Financing and fund repatriation

Financing the Indian subsidiary

In this article, we discuss different methods through which international entities can finance their subsidiary in India.

Investment through shares and convertible instruments

Foreign corporations can fund the operations of their Indian subsidiaries by employing shares and convertible financial instruments. The legal framework permits investments via equity shares, mandatory convertible preference shares, mandatory convertible debentures, and warrants.

External commercial borrowings

A foreign shareholder has the option to provide funding through debt. Nevertheless, obtaining third-party loans within India can be relatively expensive when compared to sourcing funds from international markets, and they may not be readily accessible. Nonetheless, there are feasible debt alternatives that foreign parent companies can explore to finance their Indian subsidiaries, earn interest on their investments, and eventually recoup the funds.

As per the FEMA regulations, an Indian subsidiary has the opportunity to obtain debt from its foreign shareholder through external commercial borrowings (ECBs). This provision allows a foreign equity holder who directly owns at least 25 percent equity in the Indian subsidiary, an indirect equity holder with a minimum indirect equity holding of 51 percent in the Indian subsidiary, or a group company with a common overseas parent to provide an ECB to its Indian counterpart.

The borrowings can be categorized into one of three categories, depending on several factors including the nature of the Indian subsidiary's business, the intended use of the ECB funds, the currency of the borrowing, and the average tenure of the ECB. Additionally, as per the relevant guidelines, the Indian subsidiary is required to maintain a debt equity ratio of 7:1. It is worth noting that this ratio is not applicable if the total of all ECBs raised by an Indian entity is up to US$5 million or its equivalent.

Masala bonds

In September 2015, RBI granted permission for Indian corporations to issue rupee-denominated bonds (nicknamed as Masala bonds) under the ECB regime. The Masala bonds regime is more liberal than the ECB one. The minimum original maturity for Masala Bonds up to US$50 million per fiscal year is 3 years. For bonds exceeding US$50 million per fiscal year, the minimum original maturity is 5 years. The all-in-cost ceiling for these bonds is set at 300 basis points above the current yield of corresponding Government of India securities.

To facilitate Rupee-denominated borrowing from overseas, a framework has been established for issuing such bonds in alignment with the overarching ECB policy. Here are the key points of this framework:

Eligible borrowers: This framework is open to any corporate, body corporate, Real Estate Investment Trusts (REITs), and Infrastructure Investment Trusts (InvITs).
Recognized investors: Investors from Financial Action Task Force (FATF) compliant jurisdictions are eligible.
Maturity: The minimum maturity period for these bonds is set at 5 years.
All-in-cost: The overall cost should align with prevailing market conditions.
Amount: The bond amount will adhere to the existing ECB policy guidelines.
End-uses: There are no specific end-use restrictions, except for a negative list of prohibited purposes.

Non-convertible debentures (NCD)

Another avenue to explore is the corporate debt market. A subsidiary of a foreign shareholder has the option to register as a foreign portfolio investor (FPI) following the regulations prescribed by the Securities and Exchange Board of India (SEBI). The registration process is straightforward usually taking a few weeks to complete. An FPI is authorized to invest in listed or unlisted non-convertible debentures (NCDs). The NCD must have a minimum residual maturity of one-year, subject to specific conditions outlined in the applicable law. These NCDs can be secured or unsecured. The issuer enjoys significant flexibility regarding the utilization of funds and determining the interest rates or redemption premium for these instruments.

This approach has been extensively used, especially by foreign funds, to provide financing to Indian portfolio companies. It offers more flexibility compared to the ECB route for raising funds from foreign shareholders. However, it's essential to be aware of certain disclosure requirements associated with this option.

By way of business arrangements

Today a significant portion of Indian subsidiaries, often found within the IT sector, are established primarily to offer services exclusively to their foreign shareholders located outside India. These Indian subsidiaries engage in service arrangements with their foreign shareholder and receive income as compensation for rendering services to these shareholders. The governing law does not stipulate a cap on funds received from a foreign shareholder as part of a service contract between the Indian subsidiary and the foreign shareholder. Consequently, a foreign shareholder can raise funds for their subsidiary through such an option. Nevertheless, its essential to assess specific tax implications, such as transfer pricing, may need to be examined.

Options for repatriation of funds from India

Foreign investors with long-term business plans for India often choose to establish their presence in India by setting up one of the following entity types:

Wholly Owned Subsidiary (WOS)
Branch Office (BO)
Limited Liability Partnership (LLP)

Repatriation options and their implications on a WOS/subsidiary and its parent entity

By the very nature of the relationship between a foreign investor and its Indian WOS, there is a flow of diverse range of information, technical knowhow, and other support services from the parent entity to the WOS and a flow of funds as payment of consideration for such services and/or as repatriation of profits from the WOS to the parent entity. While entering such transactions, both, the parent entity and its WOS must ensure they are in compliance with the prevailing applicable laws and the rules framed thereunder. Typically, the laws which govern such transactions are:

The Indian Companies Act, 2013 (ICA)
Foreign Exchange Management Act, 1999 (FEMA)
The Income-tax Act, 1961 (ITA)
The Goods and Services Tax (GST)

Apart from the above laws, in case of transactions between two countries, the provisions of a Double Taxation Avoidance Agreement (DTAA) become relevant.

A DTAA is a tax treaty or agreement between two or multiple countries, to prevent double taxation of income earned in both countries.

