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India offers significant opportunities for Japanese corporations expanding into new growth markets

India and Japan are among the most stable and strongest economies in the world, with centuries-old historical and cultural ties. For a meaningful presence in India, beyond legalese, the essentials of clarity, structure and intent must be focused on. Business in India needs careful navigation of various laws including:

1. Formation and operation of entities such as partnerships, limited liability partnerships (LLPs) and companies are governed by central laws which apply uniformly across India.
2. The Foreign Exchange Management Act, 1999 (FEMA) and its rules/regulations govern inflow and outflow of foreign capital to/from India.
3. Worker/employee relations are governed by a combination of central and varying state laws.
4. Certain products, services and businesses are also regulated by sector-specific laws.
5. Direct taxes are governed by central laws and indirect taxes (excise, goods and services taxes) are governed by a combination of central and state laws.

Inflow of foreign capital

As an exchange-controlled economy the inflow of foreign exchange into India is governed by the FEMA, the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI rules), and the Consolidated Foreign Direct Investment Policy Circular (FDI policy”). These regulations set out sectoral caps, pricing guidelines and reporting requirements relating to operating in India.

Investments with beneficial ownership from countries that share land borders with India require prior government approval. For investments from most jurisdictions, including Japan, no such additional scrutiny applies. However, having investors in the Japanese corporations who are citizens or based out of countries sharing land borders with India could require prior approval for the Japanese corporation to invest into India. Therefore beneficial ownership structures must be evaluated to ensure an efficient investment process.

No assured returns: Exit clauses with guaranteed returns such as fixed internal rates of return (IRRs) or floor pricing are not enforceable.

Optionality clauses: Optionality clauses entitling an investor to trade a security at a predetermined price per a specific timeline are permitted, provided the security is held for at least one year and does not have an assured exit price.

Deferred consideration: Deferred consideration of up to 25% is allowed but must be paid within 18 months unless RBI approval is obtained.

Partly paid shares: Issuance of partly paid equity shares is permitted under the FDI route, provided at least 25% of the consideration is received upfront, the balance is paid within 12 months, and the upfront amount complies with the minimum pricing guidelines.

Escrow arrangements: Escrow accounts are permitted for foreign investment transactions, subject to the RBI and authorised dealer bank guidelines. They are permitted for a period of up to 18 months, provided the escrow amount does not exceed 25% of the total consideration, unless otherwise approved.

Operational structures

The structure for operation in India depends on the intent of the foreign entity.

(1) Explore: Liaison office, branch office or project office. For businesses in the exploratory or contract-specific phase. These are extensions of the foreign parent and not separate legal entities, have limited functionality and require prior approval from the RBI or an authorised dealer bank. For substantial operations in India with minimal compliance overhead, LLPs are a better alternative.

(2) Enter: LLP is suitable for capital-light sectors where 100% FDI is permitted under the automatic route without performance conditions. LLPs have fewer compliances, enjoy tax transparency, and provide limited liability protection.

(3) Embed: Private limited company requires a minimum of two members and two directors. It is the most robust and scalable form of entry. Offers limited liability, perpetual succession, and full access to foreign investment across equity and debt instruments.

Sectoral investment restrictions

The consolidated FDI policy and the NDI rules categorise sectors in India by the degree of openness to foreign investment.

1. Prohibited sectors: Foreign investment in activities like lottery, gambling, betting, atomic energy, real estate (with exceptions), and tobacco is prohibited.
2. Fully automatic (100% permissible): Most business activities fall under this category. No prior approval is needed, only post-investment reporting is mandated, and fulfilling some conditions.
3. Hybrid sectors: FDI is allowed under the automatic category up to certain percentage and beyond which, FDI requires prior approval. Includes telecoms, defence, and certain air transport services.
4. Capped sectors: In sectors such as banking in private sector, FDI is capped at various levels and further is subject to conditions.
5. Approval route: In certain sectors such as mining, FDI is allowed up to 100% but only with prior government approval.

Investor rights and exposures

Investor rights can be understood as:

1. Contractual rights: Certain foreign investors negotiate rights such as veto rights, information rights, preferential liquidation rights, anti-dilution protect-ions, pre-emptive rights, and exit and drag-along rights.
2. Statutory rights: Under law, investors have certain rights automatically such as voting rights (with variability), dividend rights, share participation rights, and basic liquidation and information rights.
3. Board representation: Investor/acquirer nominees appointed on the board are typically designated as non-executive or nominee directors. While representing investor/acquirer interests, by law they must exercise independent judgment and discharge fiduciary duties to the company, not just their appointor. Under Indian law, nominee directors may be held liable for lapses in governance.
4. Risk and exposures: Shareholders do not incur liability beyond their subscribed capital in a limited liability vehicle, however they may face indirect exposure if they are involved in management decisions beyond shareholder rights, and foreign investment regulation violations.

Exiting

Common modes of exit include:

1. 1. Strategic sale: Most common. Requires adherence to pricing guidelines.
   2. IPO: Tax efficient, but requires scale and regulatory compliance.
   3. Buyback: Capped at 25% of paid-up capital and free reserves in a financial year. Pricing is also regulated.
   4. Secondary sale: Subject to pricing and sectoral restrictions.

Repatriation of capital is permitted for investments made on a repatriable basis. Dividends are freely repatriable, subject to tax withholding. Capital gains tax may apply.

India offers a significant investment opportunity with strong outlook. For sustained returns and smooth operations India-specific legal aspects must be considered.