies and thus to each and every Indian
Company.
 RULES AND REGULATIONS RELATED TO IFI

Department of Industrial Policy and Promotion (“DIPP”), Ministry of Commerce

and Industry, Government of India issues Press Notes (“PN”) from time to time to
pronounce the FDI Policy of the Central Government.
Prior to 2009, there were no clear and concise rules on Downstream Investment.
There were only some rules for Telecom, broadcasting, insurance and infrastructure
service sectors prior to 2009. DIPP issued press notes in February 2009 bringing in
the concept of DI for the first time. Thereafter DIPP has issued Press notes 2 (2009
Series), 3 (2009 Series), both dated 13th February 2009, and 4 (2009 Series), dated
25th February, 2009 bringing more clarity on DI and also provided guidelines on
calculation of Indirect Foreign Investment. These are now subsumed within the
Consolidated FDI Policy.

RBI incorporated DIPP’s DI related guidelines in its Foreign Exchange Management

(Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017,
commonly known as “FDI Regulations”. In short, DI is governed by DIPP PNs and
RBI FDI Regulations.

Press Note 3 (2020)

The Government of India has changed its foreign direct investment policy ("FDI
Policy") pursuant to a Press Note No. 3 (2020 Series) dated April 17, 2020, (the
"Press Note"). The Press Note seeks to curb "opportunistic takeovers/acquisitions of
Indian companies" due to the current COVID-19 pandemic.

In terms of the Press Note,

(i) all investments by entities incorporated in a "country which shares land
border with India or where the beneficial owner of an investment into India
is situated in or is a citizen of any such country" ("Restricted Investor") will
require prior approval of the Government of India; and
(ii) in the event of any transfer of ownership of any existing or future foreign
direct investment ("FDI") in an entity in India, directly or indirectly, resulting
 in the beneficial ownership falling within the restriction/purview of (i) above,
such change in beneficial ownership will also require prior government
approval. The countries which share a land border with India are Afghanistan,
Bangladesh, Bhutan, China, Myanmar, Nepal and Pakistan ("Bordering
Countries").

The Press Note changes the FDI Policy in two fundamental respects:
First, it expands the list of countries whose investors are no longer eligible to invest
in India under the automatic route. Second, an investment in India – that would
otherwise fall under the automatic route – now falls under the government route if it
is from an entity whose "beneficial owner" is from such Bordering Country. These
changes have far-reaching implications on the overall FDI regime.

The term "beneficial owner" has different meanings under different laws in India.
Depending on how it is defined it could mean (i) an entity with a prescribed
shareholding level in the investing entity (as is the case under the Companies Act of
2013) or (ii) the owner or holder of ultimate control over the investing entity (as
defined under the Prevention of Money-laundering Act, 2002). A somewhat similar
concept is also used by the Securities and Exchange Board of India to identify the
ultimate beneficial owner for the purposes of certain securities laws.

Investment by an Indian entity which is not owned or controlled by Indian residents

("FOCC Entity") into another Indian entity ("Downstream Investment") is required
to be made in compliance with the applicable foreign investments conditions as if the
target entity was directly receiving foreign investment.

IMPLICATIONS OF INDIRECT FOREIGN INVESTMENT

All IFI have to comply with all FEMA rules - sectoral caps, conditions or restrictions
of FDI policy. This includes capitalisation norms, valuation rules, optionality clauses,
etc. Where approvals are required, the same have to be obtained. Thus, even though the
transactions may be between Indian entities, if one of them is Indirect foreign investor,
FEMA applies.

The Foreign Exchange Management Act, 1999 (FEMA) deals with cross border
investments, foreign exchange transactions and transactions between residents and non-
residents. It has come into force from June 1, 2000.

The operation of FEMA is akin to any other commercial law. However as compared to
most other commercial laws FEMA is one of the smallest, having only 49 Sections. If
guidelines, rules etc. are followed, the person can undertake most transactions without
any approvals. If proposed transactions fall outside the guidelines, one will have to
obtain necessary prior approvals. The consequence of any violation is a penalty. If
penalty is not paid within the specified time, then there can be prosecution

FEMA extends to the whole of India. It also applies to all branches, offices and agencies
outside India, which are owned or controlled by a person resident in India, in this
respect FEMA can be said to acquire extra-territorial jurisdiction.

