CROSS-BORDER SHARE SWAPS REDEFINED: NAVIGATING THE 2024 NDI RULES AMENDMENT

This post is authored by Shourya Sharma, 3rd Year B.B.A. LL.B. (Hons.) student at Jindal Global Law School, Sonipat and Manav Pamnani, 3rd Year B.A. LL.B. (Hons.) student at NALSAR University of Law, Hyderabad

1. INTRODUCTION

The Indian Government has consistently taken measures to attract greater investments, and the results are evident. According to World Bank’s Doing Business Report, India has registered an improvement of an impressive seventy-nine ranks in the span of five years between 2014 and 2019. Taking another step forward, the Department of Economic Affairs (‘DEA’), Ministry of Finance has recently amended the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 (‘NDI Rules’), vide a notification dated August 16, 2024. This Amendment aims to simplify cross-border share swaps, by reducing compliance requirements that have previously acted as significant bottlenecks to smooth economic growth.

It introduces several key changes. First, it removes the distinction between the government-approval route and the automatic route for share swaps, except in exceptional circumstances, specifically requiring government approval. Second, it recognises secondary transfers in share swaps. Third, it broadens the definition of ‘equity instruments’ to the extent of including foreign companies. Fourth, it aligns the definition of ‘control’ and ‘start-up’ with current legislative enactments like the  Companies Act, 2013 and the 2019 notification issued by the Department for Promotion of Industry and Internal Trade (‘DPIIT’) respectively, alongside removing the ten percent determinative threshold to ascertain control.

The present article begins by exploring the legal background of the Amendment. Thereupon, it explores its practical implications on Indian investment dynamics.

2. MAPPING THE TRAJECTORY OF THE NOTIFICATION: A PARADIGM SHIFT IN LEGAL POSITION

The amendment has fundamentally enhanced the share swaps legal regime, aligning the framework with the Ease of Doing Business Initiative introduced by the Government of India in 2014. It simplifies commercial transactions in an increasingly globalized and digitally connected twenty-first century world. The share swaps jurisprudence reflects the evolution towards easing tedious compliance requirements. Rule 3(c) of the erstwhile Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 adopted a restricted approach by permitting share swaps only through the Government-approval route. This was significantly altered under the 2017 Regulations that effected a reasonable differentiation between transactions that by their nature qualify under the ‘automatic route’ and those that require prior government approval. This was further upheld in the NDI Rules and the  Foreign Exchange Management (Overseas Investment) Regulations, 2022 (‘ODI Regulations’) introduced subsequently. This established a concretised middle-ground approach between the initial restricted interpretation and the latter liberal connotation. The liberal perception has emerged only through this notification, which significantly alters the previous median approach. Clause 6, sub-clause (i) of the notification explicitly removes the terms ‘government-approval’ and ‘automatic’ from Schedule I of the 2019 Rules. This indicates the Legislature’s intention to introduce a balanced, flexible framework by discarding the previous stringent requirement of a particular approval route, while excluding certain transactions that might potentially affect national interests and public perception, such as between Indian residents and entities or persons in a bordering country. However, the in flip-side  it brings  considerable ambiguity and uncertainty due to the blurred separating line between transactions that expressly require government approval and the others. This necessitates the introduction of a more detailed framework, specifying clear guidelines to facilitate meaningful realisation and effective implementation.

Additionally, the other changes also align with the imperative for effecting liberal and flexible transactions. Rule 4 of this Notification adds Rule 9A to the previous rules. Rule 9A explicitly recognises a secondary transfer under the ambit of share swaps, which positively contradicts the previous NDI Rules and ODI Regulations that restricted share swaps to primary transfers only. The major difference between the conceptual understanding of a primary and a secondary transfer is that a primary transfer only permits the issuance of new equity instruments to facilitate a share swap transaction between a Person Resident in India (‘PRI’) and a Person Resident out of India (‘PROI’) whereas a secondary transfer fosters a direct swap utilising pre-existing equity instruments. An important point to note here is that although the on-ground implementation of Regulation 8(iii) of the ODI Regulations permitted secondary swaps, their explicit recognition has only been accorded by this Amendment. This move satisfactorily settles the legal position alongside providing the much-needed flexibility to accommodate broader options for share swaps.

Furthermore, even the scope of ‘equity instruments’ involved in a swap has been widened. Earlier, it was limited to equity instruments or shares or compulsorily convertible debentures (‘CCDs’) of only an ‘Indian company’ but currently, this requirement has been omitted. This demonstrates the patent intention of the Legislature to extend this provision to equally include equity instruments of a foreign company. This has been expressly provided under the explanation to Rule 4 of this Notification which aligns the meaning of ‘equity capital’ with that stipulated under the Foreign Exchange Management (Overseas Investment Rules), 2022. Rule 2(e) of these Rules specifically includes a foreign company within its ambit, thus indicating that the scope of share swaps has been extended to also cover equity instruments of foreign companies. The broadening of this definition has multiple positive ripple-effects in the Indian investment landscape, including promoting greater flexibility in cross-border transactions, enhancing investment opportunities and encouraging international collaboration.

