Abhishek Dubey
Trilegal, Delhi
abhishek.dubey@trilegal.com

Sagnik Sarkar
Trilegal, Delhi
sagnik.sarkar@trilegal.com

Introduction

India has emerged, and continues to be, a leading global destination for foreign direct investment (FDI) and merger and acquisition (M&A) activity. According to periodic data released by the Reserve Bank of India (RBI), India’s central bank, FDI inflows into India peaked in the 2021–2022 financial year. The World Investment Report 2023 published by UN Trade and Development (UNCTAD) reported that, globally, India was the eighth largest recipient of FDI, the third largest recipient of FDI in ‘greenfield projects’ (ie, new projects), and the second largest recipient of FDI in international project finance deals in 2022. In spite of the contemporaneous global downturn, M&A activity in India reached a ten year high in 2023, according to the M&A Report 2023 published by Bain & Company. Against this backdrop, however, the prevailing regulatory uncertainty regarding downstream investments by ‘foreign owned or controlled companies’ (FOCCs) in India, and the conservative view that has been taken by most stakeholders since the RBI’s action last year, continues to pose a challenge to foreign investors intending to invest in India.

In 2023, a leading financial newspaper in India reported that the RBI, which in addition to being India’s central bank also monitors compliance with Indian foreign exchange control norms, had issued notices to a few FOCCs for contravention of FDI norms. What did this contravention entail? These FOCCs had deferred a portion of the consideration payable in regard to their downstream investments in other Indian companies.

Most legal practitioners and authorised dealer banks (financial intermediaries through which foreign investment transactions must be routed under the applicable law) (AD Banks) in India had hitherto taken the view that FOCCs can defer a part of the consideration payable on investments in other Indian companies. However, these developments have left several acquisition and investment transactions structured through FOCCs in limbo.

This is, fundamentally, an issue of regulatory uncertainty. In the absence of an explicit provision in Indian FDI norms or a clarification from the RBI as to whether a purchase consideration for downstream investments can be deferred, stakeholders have had to form their own view on the subject. They had previously taken a general view of the applicable law, which changed after the RBI issued the notices mentioned above, in light of the RBI’s perceived regulatory stance on this issue. This regulatory uncertainty is impacting deal structures and leading to elongated deal timelines. As M&A practitioners, we have seen the statutorily required reporting on downstream investments that involve a deferred consideration component being held up because the relevant AD Bank is hesitant to approve the filing owing to the regulatory overhang.

A complete prohibition on deferred consideration in downstream investments is worth reconsidering because it is neither aligned with the regulatory intent of the Indian FDI norms applicable to FOCCs, nor is it commercially practical.

FDI norms applicable to cross-border M&A transactions

Indian FDI norms ordinarily apply only to ‘cross-border’ share transfers, ie, share transfers between resident Indian individuals or Indian body corporates (‘Residents’), and share transfers between individuals resident outside of India or foreign body corporates (‘Non-Residents’), but not to share transfers between Residents and Residents or between Non-Residents and Non-Residents. Hence, the FDI norms are applicable to all cases where a Non-Resident directly invests in a Resident Indian entity.

Now, what are the FDI norms that apply when an FOCC acquires the shares of an Indian entity, ie, in cases of indirect foreign investment? There are primarily two rules that apply, as follows:

1. pricing guidelines: the price per share being paid by the Non-Resident acquirer to the Resident seller shall be at, or higher than, the fair market value of the shares; and

2. ‘18–25 rule’: the payment of the purchase consideration by the Non-Resident acquirer can be deferred for no more than 18 months from the execution of the principal transaction documents. Further, the Non-Resident acquirer can defer, hold back, or place in escrow, only up to 25 per cent of the total consideration, for matters such as post-closing adjustments, earnouts, or general or specific indemnity items under the principal transaction documents.

The controversy regarding the ‘18–25 rule’ in respect of FOCCs

An FOCC is an Indian company that is either ‘owned’ (ie, majority shareholding) or ‘controlled’ (ie, a majority of directors on the board) by a Non-Resident. Investments by FOCCs into other Indian companies are known as ‘downstream investments’ or ‘indirect foreign investments’, which, despite being domestic transactions, are subject to FDI norms. This position of the law stems from the concern that Non-Residents should not be able to do indirectly, what they cannot accomplish directly. If FOCCs are not subject to FDI norms, a Non-Resident may incorporate or invest in a company in India and use this company as a vehicle to invest in other Indian entities, thus sidestepping the FDI norms.  

