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FDI in India : Truths and Myths
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This was presented by CA. Sudha G. Bhushan as a key note speaker in the national seminar on Foreign INvestment Flows in India organised by Lala Lajpat Rai Institute of Management.

This was presented by CA. Sudha G. Bhushan as a key note speaker in the national seminar on Foreign INvestment Flows in India organised by Lala Lajpat Rai Institute of Management.

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  • 1. Foreign Investment flows in India By : CA. Sudha G. Bhushan Presented in National Seminar of Lalalajpat Rai Institute of Management 1/12/2013This write up talks about the flow of Foreign Investment in India and the truths and myths relating to it.
  • 2. Foreign Investment Flows to India‘Investment’ is understood as financial contribution to the equity capital of an enterprise or purchase ofshares in the enterprise. ‘Foreign investment’ is investment in an enterprise by a Non-Residentirrespective of whether this involves new equity capital or re-investment of earnings. Foreigninvestment is of two kinds – (i) Foreign Direct Investment (FDI) and (ii) Foreign Portfolio Investment.International Monetary Fund (IMF) and Organization for Economic Cooperation andDevelopment(OECD) define FDI similarly as a category of cross border investment made by a resident inone economy (the direct investor) with the objective of establishing a ‘lasting interest’ in an enterprisethe direct investment enterprise) that is resident in an economy other than that of the direct investor.The motivation of the direct investor is a strategic long term relationship with the direct investmententerprise to ensure the significant degree of influence by the direct investor in the management of thedirect investment enterprise. Direct investment allows the direct investor to gain access to the directinvestment enterprise which it might otherwise be unable to do. The objectives of direct investment aredifferent from those of portfolio investment whereby investors do not generally expect to influence themanagement of the enterprise.In Indian context ‘FDI’ means investment by non-resident entity/person resident outside India in thecapital of the Indian company under Schedule 1 of FEM(Transfer or Issue of Security by a Person ResidentOutside India) Regulations 2000.FDI constitutes three components; viz., equity; reinvested earnings; and other capital.Reinvested earnings represent the difference between the profit of a foreign company and itsdistributed dividend and thus represents undistributed dividend. Other capital refers to theintercompany debt transactions of FDI entitiesIt is the policy of the Government of India to attract and promote productive FDI from nonresidents in Regulatory Framework Contributed by CA. Sudha G. Bhushanactivities which significantly contribute to industrialization and socio-economic development. FDIsupplements the domestic capital and technology.Foreign Direct Investment by non-resident in resident entities through transfer or issue of security toperson resident outside India is a ‘Capital account transaction’ and Government of India and ReserveBank of India regulate this under the FEMA, 1999 and its various regulations. Keeping in view thecurrent requirements, the Government from time to time comes up with new regulations and
  • 3. amendments/changes in the existing ones through order/allied rules, Press Notes, etc. The Departmentof Industrial Policy and Promotion (DIPP), Ministry of Commerce & Industry, Government of India makespolicy pronouncements on FDI through Press Notes/ Press Releases which are notified by the ReserveBank of India as amendment to notification No. FEMA 20/2000-RB dated May 3, 2000. Thesenotifications take effect from the date of issue of Press Notes/ Press Releases. The proceduralinstructions are issued by the Reserve Bank of India vide A.P.Dir. (series) Circulars. The regulatoryframework over a period of time thus consists of Acts, Regulations, Press Notes, Press Releases,Clarifications, etc.It is the intent and objective of the Indian Government to promote foreign direct investment through apolicy framework which is transparent, predictable, simple and clear and reduces regulatory burden.The system of periodic consolidation and updation was therefore introduced as an investor friendlymeasure.Prior to 1991, the FDI policy framework in India was highly regulated. The government aimed atexercising control over foreign exchange transactions. All dealings in foreign exchange were regulatedunder the Foreign Exchange Regulation Act (FERA), 1973, the violation of which was a criminal offence.Through this Act, the government tried to conserve foreign exchange resources for the economicdevelopment of the nation. Consequently the investment process was plagued with many hurdlesincluding unethical practices that became part of bureaucratic procedures. Under the deregulatedregime, FERA was consolidated and amended to introduce the Foreign Exchange Management Act(FEMA), 