October 17, 2012

Recent Developments in India Aim to Encourage Foreign Investment

Appetite for foreign investment into India has cooled since the beginning of 2012, partly due to uncertainties in India’s tax regime, and economic activity in general has slowed amidst the government’s inability to implement economic reforms and a perceived “policy paralysis.” However, there have been several encouraging signs over the last few weeks that the Indian government remains committed to creating an attractive legal and regulatory environment for foreign investment. As more fully described below, these include:

  • Recent encouraging developments for investors looking to invest into India through the Mauritius route, including recommendations by a government-appointed committee that (i) recent retrospective amendments to Indian tax laws be made prospective in their application and limited in their scope, (ii) the implementation of the General Anti Avoidance Rules (“GAAR”) be delayed and (iii) the validity of a Mauritius tax residency certificate be recognized;
  • Permitting foreign investment into multi-brand retail, despite political opposition;
  • Relaxing foreign investment restrictions in single-brand retail, aviation, broadcasting and power trading exchanges; and
  • Proposing to permit foreign investment in pension funds and relax foreign investment restrictions in the insurance sector.

Rollback of GAAR and Retrospective Tax Provisions

Foreign investment into India has slowed in recent months amidst uncertainty arising from tax policies announced during former finance minister Pranab Mukherjee's tenure.  As finance minister, Mukherjee (i) implemented retrospective amendments to India’s tax laws, designed to allow Indian tax authorities to levy retrospective taxes on transactions outside India involving indirect transfers of Indian assets going back 50 years, thereby attempting to reverse the Supreme Court’s decision in the Vodafone case and (ii) sought to introduce vague anti-tax avoidance provisions (GAAR) that gave Indian revenue authorities wide discretionary powers to look through tax mitigation structures commonly used by foreign investors and override tax treaty benefits.  See Goodwin Procter’s October 4, 2010 Client Alert, “Recent Developments Threaten Private Equity Structures in India.” These proposals raised a storm of domestic and international protest, and the government decided to defer implementation of the GAAR provisions by a year to April 2013. In response to criticism that the GAAR provisions allowed tax authorities too much discretion, the government tasked a committee with formulating draft guidelines for their implementation, but these guidelines, when issued, did little to manage industry and investor concerns.

The Indian tax authorities, meanwhile, chose not to make any tax demands on the basis of the retrospective taxation provisions. After Mukherjee resigned in July 2012, the prime minister constituted another committee to rework the GAAR guidelines. This committee recently recommended in its draft report that (i) the implementation of the GAAR provisions be deferred until April 1, 2016, (ii) GAAR treaty override provisions not apply in respect of a tax treaty that includes anti-avoidance provisions in the form of a limitation of benefits provision (e.g., the Singapore-India treaty), (iii) GAAR provisions not be invoked to examine whether an entity is a genuine resident of Mauritius when such entity has been issued a tax residency certificate by the Mauritius Revenue Authority (“MRA”) and (iv) capital gains on listed securities be abolished.

The committee’s recommendation that a tax residency certificate issued in Mauritius should be conclusive proof of residence in Mauritius echoes the law on this point as laid down by the Supreme Court of India in the Azadi Bachao Andolan case [263 ITR 706 (SC)]. The Authority for Advance Rulings (a governmental body that provides binding advance rulings on tax questions brought before it) recently relied on the Azadi Bachao Andolan case to confirm that a fund incorporated in Mauritius, being the holder of a valid tax residency certificate issued by the MRA, would be eligible for treaty benefits under the India-Mauritius DTAA. The Authority rejected the Indian tax authorities’ arguments that the fund was controlled and managed in India since the majority of the fund’s board of directors were from India and that routing investments through Mauritius constituted a scheme to evade capital gains tax [Dynamic India Fund, AAR No. 1016 of 2012, decision dated July 18, 2012].

