Introduction – FDI In India

India's position as a technology development hub has led to a significant increase in startup funding in India. With abundant talent and economic efficiency, India has become an attractive destination for global investors seeking to invest in technology. And this continues to be a growing trend where many US-based and European Companies are also incorporating technology back office and developing ultra-sophisticated applications for end-user customers. India will continue to play a pivotal role in the development of Artificial Intelligence (AI), Education Technology (Ed - Tech), Finance Technology (FinTech), Block Chain, ITES-BPM, and Health Tech for Western economies.

Setting up an offshore development centre (ODC) in India is one of the best solutions for international investors wishing to invest in India's IT sector. A foreign firm that wants to outsource its software development, maintenance, and support services to India would set up an ODC, a specialised facility. This enables enterprises to access a highly trained workforce while benefiting from advantageous FDI policies in India.

Some of the significant FDI announcements made recently in the Tech Sector are as follows:

• On September 08, 2020, BYJU’s (an Indian education technology firm) raised US$ 500 million in a new round of funding led by Silver Lake, a US-based private equity company; this move pushed the company’s valuation to US$ 10.8 billion.
• In September 2020, Unacademy, an EdTech platform, raised US$ 150 million from SoftBank Group (a Japanese conglomerate), boosting its valuation to US$ 1.45 billion.
• On 14 August 2020, Israel-based Coralogix, a provider of machine-learning-based log analytics and monitoring solution, announced a strategic expansion into India with a commitment to invest over US$ 30 million in the next five years.

FDI Policy

Foreign investment policies in India are a collection of rules and regulations that control how much money comes into a nation from abroad. It explains the regulations and requirements foreign investors must follow when investing in a specific field or business. The FDI policies may differ depending on each nation's political and fiscal goals.

FDI or Foreign Direct Investment in India is permitted through two routes: -

• Automatic Route

Under the Automatic Route, the non-resident investor or the Indian company does not require any approval from the Government of India for the investment.

• Government Route

Under the Government Route, prior to investment, approval from the Government of India is required. Proposals for foreign direct investment under the Government route are considered by the respective Administrative Ministry/ Department.

Up to 100% FDI is allowed in Data processing, Software development and Computer consultancy services; Software supply services; Business and management consultancy services, Market research services, Technical testing and Analysis services, under automatic route. 100% FDI in the IT sector in India is permitted in B2B E-commerce.

Type of Entities to choose for FDI

As per the Reserve Bank of India (RBI), FDI Investment in India means any investment made by a person resident outside India on a repatriable basis in capital instruments of an Indian company or to the capital of an LLP. Hence only 2 types of entities are allowed to receive FDI:

• Limited Company

Companies are broadly classified as private limited companies, public limited companies, small companies and OPCs. Companies may have limited or unlimited liability. A limited liability company can be limited by shares (the liability of a member is limited to the amount unpaid on the shares held) or by guarantee (the liability of a member is limited to the amount for which a guarantee is given). Companies limited by shares are a common form of business entity. Public limited companies can be closely held and unlisted or listed on a stock exchange.

In the case of a Listed Company, foreign investors acquiring 10% or more shares in the listed Indian Company will be treated as FDI. In Unlisted Companies, any amount of investment by a Foreign Investor is treated as FDI.

• Limited Liability Partnership

An LLP is a corporate body that is a separate legal entity distinct from its partners. An LLP must be registered under the Limited Liability Partnership Act, 2008 (LLP Act) with the ROC. Any individual or corporate body (including an LLP, a foreign LLP and an Indian or foreign company) can partner in an LLP. When establishing a branch office in India as an LLP, it is important to ensure that at least two designated partners are appointed, and at least one must be resident in India (for bodies corporate, an individual who is a partner or nominee may act as a DP). DPs are liable for compliance under the LLP Act, and in the event of noncompliance, they will be liable for penalties. Every DP must obtain a DIN before becoming a DP.

Types of Instruments in FDI

‘Capital Instruments’ means equity shares, debentures, preference shares and share warrants issued by the Indian company.

• Equity shares: Equity shares are those issued in accordance with the provisions of the Companies Act, 2013 and will include partly paid equity shares issued on or after July 8, 2014.

• Share warrants: Share warrants issued on or after July 8, 2014, will be considered capital instruments.

• Debentures: ‘Debentures’ means fully, compulsorily and mandatorily convertible debentures.

