Despite the elaborate definition of ‘beneficial owner’, the July 23 memorandum inadvertently overlooks a possible workaround which may be used by Chinese companies to overcome the registration requirement
Shinoj Koshy and Aishwarya Mudgil
Lately, India has witnessed major policy reforms with a view to economically distance itself from certain countries. One such prominent change was Press Note 3 aimed at preventing the opportunistic takeover of Indian companies during the COVID-19 pandemic.
On July 23, the Government of India amended the General Financial Rules, 2017 and issued a memorandum which, with immediate effect, restricted, among others, Chinese companies or any company whose ‘beneficial owner’ is situated in a country which ‘shares a land border with India’, or is a neighbouring country, from participating in a government procurement process (GPP) involving instrumentalities of the government.
Currently, the memorandum mandates registration only for bidders that are incorporated in or controlled through a company in the neighbouring country (either as subsidiary or otherwise), or whose beneficial owner is situated in a neighbouring country.
Unlike the press note, the memorandum defines ‘beneficial owner’ to mean a natural person, who, whether acting alone or together, or through one or more judicial person(s), has a controlling ownership interest or who exercises control.
The memorandum defines ‘controlling ownership interest’ as ownership of, or entitlement to, more than 25 percent of shares or capital or profits of the company, and control to include the right to appoint a majority of the directors or to control the management or policy decisions, including through their shareholding or management rights or shareholders agreements or voting agreements (Control Test).
Additionally, the memorandum specifies that in case no natural person can be identified as the beneficial owner as per the Control Test, then the natural person holding the position of senior managing official shall be the beneficial owner (Residuary Test).
Despite the elaborate definition of ‘beneficial owner’, the memorandum inadvertently overlooks a possible workaround which may be used by Chinese companies to overcome the registration requirement.
For instance, a bidder’s intervening holding company (based in China or Hong Kong) and its beneficial owner (a Chinese citizen) may choose to move out of China to say Dubai to fall outside the mischief regulated by the memorandum. In such case, the memorandum will no longer apply to the bidder, irrespective of the fact that the beneficial owner may be a Chinese citizen, but now located in Dubai. In striking contrast to this, the press note applies to entities where the beneficial owner is a citizen or is located in a neighbouring country.
When the Control Test fails to identify a natural person as beneficial owner, the Residuary Test treats the ‘senior managing official’ to be the beneficial owner. However, the memorandum does not define the term. Further, it does not clarify whether such Residuary Test shall be applied to the bidder or will the government look up the holding structure of the bidder (Holding Structure) to identify the ‘senior managing official’.
A literal interpretation of the memorandum leads to the conclusion that the ‘senior managing official’ of the bidder should be treated as the beneficial owner. This would imply that the Holding Structure would not be screened.
For instance, the senior managing official of an Indian bidder may not be located in China. However, a senior managing official of the Dubai-based holding company of the bidder could be located in China. In such a case, the bidder will be able to avoid the registration requirement. This interpretation defeats the purpose of the memorandum.
Therefore, it is important to interpret the memorandum in its geopolitical context to give it its intended effect. The memorandum vests the government with immense discretion to review and limit the participation of Chinese-controlled companies in the GPP. Hence, it is likely that the government will look through the Holding Structure to screen ‘senior managing officials’. This will ensure that a bidder whose Holding Structure has a ‘senior managing official’ situated in a neighbouring country will have to register under the memorandum.
However, a bidder is required to self-certify its compliance with the memorandum. Thus, if a bidder, based on a literal interpretation of the Residuary Test chooses not to register, it is unclear as to how the government will regulate its participation in the GPP.
Hence, it is important that government immediately clarifies: (i) the restrictions applicable to ‘beneficial owner’ and ‘senior managing official’ (as in the press note) are linked to his citizenship of, and location in, a neighbouring country and not merely the latter; and (ii) senior managing official will be identified not just at the bidder level, but throughout the Holding Structure.Shinoj Koshy is partner and Aishwarya Mudgil is associate, at L&L Partners’ Law Offices. Views are personal.