The new finance minister, P. Chidambaram, also directed this committee to review the retrospective tax provisions, promising that such provisions would not be “rashly” implemented by tax authorities. The committee recently issued a draft report on this subject, recommending, inter alia, that (i) the retrospective tax provisions be applied prospectively, (ii) a transaction involving the sale of shares of an overseas company that derive their value, directly or indirectly, from Indian assets be taxable in India only where such assets constitute more than 50% of the global assets of the Indian company and (iii) transfers of minority shareholdings (defined as less than 26%) and interests in registered foreign institutional investors (“FIIs”) not be taxed. The committee also noted that retrospective application of tax law should occur only in “exceptional” cases and after due consultation with those affected.

The sequence of events above indicates that Finance Minister Chidambaram is working to gradually roll back his predecessor’s tax legacy, and has the government’s backing to do it.

Reforms to India’s Foreign Investment Regime, including in Multi-Brand Retail

On September 14, 2012, the Indian government announced its intention to further liberalize India’s foreign investment policy by allowing:

  • foreign direct investment (“FDI”) in multi-brand retail (with a cap of 51% foreign ownership),
  • foreign airlines to invest in domestic passenger airlines (with a cap of 49% foreign ownership),
  • FDI in exchanges for trading electric power (with a cap of 49% foreign ownership), and
  • FDI in broadcast carriage services (with a cap of 74% foreign ownership).

These amendments to the existing foreign investment policy were subsequently made effective through a series of government notifications issued on September 20, 2012 (the “September Amendments”).

On October 4, 2012, the Indian government also announced that it proposed to permit foreign investment in domestic pension funds, subject to a cap of 49%, and increase the limit on foreign investment in the insurance sector from 26% to 49%. These proposed amendments have not yet been made effective.

Multi-Brand Retail

The last time the Indian government attempted to open up the country’s fragmented and disorganized retail sector to foreign investment was in November 2011. At that time, it had announced that FDI would be allowed in both single-brand and multi-brand retail but, facing intense opposition from coalition partners and lobbying groups, rolled back the proposed reforms in multi-brand retail. It did, however, in January 2012, permit 100% FDI (subject to prior government approval) in single-brand retail, provided that (i) the foreign investor was the owner of the brand and (ii) for FDI exceeding 51%, the single-brand retailer sourced 30% of its goods from “small-scale” Indian manufacturers.

Despite similar protests and threats from coalition partners to withdraw support in parliament, the government has followed through this time and allowed FDI in multi-brand retail in the September Amendments, albeit subject to significant riders (many of which had previously qualified the government’s November announcements), including:

  • FDI in multi-brand retail is subject to prior government approval, i.e., not under the “automatic route.”
  • The policy is subject to implementation by individual states. Retail outlets may only be set up in states that choose to allow FDI in multi-brand retail.
  • Retail sales outlets may only be set up in cities with a population exceeding one million.
  • The foreign investor must make a minimum investment of US$100 million, 50% of which is to be invested in “back-end infrastructure” (e.g., investments towards processing, manufacturing, distribution, quality control, packaging, logistics, storage and warehousing) within three years of the initial investment.
  • At least 30% of the value of manufactured products must be sourced from small-scale Indian manufacturers. This requirement is to be met, for the first five years, as an average of the total value of manufactured products purchased over that period. Thereafter, the 30% requirement is to be met on an annual basis.

The September Amendments also approve the following amendments to the FDI policy in respect of single brand retail:

  • the foreign investor need not be the owner of the brand, but may undertake single-brand product retail trading in India for a specific brand subject to an appropriate agreement with the owner of that brand; and
  • the requirement that 30% of the products must be sourced from a small-scale Indian manufacturer has been amended to require only that 30% of the products, on an average over five years, are to be sourced from India, “preferably” from small-scale Indian manufacturers, “where feasible.” This means single-brand retailers will probably find themselves establishing production capacity in India, but will have the flexibility to work their way up to meeting the 30% local sourcing requirement over five years.

