Recent Changes to FEMA Rules makes it easier for OCI Holders to manage AIFs

Last week, the Ministry of finance issued a notification dated August 16, 2024 (Notification) in order to amend the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (Non-debt Rules). One of the important changes made by the notification is the exclusion of NRI and OCI investments from the scope of “indirect foreign investment”. Until now, investments by NRIs and OCIs on a non-repatriation basis have always been treated on par with domestic investments and applying the same yardstick to indirect investments makes eminent sense. For this purpose, the Notification has made the following changes in Rule 23 of the Non-debt Rules which deals with “downstream investment”:

(a) Deleted sub-clause (d) of Rule 23(7), which stated as follows:

“control” shall mean the right to appoint majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreement or voting agreement and for the purpose of LLP, “control” shall mean the right to appoint majority of the designated partners, where such designated partners, with specific exclusion to others, have control over all the policies of an LLP;

(b) Modified the “Explanation” given in in Rule 23(7)(i), to read as follows:

“Explanation. –– An investment made by an Indian entity which is owned and controlled by a Non-Resident Indian or an Overseas Citizen of India including a company, a trust and a partnership firm incorporated outside India and owned and controlled by a Non-Resident Indian or an Overseas Citizen of India, on a non-repatriation basis in compliance with Schedule IV of these rules, shall not be considered for calculation of indirect foreign investment.”

Prior to the Notification, the aforementioned Explanation used to read as follows:

“Explanation: An investment made by an Indian entity which is owned and controlled by NRI(s), on a non-repatriation basis, shall not be considered for calculation of indirect foreign investment.”

The Notification has an additional implication for alternative investment funds (AIFs) and their investment managers.

Until now, if the investment manager or sponsor of an AIF is owned or controlled by any person who is either a non-resident or a foreign citizen, such investment manager or sponsor and the AIF managed/sponsored by such investment manager /sponsor would be treated as a foreign owned/controlled entity. Now, on account of the Notification, even if the controlling shareholder/partner of the investment manager/sponsor is an OCI, such investment manager/sponsor will be treated as a domestic entity and any AIF managed/sponsored by such investment managers/sponsors will also be treated as a domestic fund.

Under the Foreign Exchange Management Act, 1999, residency in India and not citizenship, is the main yardstick for applying foreign exchange controls and restrictions on ownership of Indian securities. However, for the purpose of regulating downstream investment and indirect foreign investment, Explanation (b) to Rule 23(7) defines a “company owned by resident Indian citizens” to mean an Indian company where ownership is vested in resident Indian citizens and/or Indian companies, which are ultimately owned and controlled by resident Indian citizens. A similar definition applies in case of “LLP owned by resident Indian citizens”. One of the (possibly unintended) consequences of this definition has been that many individuals who held foreign passports and Overseas Citizen of India documents (“OCI”) and worked for fund managers were adversely affected since investment management entities controlled by such OCI holders were suddenly classified as foreign owned and controlled entities. This in turn meant that any AIF managed by such investment managers would be treated as an investment vehicle that is not controlled by Indians and hence had to comply with all foreign direct investment (“FDI”) norms, which include sectoral caps, restrictions on pricing and the type of instruments in which investments could be made. The recent amendment to the Non-debt Rules turns the clock back and will be sincerely welcomed by investment managers who were hamstrung by this rule!

You may find this Notification here.

We hope you have found this information useful. For any queries/clarifications please write to us at insights@elp-in.com  or write to our authors:

Vinod Joseph, Partner – Email – vinodjoseph@elp-in.com

Paridhi Jain, Associate, Email – paridhijain@elp-in.com