Pricing dilemma in acquisitions by foreign owned companies

Rule 23(1) of the Foreign Exchange Management (Non-Debt Instruments) Rules 2019 (rules) provides that investments by foreign-owned or controlled companies (FOCC) in an Indian company shall be subject to “entry route, sectoral caps, pricing guidelines and other attendant conditions as applicable for foreign investment”. This legal fiction which treats FOCCs as being on an equal footing with non-residents was created to prevent foreign investors from bypassing exchange control laws through Indian entities that are owned or controlled by them. However, the rules rightly treat FOCCs as residents for all other purposes, such as not requiring the FOCC to file form FCGPR when making investments in Indian companies. This dual treatment of FOCCs has resulted in several unintended consequences, due to the absence of adequate clarifications in the rules. There are thus certain practical difficulties when assessing the applicability of the pricing guidelines to the purchase by an FOCC of the shares of an Indian company that are held both by residents and non-residents at the same time.

As a broad principle, rule 21 of the rules, which sets out the pricing guidelines, states that the transfer of shares from a non-resident to a resident should be made at a price that is not more than the fair market value (FMV) as determined as per any internationally accepted pricing methodology and on an arm’s length basis, and that the transfer of shares from a resident to a non-resident, should be made at a price that is not less than the FMV. The rules exempt the transfer of shares between two non-residents from the requirement of complying with such pricing guidelines.

Rule 23(5) of the rules, however, is silent on the applicability of pricing guidelines to the acquisition of shares by an FOCC and only addresses instances when the FOCC is selling and not buying shares. Additionally, and while the rules are silent on this aspect, the Master Direction on Foreign Investment issued by the Reserve Bank of India has clarified that the pricing guidelines will not apply to the transfer of shares by an FOCC to a non-resident. In the absence of a specific clarification and because of the overarching language used in Rule 23(1) as set out above, authorised dealers (AD Banks) have in practice refrained from assuming that the pricing guidelines do not apply to the purchase of shares by FOCCs from non-residents. The logical extension of treating FOCCs on an equal footing with non-residents, and the explanation provided in the Master Direction, would justify such an assumption.

This lacuna is exacerbated when the FOCC acquires shares at the same time from residents and non-residents. Taking into account a combined reading of rules 21 and 23, the recent views adopted by AD Banks suggests that if the FOCC is acquiring shares simultaneously from non-residents and residents, it should purchase shares from non-residents at or below the FMV but from residents at or above the FMV. This leads to the absurd situation where the FOCC is treated as a resident when buying from non-residents but as a non-resident when buying from residents.

Therefore, to comply with the above pricing guidelines, the FOCC must either adopt marginal differential pricing, that is purchase shares from the residents above FMV and from non-residents below FMV in such a way that the aggregate purchase price remains unchanged, or purchase all shares at the exact FMV.

Often, the contractually agreed price is higher than the FMV. In such cases, the shares cannot be purchased at the exact FMV. Purchasing shares from residents and non-residents at differential prices to ensure that the aggregate purchase price remains the same may also be challenging, especially if all the sellers are unrelated entities and are not willing to sacrifice their individual interests.

FOCCs are increasingly being used for platform deals where the foreign investor acquires a majority stake in the platform, that is the FOCC, and then uses the FOCC to acquire other companies in India. Given the lack of clarity on the inconsistent applicability of aspects of the pricing guidelines to FOCCs, there is an urgent need to issue clarifications on such aspects and to avoid situations as discussed above.

Anshuman Mozumdar is a partner and Ankur Kumar is an associate at L&L Partners.