1999. The new Act was less stringent and aimed at improving the capital account managementof foreign exchange in India. The Act sought to facilitate external trade and payments and to promoteorderly development and maintenance of the foreign exchange market in India. It resulted in improvedaccess to foreign exchange.Foreign Exchange Management Act, 1999 (“FEMA”) has come in force from 1st June, 2000 by replacingForeign Exchange Regulations Act (“FERA”). The main change that has been brought is that FEMA is acivil law, whereas the FERA was a criminal law. FERA was popular for its draconian provisions. The shiftof FERA to FEMA was the shift of control of foreign exchange to regulation and promotion and orderlydevelopment of Foreign exchange. FEMA is forward looking legislation which aims to facilitate foreigntrade.FEMA aims to achieve self regulation instead of imposed restrictions. The rationale for strict regulations Contributed by CA. Sudha G. Bhushanunder FERA 1973 after Independence was that India was left with little forex reserves and during theoil–crisis of seventies ballooning oil import bills further drained foreign exchange reserves.Unsatisfactory reserves made it imperative to put in place stringent controls to conserve foreignexchange and to utilise it in the best interest of the country.Foreign Direct investment policyAs per the policy the investment can be made in India through two routes being Automatic route orapproval route. Under the automatic route the investment can be made without prior approval ofcentral government but in the case of approval route the prior approval of Central government is
  • 4. required. India has among the most liberal and transparent policies on FDI among the emergingeconomies. FDI up to 100% is allowed under the automatic route in all activities/sectors except thefollowing, which require prior approval of the Government:- 1. Sectors prohibited for FDI 2. Activities/items that require an industrial license 3. Proposals in which the foreign collaborator has an existing financial/technical collaboration in India in the same field 4. Proposals for acquisitions of shares in an existing Indian company in financial service sector and where Securities and Exchange Board of India (substantial acquisition of shares and takeovers) regulations, 1997 is attracted) 5. All proposals falling outside notified sectoral policy/CAPS under sectors in which FDI is not permittedMost of the sectors fall under the automatic route for FDI. In these sectors, investment could be madewithout approval of the central government. The sectors that are not in the automatic route, investmentrequires prior approval of the Central Government. The approval in granted by Foreign InvestmentPromotion Board (FIPB). In few sectors, FDI is not allowed.Current Account Transactions and Capital account transactionsAll transactions involving the foreign exchange are divided into two • Current account transactions • Capital account transactionsGetting FDI is capital account transaction. The two types have been described briefly below.“current account transaction” means a transaction other than a capital account transaction and withoutprejudice to the generality of the foregoing such transaction includes,— (i) payments due in connection with foreign trade, other current business, services, and short-term banking and credit facilities in the ordinary course of business, (ii) payments due as interest on loans and as net income from investments, Contributed by CA. Sudha G. Bhushan (iii) remittances for living expenses of parents, spouse and children residing abroad, and (iv) expenses in connection with foreign travel, education and medical care of parents, spouse andchildren;As per section 5 of FEMA“Any person may sell or draw foreign exchange to or from an authorised person if such sale or drawal isa current account transaction:Provided that the Central Government may, in public interest and in consultation with the Reserve Bank,impose such reasonable restrictions for current account transactions as may be prescribed. “
  • 5. Capital account transactions“capital account transaction” means a transaction which alters the assets or liabilities, includingcontingent liabilities, outside India of persons resident in India or assets or liabilities in India of personsresident outside India, and includes transactions referred to in sub-section (3) of section 6;Introduction with RegulatorsFDI policy in India is regulated by following regulators as indicated in the diagram below. Briefdescription of ach authority is provided later on. Regulators Under FEMA Central Goverment Reserve Bank of India Ministry of Commerce Ministry of finance and Industry Department of Policy Department of Department of Revenue and Promotion Economic Affiars Enforcement Foreign Investment Directorate Promotion Board Contributed by CA. Sudha G. BhushanReserve Bank of IndiaThe Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of theReserve Bank of India Act, 1934.The Central Office of the Reserve Bank was initially established inCalcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sitsand where policies are formulated. Has 22 regional offices, most of them in state capitals. Though