• Preference shares: ‘Preference’ shares mean fully, compulsorily and mandatorily convertible preference shares.

Non-convertible/ optionally convertible/ partially convertible preference shares issued as on and up to April 30, 2007, and optionally convertible/ partially convertible debentures issued up to June 7, 2007, till their original maturity are reckoned to be FDI-compliant capital instruments. Non-convertible/ optionally convertible/ partially convertible preference shares issued after April 30, 2007, and optionally convertible/ partially convertible debentures issued after June 7, 2007, shall be treated as debt and shall require conforming to External Commercial Borrowings guidelines regulated under Foreign Exchange Management (Borrowing and Lending in Foreign Exchange Regulations), 2000, as amended from time to time.

FDI Compliances and Process

Initial Investment process

Documents for Form FC-GPR (Foreign Currency - Gross Provisional Return) SMF

• CS Certificate

• Declaration by the Authorized Representative of the Indian Company/LLP

• Pre and post shareholding pattern in the Indian company

• Copy of government approval (if applicable)

• Copy of the order of the High Court on the scheme of merger/ demerger/ amalgamation (if applicable)

• RBI approval on the amount of refund concerning the amount of the issue (if applicable)

• Valuation certificate from Chartered Accountant

• FIRC/ Debit statement

• Know Your Customer (KYC)

• Board Resolution

Non Repatriable Foreign Investment

Non-Resident Indians and Overseas Citizens of India can invest in Indian Startups through Non-Repatriable Mode. This investment will be treated on par with domestic Investment and there is no need to comply with reporting requirements prescribed by RBI for FDI. However, the profits generated by the Indian Company cannot be transferred to the NRI or OCI overseas but will remain in India.

Annual Compliances

Filing FLA Returns

The annual return on Foreign Liabilities and Assets (FLA) is required to be submitted directly by all the Indian companies which have received FDI (foreign direct investment) in the previous year(s), including the current year, i.e. who hold foreign Assets or Liabilities in their Balance Sheets, by July 15 every year.

Penalties:

In case of non-filing of FCGPR or FLA filings within the prescribed period, shall attract a general penalty as per Section 13 of FEMA,1999:-
1. thrice the sum involved in such contravention where such amount is quantifiable, or
2. up to two lakh rupees where the amount is not quantifiable,
3. and where such contravention is a continuing one, the further penalty may extend to five thousand rupees for every day after the first day during which the contravention continues

However, to avoid penalties, the applicant can apply for compounding of violation by paying the following amounts:

1] AAC/ APR/ Share certificate delays In case of non-submission/ delayed submission of APR/ share certificates (FEMA 120) or AAC (FEMA 22) or FCGPR (B) Returns (FEMA 20) or FLA Returns (FEMA 20 (R))	Rs.10000/- per AAC/APR/FCGPR (B) Return delayed. Delayed receipt of share certificate – Rs.10000/- per year; the total amount is subject to a ceiling of 300% of the amount invested.
2] Allotment/Refunds Para 8 of FEMA 20/2000-RB (non-allotment of shares or allotment/ refund after the stipulated 180 days)	Rs.30000/- + given percentage: 1st year: 0.30% 1-2 years: 0.35% 2-3 years: 0.40% 3-4 years: 0.45% 4-5 years: 0.50% >5 years: 0.75% (For project offices, the amount of contravention shall be deemed to be 10% of the cost of the project).

Tax Planning in FDI Transactions

Tax effect on FDI transactions is at 3 stages under the Indian Income Tax Act.

Investment Stage

The foreign investment policy in India plays a crucial role in the regulations surrounding the acquisition of shares in Indian companies by foreign investors. Foreign investors in limited companies in India can acquire shares through equity shares or convertible debentures either at a premium or at Par/ Face value. As per Income Tax Act, private limited companies receiving money towards equity share capital at a premium is taxable if the issue price is above the fair value determined by the merchant banker; however, this provision is not applicable for FDI as the investment is by Non-resident.

Financial Year End

At the end of every financial year, the company has 3 stages of tax implications.

Net Profit is nothing but Profit before Taxes which every business generates. Tax Rates on profits differ based on the nature of the entity. Usually, Limited Companies attract a 22-25% tax rate and LLP attracts a 30% tax rate excluding surcharge and Cess.
What is important to note here is that if the Indian Company generates revenue from its foreign Parent Company or pays for the direct costs of the foreign Parent Company, then such transactions have to be benchmarked to arm’s length pricing as per Transfer Pricing Guidelines, which is in line with OECD.
Refer our Newsletter and Booklet on International Transfer pricing for more information.

