After embracing market-oriented reforms in 1991, India’s economy has grown significantly to become one of the largest economies in the world. Despite the COVID-19 pandemic, the foreign direct investment (FDI) inflow in India stood at United States Dollars (USD) 83.57 billion in financial year (FY) 2021-22 1 making India one of the top 10 FDI recipients in the world.
Cross border M&A deals have been the primary drivers of the staggering FDI inflow numbers in FY 2021-22. There is no doubt that cross border FDI is going to be a key driver for the Indian economy despite global factors such as protectionism, the conflict between Russia and Ukraine, sanctions on Russia, rising oil prices as well as supply chain constraints emanating from China’s ineffectiveness in tackling COVID-19.
Despite promising trends, there continue to be certain critical risks associated with FDI in India which the authors have sought to analyse in this article. For the purpose of this article, the authors have categorised the deal risks in relation to cross border M&A involving inbound investments into India into four categories: (i) ‘Entry Risks’, (ii) ‘Pricing and Exit Risks’, (iii) ‘Tax Risks’, and (iv) ‘Other Risks’.
I. ENTRY RISKS
1. Permissibility of FDI in the Indian company
Identifying the sector(s) in which the Indian company is operating is a key gating item that should be identified upfront at the time of undertaking due diligence and structuring the transaction.
The principal regulations governing investments by foreign investors into India are the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) issued under the Foreign Exchange Management Act, 1999 (FEMA). As per the NDI Rules, the limits on FDI by foreign investors are as follows:
(i) 100% FDI is allowed under the automatic route (i.e., prior government approval is not required for an Indian company to induct foreign investment) for most sectors;
(ii) FDI is allowed under the automatic route upto a sectoral cap. For e.g., FDI upto 49% and 74% of an Indian company’s share capital is allowed without government approval in scheduled air transportation services and brownfield pharmaceutical sectors, respectively;
(iii) FDI is allowed but requires prior government approval (i.e., any amount of FDI will require prior government approval) – this includes entities engaged in unregulated financial services or multi-brand retail trading; and
(iv) FDI is not allowed at all: Under this category, there is no scope for seeking government approval as the government has not allowed any foreign investments in these sectors owing to strategic and economic sensitivities. For e.g., no FDI is permitted in entities engaged in gambling, tobacco or atomic energy.
Approval process: If FDI is to be made in an Indian entity engaged in a sector that requires prior government approval, then the application for such approval has to be routed through the concerned ministry through the Indian government’s ‘Foreign Investment Facilitation Portal’. While the approval process has been streamlined to a great extent by the Indian government, the timelines for receipt of approval could range from 4 to 12 weeks subject to questions from and clarifications sought by the Indian government. Therefore, in case of cross border transactions in sectors that require government approval, the parties need to factor this in the overall timeline of the deal.
2. Sectors having FDI linked performance conditions
After crossing the hurdle of determining whether the Indian entity’s business falls in the automatic or approval route, it is important to understand whether there are any ‘FDI linked performance conditions’ that will be triggered under NDI Rules on account of the M&A transaction.
Certain sectors such as e-commerce, retail trading, wholesale trading, construction and development, etc. prescribe conditions that the Indian investee company has to comply with on a continuous basis from a business and operations standpoint after receiving foreign investment. These performance linked conditions do not apply if the Indian investee company does not have FDI, however, from the time it receives foreign investment, these conditions become applicable due to which the landscape of the company’s business and operations may change significantly. E.g., an Indian company operating in the e-commerce sector cannot own or control inventory of products after receiving foreign investment as FDI in inventory-based e-commerce (other than ‘Business-toBusiness’ transactions).
Applicability of performance linked conditions and its impact after the deal needs to be assessed upfront at the commencement of due diligence and deal structuring by the investor and the investee to mitigate any post deal business cash flow and profitability risk.
3. Investment from persons / entities situated in India’s land bordering nations
Under Press Note 3 of 2020 issued by Indian Government’s ‘Department for Promotion of Industry and Internal Trade’ (DPIIT) (and subsequently incorporated in the NDI Rules), prior approval of Indian government is required for FDI investment by any person/entity situated in any of India’s land bordering nations. Prior government approval is also required where the beneficial ownership of an investment into India is with a person/entity situated in any of India’s land bordering nations. Further, the transfer of ownership of any existing or future FDI in an entity in India, directly or indirectly, resulting in the beneficial ownership falling within the abovementioned restriction will also require prior government approval.