  • 6. originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by theGovernment of India.PreambleThe Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stabilityin India and generally to operate the currency and credit system of the country to its advantage."Department of Industrial Policy and PromotionThe Department of Industrial Policy & Promotion was established in 1995 and has been reconstituted inthe year 2000 with the merger of the Department of Industrial Development. Earlier separate Ministriesfor Small Scale Industries & Agro and Rural Industries (SSI&A&RI) and Heavy Industries and PublicEnterprises (HI&PE) were created in October, 1999.With progressive liberalisation of the Indian economy, initiated in July 1991, there has been a consistentshift in the role and functions of this Department. From regulation and administration of the industrialsector, the role of the Department has been transformed into facilitating investment and technologyflows and monitoring industrial development in the liberalised environment.Foreign Investment promotion Board The Foreign Investment Promotion Board (FIPB) is a government body that offers a single window clearance for proposals on Foreign Direct Investment (FDI) in India that are not allowed access through the automatic route. FIPB comprises of Secretaries drawn from different ministries with Secretary, Department of Economic Affairs, MoF in the chair. This inter-ministerial body examines and discusses proposals for foreign investments in the country for sectors with caps, sources and instruments that require approval under the extant FDI Policy on a regular basis. The Minister of Finance, considers the recommendations of the FIPB on proposals for foreign investment up to 1200 crore. Proposals involving foreign investment of more than 1200 crore require the approval of the Cabinet Committee on Economic Affairs (CCEA). Enforcement Directorate Contributed by CA. Sudha G. Bhushan Central Government has established a Directorate of Enforcement for the purpose of enforcement of Act [section 36]. Officers under Directorate of Enforcement are known as Officers of Enforcement. The officers shall exercise the like powers which are conferred on the Income Tax authorities under the Income tax Act, 1961 [subject to such conditions and limitations as the central government may impose] [Section 37]. These officers can investigate the contraventions of FEMA. The Role of Directorate of Enforcement is as under:
  • 7.  To collect and develop intelligence relating to violation of the provisions of Foreign Exchange Management Act.  To conduct searches on suspected persons, conveyances and premises for seizing incriminating materials (including Indian and foreign currencies involved).  To enquire into and investigate suspected violations of provisions of the Foreign Exchange Management Act.  To adjudicate cases of violations of Foreign Exchange Management Act for levying penalties and also for confiscating the amounts involved in contraventions;  To realize the penalties imposed in departmental adjudication;Secretariat for Industrial Assistance (SIA)The Secretariat for Industrial Assistance (SIA) has been set up by the Government of India in theDepartment of Industrial Policy and Promotion, Ministry of Commerce & Industry to provide a single-window service for entrepreneurial assistance, investor facilitation, receiving and processing allapplications which require government approval, conveying government decisions on applications filed,assisting entrepreneurs and investors in setting up projects (including liaison with other organisationsand state governments) and monitoring the implementation of projects. It also notifies all governmentpolicy decisions relating to investment and technology, and collects and publishes monthly productiondata for select industry groups.Foreign Investment Implementation Authority FIIAForeign Investment Implementation Authority (FIIA) The Government of India has set up the ForeignInvestment Implementation Authority (FIIA) to facilitate quick translation of Foreign Direct Investment(FDI) approvals into implementation, and to provide a pro-active one-stop after-care service to foreigninvestors by helping them obtain necessary approvals, sort out operational problems and meet withvarious government agencies to find solutions to their problems. The Secretariat for IndustrialAssistance (SIA) in the Department of Industrial Policy & Promotion (DIPP) functions as the Secretariat ofthe FIIA. Contributed by CA. Sudha G. Bhushan
