Foreign Direct Investment in Indian Start-Ups: Opening up the Flood Gates

The Reserve Bank of India (India’s apex bank) (“RBI”) has recently amended and notified its Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) (Fifteenth Amendment) Regulations, 2016 (the “Regulations”) whereby it is now easier for the foreign investee to invest in Indian start-ups by issuing Convertible Notes.

The Amendment now permits Indian start-ups to raise early-stage funding by issuing Convertible Notes (the “Note”). The Note is an instrument which is issued as an instrument of debt which later gets converted into equity if and when certain specified conditions are met. If the contingent event does not take place, the instrument continues to be held as a debt which the issuing start-up will have to repay. Uptil now, the start-ups were not permitted to issue Convertible Notes and could raise funds only by way of equity participation.

The RBI has outlined certain key features of these Notes which are briefly explained as under:-

·       Definition of Note: The Note has been defined as an instrument which is issued by an Indian start-up to a foreign investor investing in the start-up on receipt of the money initially as a debt and which later gets converted into equity shares when certain specified conditions as mentioned in the Note are met. This conversion has to take place within 5 years from the date of issue of the Note. Alternatively, the holder of the Note has the option to continue it as a debt which becomes repayable by the start-up as per the terms and conditions stated therein.

·       Definition of a start-up: The start-ups for the purposes of these Regulations has been defined as a private company incorporated under the Companies Act, 2013 and 1956 and has been recognised as a start-up by the Department of Industrial Policy and Promotions, Ministry of Commerce. Effectively, this means that the start-up company must not be older than 5 years from the date of its incorporation and turnover of which has not exceeded INR 25 million in any financial year.

·       Minimum Amount: The minimum amount which the foreign investor needs to invest under the amended Regulations is INR 25,00,000 in a single tranche. Non-resident Indians may acquire the Notes but on non-repatriation basis in accordance with the Regulations.

·       Remittances: The amounts shall be received by the start-ups through normal banking channels or by debit to the NRE/FCNR (B) accounts. Additionally, the Regulations permit opening of the Escrow accounts for this specific purpose. Such Escrow accounts shall be closed immediately after the requirements have been met or not later than six months from the date of opening of the account.

·       Issuance of Equity: The equity shares shall be issued as per the provisions of the Regulations.

·        Transferability: The Notes are transferable. A person resident outside India may acquire or transfer, by way of sale, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. Prior approval from the Government shall be obtained for such transfers in case the start-up company is engaged in a sector which requires Government approval.

·       Compliances: The reporting of the issuance of the Notes by the start-ups have to be made to the RBI as prescribed in the Regulations.

Gray Areas

·       The start-ups engaged in the sectors where foreign investment is permitted on government approval, have to take prior approval of the government for issuance of convertible Notes. This may make the whole process more time-consuming and tedious.

·       The non-repatriation restriction for NRIs may make the instrument less attractive to them for investing and this may prove to be a substantial loss to the start-ups.

·       The Regulations are silent on the pricing/interest rate at the time of issuance of the Notes.

·       The Regulations are also ambiguous on the five-year period within which the Notes must be converted, if opted for conversion by the holder. Do they become compulsorily convertible at the end of the 5-year term?

Conclusion

All said and done, these amendments do open a new avenue for raising early-stage funding by the Indian start-up companies and also for foreign investment to come into India. Foreign investors too can rest at peace with their funds because if the start-up does well, they have an option to be a shareholder and reap benefits on their investments.

India is witnessing a surge in entrepreneurship and start-ups with the young technocrats eager and raring to take risks with their technological innovations. These Regulations surely seem to be a step in the right direction.

India-Mauritius Double Tax Avoidance Treaty Amended

“The protocol for amendment of the convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains between India and Mauritius was signed by both countries on May 10 at Port Louis, Mauritius,” the Finance Ministry of the Government of India said in a statement.

This is a much needed amendment to the India-Mauritius Double Tax Avoidance Agreement (“the Treaty”). This bilateral agreement earlier provided that the capital gains tax on sale of securities in India can be taxed only in Mauritius. The laws of Mauritius, on the other hand, provided zero tax under certain conditions. Hence, the Mauritius route to Indian capital markets was the most preferred and profitable route for foreign investors.