The term ‘beneficial ownership’ is not defined under the FEMA or NDI Rules. However, the (Indian) Companies Act, 2013, the Prevention of Money Laundering Act, 2002 and certain public procurement norms of the Indian government have prescribed different thresholdsfor determining ‘beneficial ownership’/‘significant beneficial ownership’ which range from 10% to 25% of a company’s shareholding. But none of these laws or thresholds apply to determine ‘beneficial ownership’ under Press Note 3 of 2020.
Despite more than 2 years having passed since the notification of Press Note 3 of 2020, the Indian government has not come out with any clarification on what amounts to ‘beneficial ownership’ under Indian exchange control norms. This continues to pose challenges in attracting FDI especially because in case of overseas funds, trusts and listed companies, it is quite difficult to determine beneficial ownership due to which the threat of (unknown or inadvertent) noncompliance under exchange control norms continues to persist.
Unlike due diligence items that focus on issues surrounding the Indian target, the Press Note 3 of 2020 issue requires careful due diligence on the investor to ascertain whether at any level it has persons from India’s land bordering countries who/which could be considered as beneficial owners of the Indian entity’s shares. Recently, the Indian government has clarified that the onus of ensuring compliance of Press Note 3 of 2020 restrictions lies with the Indian investee entity. This essentially means that if a non-compliance with Press Note 3 of 2020 is identified, the liability for penalty(ies) under FEMA will be on the Indian target and not the foreign investor. Due to this, the Indian target entities may ask for appropriate representations, warranties and indemnities from the non-resident investor in relation to any non-compliance under Press Note 3 of 2020 and this becomes a key deal negotiation point.
4. Round Tripping Risks
Round tripping is a practice where funds are transferred from one country to another and transferred back to the country of origin of the funds for purposes that may include tax evasion/tax avoidance, outflow of black money which is brought back into India with the intention to convert it into white money. While considering a cross border M&A transaction, the foreign investor should look at its holding structure to ascertain whether it has any Indian resident shareholders in it, as any investment by the foreign investor (having Indian shareholders) in an Indian entity runs the risk of triggering the ‘round tripping restriction’.
Any transaction that triggers a round tripping restriction requires prior approval of the Reserve Bank of India (RBI). This is on account of RBI’s stance that any funds remitted outside India that are brought back to India through foreign investment may be a device for tax avoidance.
Round tripping restrictions become a significant gating item in case of transactions where Indian founders are looking at externalisation structures by putting an overseas holding company with the Indian operating entity as a subsidiary of the overseas holding company. In ‘De-SPAC’ transactions as well, where Indian founders seek to migrate to the cap table of the overseas listed holding entity, round tripping restrictions pose significant structuring challenges.
5. Share Swaps
Structures involving share swaps are increasingly being adopted in cross border M&A deals. Share swap deals are an excellent way of doing an M&A transaction without there being any involvement of a cash pay-out. Share swap deals also present an incentive to the shareholders of the target entity to get shares of the acquirer and potentially enjoy upside in share value if the consolidated business ends up doing well. FDI transactions involving share swaps used to require prior government approval even if the Indian entity’s business sector fell under the automatic route. This was subsequently liberalised by the Indian government and now, share swaps involving an Indian company in an automatic sector route does not require prior government approval. However, valuation of the shares of both the entities involved in a share swap transaction should be done by a merchant banker.
However, the NDI Rules only allow ‘primary share swaps’ in cross border M&A deals (i.e. share swaps that necessarily involve issuance of shares at one end of the transaction). Further, since share swaps also involve an overseas direct investment leg, the Indian exchange control restrictions applicable to overseas investments will also have to be complied with. The authorised dealer banks in India, who are the watchdogs of RBI tasked with overseeing compliance with FEMA and its attendant regulations, also additionally require details of the transactions such as number of shares received / allotted, premium paid / received, brokerage paid / received, etc., and also give a confirmation to the effect that the inward leg of transaction has been approved by DPIIT (if applicable) and the valuation has been done as per the laid-down procedure and that the overseas company’s shares are issued / transferred in the name of the Indian investing company. This places severe constraints in structuring M&A deals through share swaps.