  • 8. Importance of Foreign InvestmentsAs described above FDI is a source of finance to the country. It is usually preferred over other forms ofexternal finance because they are non-debt creating, non-volatile and their returns depend on theperformance of the projects financed by the investors. FDI also facilitates International trade andtransfer of knowledge, skills and technology. In a world of increased competition and rapid technologicalchange, their complimentary and catalytic role can be very valuable.Further, FDI plays an important role in raising productivity growth in sectors in which investment hastaken place. In fact, sectors with a higher presence of foreign firms have lower dispersion of productivityamong firms, thus indicating that the spill-over effects had helped local firms to attain higher levels ofproductivity growthFDI helps in the transmission of capital and technology across home and host countries. Benefits fromFDI inflows are expected to be positive, although not automatic. A facilitating policy regime withminimal interventions may be ideal to maximise the benefits of FDI inflows.An important question that arises is whether FDI merely acts as filler between domestic savings andinvestment or whether it serves other purposes as well. At the macro–level, FDI is a non-debt-creatingsource of additional external finances. This might boost the overall output, employment and exports ofan economy. At the micro-level, the effects of FDI need to be analysed for changes that might occur atthe sector-level output, employment and forward and backward linkages with other sectors of theeconomy. There are fears that foreign firms might displace domestic monopolies, and replace these withforeign monopolies which may, in fact, create worse conditions for consumers. Thus, it is important tohave an efficient competition policy along with sector regulators in place.Besides capital flows, FDI generates considerable benefits. These include employment generation, theacquisition of new technology and knowledge, human capital development, contribution tointernational trade integration, creation of a more competitive business environment and enhancedlocal/domestic enterprise development, flows of ideas and global best practice standards and increasedtax revenues from corporate profits generated by FDI.Besides being an important source for diffusion of technology and new ideas, FDI plays more of acomplementary role than of substitution for domestic investment. FDI tends to expand the local market,attracting large domestic private investment. This “crowding in” effect creates additional employment in Contributed by CA. Sudha G. Bhushanthe economy. Further, FDI has a strong relation with increased exports from host countries. FDI alsotends to improve the productive efficiency of resource allocation by facilitating the transfer of resourcesacross different sectors of the economy. Increased flow of capital raises capital intensity in production,resulting in lower employment generation. However, a higher level of investment accelerates economicgrowth, showing wider positive effects across the economy.While the quantity of FDI is important, equally important is the quality of FDI. The major factors thatmight provide growth impetus to the host economy include the extent of localisation of the output ofthe foreign firm’s plant, its export orientation, the vintage of technology used, the research anddevelopment (R&D) best suited for the host economy, employment generation, inclusion of the poorand rural population in the resulting benefits, and productivity enhancement.
  • 9. Capital formation is an important determinant of economic growth. While domestic investments add tothe capital stock in an economy, FDI plays a complementary role in overall capital formation and in fillingthe gap between domestic savings and investment. At the macro-level, FDI is a non-debt-creating sourceof additional external finances. The below chart shows the FDI flows in India. FDI EQUITY INFLOWS (MONTH-WISE) DURING THE FINANCIAL YEAR 2012-13 October, 2012 August, 2012 Amount of FDI inflows June, 2012 (In Rs. Crore) April, 2012 0 5,000 10,000 15,000 20,000 25,000 30,000Spillover effect of FDIBesides having direct benefits FDI also have spillover effects. The spillover effect of FDI can beHorizontal or vertical. The top FDI receiving sectors, as per the DIPP 4-digit classification, have strongbackward and / or forward linkages with the economy. The sectors with strong backward and forwardlinkages include construction; fuels; chemicals; and metallurgical industries. The sectors with strongbackward linkages include electrical equipment; drugs and pharmaceuticals; food processing; andtextiles. Services sectors, telecommunications, and consultancy services have strong forward linkages.The backward and forward linkages provide for spillover effects of FDI. When mutlinational Domestic firms may also Horizontal Vertical entities enter into host benefit when they are countries, the Domestic employed as suppliers or firms are supposed/forced subcontractors to MNEs as Contributed by CA. Sudha G. Bhushan to increase their that helps them to expand productivity by adopting output and achieve the brand new economies of scale technologies of MNEs.There is both a positive competition effect from the presence of foreign firms and a positivecomplementary effect due to backward linkages between domestic firms and foreign firms, where localfirms act as suppliers of raw materials to the foreign firms.
