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September 30, 2019

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Can SBO Declaration Lead To FEMA Non-Compliance?


- Hemang Parekh, Partner [ DSK Legal ]
- Supallab Chakraborty, Associate [ DSK Legal ]

Hemang-Parekh-&-Supallab-Chakraborty

The concept of having a downstream investment falls flat if Indian companies receiving investment from IOCC(s) is also considered as a recipient of foreign investment due to the foreign investor/individual declaring beneficial ownership...

Meaning of Significant Beneficial Ownership

The fundamental reason of incorporating a company to undertake a business is to separate the individual owners from the corporate personality. However, this is the very reason corporate personalities are often used by its controllers as conduits for conducting illegal and fraudulent activities, and administrators and adjudicators often have taken measures to blur the distinction between the corporation and its controllers to prevent injury to any third-party including injury to society at large.

One of the most impactful measures taken recently by our Ministry of Corporate Affairs (Government of India) (“MCA”) to pierce the corporate veil is to require companies incorporated in India to declare their significant beneficial owners (“SBO”). Simply put, companies will have to trace back through their body corporate and non-individual shareholders to find the ultimate individual (natural person) beneficially holding the ownership of the company. The intent is to bring more transparency in the manner in which shares of the companies are held and to ensure that the country’s regulatory framework is in compliance with the recommendations of Financial Action Task Force.1

MCA notified the relevant provisions i.e. Section 90 of the Companies Act, 2013 (“Act”) and the Companies (Significant Beneficial Owners) Rules, 2018 (“Rules”) on June 13, 2018. As per Section 90 and the Rules, every company is supposed to take necessary steps to identify individual(s) who are SBO(s) of the company, obtain declaration from such SBO regarding the nature of their holding and report the same to the registrar of companies.

Nexus with foreign exchange laws

The broad wordings of Section 90 of the Act and the Rules and the framing thereof has given enough scope for legal minds of the country to interpret and deliberate upon. Immediately upon notification of the Rules, almost everyone was grappling to understand its implications on tax, compliance, etc. One such aspect that requires speculation is that, if declaration of SBO has any implication on the compliance with foreign exchange laws of the country.

Under Foreign Exchange Management Act, 1999 (“FEMA”) and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“TISPRO”), a particular company which has received foreign investment is categorized as ‘Indian Companies’ if more than 50% (fifty per cent) of its capital instruments are beneficially owned and controlled by resident Indian citizens and / or Indian companies (“IOCC”).2 Accordingly, further investment made by such IOCC is considered as a domestic investment and not an indirect foreign investment or downstream investment. Categorization of a company as a recipient of domestic investment would mean that the foreign direct investment (“FDI”) related restrictions and performance conditions will not apply to such company. This makes investment through an IOCC popular structuring tool to channelize foreign funds as investments in sectors which have onerous performance conditions or sectoral caps, such as e-commerce. The foreign investors usually invest in an IOCC and then such IOCC makes further investments in the actual intended recipient and thereby avoiding stringent FDI norms.

Contradiction in law or Contravention?

The kind of structure discussed above works only if the investment made by the IOCC is categorized as an Indian investment and not foreign investment. However, an explanation appended to the definition of ‘Foreign Investment’ in TISPRO3 (“Explanation”) reads that if any declaration is made by any persons, as per the provisions of the Companies Act, 2013, about a beneficial interest being held by a person resident outside India, then even though the investment may be made by a resident Indian citizen, the same shall be counted as foreign investment. The same language is reiterated in the Reserve Bank of India’s Master Direction on Foreign Investment in India.4 The Explanation does not specify as to whether such declaration under Companies Act, 2013 being referred to pertains to declaration under Section 89 of the Companies Act, 2013 (declaration is made pursuant to shares directly held in the Indian company in someone else’s name) or Section 90 of the Companies Act, 2013 (declaration is made pursuant to beneficial ownership held through multiple layers), as both sections use the term declaration of beneficial interest. Although the term used in the sections is the same, it means two completely different things.

If the interpretation of the Explanation is stretched to as having reference to Section 90 of the Companies Act, 2013 then, the construct of the Explanation prima facie would mean to suggest that the foreign investment received in an Indian company through an IOCC will be considered as foreign investment, due to declaration of significant beneficial ownership made by a foreign investor to such investee Indian company. If this interpretation is taken, then there will be many Indian companies which may have received foreign investment through an IOCC but have not have adhered to FDI related restrictions and/or performance conditions and therefore will be in contravention of the provisions of FEMA and TISPRO, as they may have not considered that through multiple layers, the investing Indian company might have a foreign shareholder who may be the significant beneficial owner and investment by them through layers can therefore be considered as foreign investment.

However, this cannot be a plausible interpretation to the Explanation, and the reason for the same is two-fold. Firstly, because the concept of having a downstream investment falls flat if Indian companies receiving investment from IOCC(s) are also considered as a recipient of foreign investment due to the foreign investor/individual declaring beneficial ownership of having even if the investor has less than 50% (fifty per cent) shareholding or control in the Indian Company. This also contradicts the provisions of the FDI Policy, 2017 as it clearly states that the foreign investment received through Indian company/LLP would not be considered for calculation of total foreign investment in case such Indian companies/LLPs are ‘owned and controlled’ by resident Indian citizens and/or Indian Companies/LLPs.5 Therefore, a reading of Section 90 of the Companies Act, 2013 into the Explanation would contradict with the existing provisions pertaining to downstream investment in TISPRO and FDI Policy, 2017 and would render the concept of downstream investment obsolete. Thus, they cannot be read together.

Secondly, the FDI Policy, 2017 specifies that if any declaration is made by any non-resident entity/persons about beneficial interest being held by them in any investment made by any resident Indian citizen and such declaration is either under section 187C of the Companies Act, 1956 or Section 89 of the Companies Act, 2013, only then such investment will be counted as ‘Foreign Investment’.6 Therefore it becomes abundantly clear that the term ‘declaration of beneficial interest’ refers to Section 89 of the Companies Act, 2013 only and not Section 90 of the Companies Act, 2013.

Conclusion

It appears that the broad and open way to interpret the nature of the wording used in Section 90 of the Companies Act, 2013, the Rules, TISPRO and the relevant foreign exchange legislation has given rise to massive confusion as to whether entities are in contravention of law. If Section 90 is reworded to replace ‘beneficial interest’ with ‘significant beneficial ownership’ and/or if the Explanation is appropriately amended to clarify that the term ‘declaration of beneficial interest’ refers only to Section 89 of the Companies Act, 2013, it will be a step in the right direction.

1 Recommendation No. 24 and 25, Recommendation of the Financial Action Task Force on International Standards on Combating Money Laundering and the Financing of Terrorism & Proliferation, adopted on February 2012 (updated on June 2019); available at: https://www.fatf-gafi.org/media/fatf/documents/recommendations/pdfs/ FATF%20Recommendations%202012.pdf.
2 Regulation 14(1)(a) of TISPRO, Definition of ‘Ownership of an Indian company’.
. 3 Regulation 2 (xviii) of TISPRO, Definition of ‘Foreign Investment’.
4 Direction 2.9.2 of Reserve Bank of India’s Master Direction on Foreign Investment in India.
. 5 Para 1.2, Annexure 5 of FDI Policy, Total Foreign Investment i.e. Direct and Indirect Foreign Investment in eligible Indian entities.
6 Para 1.2, Annexure 5 of FDI Policy, Total Foreign Investment i.e. Direct and Indirect Foreign Investment in eligible Indian entities.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.

 

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