II. PRICING AND EXIT RISKS
The Indian government has imposed capital controls in relation to inflow and outflow of money into/from India. As a consequence of this, certain pricing norms have been prescribed under the NDI Rules that are required to be complied with in case of an FDI transaction.
It is also important to note that FDI is allowed only in equity shares (including partly paid equity shares), compulsorily convertible preference shares, compulsorily convertible debentures and warrants. FDI is not allowed in optionally convertible or non-convertible preference shares or debentures as these are treated as debt instruments under FEMA.
In case of issuance of shares by an Indian unlisted company to a non-resident or in case of transfer of shares by an Indian resident to a non-resident, the floor price at which the issuance/transfer can take place is the fair value of shares of the Indian company which is to be determined by a chartered account/merchant banker/cost accountant in accordance with any internationally accepted pricing methodology on an arm’s length basis.
On the other hand, when a non-resident investor seeks to sell its shares to a resident, the fair value of the Indian company’s shares becomes the ceiling price. Likewise, in case of listed Indian companies, the floor / ceiling price is required to be determined in accordance with the norms laid down by India’s securities market regulator, The Securities and Exchange Board of India (SEBI).
In a nutshell, at the time of entry of a non-resident investor, the fair value becomes the ‘floor’ whereas as the time of non-resident investor’s exit (at the hands of Indian residents), the fair value becomes the ‘ceiling’. This places constraints on structuring exits through put/call options as these options are also bound by the pricing norms due to which the foreign investors get bound by the ‘ceiling’ price. In terms of exit, the RBI has stated that the non-resident investor is not guaranteed any assured exit price at the time of its entry and the exit has to be at the prevailing fair value of shares of the Indian company. Due to these reasons, the exit mechanisms under the transaction documents need to be carefully constructed to ensure that the assured exit related stipulation put in place by RBI is not violated.
III. TAX RISKS
Tax implications on the parties involved in a cross-border M&A transaction depend on the jurisdiction where the parties are domiciled. In case of direct acquisition of business/assets of an Indian company, the buyer is required to be incorporated in India due to exchange control related requirements. On account of the buyer’s incorporation in India, the buyer’s income will be taxed at the usual Indian income tax rate which ranges from 25.17% to 34.94%, inclusive of surcharge and cess or, in case of new manufacturing entities, from 17.16% to 34.94%, inclusive of surcharge and cess. The implication on the Indian entity selling the business/assets is the tax liability on income earned from the sale of such business/assets which depends on the holding period of such business/assets.
However, in case of share acquisition deals, the investor can be incorporated abroad and its investments will be regulated under the NDI Rules/FEMA as discussed above. There is no ‘one size fits all’ formula and the preferred mode of acquisition would depend on various considerations such as the underlying commercial objective, tax efficiency, ability to preserve past tax losses of the target, transaction costs, deal timelines, etc. Other structuring considerations include (a) choice of the jurisdiction to make Indian investments from; and (b) choice of instrument for investing into the Indian target.
In terms of taxability of returns, effective 1 April 2020, dividends earned on shares of an Indian company is taxable in the hands of the shareholders (earlier Indian distributing companies were subject to distribution tax and dividends were exempt for non-resident shareholders). The tax rate applicable to a non-resident is 20% (plus applicable surcharge and cess) and the Indian company distributing the dividends is required to withhold applicable tax. For interest earned on debt instruments, the tax incidence could vary from 5% to 40% (plus applicable surcharge and cess). At the time of eventual exit, gains on sale of these instruments by a non-resident investor will entail capital gains tax in India ranging from 10% to 40% (plus applicable surcharge and cess) depending on the nature of the instrument and the period of holding. The aforesaid tax treatment is subject to the applicability of beneficial provisions under the tax treaty between India and the country of residence of the non-resident. For transactions involving fresh issuances of shares by an Indian company, the amount of premium received by the Indian company is taxable as income in the hands of the Indian company.
Depending on the residency of the seller, the buyer of shares may be required to withhold a portion from the purchase consideration and deposit it with the Indian income tax authorities. If the seller is an Indian resident, there is no requirement for withholding of taxes (although requirement to collect tax at source may arise in certain situations), but a withholding requirement arises if the seller is a non-resident. Typically, buyers insist on withholding of taxes at the full rate even if the seller is a resident of a beneficial tax treaty country, unless the seller furnishes a certificate from the income tax department certifying a nil or a lower rate for withholding tax on the transfer. Sometimes buyers also agree to withhold lower or nil taxes, subject to contractual indemnities or withholding insurance under the transaction documents, which are usually negotiated.