The Dividend is a mode of distribution of profits the business generates to its shareholders. This applies only to limited Companies and not to LLP.
As per Indian Income Tax Act, Dividends are no longer taxable in the hands of the companies as the Dividend Distribution Tax has been removed. Now the shareholder has to pay the tax on receiving dividends as per applicable dividend tax rates.
However, as per Section 195, every foreign remittance from India attracts withholding of taxes at applicable rates in conjunction with DTAA. Usually, withholding on dividends ranges from 10% - 20%. Dividends are taxable in the country of residence or source depending on the provisions of DTAA, and taxes withheld are available for set off in the investor's country of residence.
However, for LLP, Profit after Tax is freely repatriable to partners overseas.

Tax Planning Note: You may note that although LLPs attract higher taxes on profits, the effective tax is lower than Limited Companies (including dividends).
Refer Profit Repatriation section below for more options on transferring earnings.

Exit

The Foreign Investor may exit from Investment in an Indian Company by selling the stake, i.e., Equity Shares in the case of a Limited Company or Partnership in the case of an LLP. Equity Shares are considered Capital assets per the Income Tax Act, so transfer attracts Capital Gain Tax.

• In the case of listed equity shares holding period over 12 months is considered a long-term capital asset

Tax Planning Note:

Capital Gains are arrived at by reducing the Cost of Acquisition from the Sales Consideration. Cost of Acquisition includes all allied costs of acquiring the shares like Share premium, Legal Costs and other relevant costs; apart from this, the price can be expanded by applying the inflation index pertinent to the year of the sale, thereby reducing tax impact. Hence proper documentation will help in minimising the tax impact.

Remitting Money from India – Choosing the Right Profit Repatriation Strategy

As discussed in the tax planning section, transferring profits generated by the Indian Business to the foreign subsidiary of an Indian company or the foreign promoter or investor can be expensive due to the incidence of Income Tax at dual stages in the case of a Private Limited Company. It is important for companies to consider their options for profit repatriation carefully and to seek professional advice to minimise their tax liabilities.
Many companies use the following strategies to transfer profits from Indian entities.

Royalties

Commonly, Indian companies pay a royalty to either a holding company or the foreign owner company for technological collaboration. The payment is made for the right to use manufacturing processes, technical expertise, design, drawings, trademarks, and brand names.
If an Indian subsidiary of a foreign company uses a technology, process, or brand name patented or trademarked by the foreign parent company, the Indian subsidiary is liable to pay royalties to the foreign company for using its intellectual property.
Royalty payments to a foreign company usually attract withholding of taxes at 10-15% Under the Income Tax Act, plus any applicable surcharge and education cess. The tax is calculated on a gross basis on the total royalty payments. The taxability of royalty may also differ based on DTAA with the recipient country.
Such payments are deductible expenses for the Indian company under section 37 as it is a business expenses, reducing the tax outflow for the Indian Company. The Foreign parent company can claim credit for withholding taxes paid in India while filing Income Tax returns in the respective country. However, suppose the Indian Company is a captive unit of the parent company. In that case, this mode of payment can be counterintuitive as every cost has to be billed back to the parent company as per Transfer pricing guidelines.
Under FEMA, royalty payments are categorised as current account transactions and are permitted under the automatic route without any limits.

Interest on Loan

RBI allows Investment in Indian Companies through Equity (FDI) and Debt. Debt, as per FEMA, is termed External Commercial Borrowings (ECB).
Even though ECB is not as simple as FDI compliances (read ECB guidelines), it is an effective way of raising finance for capital-intensive businesses. The Compliances include initial reporting of ECB and monthly ECB returns to be filed with RBI. It is important to note that ECB is allowed only for investment in Machinery and Capital assets and not for working capital purposes like salaries.
The advantages of the ECB are that.
• the capital invested is not locked like FDI forever, and the Indian Company can repay it along
• Interest on ECB can be paid by the Indian company, which is tax-deductible
Another option if you find the ECB route as complicated would be to issue convertible debentures, which are considered as FDI under the FEMA; however, they can carry interest on the same, payable by the Indian Company.
Under FEMA, Loan Repayment and Interest are allowed under automatic route. Only monthly reporting is required.

