Investment in Offshore Real Estate under FEMA – SAFEMA Shows the Way Ahead!

-      Ashish Sodhani & Jenisha Parikh[1]

Recently, the Appellate Tribunal under the Smugglers and Foreign Exchange Manipulators (Forfeiture of Property) Act, 1976 (SAFEMA) (“Tribunal”) ruled that a solitary purchase of real estate does not mean that the foreign entity is in the business of real estate. It also ruled that merely because part of the funds to acquire immoveable property outside India were made via direct investment from India (under the Erstwhile ODI Regulations), it does not result in the Indian entity being considered as the owner of the immoveable property outside India.

Whilst this ruling was in relation to the Erstwhile ODI Regulations (and accordingly, the erstwhile Section 6(3)(a) and Section 6(3)(h) of FEMA), the take aways from this ruling should continue to apply to the interpretation of the relevant / corresponding provisions under the successor rules and regulations as well (that is, the Sections 6(2) and 6(2A) of FEMA and Foreign Exchange Management (Overseas Investment) Rules, 2022 ; Foreign Exchange Management (Overseas Investment ) Directions, 2022) (collectively referred as “New Regulations”).

Background

An Indian entity, Nirayu Pvt. Ltd. (“India Co”) (f/k/a Whitefield Chemtech Pvt. Ltd.) transferred USD 2.4 mn in three tranches to its Wholly Owned Subsidiary in Singapore, namely, Techno Global Holdings Pte. Ltd. (“Sing Co” / “WOS”).

The WOS transferred a part of that money to the first Step-Down Subsidiary Techno Global Trade and Investment Ltd., a company set-up in UAE (“SDS-1”). SDS-1 transferred a further part of that amount to the second Step-Down Subsidiary Whitefield Global Investment Ltd., a company set up in the BVI (“SDS-2”) and the WOS also extended USD 150,000 directly in SDS-2. SDS-2 obtained loan of GBP 2,750,000 (USD 3.9 mn) from Silverwood Enterprises Ltd. and was mandated to purchase a real estate property in London for USD 5.5mn (USD 3.9 mn from the loan amount and USD 1.6 mn from the transfer by SDS-1 and by the WOS). It was alleged that the purchase of residential property was in contravention to the provisions of the Foreign Exchange

Management Act, 1999 (“FEMA”) and accordingly show-cause notices were issued to India Co, directors of India Co and to the person controlling the business activities as well as being responsible for the conduct of business of India at the relevant time. The Directorate of Enforcement (“ED”) stated that provisions of FEMA were contravened to the tune of USD 1.6 mn and accordingly it seized mutual funds held by India Co of the said amount. The seizure order was confirmed by the competent authority.

However, the Adjudicating Authority (“AA”) held that the charges are not proved and directed release of the seized mutual funds. The AA in its Adjudication Order (“AO”) held as follows:

• Direct investment way of contribution to equity capital was made by the India Co into the WOS. This was in accordance with the Regulation 5[2]of the Erstwhile ODI Regulations.

• The WOS is Special Purpose Vehicle which was also declared as such to the Authorised Dealer and to the Reserve Bank of India (“RBI”) in the relevant forms that were filed and the WOS was not a foreign entity which was engaged in real estate business.

• The WOS was not engaged in any activity which is concerning fraud and deception and no reasons were provided as to why the WOS was not engaged in a bona fide business.

• Real estate business as defined under Regulation 2 (p) of the Erstwhile ODI Regulations does not include a solitary transaction of purchase of a residential real estate outside India.

• Real estate was purchased by SDS-2 which was a BVI entity and hence not a resident of India. Accordingly there was no contravention of the erstwhile Section 6(3)(a) & Section 6(3)(h)[3] of FEMA read with Regulations 5[3] & 6 (2) (ii)[5] of the Erstwhile ODI Regulations

• India Co in its declaration to the Authorised Dealer in the Form ODI at the time of making remittance and on filing of Annual Performance Report fully disclosed the purpose of remittance as well as the details of all the subsidiaries. The purpose of remittance has been mentioned as equity contribution. Further R-1 declared in the Form ODI submitted to the Authorised Dealer that the WOS in Singapore was intended to be a Special Purpose Vehicle to make downstream investment in trading activities. As per the AA, Section 10(6)[6] of FEMA does not regulate the ultimate end users of the foreign exchange and applies only to the person who has purchased the foreign exchange.

