Who is a beneficial owner? FDI recast negotiates many tricky bends

To give you a perspective, all foreign equity investments in India are governed by the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, notified in October last year. Till now, the government approval was required only for investments originating from Pakistan and Bangladesh.

According to the amended rules, any investment from an entity of a country which shares land border with India or the ‘beneficial owner’ of an investment into India who is situated in or is a citizen of any such country would require prior government approval. Although the new rules do not specifically name China, the policy changes seem to have been directed towards it, given that India has received negligible FDI from other neighbours historically.

According to the data compiled by Department for Promotion of Industry and Internal Trade (DPIIT), India has received FDI from China worth $2.34 billion (Rs 14,846 crore) in the past two decades as against a minuscule chunk from the rest of the neighbours.

The amended guidelines, however, have left too many loose ends for guess work and interpretation by the industry. One of the most prominent is the term beneficial owner which is not defined. The rules cite the term ‘beneficial interest’ only in the context of any investment made by Indian residents. Such investment may be counted as foreign investment if the beneficial interest is held by a foreign resident and is declared accordingly to the Indian company under the Company Law provisions.

The Company Law defines the term beneficial interest in a share or class of shares very widely to include, directly or indirectly, the right or entitlement of a person to exercise any right on such shares or enjoy the economic benefits in such shares. There are no numeric thresholds assigned to the beneficial interest under the Indian provisions.

The new regulatory regime requires government approval for not just the direct investment originating from its bordering nations, including China, but also those from entities or pooling investment funds set up in other countries say, Singapore or Mauritius.

In the absence of any numeric threshold, it is unclear how to determine a beneficial interest for such an entity or pooling investment fund set up in other countries. It is quite possible that such entity or funds may have Chinese investors as beneficiaries with insignificant interest.

Besides, the Company Law uses the term ‘significant beneficial owner’ (SBO) requiring him or her to make a declaration specifying the nature of the beneficial interest. The SBO should ultimately be an individual, who alone or in conjunction with others, holds at least 10 percent shares, voting rights or dividends, or exercises or has the right to exercise 'control' or 'significant influence' over the Indian company.

The term ‘beneficial owner’ has also made its way to the Prevention of Money Laundering Act, 2002 (PMLA), the Income Tax law, the recently introduced Benami Transactions Act and other such legislations.

Currently, it is not clear how the term beneficial owner should be interpreted under the amended FDI rules because of inference issues. This will have a serious impact on timelines of such investment. There is also no clarity whether approval will be a one-time process or a fresh nod will be required for each successive stage of foreign investment from bordering countries, including China.

A likely approach may be to refer to SBO rules that provide for a 10 percent threshold of significant beneficial interest. By that logic, only the entities and pooling investment funds with significant beneficial interest of 10 percent or more from India’s bordering nations, including China, should require Indian government approval.

Yet another way to look at it is from the PMLA perspective where different thresholds between 10-25 percent have been prescribed for identification of a beneficial owner. This approach seems to be more logical, considering the overall objective of the government to keep Chinese aggression in check. This has been tested and used as a KYC (know your customer) verification tool for beneficial owners of foreign portfolio investors in the past.

Similarly, Chinese investment in Indian alternative investment funds (AIFs) regulated by SEBI (Securities and Exchange Board of India) remains a grey zone. Also, the beneficial ownership determination in the context of AIFs may be challenging as beneficial ownership and significant beneficial ownership rules as laid down in the Indian Company Law are not applicable to AIFs. The AIFs being pooling funds follow ‘operational and management control’ led test, irrespective of the beneficial interest of investors. The government is also required to clear the air on Indian entities owned and controlled by an existing Chinese entity or a group of Chinese investors. It needs to be seen if that requires prior government approval for sectors falling under the 100 percent automatic route.

The follow-on investment by existing Chinese investors in an Indian company and that of China’s Special Administrative Regions (SARs) such as Hong Kong, Macau and Taiwan are yet another tricky area to deal with. Whether they need prior government approval is still not clear.

With so much of friction in Indo-China ties and Chinese hot money fuelling India’s start-up ecosystem, the government felt it imperative to keep a hawkish eye on such incoming capital. This comes at a time when Indian companies are reeling under the COVID-19 impact. Their attractive valuations are making them a soft and easy target for a hostile takeover by cash-rich Chinese firms.

The implications for India’s unicorn club are huge as most of them have been funded directly or indirectly by listed and privately-held Chinese firms. That puts the onus on the government to set the record straight as India badly needs foreign capital in these turbulent times.

Puneet Shah is a Partner with law firm IC Universal Legal, Mumbai. Views are personal.