Management Fees

In the case of a foreign subsidiary of an Indian company, the parent company may charge management fees for deputing management staff, such as the Group CFO, who will oversee the finances of all subsidiaries. Similarly, HR policies may be framed at the group level, headed by Group HR. Along with CFO outsourced services, other management fees like training, ERP deployment consulting, and marketing strategy services can also be provided at the group level, benefitting the Indian Company business. They can pay for such service fees.
Payments for services, such as management and consultancy fees or IT services by Indian companies, may or may not attract withholding of taxes, depending on the nature of payments and definitions as per DTAA. Withholding of taxes may range from 0% to 10% plus surcharge and cess. Such payments are deductible expenses for the Indian Company as per Income Tax. Captive centres will attract provisions similar to Royalties.
Meanwhile, under FEMA, payments for services qualify as current account transactions. Service fees up to US$1,000,000 per project (US$10,000,000 per infrastructure project) can be remitted under the automatic route. However, any remittance exceeding this amount requires RBI approval.

Share buyback

Due to the removal of dividend distribution tax (DDT), now the profits distributed by a private limited company are fully taxable in the hands of the recipient, and many Indian companies are looking at different options to distribute the profits generated by the company. One of the ways is that Company can explore the share buyback option. Here the company can utilise reserves by offering to buy the shares at a pre-defined price. Usually, this price will be at a premium, which is more than the acquisition price. After the buyback of shares, the company will cancel the shares and reduce its share capital so that the shareholding pattern will remain unchanged. However, there is a withholding tax of 20 percent on distributed income at the time of buyback. Distributed income is the difference between the amount paid at the time of buyback and the amount received by the company at the time of the issue of shares.
Taxation will depend on the DTAAs, in the event of share buybacks, operate diversely, and the tax liability depends on the specific tenets of each DTAA.
The Companies Act of 2013 also creates several regulatory obligations for companies that want to use share buybacks:
• The Articles of Association (AOA) for the Indian company should be amended to authorise share buybacks.
• Each buyback should be authorised through a special resolution passed at the general meeting of the respective company and completed within 12 months of any such resolution.
• A limit of 25 percent per financial year (FY) applies on equity share buyback. The consideration for such shares is capped at 25 percent of the total paid-up capital plus free reserves per FY.
• In addition, no free securities should be issued for six months after a share buyback and the debt-to-equity ratio post-buyback should be 2:1.
As per FEMA, the pricing of shares should be as per internationally accepted pricing methodologies.

Capital reduction

Capital reduction is similar to share buyback however, under capital reduction, there is no limit described as per companies act of 25% of share capital and free reserves for the financial year. Hence this method is used when the amount exceeds the share buyback limit per the Companies Act.
Capital reduction is similar to share buyback however, under capital reduction, there is no limit described as per companies act of 25% of share capital and free reserves for the financial year. Hence this method is used when the amount exceeds the share buyback limit per the Companies Act.
Under FEMA, the pricing of capital should adhere to RBI guidelines; no approvals are required for non-resident investors for capital reduction, so long as a few procedural compliances are ensured.

Exit from FDI

*Indian here refers to Resident Indian as per the definition of residential status provided by RBI
Form FC-TRS or Foreign Currency Transfer of Shares needs to be filed in case of transfer of shares of an Indian Company from a resident to a Non-Resident/Non-Resident Indian and vice versa through its authorised dealer bank.
The form shall be filed with the Authorized Dealer bank within Sixty days of the transfer of capital instruments or receipt/remittance of funds, whichever is earlier.
The penalty for non-filing of FC-TRS is imposed by way of a Late Submission Fee (LSF)

Amount involved (₹)	LSF as % of amount involved	Maximum amount of
Up to ₹10 million	0.05%	300% of the amount involved or ₹1 million, whichever is lower
More than ₹10 million	0.15%	300% of the amount involved or ₹10 million, whichever is lower

* The % of LSF will be doubled every twelve months.
The floor (minimum applicable amount) for LSF will be Rs. 100. Company can apply for compounding of Violation as mentioned in Initial Investment Section

FAQ’s by RBI

Disclaimer: “Information contained herein is for informational purposes only and should not be used in deciding any particular case. The entire contents of this document have been prepared based on relevant provisions and as per the information existing at the time of the preparation. Though utmost efforts have been made to provide authentic information, it is suggested that to have a better understanding and obtaining professional advice after a thorough examination of a particular situation.”