• Section 4[7] of FEMA also was not contravened as it was SDS-2 which purchased the property in UK and since it does not qualify as a person resident in India as per FEMA the charge under the section is not proved.

  Aggrieved by the AO, the ED filed an appeal before the Tribunal.

  
  

Tribunal's Ruling

Pursuant to hearing arguments from both sides, the Tribunal framed the following questions which required to be answered to put to rest the issue at hand:

1. Whether the fact of the purchase of residential real estate by SDS-2 makes the purpose of the direct investment by India Co in the WOS as not being bona-fide?

2. Whether the declarations and the procedural requirements met by India Co are invalidated in view of the aforementioned purchase of the residential real estate in UK by SDS-2?

3. Whether the purchase of the residential real estate in UK by SDS-2 located in BVI was actually by India Co which is a company resident in India?

While the Tribunal answered all three questions in favour of the respondents, there were various findings made by it to reach to this conclusion. These have been summarised below:

• Bona-fide business should also be carried out by the step-down subsidiaries:

  As per the Estwhile ODI Regulations (and the New Regulations as well), direct investment should be made in an offshore entity (Joint Venture or WOS) which is engaged in bona-fide business activity. While what constitutes bona-fide business has been not be prescribed by the RBI, the Erstwhile ODI Regulations specifically provide that real estate business and banking business are not bona fide business. In this context, the argument of the respondents was that the restriction of carrying out bona fide business was restricted to only the WOS and cannot be extended to SDS-1 and SDS-2. The Tribunal, rejecting the argument of the respondent, held that the intention of the regulations cannot be that merely by forming a step subsidiary an Indian Party can escape the responsibility casts upon its wholly owned subsidiary and run a non- bona fide business activity through a step down subsidiary. The applicability of these provisions of the Erstwhile ODI Regulation cannot be exempted for the step down subsidiaries and need to be read as a whole. Accordingly, the requirement of having bona fide business activity will also need to be complied by the step down subsidiaries as well.

• Does a solitary purchase of real estate abroad amount to carrying out real-estate business?

  In relation to the question of whether the purchase of the sole residential real estate property in UK amounts to SDS-2 carrying out real estate business, the argument of the respondents was that the purchase of the real estate property was to use it as a guest house for facilitating business of trade from within the property. To showcase that actual trade took place SDS-2 submitted trade transactions which were also relied upon by the ED. Considering the ,above, the Tribunal held that a solitary purchase of real estate abroad does not constitute rea; estate business and hence it cannot be said that SDS-2 was not carrying out bona-fide business.

• Power of RBI to regulate ultimate end-use of foreign exchange sent from India:

  The argument of the respondent was that the FEMA does not regulate the ultimate end use of foreign exchange purchased but only the immediate purpose, as the purchaser of foreign exchange only has control over the immediate purpose for which such foreign exchange may be utilized. The Tribunal, rejecting the argument of the respondent, held that in the present case at least USD 1.6 mn has flowed through the WOS to SDS-1 and then to SDS-2. The original funds acquired by India Co, from the Authorised Dealer, to the extent of USD 1.6 mn was put to use for the first time by the SDS-2 in purchase of the real estate property and hence RBI has the power to regulate the ultimate end-use of the foreign exchange acquired by the India Co and then sent to SDS-2.

• Importance of declarations and procedural requirements:

