Permissibility of swap under FEMA

Recently, the Central Government notified amendments to the Foreign Exchange Management (Non Debt Instruments) Rules, 2019 (“NDI Rules”) vide the Foreign Exchange Management (Non-debt Instruments) (Fourth Amendment) Rules, 2024 (“Amendment”). One of the key changes introduced by the Amendment is to permit swap of shares of an Indian company (in case of a secondary transfer) and vis-a-vis shares of a foreign company, which is expected to  allow for smoother and efficient cross-border transactions.

What does the current law provide for?

Before the Amendment, Indian companies were permitted to issue equity instruments^[1] to persons resident outside India against the swap of equity instruments strictly of another Indian company. A diagrammatic representation of what was previously allowed is provided below:

In this structure, F Co sold shares held by it in A Co to B Co and in return B Co issued its own shares to F Co. This results in F Co becoming shareholder of B Co which in-turn is holding A Co. This transaction was permissible, provided it complies with the sectorial caps, pricing guidelines and other conditions prescribed by the Central Government and Reserve Bank of India.

What does the Amendment provide for?

In addition to the permissibility of swap of shares in case of a primary issuance as mentioned above, the Amendment has now allowed an Indian company to issue its equity instruments to a person resident outside India by way of swap of equity capital of a foreign company, provided it complies with the Foreign Exchange Management (Overseas Investment) Rules 2022 (“OI Rules”). Thus, apart from the above, the following has also been allowed.

In this structure, F Co, a foreign company has sold shares in A Co (also a foreign company) to B Co. B Co has issued equity instruments to F Co as consideration for shares in A Co received by it. This results in F Co holding shares in B Co which in turn holds shares in A Co. This Amendment harmonizes the legal provisions under NDI Rules with those under OI Rules where Indian company is permitted to undertake ODI by way of swap of securities.

The Amendment further introduces Rule 9A to also permit the transfer of equity instruments of an Indian company between persons resident in India and persons resident outside India by way of swap of equity instruments of an Indian company or by way of swap of equity capital^[2] of a foreign company. What has been permitted has been outlined in the below structures.

I. Where the resident (B Co) is selling shares of Indian Company (A Co) to a non-resident (F Co).

In each of the above structures, B Co, an Indian company is selling shares of A Co (also an Indian company) in return for either F Co issuing its own shares to B Co or F Co transferring shares of C Co (a foreign company) to B Co or F Co transferring shares of C Co (an Indian company) to B Co.

II. Where the resident (B Co) is buying shares of Indian Company (A Co) from a non-resident (F Co)

In each of these structures, F Co (a foreign company) is selling shares of A Co (an Indian company) to B Co (also an Indian company) in return for B Co transferring shares of C Co (an foreign company) or B Co transferring shares of C Co (an Indian company).

However, under the OI Rules a person resident in India cannot acquire securities of the foreign company through swap route unless it is pursuant to a merger, demerger amalgamation or liquidation. Therefore, the above amendments will not apply where the resident in India (selling Indian company shares to a non-resident, in lieu of shares of a foreign company) is an individual.

Implications & unanswered questions

While the changes are a welcome move and will facilitate greater cross-border transactions and structuring, it would be interesting to see what will be the treatment /applicability of the Amendment in a situation where: (i) a Foreign Owned or Controlled Company is either the buyer or seller of the Indian equity instruments; (ii) a resident individual who had acquired shares of the Indian entity as a resident but is an NRI today – will the individual be able to avail the swap option (to swap its shares as a resident to a non-resident in lieu of shares of a foreign company) considering the OI Rules do not apply to such an individual?

Further, the rules of disinvestment under OI Laws require the proceeds of the disinvestment to be repatriated back into India. This will need to be amended to carve out an exception for a swap scenario where a resident transfers its holding in a foreign company to a non-resident in lieu of such non-resident transferring the shares of the Indian company to the resident seller.

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[1] Section 2(k) of the NDI Rules states that equity instruments means equity shares, convertible debentures, preference shares and share warrant issued by an Indian company. Therefore, the swap could only involve equity instruments (of an Indian company).

[2] Equity Capital has the same meaning as under the OI Rules. As per Section 2(e) of the OI Rules Equity Capital means equity shares or perpetual capital or instruments that are irredeemable or contribution to non-debt capital of a foreign entity in the nature of fully and compulsorily convertible instruments.