The Enforcement Directorate (ED) has initiated investigation into 4 (four) technology firms and unicorns regarding potential violations of the Foreign Exchange Management Act, 1999 (FEMA). The primary focus of the investigation is the offshore fundraising structures employed by these companies, particularly the ‘gift’ of shares to Indian founders in such offshore entities. While the names of these companies have not been disclosed, this transaction mechanism has raised concerns over the legitimacy of Overseas Direct Investment (ODI) practices.

The transactions under scrutiny were primarily executed between the year 2014 to 2016. These transactions involved the creation of foreign holding companies by using the ‘gift route’ to Indian promoters, which subsequently established Indian subsidiaries to manage the actual business operations.

I. Legal Concerns Leading to ED Involvement

1. Regulatory Ambiguity: Due to a lack of clarity in the ODI regulatory regime, prior to 2022, on the ‘gift’ of shares view was that gifts of foreign securities would not be treated as ODI. Leveraging this ambiguity, Indian promoters, to attract foreign investors who preferred exposure in an overseas company than an Indian entity, adopted a structure whereby they acquired the shares of the overseas entity as a ‘gift, i.e., without any monetary consideration, from the non-resident business partners to acquire control of overseas holding firm.

2. Round-Tripping and FEMA Violation: The structure of these transactions involves round-tripping, i.e., where funds leave the country and return as foreign investment. The ‘gift’ of shares to Indian promoters constitutes ODI, which is prohibited in an overseas company with a step-down subsidiary in India.

3. RBI Clarifications: RBI issued new regulations in August 2022, which clarified the rules around ODI and Overseas Portfolio Investments (“OPI”). These regulations have brought past transactions under new scrutiny.

The erstwhile ODI regime did not specifically permit or prohibit acquisitions of shares of overseas entities by way of gift. However, under the current ODI regime, this position has been explicitly clarified and the relevant provisions in relation to the gift of securities of overseas companies are as follows:

(a) A resident individual, without any limit, may acquire foreign securities by way of gift from a person resident in India who is a relative and holding such securities in accordance with the provisions of FEMA.

(b) A resident individual may acquire foreign securities by way of gift from a person resident outside India in accordance with the provisions of the Foreign Contribution (Regulation) Act, 2010 (“FCRA”) and the rules and regulations made thereunder.

Further, according to the Master Direction on ODI, overseas investment by way of gift is categorized as ODI or OPI based on the nature of investment.

4. Non-Relative Gifts: FEMA and the FCRA stipulate specific conditions for gifts received in the form of foreign securities from non-relatives. The acquisition of shares by Indian promoters during the years 2014-2016 by way of ‘gift’ did not meet such conditions.

II. Implications

1. Potential Liability: Companies found in violation may be asked to regularize the contravention of FEMA by way of compounding and paying penalties, or by unwinding the structure. This can also result in reputational harm, impacting business operations and investor confidence.

2. Increased Regulatory Scrutiny: Companies will face heightened scrutiny regarding their fundraising methods and compliance with FEMA.

3. Impact on Investment Climate: The investigation could create a cautious investment environment, potentially affecting future foreign capital inflows into Indian tech firms.

III. Conclusion and Recommendations

The ED’s investigation underscores the critical need for regulatory compliance in offshore fundraising activities. Companies must navigate the complexities of FEMA by performing thorough reviews of their past and present fundraising activities to ensure compliance. This can be achieved by understanding the implications of the new ODI regulations, appointing legal experts to regularize any non-compliant structures, and engaging proactively with regulatory bodies to clarify ambiguities and seeking necessary approvals.

Credits: Pallavi Puri (Partner), Aishwarya Gupta (Senior Associate), and Ela Bharti (Associate)