  India Co had filed all relevant declarations with the Authorised Dealer including ODI Forms providing the purpose of forming the WOS and included information about SDS-1 and SDS-2. The activity code for SDS-2 was been declared as 820.3 which has been explained as lessor of real property. Besides the ODI Forms, India Co also filed the Annual Performance Reports for the relevant years of 2015-16 and 2016-17 with the RBI through the Authorised Dealer, which substantiate the earlier filings in the Form ODI. The charge of the ED was confined to the purchase of the immovable property by the SDS-2 as neither the WOS or SDS-1 had purchased any immoveable property outside India. The Tribunal after confirming from the documents and evidence on record clarified that the contention that the SDS-2 was doing trading activities was correct. It further noted that the declarations made in the Forms ODI and the APRs were not questioned by the Authorised Dealer and the RBI. Given the fact the SDS-2 was not carrying out real estate business (due to the reasons mentioned above) and the fact that SDS-2 does not even appear to have indulged in the activity relating to lessor of real property in spite of declaration to that effect made in third Form ODI and APRs, the Tribunal ruled that the declarations and other procedural requirements filed by India Codo not get invalidated because of the purchase of the residential real estate in UK by SDS-2. Therefore, there is no contravention of Section 10 (6) of FEMA by the respondents.

• Separate legal entity:

  The argument of the ED was that SDS-2 is nothing but a branch / office / agency owned and controlled by India Co which is a person resident in India. Since India Co owns / controls SDS-2, it is also a person resident in India under FEMA. In this respect, it should be noted that the respondents had submitted certificate of incorporation of SDS-2 issued by the BVI, register of directors which names 2 directors. The Tribunal held that it cannot be denied that SDS-2 is incorporated in BVI. Further, it ruled that while branch / office / agency has not been defined under FEMA, a wholly owned subsidiary has been defined under the Erstwhile ODI Regulations and therefore while one may use branch / office / agency interchangeably, the same cannot be the case when it comes to subsidiary / step down subsidiary /wholly owned subsidiary as these entities have been specified in definite and distinct sense under the provisions of FEMA and the Erstwhile ODI Regulations respectively.

  
  

  With respect to control exercised by India Co over SDS-2, the argument of the ED was that all decisions of SDS-2 were taken by India Co without recording the minutes and that the decisions were communicated on telephone to SDS-2. However, the Tribunal on reading the statements that were placed on record stated that the proposal to purchase the said property was of the Director of the SDS-2 and was only communicated to India Co for validation purposes. The Tribunal further ruled that while each of the subsidiary abroad is a separate entity, the ownership structure in the present case may give scope to India Co to influence certain decisions of the subsidiaries. Moreover, if the buying of the immovable property in UK is regarded as one such decision which required the validation of India Co there is no evidence on record as to show that India Co exercised control on SDS-2 to obtain loan of US $ 3.9 million for the purchase of the said property. Limited influence of such kind cannot be regarded as “control” to deem the step down subsidiaries as branch / office / agency of India Co. The ED also tried to argue on the basis of the principle of place of effective management wherein it cited judicial precedents under the Income Tax Act, 1961 but were rejected by the Tribunal on the basis that there is no documentary evidence to corroborate that either de jure control and power, or de facto control and power was with India Co with regard to conduct of the affairs of the SDS-2. Considering all of the above, the Tribunal ruled that SDS-2 cannot be considered to be under the control of India Co and accordingly, SDS-2 cannot be considered to be a person resident in India and hence there is no violation of FEMA in respect of purchase of property outside India.

Key Takeaways

The ruling of the Tribunal is important in many ways and there are many take aways from the ruling:

• The reference to bona-fide business comes from Regulation 6 of the Erstwhile ODI Regulations which provides for setup of JV /WOS and accordingly, Regulation 13[8] of the Erstwhile ODI Regulations does not specifically mention that the step-down subsidiary needs to carry out bona-fide business. However, to argue that because there is no specific mention of bona-fide business in context of step down subsidiary, the same does not apply to the step-down subsidiary is a flawed argument as one flows from the other and necessitates that the conditions prescribed for one should be followed for the others in line unless otherwise provided for. Additionally, if that argument is taken forward, would that mean that the step-down subsidiaries can carry out businesses which are not bona-fide. The clarification in this respect by the Tribunal in welcomed and should continue to apply to interpretation of the bona fide requirement under the New Regulations as well.

