Introduction
Foreign investment in India is frequently accomplished through direct investment by overseas investors or downstream investments. When equity capital is directly infused into an Indian entity, such investment is classified as foreign direct investment (FDI). Investments made by an Indian entity, which itself is controlled by foreign residents, into another Indian entity constitute downstream investment. Both types are regulated centrally by the Reserve Bank of India (RBI) under the Foreign Exchange Management Act (FEMA) and the FDI Policy issued by the Department for Promotion of Industry and Internal Trade (DPIIT). This article focuses on the legal aspects of FDI in India relevant to investors.
Advantages of Foreign Investment in India
Several key benefits are offered to foreign investors choosing to invest in India:
- Expansion of market opportunities is witnessed due to India’s rapidly growing economy. The economy is forecasted to become the world’s third largest by 2030. Purchasing power is being enhanced by the fast-growing middle class.
- Supportive government initiatives provide tax incentives, subsidies, and simplified compliance measures under various schemes.
- Cost competitiveness is maintained due to relatively low labor costs, which attract manufacturing and service industries.
- Strategic geographical location benefits businesses through proximity to South Asia, the Middle East, and Africa. Free trade agreements such as ASEAN-India and partnerships with countries like the UAE and Japan widen market access.
- Improvement of infrastructure and rapid digital transformation via initiatives such as Digital India fuel fintech and e-commerce growth.
Legal Requirements Under the Companies Act, 2013
Equity investment by foreign investors is governed under Section 42 of the Companies Act, 2013, which deals with private placements. The following procedural steps must be completed:
- The company’s board of directors must approve the issuance of shares to the investor through a formal board resolution.
- A shareholders’ special resolution approving the share issuance must be passed at a general meeting.
- The shareholders’ resolution is required to be filed electronically with the Registrar of Companies (ROC).
- A valuation report obtained from a registered valuer must determine the fair market value of the shares. The share issue price cannot fall below this valuation.
- Upon filing, an offer letter is sent to the identified investor(s). The investor(s) must provide written acceptance, which creates a binding obligation.
- After receiving the investment proceeds, the board approves the allotment of shares through a formal resolution.
- The allotment resolution along with the valuation report must be filed with the ROC to complete the process.
FDI Policy and Foreign Exchange Regulations
Foreign investment in India is regulated under the Consolidated FDI Policy issued by DPIIT and FEMA Non-Debt Instrument (NDI) Rules. The framework allows for investment via two primary routes:
- Under the Automatic Route, investment is permitted in specified sectors without prior approval from the government or RBI. Such investments comply with sectoral caps and pricing guidelines. The manufacturing sector, for instance, allows 100% FDI under this route.
- Under the Government Route, prior government approval is mandatory for investment in sectors excluded from the automatic route. Investments remain subject to sectoral caps. For example, foreign investment in FM radio is capped at 49% and requires approval.
Certain sectors are entirely prohibited for foreign investment. These include lottery businesses, gambling and betting, chit funds, and real estate trading.
Instruments eligible for subscription include equity shares, compulsorily convertible preference shares, convertible debentures, and share warrants as permitted by law.
Reporting Requirements for Foreign Investment in India
Form FC-GPR must be filed with the RBI within 30 days following share allotment to foreign investors. Restricted investors from countries sharing land borders with India are required to invest only under the government approval route, as mandated by Press Note 3 (2020 Series).
Pricing of equity instruments must be based on a valuation report certified by a chartered accountant, SEBI-registered merchant banker, or practicing cost accountant. The valuation must reflect the fair market value on an arm’s length basis.
Documentation for Foreign Investment in India
The following documents are generally utilized in FDI transactions:
- Share Subscription Agreement: Although not mandatory, it is strongly recommended to lay down detailed investment terms, conditions, and obligations of all parties in this contract.
- Shareholders’ Agreement: This agreement governs relationships between shareholders as well as between shareholders and the company. It typically contains restrictions on share transfers, exit mechanisms, information rights, confidentiality provisions, and dispute resolution clauses.
- Amendment of Articles of Association: To ensure enforceability, the shareholders’ agreement provisions are usually incorporated into the company’s articles, preventing contradictions between documents.
Practical Legal Considerations for Foreign Investors
Selection of Securities
Foreign investors commonly subscribe to compulsorily convertible preference shares (CCPS) for the following reasons:
- Preferential liquidation rights give CCPS holders priority over equity shareholders during company liquidation.
- Reserved matters rights allow CCPS holders to veto key business decisions.
- Regulatory compliance under FEMA requires foreign investments to be made in securities compulsorily convertible to equity.
Separate Classes of Shares
Issuance of a unique class of CCPS not subscribed by other shareholders is the best practice. This guarantees that liquidation proceeds are distributed according to agreed liquidation preferences without being diluted by other shareholders.
Validity of Valuation Reports
Although no statutory period for valuation report validity exists, a 90-day validity from the financial date utilized for valuation is commonly accepted by regulators. Investors should ensure the valuation report is within this valid timeline at the time of issuance.
Due Diligence
Legal and financial due diligence must be conducted to assess compliance, pending liabilities, contractual obligations, intellectual property rights, tax compliance, and overall financial health. This ensures informed investment decisions and mitigates risks.
Protective Clauses in Investment Agreements
- Right of First Refusal: Investors secure the opportunity to purchase shares before they are sold to third parties, protecting ownership rights.
- Anti-Dilution Provisions: These provisions maintain investor equity if the company raises capital at a lower valuation in future rounds.
- Liquidation Preference: Priority of payments during liquidation is clearly defined to protect investor capital.
- Reserved Matters: Investors gain rights to approve pivotal company decisions, safeguarding their interests.
Conclusion
Foreign investment in India is subject to a complex yet navigable legal regime. Adherence to the Companies Act, FDI Policy, and FEMA regulations ensures full compliance in investment proceedings. By following prescribed valuation, reporting, and documentation protocols, investors and startups can realize the substantial benefits of India’s growing market with minimized legal risk. Expert legal assistance is recommended at every stage of the investment lifecycle to safeguard interests and enable successful entry.