Indian income tax law also seeks to tax indirect transfer of shares which covers transactions involving transfer of shares of a foreign company, if it derives substantial value from assets located in India. The foreign company is deemed to derive ‘substantial value’ from shares/assets located in India if such shares/assets derive more than 50% of their value from India. The Indian income tax law contains the test for determining ‘substantial value’. There are certain exceptions to this transfer which include availability of tax treaty exemption or if the shares/voting rights/interest held by the seller in the foreign entity does not exceed 5% or if the seller does not have any management rights/control over the foreign entity, any time in the 12 months prior to the exit.
IV. OTHER RISKS
1. Anti-Trust Approval
Under the (Indian) Competition Act 2002, all forms of acquisitions, mergers or amalgamations that exceed the prescribed thresholds and do not benefit from any exemption must be notified to the Competition Commission of India (CCI) for approval before the transaction can be consummated.
The first yardstick to determine the applicability of CCI approval is to check whether the target meets the ‘small target exemption’. The ‘small target exemption’ has been recently extended to continue till 26 March 2027. An Indian target will enjoy the small target exemption if its assets in India do not exceed INR 3.5 billion or its turnover does not exceed INR 10 billion. In case of acquisition of asset/business of the seller, the Indian assets and turnover attributable to such asset/business alone will be taken into account for the purpose of the small target exemption (and not the value of assets and turnover of the entire enterprise, as was previously the case). However, in the case of an acquisition of shares, voting rights or control, the assets and turnover of the entire target enterprise in India will be considered.
In terms of the combination regulations under the Competition Act, 2002, an acquisition of less than 25% of the shares or voting rights of an enterprise made solely as an investment or in the ordinary course of business, not leading to a change in control does not require any approval from the CCI. There is limited guidance from CCI on what amounts to ‘ordinary course of business’ and the expression ‘solely as an investment’ has been defined under the combination regulations in the context of acquisition of less than 10% shares/voting rights without conferring the acquirer with any special rights, board seat or participation in the affairs/management of the target.
Therefore, from an anti-trust approval perspective it becomes extremely important to ascertain the availability of small target exemption to the Indian target. Despite the Competition Act focussing on appreciable adverse effect on competition from the perspective of merger control, even acquisition of minority stakes of 10% – 25% can trip the CCI approval requirement. In this regard, negotiating the rights package for the investor becomes key to ascertain the requirement of CCI approval.
2. Indemnity
Indemnities are amongst the most crucial parts of M&A deal documents and often take a substantial amount of time to be negotiated. The limits contained in the NDI Rules also add to the complexity of indemnity negotiations in an M&A deal. Under the NDI Rules, in a cross-border M&A deal, an indemnity holdback can only be up to a limit of 25% of the purchase consideration for a maximum time period of 18 months. Also, recovery of an indemnity payment from a resident in favour of a nonresident may either require an approval from the RBI or require an arbitral award/ court order to be enforced in India, both of which are time consuming.
3. Deferment of Consideration
Deferred consideration structures are quite common in M&A deals globally. Under FEMA, deferment of consideration was historically not allowed automatically. However, in the past few years, the RBI has liberalised this and now deferment of consideration is allowed upto 25% of the total consideration for a time period of 18 months from the date of transfer agreement under the NDI Rules. This presents two risks: (i) Given that the NDI Rules have prescribed the 18 month timeline from the ‘date of the transfer agreement’ and not the ‘closing’ of the transfer agreement, effectively the time period of deferment stands reduced if there is a significant time gap between signing and closing of the transfer agreement; and (ii) deferment is allowed only upto 25% of the total consideration, which may put deal structuring constraints. Deferment beyond 18 months’ time period or in excess of 25% of the consideration requires RBI approval which may not be easily forthcoming. It is also important to note that deferment of consideration under the NDI Rules is only permitted for secondary transactions and not for primary fund infusions.
Each cross border M&A deal is unique and presents its own sets of risks depending on the facts and objectives of the buyers and sellers. Foreign investors should certainly keep the above mentioned risks in mind while structuring an M&A deal in India. It is always advisable for foreign investors to retain services of reliable and experienced M&A advisors to assist them in all aspects of the M&A transaction.
The content of this document does not necessarily reflect the views / position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at (email protected).