• The Tribunal’s ruling that purchase of a solitary real estate property does not amount to carrying on real-estate business comes as a shot in the arm to persons in India looking to structure their offshore properties. However, there are certain aspects which should be kept in mind. Under the present facts, SDS-2 also carried on its business of trading through  the real estate property that was purchased – therefore, does it mean that the offshore entity should carry on some other business and the purchase of property should only be incidental to its business? Further, does it mean that the property can be purchased only if business is to be carried out from that property? The Tribunal seems to have also given weightage to the interpretation of the term “real estate business” wherein it held that a solitary purchase of real estate cannot amount to “business” but at the same time, even the fact that SDS – 2 was a trading entity and undertook trading at the property acquired was relied upon by the Tribunal . Accordingly, it is unclear if the ruling of the Tribunal would have been different if SDS-2 did not carry out the business of trading and only bought the property.

• Another aspect that can be inferred from the ruling is how a person resident in India can hold immovable property outside India through its WOS / step-down subsidiary even though this route is not expressly covered under Section 4 & erstwhile Section 6(3)(h) of FEMA r/w erstwhile FEM (Acquisition and Transfer of Immovable Property outside India) Regulations, 2015 or the corresponding provisions under the New Regulations.

• The importance of filings and procedural requirements under FEMA cannot be stressed enough and the Tribunal’s ruling is just a reminder of the same. Additionally, it is also important to provide correct information in these forms. Interestingly, the Tribunal relies on the fact that the forms were accepted by the Authorised Dealer and RBI and no questions were raised by them. Reliance and weightage given to the decision of the Authorised Dealer / RBI in accepting the forms filed / information submitted at the time of remitting the funds outside India is assuring since this creates a precedence of not questioning the reportings / filings made subsequently if the same were not questioned by the Authorised Dealer / RBI.

• We have always heard about substance over form and place of effective management issues in income tax cases where tax benefits were being denied. The Tribunal’s ruling is an important reminder that aspects such as control, substance etc. can also play a vital role in FEMA matters. The fact that SDS-2 had independent directors and was able to demonstrate that it took decisions independently played an important role in the ruling wherein the Tribunal considered it be a separate legal entity and not lifting the corporate veil. It is important that businesses take proper care and document reasons for structuring their businesses.

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[1] Ashish Sodhani & Jenisha Parikh are co-founder and partners at Parakram Legal.

[2] Regulation 5 of the erstwhile ODI Regulations provided for prohibition on direct investment outside India and provided as follows:

Save as otherwise provided in the FEMA, rules or regulations made or directions issued thereunder, or with prior approval of the Reserve Bank

(1) no person resident in India shall make any direct investment outside India; and

(2) no Indian party shall make any direct investment in a foreign entity engaged in real estate business or Banking business.

[3] Section 6(3) of FEMA regulates capital account transactions and states that the RBI may, by regulations prohibit, restrict or regulate the following: -

(a) transfer or issue of any foreign security by a person resident in India;

h) transfer of immovable property outside India, other than a lease not exceeding five years, by a person resident in India

[4] Supra, note 2.

[5] Regulation 6 of the erstwhile ODI Regulations provide for permission for Direct investment in certain cases and one of the conditions under Regulation 6(2)(ii) is that the direct investment is made in an overseas JV or WOS engaged in a bona fide business activity.

[6] Section 10(6) of FEMA provides that any person, other than an authorised person, who has acquired or purchased foreign exchange for any purpose mentioned in the declaration made by him to authorised person does not use it for such purpose or does not surrender it to authorised person within the specified period or uses the foreign exchange so acquired or purchased for any other purpose for which purchase or acquisition of foreign exchange is not permissible under the provisions of the FEMA or the rules or regulations or direction or order made thereunder shall be deemed to have committed contravention of the provisions of FEMA for the purpose of this section

[7] Section  4 of FEMA provides that except otherwise provided under FEMA, no person resident in India shall acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India.

[8] Regulation 13 of the erstwhile ODI Regulations provide for post investment changes/additional investment in existing JV/WOS and state as:

A JV/WOS set up by the Indian party as per the Regulations may diversify its activities /set up step down subsidiary/ alter the shareholding pattern in the overseas entity

Provided the Indian party reports to the Reserve Bank, the details of such decisions taken by the JV/WOS within 30 days of the approval of those decisions by the competent authority concerned of such JV/WOS in terms of local laws of the host country, and, include the same in the Annual Performance Report required to be forwarded annually to the Reserve Bank in terms of Regulation 15