The present ambiguity that has come in the way of several FOCC transactions is with respect to the 18–25 rule. The FDI norms explicitly state that in cases of direct foreign investment, the 18–25 rule applies. However, the FDI norms are silent on the extent to which the 18–25 rule applies to downstream investments or indirect foreign investments, ie, in case an FOCC is acquiring the shares of an Indian entity from Resident sellers. The three possible interpretations that emerge are as follows:

1. there can be no deferred consideration. This is the most conservative view based on which, unfortunately, the RBI appears to have issued notices regarding the transactions undertaken by FOCCs;

2. consideration can be deferred subject to the 18–25 rule. This is a ‘middle ground’ view based on which most transactions have been undertaken since the 18–25 rule was introduced in 2016; and

3. consideration can be deferred without limit in regard to the time or amount. This is the most business-friendly view and aligns the most with the Government of India’s ease of doing business policy.

However, unfortunately, post the aforementioned RBI action regarding recent transactions undertaken by FOCCs, several AD Banks in India no longer permit any deferment of purchase consideration in downstream investments. This has led to the adoption of the most conservative view out of the three options listed above. Such an approach is both inconsistent with the purpose of regulating downstream investments and commercially impractical given the nature of M&A transactions.

From a regulatory perspective, the object of regulating downstream investments has always been to prevent foreign investors from doing indirectly what they cannot do directly under Indian FDI norms. Deferred consideration is allowed for direct foreign investments subject to compliance with pricing guidelines and the 18–25 rule. If the intent is to prevent foreign investors from circumventing these rules by utilising downstream investments, then deferred consideration in downstream investments should be allowed on a par with what is allowed in cases of direct foreign investments (ie, subject to the 18–25 rule). A complete prohibition does not align with this intent, as it treats downstream investments more strictly than direct foreign investments.

Commercial impracticality of prohibiting deferred consideration

A complete prohibition on deferred consideration by FOCCs is also commercially impractical, as it forbids three forms of deferred consideration commonly utilised in M&A deals out of both business necessity and prudence, as follows:

1. Post-closing price adjustments: In most cases, it is difficult for an investor to conclusively ascertain the valuation of a company upfront, due to the lack of availability of reliable data. The valuation can be finalised only after the investor is able to access the company’s books and records, and audited financials are prepared after the deal is closed. Hence, most deals contain a mechanism for the purchase price to be adjusted after closing. According to the latest American Bar Association (ABA) Private Target M&A Deal Points Study, 92 per cent of M&A deals in 2022–2023 contained post-closing price adjustment mechanisms.

2. Holdbacks and escrows: Since the closing date valuation is uncertain in most transactions until after closing, investors often defer the payment of a part of the purchase price beyond the closing date, as a security for any downward price adjustment. This amount is either held back unilaterally by the investor or put into an escrow account. Any purchase price reduction after the valuation is finalised is deducted from this holdback/escrow amount and the balance is paid to the sellers/company. According to the latest ABA Private Target M&A Deal Points Study, 66 per cent of M&A deals in 2022–2023 contained holdbacks/escrows. In 2018–2019, this figure was as high as 83 per cent.

3. Earnouts: As an incentive to sellers, deferred consideration is often made payable on the company satisfying a financial or operational milestone within a defined timeframe. This aligns the interests of the investor, to see the company perform well, with those of the founders. From the founders’ perspective, an earnout is also more tax efficient compared to a cash bonus. The former is a capital gain and is, therefore, taxed at a lower tax rate and the latter is taxed as a perquisite relating to employment at a higher tax rate. According to the latest ABA Private Target M&A Deal Points Study, 26 per cent of the M&A deals in 2022–2023 involved an earnout.

The regulatory overhang concerning acquisition or investment transactions by FOCCs prohibits each of these structures, which are otherwise prevalent worldwide in M&A deals. As legal practitioners, we have faced several structuring challenges in deals involving FOCCs as a result of this situation, namely that there can be no deferred consideration in deals involving FOCCs.

Conclusion

We believe that, given the underlying regulatory intent, the commercial necessity of deferred consideration in M&A investments and its widespread use, it should be permitted for downstream investments, provided they adhere to the 18–25 rule.

Firstly, this position is consistent with the regulatory intent of subjecting FOCCs to FDI norms, which aims to prevent foreign investors from doing indirectly what they cannot do directly. Allowing deferred consideration in downstream investments by FOCCs subject to the 18–25 rule would place them on a par with Non-Resident entities and investors in terms of the ability to defer consideration.

Secondly, allowing deferred consideration for downstream investment is also beneficial from an ease of doing business perspective. Deferred consideration is frequently utilised worldwide to the benefit of both buyers and sellers, in ways such as providing security for post-closing price adjustments and earnouts for sellers. Further, the same is also necessary in a large number of M&A deals, given the dynamics and practicalities of concluding such deals.

Over the years, the Government of India and the RBI have progressively liberalised the Indian FDI norms, which has been widely credited with spurring foreign investment into India. The introduction of the 18–25 rule for direct foreign investment in 2016 was one such reform, which explicitly allowed deferred consideration in direct foreign investments. We hope that, consistent with this progression, the Government of India and the RBI will allow deferred consideration in downstream investments in accordance with the 18–25 rule by issuing a clarification or undertaking an amendment to that effect.