The responsibility for compliance of IFI rules is on the investee company at all levels.
Thus, even small start-up companies which receive investment from a Venture fund,
will need to consider whether the VCF is domestic investment or foreign investor.

The first level Indian company which has received Direct Foreign Investment, is
required to get a certificate from the auditor annually that downstream investment rules
have been complied with (including its subsidiaries)
 CONCLUSIONS AND SUGGESTIONS

Exchange control rules on downstream investment form an important aspect to

consider in M&A transactions. As per the foreign direct investment policy (“FDI
Policy”) of the Department of Industrial Policy & Promotion (the “DIPP”), the
expression “downstream investment” means indirect foreign investment by one
Indian company into another Indian company (either by way of purchase of shares
or by way of fresh allotment of shares).

Since the Central government tightened the Press Note 3 norms,many private
equity/venture capital investment applications from China and Hong Kong are
pending with the government, starving the country's startup ecosystem of funds.6

The Press Note 3 (PN3) changes were affected in April, restricting foreign direct
investment from countries that share land borders with India. Analysts are of the view
that the move was primarily aimed at China as lots of private funds were investing
billions into domestic companies.
The lack of clarity on what constitutes 'beneficial ownership' as defined in the new
PN3 has also led to the steep decline in private equity/venture capital investment
investments from China and Hong Kong.

"Since the changes were affected in April 2020 to the PN3 regarding foreign direct
investment, more than 150 applications from Chinese/Hong Kong entities seeking
investments have been pending," according to the report by law firm Khaitan & Co.

As per data from Venture Intelligence, a Chennai-based firm which tracks financial
transactions and valuation of private companies, such investments from China and
Hong Kong have fallen by a full 72 per cent to USD 952 million in 2020 from USD
3.4 billion in 2019.

The countries that share land borders with India are Afghanistan, Bangladesh,

6
www.freepressjournal.in/business/press-note-3-tweak-has-govt-sitting-on-150-pevc-applications-from-china-
hk-report
Bhutan, China, Myanmar, Nepal and Pakistan. Before the April changes to PN3, only
entities from Pakistan and Bangladesh needed prior government nod for investments.

The government's intent is to "curb opportunistic takeovers/acquisitions of domestic

companies due to the pandemic, the primary target seems to be China." The Press
Note 3 changes are seen as retaliatory measures to put economic pressure on Beijing.

The new PN3 guidelines state that an entity of a country that shares a land border
with India can invest only under the government approval route. Such proposals also
need permission from the Union home ministry.

The guidelines also cover the beneficial owner of an investment who is located in
any such country and also its citizens. The note, however, does not define the term
"beneficial owner" leading to the confusion and thus the pending applications.

Investments that have Chinese, Taiwanese, Hong Kong, and Macau beneficial
ownership now need government nod in advance, irrespective of the quantum of
investment.

While the Press Note covers investments in India where the "beneficial owner" of
such investment is situated in or is a citizen of any Bordering Country, it does not
elaborate the manner in which the beneficial ownership test is to be calculated and
applied.

If the term "beneficial owner" is not linked to control or a prescribed shareholding

threshold, the requirement for prior government approval could arguably be triggered
even if a single share of an investing entity is beneficially held by an investor from
one of the Bordering Countries. This ambiguity could significantly impact foreign
investments into India from across the globe as Chinese investors have stakes in
hundreds of companies around the world.

Clarity will also be required on how the beneficial ownership test is to be applied in
cases where the entity looking to invest in India under the FDI route is a private
equity fund. Several private equity funds have Chinese limited partners. In the
absence of clear guidance, investments by such funds could hit a regulatory
roadblock.
Given the unprecedented situation the world is faced with today, countries are re-
evaluating foreign participation from a public welfare and national security
perspective. It is important to note that, in line with global trends, the Press Note is
intended to increase regulatory oversight on investments from Bordering Countries.
However, it would be helpful for the government to clarify the matters discussed
above in the Indian foreign exchange regulations.
 BIBLIOGRAPHY
STAUTES

• Companies Act, 2013

• FEMA, 1999.
• Press Note 2009, 2017, 2020.

BOOKS
• Foreign Direct Investment and Globalisation 2014 Edition by Ramni Taneja

WEBSITES
• https://rbi.org.in