The Enforcement Directorate (ED) is now questioning the very structure and mechanism of these deals cut years ago on the grounds that they violate the Foreign Exchange Management Act (FEMA).
The specific transaction that has come under the glare of the agency is the ‘gift’ of shares of overseas holding entities to the founders of the tech companies in India. These resident promoters of the local companies received the stocks without remitting any money abroad.
Over the past few weeks, the ED has served notices to four companies, multiple sources told ET.
What during 2014-16 seemed like an aggressive transaction – which was not entirely kosher or outright banned – has now put these individuals in regulatory crosshairs.”Due to lack of clarity in the past, certain structures were set up by using the ‘gift route’ which weren’t compliant with overseas direct investment (ODI) conditions. These structures are now under scrutiny. Going forward, such structures will have to be regularised by way of appropriate administrative actions and compounding,” said Moin Ladha, partner at the law firm Khaitan & Co.But, what drove the Indian promoters to these complex structures? And, why has it raised the hackles of the ED?In attracting global investors – many of whom then preferred taking exposure to an overseas company than an Indian entity – the non-resident business partners or consultants, acting on behalf of the Indian promoters, incorporated foreign companies where the financing happened. Using the foreign direct investment channel, the offshore entity floated an Indian subsidiary which housed the actual business.
In such a structure, the ‘gift’ of shares (by non-resident partners and agents) was a strategy used by the Indian promoters to acquire control of the overseas holding firm (i.e. the parent of Indian firm). With these shares valued nominally, the local promoters paid a small tax, which they believed regularised the deal. But it didn’t, as is evident in the FEMA hurdle the deals have now run into.
And, herein lies the bone of contention: according to ED, this ‘gift’ of shares tantamount to ‘overseas direct investment’, or ODI (by the Indian founder), and ODI is disallowed in an overseas company with a ‘step down subsidiary’. Since (in such cases) the subsidiary was in India, it brought in an additional complication related to round-tripping. Besides, no monetary consideration was paid for receiving the shares. Though RBI has given some latitude post 2022, the central bank, which has the last word on cross-border deals, may not consider “holding FDI through an ODI” a bonafide structure.
“These resident investors who were served ED notices for receiving ‘gift’ of foreign securities from foreign professional who are not ‘relatives’ will have to explain the transaction to the satisfaction of the agency. Even though the shares were reported in the foreign assets schedule in the ITR, it can be termed as a violation under FEMA. Many of the foreign entities, incorporated in the US, have invested in Indian companies as FDI and shares of such foreign entities are gifted to Indian promoters is a kind of externalisation of the Indian company,” said Rajesh P Shah, partner at Jayantilal Thakkar & Co.