Last week CNBC TV18's Ronojoy Banerjee scooped a very big story and one with game-changing consequences as well. That RBI maybe planning to move all overseas investment by Indian companies from the automatic route to the approval route.
Now here's the short background to this development. On April 26th, RBI and finance ministry officials invited some private sector professionals to consult over the issue of multi-layer overseas investment structures. the finance ministry was concerned about treaty shopping.
RBI was troubled by, broadly speaking, the need for multiple overseas holding entities, the opacity of such structures and the lack of dividend repatriation. thereafter while sharing the minutes of the meeting in a letter to the finance, commerce and external affairs ministries RBI proposed that "irrespective of the structure of the overseas entities set up or acquired by eligible party, overseas investment may be allowed under the approval route..." with overriding conditions including that "eligible dues to the country are repatriated and there is no revenue loss".
If this proposal becomes policy it will have a material impact on India Inc’s ability to invest overseas. How material? To answer that i have with me Bharat Vasani of the Tata Group and Cyril Shroff of Amarchand Mangaldas – between them they have done many of India’s biggest cross-border transactions.
Doshi: The first very simple question I want to put is - are multilayered structures, structures in which there are several holding entities as well as operational entities and I am referring to offshore structures permitted under the 2004 regulations or not because RBI seems to be taking the position that that regulation never envisaged a step down holding entity.
Shroff: In my view the technical legal position is that it is not prohibited under the guidelines and the Foreign Exchange Management Act (FEMA) regulations, multilayer structures are allowed. That being said off-late we have seen a drift in terms of RBI being uncomfortable and suspicious of multilayered transactions, particularly when the layers are not operating companies but they are just holding vehicles, and I think its part of a broader feeling from the establishment. If you look at the philosophy underlying some of the positions under the Companies Act itself or for that matter tax changes that are coming, any form of complex multilayer structure, the establishment doesn’t like it. That doesn’t mean that they are forbidden and there are several examples which can be perfectly justified on the law as they are understood that they are permissible and there is nothing non-kosher about.
Doshi: Would you agree with that?
Vasani: Completely and let me put the facts in perspective. I think most of the overseas transactions which have been done from
Doshi: So in the context of this meeting that we are talking about, if I were to tell you that RBI has raised the question saying that the notification does not envisage step down holding entity, you would be surprised by that stance of RBI.
Shroff: That's a complete u-turn. On the contrary, if memory serves me right, there were statements made by very senior RBI officials which took pride in a context of a public forum claiming that they are so proud of the fact that major companies were able to make large global acquisitions without coming to them. So how liberal they were.
Vasani: If RBI now says that you cannot do it, it means the leveraged buyout (LBO) structures are virtually prohibited.
Doshi: So RBI now seems to be proposing that all overseas investments be done under the approval route and if the earlier point that we made was a 50% u-turn, this is a full 100% u-turn. I want to try and understand why the regulator is maybe turning around because same time last year it was liberalizing several aspects of overseas direct investments, allowing companies to have foreign currency accounts, allowing a lower guarantee contribution to the ceiling, so why is it that 12 months later we are seeing a very conservative RBI?
Vasani: Unless they have come across terrible instances of misuse of this automatic route, I do not see any rationale because if you see the statistics released by RBI just few weeks ago; last year out of totally 1,033 transactions which were approved for ODI route, 1,023 were under automatic route and only 10 were under approval route and if you see the pattern of the past five years, its the same- four transactions under approval route and 1,000 transactions under automatic route. RBI even doesn't have, according to me, currently the infrastructure and bandwidth to put all the transactions under approval route; they would have to significantly expand their administrative strength because all international transactions, the timelines are dictated by the investment bankers of the sellers. So you have to submit your bid within the time and I must tell you in all fairness that RBI – this ODI section has been extremely fast. I have instance of one recent experience of they approving the transactions within 48 hours where we convinced them that we have to submit the bid by this particular timeline. All I am trying to say is that I am not able to figure out they have thought through the implications of putting everything under the approval route perhaps they could have reduced if they felt that the outflow of foreign exchange is significant - its 400% to say 300% of the net worth they could have perhaps said that currently the pumping up of net worth is allowed by counting the net worth of the subsidiaries that would not be allowed…
Doshi: We will come to implications in a bit but first I want to try and understand from both of you if you were in the regulator's shoes, why you would feel the need to do 100% turnaround in policy?
Shroff: For number of reasons and one could be what Bharat just alluded to in terms of there could be some cases where people have misused it and for every regulation or law that
Doshi: So by misuse you mean what? Black money, round tripping?
Shroff: It could be anything or just a non transparent structure – that could be one possible reason.
