LawZ Magazine

Entry Options For Foreign Investors

BY Qaiser Lone

The Government of India’s new liberalisation policy and economic reforms has encouraged Foreign Direct Investment (“FDI”) into India by simplifying the legal and regulatory framework thereby making FDI into India attractive for foreign investors. A foreign company or individual proposing to invest in India has the option of setting up either a liaison office, a project office, a branch office, a subsidiary company (in a joint venture arrangement or 100% owned) or to purchase shares in an existing Indian company.

Liaison Office

A liaison office, by its very nature, is prohibited from earning any income in India. It can merely act as a post office for the foreign company. Opening of liaison office requires permission from the Reserve Bank of India (“RBI”). The permission/approval by RBI is granted ly for a period of 3 years which may be extended from time to time and such approval/permission is subject to the following conditions:

  • The liaison office shall not undertake any business activity in India and its activities shall be limited to collecting information about business opportunities in India and also to provide information about the foreign company and the products or services it offers.
  • Expenses of the liaison office shall be met entirely by the foreign company.
  • The liaison office is also prohibited from charging commission or receiving income in any other form from Indian customers for rendering liaison services.

Project Office

A foreign investor executing a project in India can open a project office subject to RBI’s approval/permission. RBI accords Approval/permission if the project has all the requisite approval from the appropriate authorities or where Indian banks or financial institutions or international financial institutions finance the project. The project office will have to be closed on the completion of the project.

The opening of a liaison office or a project office is not helpful for a foreign investor intending to carry on business/commercial activities in India. The options available in such a case are setting up a branch office, acquiring shares in an existing Indian company or incorporating a new company in India. These options are governed by different sets of rules under the regulatory, legal and tax regime and a foreign investor can choose a participation that is best suited to his investment needs.

Branch Office

Branch office of a foreign company cannot be set up in India without the prior permission of RBI and registration with the Registrar of Companies within 30 days of setting up the office in India. RBI grants permission to open branch offices on a case to case basis. The RBI while granting such permission considers the operating history of the applicant company worldwide and its proposed activities in India. Foreign companies can open branch offices in India for the limited purposes of:

  • Export/Import of goods;
  • Rendering professional or consultancy services;
  • Carrying out research work, in which the company is engaged;
  • Promoting technical or financial collaborations between Indian companies and parent or overseas group companies;
  • Representing the company in India and acting as buying/selling agent in India;
  • Rendering services in Information Technology and development of software in India; and
  • Rendering technical support to the products supplied by parent/group companies.

Taxation

Foreign companies are taxed in India at the rate of 48% on profits earned in India. Accordingly a branch office of a foreign company is liable to pay corporate tax on its net profits earned in India at the rate of 48%. No further tax is levied on distribution/repatriation of income.

Advantages

  • RBI normally grants permission within 4-5 weeks time. No further approvals are required to start operations. Post facto registration with Registrar of Companies would be required, which process is administrative in nature.
  • The foreign company has full ownership and control over the operations of the branch office in India.
  • A branch office is taxed at the rate of 48% and no other tax is levied at the time of remittance of profit or surplus of the branch office.
  • Closure of the branch office is a simpler process compared to closing or winding up an Indian company.

Disadvantages

  • A branch office can only carry out only a limited number of activities.
  • A branch office being an extension of a foreign company does not enjoy complete freedom and even for a small deviation permission from the RBI is required.
  • The branch office is not considered to be a distinct legal entity from its foreign head office and therefore the foreign company remains exposed to liabilities arising out of commercial transactions in India.
  • The branch office of a foreign company is treated for tax purposes as a permanent establishment of such foreign company in India. At the time of assessment of the branch office, difficulties arise with regard to the attribution of profits of the foreign company from its Indian operations. This exercise is not only cumbersome but also exposes the foreign company’s profit and other operations to the Indian tax authorities.

Indian Subsidiary

A subsidiary of a foreign company can be incorporated in India either as a private limited company or as a public limited company. The incorporation of the subsidiary as a private limited company has advantages over its incorporation as a public company because a public limited company is subjected to a more stringent regime under the Companies Act, 1956 compared to a private limited company. An Indian subsidiary can be either a 100% foreign owned subsidiary or a Joint Venture Company (“JVC”) depending upon the sector in which investment is to be made.

Approval Process

Under the existing policy of the Government of India FDI is freely allowed in all sectors into India except where the existing sectoral policy does not permit FDI beyond a ceiling. Where the foreigner invests by subscribing to the shares of the subsidiary within the permissible sectoral limits, it is called investment through Automatic Route. Under the Automatic Route shares can be issued to a foreign investor without obtaining any approval subject to certain requirements. In case the investment does not fall under the Automatic Route the approval of the Foreign Investment Promotion Board (“FIPB”) will be required.

Taxation

An Indian subsidiary, even though 100% foreign owned, is treated as an Indian resident for the purposes of Indian Income Tax Act. Accordingly, 38.5% (35% + 10% surcharge) corporate tax rate applies. Further the Indian subsidiary is also liable to pay a dividend distribution tax of 22% on the dividends declared by it. Due to 22% dividend distribution tax, the effective tax rate on profits of the Indian subsidiary, flowing back to home country is affected.

Advantages

  • One of the key advantages of operating through an Indian subsidiary vis-a-vis any other entity option is complete flexibility in operations. An Indian subsidiary, even though 100% owned by a foreigner, is considered as an Indian resident both for fiscal and exchange control regulations.
  • An Indian subsidiary, being a separate and distinct legal entity insulates the foreign company from its liabilities arising out of commercial transactions of the subsidiary company in India. The liability of the shareholder in an Indian subsidiary is limited only to the extent of unpaid amount on the issued shares.
  • There are certain incentives/ tax deductions, which are available only to Indian companies (and denied to branches of foreign companies in India).
  • No approvals or permissions are required from any authority before investment is made under the Automatic Route.

Disadvantages

  • One of the critical features of Indian subsidiary option is that where dividends are declared or paid for any financial year out of the profits of that year, a reserve is required to be created. The amount to be transferred to the reserve depends upon the quantum of dividend. However, the maximum transfer could be 10% where dividends proposed exceed 20%. The amount so transferred to the reserves is not a cost to the company. The amount can either be ploughed back into the business of the company or distributed as dividends during the years of lean profits.
  • The 22% dividend distribution tax is treated as tax on profits of the company and not as withholding at source on dividend payment (which is nil).
  • The process of winding up of an Indian company is very long, cumbersome and involves court approval.

Depending upon various variables like, nature of business, amount of investment, time for which investment is being made etc., a foreign investor can choose any of the aforesaid structures which is best suited to him commercially for making investments and carrying out business in India.