  • 10. The level of positive spillover effects of FDI are also dependent on the how much the domestic firms areEmerging Markets:able to absorb the technology, systems etc. brought in by Transnational companies. The R&D effort ofdomestic firms is found to be a critical factor in absorbing the positive spillovers from foreign firms bothas competitors and as suppliers.It is known fact that during the past two decades there is shift in global attention to the emergingmarkets., especially the BRICS Countries, I,e. Brazil, Russia, India, China and South Africa. The shift isdriven by their remarkable growth rates. Also, there have been significant changes in the growth modelsof developing economies/emerging markets . Many of these economies, including India, have movedaway from inward-oriented import substitution policies to outward oriented and market-determinedexport-oriented strategies. The skepticism about the role of FDI in reinforcing domestic growth hasgiven way to greater openness to FDI, with a view to supporting investment and productivity of the hostcountries. While developing countries have started accepting FDI inflows with some caution thedeveloped countries have moved their investments to foreign locations, subject to safety andprofitability of their business operations in foreign lands. The markets are broadly divided into threetypes as described below: Frontier Emerging Developed Markets Economies Markets  Developed markets like U.S., Canada, France, Japan and Australia. It consists of the largest, most industrialized economies. Their economic systems are well developed, they are politically stable, and the rule of law is well entrenched. Developed markets are usually considered the safest investment destinations, but their economic growth rates often trail those of countries in an earlier stage of development. Investment analysis of developed markets usually concentrates on the current economic and market cycles; political considerations are often a less important consideration. Contributed by CA. Sudha G. Bhushan  Emerging markets are the economies which experience rapid industrialization and demonstrate extremely high levels of economic growth. This strong economic growth is attractive to developed markets as for them it may translate into investment returns that are superior to those that are available in developed markets. However, emerging markets are also riskier than developed markets; there is often more political uncertainty in emerging markets, and their economies may be more prone to excessive booms and busts. We have discussed the various type of risk in emerging markets below. Many of the fastest growing economies in the world, including China, India and Brazil, are considered emerging markets.  Frontier markets are generally either smaller than traditional emerging markets, or are found in countries that place restrictions on the ability of foreigners to invest. They are the "the next
  • 11. wave" of investment destinations. Although frontier markets can be exceptionally risky and often suffer from low levels of liquidity, they also offer the potential for above average returns over time. Examples of frontier markets include Nigeria, Botswana and Kuwait. FDI Policy and Institutional Framework in Select Countries Year Objective Incentives Priority Sectors Unique of features Libera lisationChina 1979 Transformation of Foreign joint ventures were provided with Agriculture, energy, Setting up of traditional preferential tax treatment. Additional tax transportation, Special agriculture, benefits to export-oriented joint ventures and telecommunications, Economic Zones promotion of those employing advanced technology. basic raw materials, and industrialization, Privileged access was provided to supplies of high-technology infrastructure and water, electricity and transportation (paying industries. export promotion. the same price as state-owned enterprises) and to interest-free RMB loans.Chile 1974 Technology Invariability of tax regime intended to All productive activities Does not use tax transfer, export provide a stable tax horizon. and sectors of the incentives to promotion and economy, except for a attract foreign greater domestic few restrictions in areas investment. competition. that include coastal trade, air transport and the mass media.Korea 1998 Promotion of Businesses located in Foreign Investment Manufacturing and Loan-based absorptive Zone enjoy full exemption of corporate services borrowing to an capacity and income tax for five years from the year in FDI-based indigenisation of which the initial profit is made and 50 percent development foreign reduction for the subsequent two years. High- strategy till technology tech foreign investments in the Free late1990s. through reverse Economic Zones are eligible for the full engineering at the exemption three years and 50 percent for the outset of following two years. Cash grants to high-tech industrialisation green field investment and R&D investment while restricting subject to the government approval. both FDI and foreign licensing.Malaysia 1980s Export promotion No specific tax incentives. Manufacturing and Malaysian services. Industrial Development Authority was recognised to be one of the effective agencies in the Asian regionThailand 1977 Technology No specific tax incentives. The Thai Board of Manufacturing and - transfer and Investment has carried out activities under the services Contributed by CA. Sudha G. Bhushan export promotion three broad categories to promote FDI. 1. Image building to demonstrate how the host country is an appropriate location for FDI. 2. Investment generation by targeting investors through various activities. 3. Servicing investorsSource : http://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2513
