Investments by Indian entities in overseas subsidiaries or step-down subsidiaries (SDS) are regulated under the Foreign Exchange Management Act (FEMA) and governed by the Overseas Investment Rules, 2022 issued by the Government of India and the Reserve Bank of India (RBI).

Here’s a detailed breakdown of the regulatory framework:

1. Definitions

Subsidiary

A foreign entity in which the Indian entity holds a direct equity stake of 50% or more.

Step-Down Subsidiary (SDS)

A subsidiary or entity that is indirectly owned or controlled by the foreign entity (JV or WOS) in which the Indian entity has made the initial investment.

2. Rules for Subsidiary/SDS Investments

a. Subsidiary Investments

• Indian entities can establish or acquire a Joint Venture (JV) or Wholly Owned Subsidiary (WOS) under the automatic route if the foreign entity operates in a bona fide business and adheres to the ODI regulations.
• The aggregate financial commitment (direct equity, debt, or guarantees) must not exceed 400% of the Indian entity’s net worth as per the latest audited balance sheet.

b. SDS Investments

• Indian entities are permitted to invest in SDSs of the foreign JV/WOS, provided:
  • The SDS is directly or indirectly controlled by the foreign JV/WOS.
  • The financial commitment towards the SDS is within the prescribed limits.
  • The activities of the SDS are bona fide and aligned with the business of the foreign JV/WOS.

c. Compliance with ODI Regulations

• The Indian entity must report all investments in subsidiaries and SDSs, including details of capital infusion, loans, and guarantees.

3. Restrictions on Layering

The Government of India imposes restrictions on the layering of subsidiaries to curb excessive complexity, reduce risks of tax evasion, and ensure better regulatory oversight.

Key Layering Restrictions

1. Domestic Layering (Companies Act, 2013):
   • An Indian company cannot have more than two layers of subsidiaries within India, except in specific cases (e.g., banking companies, NBFCs).
2. Overseas Layering (FEMA):
   • Indian entities are prohibited from having more than two layers of subsidiaries or SDSs under a foreign JV/WOS, unless required by the laws of the host country.
   • Any investment structure beyond two layers requires prior approval from the RBI.

Exemptions:

• The layering restriction does not apply if the host country requires more than two layers of subsidiaries as part of its local laws or regulations.
• Banking companies or NBFCs may be exempt under certain conditions.

Implications:

• Indian entities must carefully design their investment structures to comply with these restrictions.
• Any additional layers of subsidiaries beyond the permitted limits may result in regulatory scrutiny or penalties.

4. Compliance and Reporting

Reporting Requirements

1. Form ODI:
   • All investments, including SDS, must be reported through Form ODI submitted to the Authorized Dealer (AD) Bank.
2. Annual Performance Report (APR):
   • Submit details of the financial performance of all foreign subsidiaries, including SDSs, annually to the AD Bank.
3. Post-Investment Changes:
   • Report any changes in ownership, additional investments, or restructuring involving SDSs promptly to the AD Bank.

Due Diligence

• Indian entities must ensure that all subsidiaries (direct or indirect) comply with local regulations in the host country.
• The SDS should operate in bona fide business activities and adhere to sectoral restrictions under FEMA.

5. Sectoral Restrictions

• Indian entities are prohibited from investing in foreign subsidiaries or SDSs engaged in:
  • Real estate (except development and construction).
  • Gambling, lottery, or casinos.
• Investments in sensitive sectors, such as defense or telecom, may require prior RBI approval.

6. Tax Implications

• Dividend Income: Dividends received from the foreign subsidiary or SDS are taxable in India as per the applicable tax slab.
• Capital Gains Tax: Gains arising from the sale of investments in subsidiaries or SDSs are subject to capital gains tax.
• Transfer Pricing: Transactions between the Indian entity and its foreign subsidiary/SDS must adhere to arm’s length pricing rules under Indian tax laws.

7. Practical Considerations

• Strategic Structuring: Indian entities should design investment structures keeping in mind layering restrictions, financial limits, and compliance requirements.
• Host Country Laws: Understand the legal and tax framework of the host country to avoid conflicts between Indian and local regulations.
• Long-Term Compliance: Ensure ongoing reporting and filing obligations are met to avoid penalties or regulatory issues.

Would you like assistance with specific cases of ODI or help with structuring investments in compliance with layering restrictions?