Foreign Investment and Overseas Investment Rules under FEMA

FEMA treats foreign investment as a capital account transaction. Section 2(e) defines this as a transaction that alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India, or in India of persons resident outside India. A person resident outside India cannot freely invest in India, and a resident cannot freely invest abroad. Both flows are allowed only as the rules permit. Your answer should always say what the rules permit and on what conditions.

Who makes the rules. Section 6(1) lets any person sell or draw foreign exchange through an authorised person for a capital account transaction, but this is subject to section 6(2) and 6(2A). The source of power depends on whether debt instruments are involved.

• Under section 6(2A), the Central Government, in consultation with the Reserve Bank, prescribes the permissible classes of capital account transactions not involving debt instruments, with the limits and conditions. Section 46(2)(ab) allows rules for this. This is why the Non-debt Instruments Rules, 2019 and the Overseas Investment Rules, 2022 are rules made by the Central Government.
• Under section 6(2), the Reserve Bank, in consultation with the Central Government, specifies the permissible classes of capital account transactions involving debt instruments, with the limits and conditions.
• Under section 6(7), "debt instruments" are the instruments determined by the Central Government in consultation with the Reserve Bank. Section 46(2)(aa) allows rules for this.

Inbound investment. The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 govern investment by non-residents in Indian entities through equity-type instruments. Non-debt instruments include equity shares (including partly paid equity shares), preference shares and debentures that are fully, compulsorily and mandatorily convertible, units of investment vehicles, and similar instruments. The test for preference shares and debentures is the conversion test: if they are optionally convertible, or not fully convertible, they are treated as debt instruments. Do not treat "partly paid" as a separate test for convertible instruments. Partly paid equity shares stay within non-debt instruments. Investment in non-debt instruments is foreign direct investment (FDI) when it is made in an unlisted Indian company, or in 10% or more of the post-issue paid-up equity capital on a fully diluted basis of a listed Indian company. Below 10% in a listed company it is treated as foreign portfolio investment (FPI).

Routes. Under the automatic route, the non-resident or Indian company needs no prior government approval. Under the government route, prior approval of the Government is needed. Each sector is either permitted under the automatic route up to a cap, or needs approval. Some sectors are prohibited for FDI. The prohibited list comes from the Non-debt Instruments Rules, 2019 (the Schedule I notes), not from the text of the FEMA Act. The Act gives the power to make the rules, as explained above. Verify the exact list and its exceptions against your ICAI study material. As you commonly learn it, the list covers lottery business, gambling and betting, Nidhi companies, chit funds, real estate business and trading in transferable development rights (TDRs). For chit funds, the Rules give NRIs and OCIs a limited non-repatriation exception, so check its exact scope in the ICAI material. The real estate entry is understood to exclude construction development, such as townships, housing and commercial premises, but confirm this against the ICAI material too. Agricultural or plantation activity (other than specified permitted activities such as floriculture, horticulture and tea plantation) and the manufacture of cigars, cheroots, cigarillos and cigarettes of tobacco or tobacco substitutes are also on the list. Do not guess exact caps from memory. Learn the pattern, then use the figures in your ICAI material.

Entry conditions. Conditions can include pricing guidelines, minimum capitalisation, lock-in periods and sectoral conditions. A land border restriction applies: an entity of a country sharing a land border with India, or whose beneficial owner is situated in or is a citizen of such a country, can invest only under the government route in sectors that are otherwise permitted. The sector prohibitions still apply first. A prohibited sector stays prohibited for every investor, whatever the route. The Non-debt Instruments Rules also lay down specific restrictions for investors from Pakistan and Bangladesh. Learn the details from your ICAI material. Reporting to the Reserve Bank, usually through an authorised dealer bank, is required after issue of shares, for example Form FC-GPR on allotment.

Outbound investment. The Foreign Exchange Management (Overseas Investment) Rules, 2022 allow Indian residents to make overseas direct investment (ODI), overseas portfolio investment (OPI) and to set up overseas branches or offices within limits. ODI means acquiring unlisted equity, or 10% or more of a listed foreign entity, or control in a foreign entity. OPI means investment in foreign securities other than ODI. Unlisted equity is ODI, so it is never OPI. OPI also excludes unlisted debt instruments, security receipts and certain other items specified in the Rules. Check the exact list of exclusions in the Rules and your ICAI study material. ODI is prohibited in a foreign entity engaged in real estate activity, gambling or similar business, or dealing in financial products linked to the Indian rupee without specific permission. Banking and financial services activity is allowed only under conditions. Financial commitment by an Indian entity is subject to limits specified in the Overseas Investment Rules, 2022 and the Regulations. Refer to your ICAI study material for the exact limit. Overseas investment must generally be made through an authorised dealer, with reporting requirements.

Use this order for any scenario or theory question on foreign investment.