Vasani: Or just the bogus transfers to an overseas entity.
Shroff: And there could be different fixes to that but again since we are speculating what could be in the mind of the regulator, one thought I get from the timing perspective, I think it will be just a current currency situation which has accelerated the need for this sort of thing to allow to actually put some fetters in terms of funds going out and one thought which RBI may have is let’s put the brakes on outbound investment. We do not understand this and if we do not understand this, we do not want to allow it and I think there is always a broader suspicion of use of bilateral investment treaties for tax purposes.
Vasani: The statistics given by the RBI that over the last ten years – I am just counting the actual cash outflow – it is about USD 75 billion in equity, USD 29 billion in debt and USD 63 billion in terms of guarantee but nothing much has come back at all. So RBI is claiming that huge chunk of money is going out of the country but nothing is coming back. This is in terms of the actual cash which went out of
Doshi: So are you making the case that companies should be repatriating dividend?
Vasani: No, I am saying that RBI may be wondering that you have more than USD 104 billion worth of money actually going out of the country and USD 63 billion worth of guarantee is given and how much of this money is flown back into India. Now the reasons are completely different - as you know that the current tax regime does not encourage people to bring back the money because of two reasons; you suffer, your entity suffers a tax in the host country at the corporate rate.
Doshi: And you do not get any credit for that here in
Vasani: Underlying tax credit in any of our double taxation treaties and number two 30% plus and surcharge- of course for the last two years to encourage us to bring back, they have reduced the tax rate to 15% but its only for one time. Even in this budget speech, it was very clearly said it’s only for the current financial year.
Doshi: And has it encouraged companies to bring money back? Do you think that could have added to some of the anguish at the regulator’s end saying combined between the regulator and government, we are giving you incentives to bring the money back, you are refusing to do so? When compounded by a currency situation, add on to that instances of maybe misuse and then you have got everybody in India Inc out there at every given opportunity saying while India is not a very good place, we rather go outside and now you have got this horrible recipe coming together of why this position might be hardening within the RBI and the finance ministry.
Vasani: Absolutely, and there are also statements made by a couple of leaders of industry that because of constraints of doing business in
Doshi: If this does become approval route, you may not feel the very same way right now even if they did your ODI permission in 48 hours. If all ODIs have to go through them, then they are going to have to slowdown to be able to deal with it. You made the point yourself that they don’t have the bandwidth.
Vasani: But I would like to believe that the eligibility criteria, the applicant who is there also matters and there are fly-by-night operators who are just transferring the money abroad in the garb of FDI.
Doshi: So now I want to get to what happens if this does in fact become the rule and before I get there I want to point out all the reasons that we have guessed and individual solutions to that.
Shroff: You don’t shut down something just because there have been a few fraudulent cases, you go after it.
Doshi: If they move it to approval route by the time this comes into effect, who knows where the rupee will be and whether you need currency issues.
Shroff: So you don’t change the law for that.
Doshi: Is it tax and if that is case of wanting to encourage repatriation of dividend, maybe you can find incentives instead of removing everything under the approval route.
Shroff: When you move things through the approval route, you don’t know what you are getting into.
Doshi: So let us now talk about what does the approval route mean if this were in fact not just to remain a proposal but become regulation or policy. What would happen if every Overseas Direct Investment has to go through the approval route?
Shroff: Borrowing Bharat Vasani’s phrase of the RBI being a very mature regulator which I agree with, even if you take that in view, unless there are a clear set of guidelines on how they will approve, it can’t be completely arbitrary; RBI approves because they think so… (Interrupted)
Doshi: But Regulation 9 in the 2004 guidelines puts four conditions saying that they would look at… (Interrupted)
Shroff: It can be used to either approve or reject anything. It has got such broad ramifications that you can never really predict in terms of how your transaction will be viewed - so that is one outcome.
The second thing which it does is slows you down completely. So if you are in a competitive situation between bidders from two different countries like they were in the Corus case; from a sellers perspective, I think the first thought he is going to have is how can I even be sure that this particular buyer from India is going to be able to participate on an equal footing with a Chinese bidder or a Brazilian bidder or Australian bidder who does not have any home country fetter that is available. Unless there is a practical construct which RBI evolves that in such cases they pre approve the amount of money that can go out in which case you are also running a confidentiality risk. Could they, in their example, if the approval had been applied to the RBI and said please pre-approve my bid at this price, would you have disclosed that to the Regulator at that stage?