The key objectives of the DTAA are to ensure that:

There is no tax evasion.
There is exchange of information between the countries.
To prevent double payment of tax as such agreements ensure that the tax to be paid shall be borne in only one of the countries.

Following are the ways where funds can be repatriated outside India:

Comparative overview of different repatriation options

Particulars/options	Payment of royalty/fee for technical services/business support services	Dividend pay-out	Buy back of shares	Capital reduction
Brief understanding	Royalty is typically a sum of money paid to the Licensor of Intellectual Property (IP) Rights for the benefits derived, or sought to be derived, by the user (the Licensee) through the exercise of such rights. It is common for a foreign parent company to license the rights to use its registered intellectual property in India to its wholly owned subsidiary (WOS) in furtherance of its business plan. Technical or Consultancy Fees may be one-time lumpsum fees linked to the establishment of a project or related to the installation, commissioning and use of Plant and Machinery. Royalty, technical, or consultancy fees may also be paid periodically (monthly, quarterly, half-yearly or annually), if such payments are with the view to improve the turnover of the business or for the ongoing use of trademarks/tradenames. The amount of royalty usually is a percentage of the net sales during the period.	The dividend pay-out may be annual or at pre-determined time intervals in the form of interim dividends and is usually a share of the profits that the Indian subsidiary has earned.	A WOS may decide to buy back its shares in accordance with the provisions of the ICA with the principal aim of increasing shareholder value for the reasons. Once the shares are bought back, they are subsequently cancelled.	Section 66 of the ICA provides that, subject to authorisation by a resolution and approval of the NCLT on an application, a company may reduce the share capital including paying-off any share capital under the Capital reduction scheme as may be approved. The steps are briefly as follows: Authorisation by a resolution. Filing an application to the NCLT along with the requisite documents. NCLT will take necessary actions and pass the order confirming the reduction subject to the satisfaction of certain requirements. Action by the company on receipt of order confirming the restructuring scheme.
Taxability in the hand of the company.	Lumpsum Payment is capitalised, and depreciation is allowed as a deductible expense. Recurring Payments are allowed as a deductible expense.	Dividend is declared out of the post-tax profit of the company.	20 percent of distributed income (plus surcharge and HEC, as applicable).	15 percent of the amount of capital reduction to the extent of accumulated profit (plus surcharge and HEC, as applicable).
DTAA	20 percent of Royalty Amount, subject to some conditions (plus surcharge and HEC, as applicable).	10 percent of the Dividend paid (plus surcharge and HEC, as applicable).	Do as above.	Do as above.
Transfer pricing (TP)	Transfer pricing provisions will be applicable. There are no limits prescribed for the payment of Royalty or lumpsum technical fees. However, the reasonableness of the amounts paid would have to be established by virtue of a comparative study with companies in similar lines of business. The uniqueness of patented technologies would be an important consideration in establishing the fairness of the amounts paid.	Not applicable since the Dividend is declared out of the Profit after Tax, reckoned after Transfer Pricing adjustments (if applicable).	Share buyback being a capital account transaction is not subject to transfer pricing scrutiny.	Capital reduction being a capital account transaction is not subject to transfer pricing scrutiny.
Advantages	There is no prescribed limit to the amount of recurring royalty/lumpsum fee payable under any law. It is a tax-deductible expense for the WOS. Royalty can be paid after withholding the tax @ 10 percent (that is, rate as per Income-tax Act since it is more beneficial as compared to the rate under the DTAA).	There is no limit on the amount of Dividend to be paid by a Company. Dividend 0020 be freely repatriated after withholding the tax @ 10 percent (i.e., as per the WHT rate under the DTAA, which is more beneficial as compared to the rate under ITA.	Share buyback is a method to transfer increase in enterprise value to the shareholder. Consideration received by a shareholder is not taxable in the hands of the shareholder.	Capital reduction is a way out of reviving a distress company. Assets that cannot be deployed in the business, can be sold during the Capital reduction process.
Disadvantages	Payments of royalty/technical fee are subject to transfer pricing scrutiny and elaborate justifications to establish the reasonableness of the amounts paid have to be done through comparative studies or through establishing the uniqueness or value of the patented technologies or registered trademarks/tradenames.	Dividend can only be paid if the WOS is profitable. Dividend cannot be paid in the absence of Profits. Dividend is paid out of the post-tax profits of the WOS. In other words, it is not a tax-deductible expense.	Company must have surplus reserves matched with cash to buy back shares. Buy Back cannot be done through borrowed funds. Company has to pay a flat tax of 20 percent on the net consideration. This is over and above the tax otherwise payable by a company on its other income.	Capital reduction is usually done by a company that is in the distress and it is a very complex process as it involves taking approval from the NCLT (National Company Law Tribunal). The shareholders don't get the full value of the shares as the capital reduction is an outcome of revival of the company.

Disclaimer

The Canadian Trade Commissioner Service in India recommends that readers seek professional advice regarding their particular circumstances. This publication should not be relied on as a substitute for such professional advice. The Government of Canada does not guarantee the accuracy of any of the information contained on this page. Readers should independently verify the accuracy and reliability of the information.

Content on this page is provided by Dezan Shira & Associates a pan-Asia, multi-disciplinary professional services firm, providing legal, tax, and operational advisory to international corporate investors.

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