  • 12. Risk in investment in foreign markets especially emergingMere openness to FDI inflows may be a necessary but insufficient condition and the host economyneeds to provide a sufficiently enabling environment to attract foreign investors. It needs to create alevel playing field through developing an efficient, competitive and regulatory regime, such that bothdomestic and foreign invested companies play a mutually reinforcing role within a healthy competitiveenvironment. Following types of risk are seen in the emerging markets:  Political Risk  Regulatory Risk  Industry Risk  Population Demographics Risk  Economic Risk Openness Macroeconomic Market Size stability Variables significant in determining FDI Exchange Rate Governence valuation Clustering Effects Contributed by CA. Sudha G. BhushanVertical and Horizontal FDIFDI in host country can come through different types. Investor may decide to replicate its process inother countries or it may decide to produce different parts of production process internationally,
  • 13. locating each stage of production in the country where it can be done at the least cost. Broadly FDI canbe divided into two as mentioned below: • Vertical FDI: It takes place when the multinational fragments the production process internationally, locating each stage of production in the country where it can be done at the least cost. • Horizontal FDI: - occurs when the multinational undertakes the same production activities in multiple countries.In other words, A vertical pattern arises when the multinational firm fragments the production processinternationally, locating each stage of production in the country where it can be done at the least cost. Ahorizontal pattern occurs when the multinational produces the same product or service in multiplecountries. Vertical FDI may compress the skilled-nonskilled wage differential across countries as well aschange the income distribution within countries. Horizontal FDI may increase income in each countrywith minor distributive impact.Horizontal FDI is considered to be more beneficial for host country as it transfers the whole productioncycle to the host company. Also , vertical FDI is risky for the investor if it is completely dependent on theinvestment in other country for completing its production cycle.Horizontal production also entails lower exposure to sovereign risk than does a vertical productionstructure. Suppose that the host country reverses its attitude towards multinationals and tries to forcethe multinational to renegotiate policies by threatening nationalization, production disruptions orsimilar actions. Hence, predatory behavior by the host country is more costly to the multinationalengaged in vertical FDI.Global Competitiveness of India’s FDI*Another method of assessing the investment potential of an economy is its rank on globalcompetitiveness.5 The Global Competitiveness Index (GCI) is a comprehensive index developedby the World Economic Forum (WEF) to measure national competitiveness and is published inthe Global Competitiveness Report (GCR). It takes into account the micro- and macro-economicfoundations of national competitiveness, in which competitiveness is defined as the set of Contributed by CA. Sudha G. Bhushaninstitutions, policies and factors that determine the level of productivity6 of a country andinvolves static and dynamic components. The overall GCI is the weighted average of threemajor components:a) basic requirements (BR)7;b)efficiency enhancers (EE); and c) innovations and sophistication factors (ISF).Within the information available for 131 countries, the United States is ranked the highest, withan overall index of 5.67, and Chad is ranked the lowest with an overall index of 2.78; the overallindex is 107 for Bangladesh, 92 for Pakistan and 70 for Sri Lanka. The overall rank of India at 48is still below that of China at 35. In terms of the components, India holds a relatively low rank
  • 14. for BR (74), but higher ranks for EE (31) and even higher for ISF (26). Compared to China, India’sTypes of Foreign Investment in IndiaBR rank is lower, but it is higher than China’s on EE and ISF.*Source : Study by National Council of Applied Economic ResearchThe choice of entry mode is considered a strategic decision by the foreign investor. The keydriving forces in such decisions depend on the investor’s interest in seeking resources, markets,and efficiency or strategic asset ownership in the host country. While the major motive of anyinvestment is profit, a firm may opt for a particular entry strategy best suited to its short- orlong-term interests.The entry modes in India are as follows : Foreign Institutional Foreign Direct Foreign Venture Capital Qualified Foreign Investors (FIIs) / sub- Investment (FDI) Investments (FVCI) Investors (NEW) accountPortfolio Investment Strategic investments Long term investment in New Investment Route identified venturesInvestment in Equity, Routes:Automatic or SEBI Registration: Investment: Equity, MutualDebt, F&O FIPB Approval Required but perpetual Fund, Corporate DebtSEBI Registration: Investments: Private Subscription to IPO: SEBI Registration: Not RequiredRequired but perpetual placements of listed / Permitted as per limits unlisted equity, CCDs (QIB status)Trade listed securities: Permitted Trades: No Permitted Trades: No Trade listed securities: StockRegistered Brokers secondary market secondary market Exchanges purchases purchases Contributed by CA. Sudha G. BhushanForeign direct investment (FDI) constitutes three components; viz., equity; reinvested earnings;and other capital. Equity FDI is further sub-divided into two components, viz., greenfieldinvestment; and acquisition of shares, also known as mergers and acquisitions (M&A). FDI maycome through Joint ventures (merger and acquisition (M&As)) and wholly owned subsidiaries.Wholly owned subsidiary is also referred as Greenfield Investment.
