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An Indian company that issues shares to a non-resident investor is required to receive the consideration for the shares by inward remittance through normal banking channels as per the current foreign direct investment (FDI) scheme included in the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000.

The exceptions are the issue of shares: (i) against a lump sum technical know how fee or royalty due for payment, and (ii) on conversion of external commercial borrowings. These specific instances of the issue of shares for non-cash consideration to non-residents do not require the prior approval of the Foreign Investment Promotion Board (FIPB), provided certain conditions and safeguards are satisfied, including pricing guidelines and reporting requirements.

However, other cases of the issue of shares against non-cash consideration – share-swaps, trade payables, preincorporation expenses, import of capital goods and machinery, and supply of services – require prior FIPB approval.

The reason for restricting the issue of shares to non-residents for consideration other than cash is that it is seen as defeating a conventional purpose of FDI: to increase foreign exchange inflow into India. Another reason is that there could be misuse and issue of excess shares as there are no fixed valuation guidelines.

In the absence of any formal guidelines or parameters on the issue of shares for non-cash consideration, the FIPB approval is largely discretionary and granted on a case-by-case basis.

DIPP’s views

These concerns were raised in a discussion paper dated 28 September 2010 on the issue of shares for noncash consideration released by the Department of Industrial Policy and Promotion (DIPP), which is responsible for formulating policies relating to FDI in India.

The DIPP recognizes the need to permit the issue of shares to non-residents for non-cash consideration and believes it could be permitted with prior FIPB approval if the value of the noncash consideration can be ascertained. For example, the DIPP has stated that shares issued against import of capital goods, machinery and equipment could be permitted under the approval route, as there are procedures for verification of the value of the imported goods.

But for shares issued against intangible assets (e.g. franchisee rights), the DIPP has noted that as there are no specific guidelines to value intangibles there is a risk that a non-resident investor could receive excess shares. Unless an effective valuation mechanism is evolved for intangible assets, the DIPP does not appear inclined to consider such proposals even under the approval route.

Case for automatic route

The issue of shares to non-residents for non-cash consideration could reduce transaction costs, allow more flexibility to structure investments in Indian companies and increase access to technology, know-how, capital goods and services. These are strong arguments for permitting the issue of such shares under the automatic route, as long as the noncash consideration has an ascertainable value, valuation guidelines are clearly specified and disclosure and reporting requirements are prescribed.

Currently the FDI regulations prescribe minimum pricing guidelines and reporting requirements for the issue of shares to non-residents, which also apply to shares issued against a lump sum technical know-how fee or royalty due for payment and on conversion of external commercial borrowings.

Similarly, for share-swap transactions, the Reserve Bank of 含羞草社区 Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (ODI regulations) require that the shares of a foreign company be valued by a registered merchant banker in India or an investment bank registered with an appropriate regulatory authority in the country where the overseas company is incorporated. The shares issued by the Indian company should be in accordance with the pricing and reporting requirements specified in the FDI regulations. Such share-swap transactions currently require prior FIPB approval.

However, as there are proper valuation mechanisms and each leg of the transaction (i.e. issue of shares to nonresidents and acquisition of shares of an overseas company) does not require prior government approval, shareswaps should be permitted under the automatic route.

Finally, the ODI regulations permit (without any prior approval requirement) Indian companies to make a direct investment in overseas companies by way of capitalization of exports or other dues (e.g. royalties, technical know-how fees and consultancy fees). As this is permitted under the automatic route, the government should also consider permitting foreign investment in India through the issue of shares for non-cash consideration under the automatic route as long as valuation norms and other safeguards exist.

The government has not yet made any policy changes and the outcome of the discussion paper is still awaited.

Juhi Singh is a partner at S&R Associates, where Sarah Rufus is an associate