Vasani: I have one more interesting fundamental philosophical issue with approval route. RBI, there are multiple heads; apart from being a Central Bank, it is a regulator for foreign exchange. Unlike other regulators, where for example SEBI, one can go to SAT for appeal. Today if I am at RBI, I find the target is very attractive but if RBI does not approve my proposal, I have no Appellate Tribunal and courts do not intervene in matters which are relating to policy. So unlike SEBI, Competition Commission, TRAI where everywhere there is an Appellate body, RBI doesn’t have an Appellate body. So if RBI says ‘NO’, I am stuck. So approval route was slowly dismantled because of this reason that the applicant has no recourse.
Doshi: Can all of this be fixed to some extent if they were to move stuff to the approval route mandatorily and yet say for instance that we will give you a clearance if you are in the middle of a deal within 48 hours or will narrow down the conditions on the basis of which, we may not give you an approval?
Shroff: Either that or keep it under the automatic route but if you like, prescribe conditions on it that I will either bring the money back… (interrupted)
Vasani: I would still like to believe that this may not go through and eventually wisdom will prevail, but I think it can be curtailed. One of the worries of RBI is that they do not have much of visibility on what is happening on the overseas multiple layered structures. Provide for this in the form; every year we are required to file forms with RBI, more disclosures will solve that problem
Doshi: You know why I am not as hopeful as you are of this not becoming policy is because if you read the draft regulations in the case of core investment companies making overseas investments, there too RBI has mentioned in the draft regulations that Core Investment Companies (CICs) must ensure that investments made abroad do not result in creation of complex structures. They have said all subsidiaries and joint ventures setup abroad must be operating entities. So they have done away with whole holding entity problem. CIC, which already have non-operating holding companies in existence overseas, will need to report the same to the Reserve Bank for a review. That means they could in fact ask you to change a structure that is already in place if you are a core investment company.
Shroff: I think they are dealing with past structures is another big topic by itself because it may not be possible (Interrupted)
Doshi: No I am just saying why I do not think, I am as hopeful as Mr. Vasani is, is because across the broad view in RBI seems to be converging to a point whereby you do not want too much complexity, too many layers and you definitely don't want too many holding entities offshore.
Vasani: I would like to believe that RBI would still like to have only ten cases to be approved and not 1133 cases.
Shroff: The realities of acquisition financing in the international market is something which has to be recognized. A lot of these outbound acquisition are not feasible if acquisition finance from outside is not available and there is a reason for that because under the current regulatory framework here, banks cannot lend for acquisition finance; so you have to do it outside. Then you have to function as per the market practice over there and acquisition finance in most cases involves complex structures. There are layers of subsidiaries, different priority lenders come in at different levels. So you create what is called subordination through a set of subsidiaries and if you start changing the market practices of that because of some obscure home country regulation, it is a complete disadvantage because the bankers may not touch you; they won't understand it. They would want to understand - suppose you are to take financing only in the operating company, the risk which a lender would see in terms of lending to a company which has got an operating business which can drive the whole investment bankrupt is completely different from having a special purpose vehicle which has only got the asset of the share in it. So the risk profile- from a lenders perspective- changes completely. That actually will not add to the cost of the financing, it will add to the delays, the documentations; everything changes.
Vasani: There is also very limited ability to do certain high value transactions, the very ability of Indian corporate. So in a manner of speaking I would say that they would almost ban the leveraged buyouts (LBO) structures if they do so.
Dhoshi: If you can shortly wrap up by telling me - looking at this from the point of view of RBI and all the issues that may have prompted them to do this, what that better solution can be?
Shroff: I think better transparency of multi-layered structures. Secondly in terms of- if the tax regime can be made more friendly because that is a serious commercial issue of bringing the money back over here- after you have discharged offshore debt because nobody is going to allow you to bring money back home till you have retired the offshore debt. So mandatory repatriation provided its tax friendly. So that would serve one of the main objectives that RBI is driving at. We have allowed corporate
Third part is just provide better clarity in terms of what situations are you going to allow it if you were to take it under approval route. So give us more visibility.
Doshi: Are you okay with mandatory repatriation of dividends because as you have pointed out, no companies have brought money back?
Vasani: Fix the tax problem first and I think most companies would be willing to come back.
Doshi: But they have now reduced it to 15%; now how much further can they go?
Vasani: There is already a tax borne outside; so underlying tax credit.
Doshi: A credit for the overseas tax paid.
Vasani: And also the fact I think instead of bringing everything under the approval route, they can provide for, perhaps for a short-term period till India is facing this USD 185 billion of credit account deficit, it will bring down from 400% to 300% of networth or even 200%.
Shroff: The minimum request that I would have is at least whatever they are proposing let them put it out in a draft form. Let there be a public debate on it rather than all of us being surprised one fine morning, reading a regulation in the newspapers which has profound implications on the whole idea of Indian multinational.