The statement further said, “The protocol will tackle the long pending issues of treaty abuse and round tripping of funds attributed to the India-Mauritius treaty, curb revenue loss, prevent double non-taxation, streamline the flow of investment and stimulate the flow of exchange of information between India and Mauritius.”

Under the new protocol, capital gains arising from sale of shares of Indian resident companies acquired after April 1, 2017 will be taxed in India. This will apply to Singapore based companies also.

A transition window has been provided to the companies before the rules kick in. The following is the broad framework:-

·       Presently, under the Treaty, India does not tax capital gains on sale or transfer of shares of Indian-resident companies by Mauritius-resident companies.

·       From April 1, 2017 to 31^st March, 2019, companies based in Mauritius and Singapore will pay capital gains tax @50% of the domestic tax rate. For example, if the current rate is 15%, the companies shall pay only 7.5%.

·       After April 1, 2019, the companies will have to pay full tax.

·       The benefit of tax at half the domestic tax rate will be given under special conditions of passing the main purpose test and bonafide business test.

·       In case the expenditure of a company resident in Mauritius is less than Rs. 2,700,000 in the immediately preceding 12 months, it will be considered as a shell company.

·       Not only capital gains tax, there is a witholding tax of 7.5% on interest income arising in India in respect of claims and loans to the banks resident in Mauritius. This will be triggered from April 1, 2017.

Increased cooperation between India and Mauritius is envisioned with respect to exchange of information and collection of taxes, among other things.

Big Push to FDI Reforms in India

The Indian Government has come out with radical reforms to the Foreign Direct Investment (FDI) in order to give a boost to many schemes launched by Prime Minister Narendra Modi since his coming to power in 2014. These schemes are Make in India,Skill India, and in the pipeline are Startup India. Another reason for these changes in FDI reforms can also be linked to the poor show by the BJP in the recently held elections in Bihar. The detractors may term the timings of these reforms as to take away the attention of the people from the shameful defeat of Modi government in BJP and toward the much-needed economic reforms. The people of India have started to be disillusioned by the policies of the Modi government and the communal tensions and disharmony in the society off late, and the push in FDI is the much-needed distraction the Modi government needs at the moment.

The Government has announced opening of the following 15 sectors with either increasing the investment limits in the sectors or putting these sectors in automatic route rather than in the approval route. The following sectors have been opened up:- 

• Investment in private banking – Foreign Institutional Investors (FIIs)/Foreign Portfolio Investors (FPIs)/Qualified Foreign Investors (QFIs) can now invest upto 74%
• Cable TV networks – 100% FDI is allowed with upto 49% under automatic route
• DTH TV - 100% FDI is allowed with upto 49% under automatic route
• Plantations of coffee/rubber/cardamom/palm oil – 100% FDI under automatic route
• FM Radio – upto 49% under approval route
• News/current affairs TV Channels – upto 49% with government approval
• Non-news TV Channels – 100% FDI without prior approval, that is, under automatic route
• Duty-free shops – 100% FDI under automatic route
• Same Entity for single brand retailing/wholesale – 100% under automatic route
• LLPs – 100% under automatic route
• In the aviation sector, the sectoral cap of 49% without prior approval has been increased to 74% without prior approval for foreign general aviation charter operators and large ground handling companies to set up their own bases in India. The Government has also allowed 49% FDI in regional air transport services thereby giving a boost to its initiative to grow the regional air transport services in India.
• Investment in defence sector has also been eased from 26% earlier to 49% now.
• The construction sector has also been opened up by removing all restrictions on FDI except for a three-year lock in period in select projects.
• The companies owned and  managed by NRIs can now invest in Indian companies.
• Beside opening up the various sectors as above, the Foreign Investment Promotion Board (FIPB) has now been empowered to give single-window clearance to projects worth up to Rs. 50 billion or USD 753 million

There is no doubt that the government appears to be committed to push the economy and the industry has taken these reforms well and in a positive manner. It is to be seen how much these reforms convert into real economic growth.