  • 15. While these two modes of entry for direct investment are generally considered to bealternatives, there may be situations where only M&As appear to be the realistic option. Forinstance, in the absence of any domestic buyers for a large firm that has been declared sick, across-border M&A is viable option.Opening of wholly owned subsidiary by foreign entity is more useful to developing countries. Asit is more likely to furnish the host country with financial assets, technology and skill resources,Foreign Direct Investment: Mythsenhance productive capacity and generate additional employment.In all the Euphoria about the increasing FDI in India, we should not forget to look into look intofew facts keenly  The purpose of investment in genuinely to earn profits or is the entity created just to earn some tax benefits.  Money coming from other countries is the clean and genuine or it is the black money which is coming in the country through FDI mode?  Is it creating any political threat to the country.  India being a country where savings are more than spending do we need FDI or can we make the internal systems stronger to generate the liquidity required by our corporations?  Are Indian Brands dying away? Contributed by CA. Sudha G. BhushanWe have discussed few of these issues in detail below:Shifting of profits from high tax jurisdiction to low tax jurisdictionDiffering tax rates in different tax jurisdictions provide avenues to corporations to shift taxableincome from jurisdictions with relatively high tax rates to jurisdictions with relatively low taxrates as a means of minimising their tax liability. As a matter of fact more than 60 per cent ofglobal trade is carried out between associated enterprises of multinational enterprises (MNEs).
  • 16. Allocation of costs and overheads and fixing of price of product/services are highly subjective,MNEs enjoy considerable discretion in allocating costs and prices to particularproducts/services and geographical jurisdictions. Such discretion enables them to transferprofit/income to no tax or low tax jurisdictions. For example, a foreign parent company coulduse internal ‘transfer prices’ for overstating the value of goods and services that it exports to itsforeign affiliate in order to shift taxable income from the operations of the affiliate in a high taxjurisdiction to its operations in a low-tax jurisdiction.Use of participatory NotesParticipatory notes are instruments used for making investments in the stock markets. However,they are not used within the country. They are used outside India for making investments inshares listed in the Indian stock market. Foreign institutional investors (FIIs) and their sub-accounts mostly use these instruments for facilitating the participation of their overseas clients,who are not interested in participating directly in the Indian stock market. Investment in theIndian Stock Market through PNs is way in which the black money generated by Indians is re-invested in India. The investor in PNs does not hold the Indian securities in her/his own name.These are legally held by the FIIs, but s/he derives economic benefits from fluctuation in pricesof the Indian securities, as also dividends and capital gains, through specifically designedcontracts. Thus, through the instrument of PNs, investment can be made in the Indian securitiesmarket by those investors who do not wish to be regulated by Indian regulators due to a varietyof reasons. It is possible to hide the identity of the ultimate beneficiaries through multiple layers.The ultimate beneficiaries/investors through the PN Route can be Indians and the source of theirinvestment may be black money generated by them.Investment in NGOForeign Contribution for Charitable purposes is regulated through the Foreign ContributionRegulation Act. However, how much of these contributions are genuine is not known. As perthe search of non-government organisations (NGOs), and associations receiving foreigncontributions more than 70% of the funds goes in acquisition of immovable property. They are Contributed by CA. Sudha G. Bhushanrequired to file an annual return to the Ministry of Home Affairs in Form FC-3. In the said form,only the name and address of the foreign donors are mentioned, with no further details of thebeneficial owners. It is possible that in many such cases, the black money generated by Indiansis being routed back to India.Flouting of FDI policyThe FDI policy of government is based on the sectoral needs and Department of policy andpromotion decides the levels of FDI to be allowed in any sector based on the need of the sector