Lastly, the alignment of the definition of ‘control’ and ‘startup’ with existing enactments introduces clarity, consistency and standardisation in India’s share swaps legal framework. This facilitates easier navigation of India’s legal landscape by foreign entities, resulting in increased confidence and investment in the Indian market, ultimately fostering economic growth and development. Moreover, the determinative threshold of ‘control’ has also been significantly altered. The erstwhile NDI Rules prescribed a ten percent requirement of voting rights and alike to constitute control. This placed excessive burden on shareholders because if their share exceeded ten percent, they would be deemed to have control over the affairs of the company, the legal effect of which would be to impose excessive compliance burdens under the Foreign Exchange Management Act, 1999 (‘FEMA’) and its several corresponding regulations and rules. It was primarily this reason that prompted the Legislature to effect changes and through the current Amendment, the ten percent requirement has been done away with. This relaxation largely relieves the compliance burden off shareholders, thus encouraging greater domestic and foreign investor participation in the capital markets. This ultimately fosters a dynamic and robust business environment in India. However, the removal of the ten percent threshold is not without its drawbacks. It vitiates several compliance requirements that are fundamental to ensuring transparency and accountability in corporate governance, potentially leading to increased risks of mismanagement and shareholder disputes. Additionally, in the absence of any specific threshold, it creates ambiguity, which might lead to hostile takeovers due to a small group of shareholders dominating and exercising control over decision-making. This will hamper the rights of the minority shareholders, thus acting as a deterrent to investment and leading to protracted conflict and litigation.

3. UNPACKING THE PRACTICAL IMPLICATIONS

This Amendment brings forth a few challenges, alongside several practical benefits, which must be counterbalanced. The most natural implication is the simplification of cross-border transactions for companies engaging in corporate restructuring with foreign entities. The elimination of bureaucratic red tape processes attracts foreign investment by making transactions easier and faster, thus positively contributing to India’s business landscape. Previously, the government-approval route delayed transactions by several months, as it required detailed reviews by multiple authorities without any specific timelines. However, by removing this impediment, international mergers and acquisitions (‘M&A’) and market expansion can be accomplished more effectively.

Another benefit pertains to the broadened definition of ‘equity instruments,’ which now categorically allows share swaps between Indian companies and foreign entities through the automatic route, thereby reducing compliance burdens. Particularly, this is advantageous in the pharmaceutical and technology sectors, where cross-border expansion is quintessential to growth. Prospectively, this would further facilitate joint ventures and strategic partnerships between Indian companies and their foreign counterparts.

The explicit recognition of secondary transfers also introduces certainty in the business fraternity, alleviating the ambiguity surrounding the status of secondary share transfers that dissuaded companies, and brought about an unfavourable chilling-effect previously. This change is expected to result in more secondary share transfers, which would involve existing equity instruments, without triggering the issuance of new equity, thus fostering time-efficient transactions.

However, this increased flexibility in share swaps equally raises the risk of capital flight. This is particularly concerning in times of economic downturn. The ease of transferring shares may result in situations where foreign investors quickly retract their capital from Indian companies, leading to high capital outflow. Thus, with the increasing liquidity of shares across the borders, risks of market instability are also foreseeable. Therefore, it is imperative to arrive at a balance between market stability and regulatory oversight. This necessitates instituting appropriate real-time monitoring mechanisms and due-diligence protocols to mitigate such adverse effects.

An important point to consider with respect to these cross-border share swaps is the corresponding tax implications. Indian tax laws do not offer tax neutrality to share swaps unless such swaps are achieved through a merger or demerger and subject to conditions prescribed under Section 47 of the Income-tax Act, 1961. Section 47, being an exception to the capital gains tax provided under Section 45, provides specific exemptions for transactions conducted as part of a tax-neutral merger or demerger, where certain conditions, such as continuity of shareholders, are satisfied. However, if the share swap transaction does not meet these conditions, it will be liable to tax in India, subject to any tax treaty benefit available to foreign shareholders. This lack of tax neutrality creates an additional compliance burden for the parties involved, potentially deterring foreign investors from participating in these profitable transactions. To effectively implement this Amendment, policymakers should consider introducing targeted tax incentives or relief mechanisms for share swaps to ensure their feasibility and encourage their adoption. For instance, deferring capital gains tax liabilities for a specified period or offering lower tax rates for share swap transactions in identified priority sectors could significantly improve the investment climate. This would particularly benefit high-growth sectors such as technology and renewable energy, where cross-border transactions are pivotal to expansion. By addressing these tax implications comprehensively, India can further cement its appeal as an investment destination, facilitating sustainable growth and innovation in critical industries.

4. CONCLUSION

This Amendment marks a significant stride in the right direction by simplifying cross-border share swap transactions and attracting foreign investors. It enhances India’s Ease of Doing Business and provides global access to Indian companies. However, these promising changes are accompanied by practical risks that warrant attention of policymakers, such as upholding the rights of minority shareholders and avoiding market instability. Additionally, as explained above, to truly realise the transformative power of these reforms, further targeted incentives including tax concessions and other sector-specific benefits are required. It is only if these strategies are effectively implemented that India can become a global hub for business activities, particularly with initiatives such as GIFT City occupying the centre stage.