The 30% sourcing requirement was generally seen as a major obstacle to attracting foreign investment in single-brand retail (a point acknowledged by the government) and its rollback offers hope that the government may consider relaxing restrictions on multi-brand retail in due course as well.

The September Amendments also clarify that existing restrictions prohibiting FDI in online retailers will continue to apply, both in respect of single- and multi-brand retailing.


India’s foreign investment policy allows FDI up to 49% in domestic scheduled passenger airlines (under the “automatic route,” i.e., without prior government approval) and 74% in unscheduled air transport services, including cargo airlines (up to 49% under the automatic route and thereafter with government approval). However, the policy does not currently allow foreign airlines to invest in domestic scheduled or unscheduled passenger airlines.

The September Amendments remove this prohibition, and allow foreign airlines to own up to 49% of an Indian company providing scheduled and non-scheduled “air transport services,” subject to specified conditions, including that:

  • the target company’s chairman and at least two-thirds of the directors of the target company continue to be citizens of India, and
  • the substantial ownership and effective control of the company be vested in Indian nationals.

The 49% limit is to be computed by aggregating FDI investment and investments by FIIs.


India’s foreign investment policy currently allows FDI up to 49% in cable networks and direct to home services. This is an aggregate cap, meaning all foreign investment, whether by non-resident Indians (“NRIs”) or FIIs, or under the “FDI route,” must be counted towards this limit.

The September Amendments seek to raise this limit to 74%, with the first 49% to be permitted under the automatic route and thereafter subject to prior government approval. However, this increased limit is only applicable to “multi-system” cable network operators at a national, state or district level who are upgrading their networks for digitization and addressability. Local cable operators and those not upgrading their networks will continue to be subject to the existing limit of 49%.

The September Amendments provide that for the purposes of determining the aggregate foreign investment in a company in the broadcasting sector investments in Foreign Currency Convertible Bonds (“FCCBs”), American Depository Receipts (“ADRs”), Global Depository Receipts (“GDRs”) and convertible preference shares held by foreign entities will be regarded as foreign investment and counted towards the applicable foreign investment limits.

The September Amendments also approve FDI up to 74% in mobile television, with the first 49% to be permitted under the automatic route and thereafter subject to prior government approval.

The aggregate foreign investment limit of 26% in respect of news and current affairs television channels and terrestrial FM radio broadcasting will remain. The new reforms, once implemented, will therefore allow greater foreign investment in broadcast carriage services, not in content production.

Power Trading Exchanges

The FDI policy permits FDI up to 100%, under the automatic route, in the power sector (except atomic energy). This includes generation, transmission and distribution of electricity as well as power trading, subject to applicable legislation (i.e., the Electricity Act, 2003).

The September Amendments permit, for the first time, foreign investment of up to 49% in power trading exchanges. Such foreign investment may be in the form of FDI and FII investment, although FDI is capped at 26% and FII investments are capped at 23%. FDI investment requires prior approval from the government, and no single non-resident (including persons acting in concert) may hold more than 5%. The expectation appears to be that such power trading platforms will provide a platform for efficient price discovery and lead to the evolution of the nascent power trading market in India.


The developments above reflect a concerted effort by the Indian government to restore investor confidence and resuscitate a slowing economy by creating a legal and regulatory framework conducive to foreign investment. The markets have reacted positively to the recent reforms, and increased investment by foreign institutional investors (FIIs) has driven the benchmark Indian index, the Sensex, to rally by more than 7% to a new 15 month high. While in the short term the market will no doubt continue to fluctuate, India’s long-term growth story and compelling demographics already make it a prime destination for the large amount of international capital that is sitting on the sidelines seeking avenues for deployment. If the Indian government is able to deliver on the promise of these measures, the years ahead may see a resurgence in foreign investment into India.

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For more information on the issues discussed in this Alert, contact Yash Rana.

Goodwin Procter LLP is a U.S. law firm and does not practice Indian law. The information contained in this publication is based upon the current understanding of Goodwin Procter lawyers active in the firm’s India practice.