  • 17. and the based on the maturity. Those sector which are of national importance or where it isconsidered that the sector need more time to mature or there is no benefit that can be derivedfrom FDI in the sector are not opened. Entries in these sectors is either prohibited or is subjectto restrictions. Few companies however, have been able to flout the FDI policy and come withcomplex structure. One of such sector recently is FDI in E-Commerce. Retail trading. , in anyform, by means of e-commerce, is not permissible for companies with FDI, engaged in theactivity of multi-brand retail trading. A wholesale/cash & carry trader cannot open retail shopsto sell to the consumer directly. , says the Department of Industrial Policy and Promotion’s(DIPP) ‘Consolidated FDI Policy’ document dated 10 April 2012. That’s the law. The reality is,every foreign-funded e-tailer goes around it using the two-company route.Round tripping of money One of the other key factor is whether the money which is coming from outside India is Indian money(black) routed through different routes to India. The illicit money transferred outside India maycome back to India through various methods such as hawala, mispricing, foreign directinvestment (FDI) through beneficial tax jurisdictions, raising of capital by Indian companiesthrough global depository receipts (GDRs), and investment in Indian stock markets throughparticipatory notes.As per data by the Department of Industrial Policy and Promotion (DIPP), from April 2000 toMarch 2011 FDI from Mauritius is 41.80 per cent of the entire FDI received by India. The twotopmost sources of the cumulative inflows from April 2000 to March 2011 are Mauritius (41.80per cent) and Singapore (9.17 per cent) (refer the chart below). Mauritius and Singapore withtheir small economies cannot be the sources of such huge investments and it is apparent thatthe investments are routed through these jurisdictions for avoidance of taxes and/or forconcealing the identities from the revenue authorities of the ultimate investors, many of whomcould actually be Indian residents, who have invested in their own companies, though a processknown as round tripping.A large number of foreign institutional investors (FIIs) who trade on the Indian stock markets Contributed by CA. Sudha G. Bhushanoperate from Mauritius. According to the Double Taxation Avoidance Agreement (DTAA)between India and Mauritius, capital gains arising from the sale of shares are taxable in thecountry of residence of the shareholder and not in the country of residence of the companywhose shares have been sold.Therefore, a Company resident in Mauritius selling shares of an Indian company will not pay taxin India. Since there is no capital gains tax in Mauritius, the gain will escape tax altogether.Further, the treaty does not include a limitation of benefit (LOB) clause, which is like a “lookthrough” provision in tax treaties to ensure that only residents of treaty countries who arebeneficiaries avail such benefits.
  • 18. SHARE OF TOP INVESTING COUNTRIES FDI 1 MAURITIUS 2 SINGAPORE EQUITY INFLOWS 2012-13(April–Oct.) 3 U.K. 4 JAPAN 5 U.S.A. 6 NETHERLANDS 7 CYPRUS 8 GERMANY 9 FRANCE 10 U.A.E.Investment by SWFA sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assetssuch as stocks, bonds, property, precious metals or other financial instruments. Sovereignwealth funds invest globally. There is an increase in investment by SWF in Indian economy. SWFbeing the state owned investment may raise political issues. There have been investment fromSingapore, Russian funds etc. Although, the matter is already overly debated in developedConclusioncountries yet a keen watch is required.India is one of the most desired global investment destinations because of the growth rate ithad been able to sustain in the last decade. The foreign investment is welcome and promoted.The Government is taking active steps in liberalizing the regulations for making them moreinvestor friendly. Recent decision of government to open multi brand retail, civil aviation forforeign participation is example for this. FDI not only provide the much required liquidity to the Contributed by CA. Sudha G. Bhushanindustry also it provides technology up gradation. However, as we move towards fuller accountconvertibility the internal systems should be strong and self-sustaining so as to avoid any crisislike Asian Crisis of 1997. The proper check and balances have to be in place.