Valuation under FEMA (Foreign Exchange Transactions)

The Foreign Exchange Management Act (FEMA), 1999, plays a vital role in regulating foreign exchange transactions in India. A critical aspect of FEMA compliance is ensuring accurate valuation of shares and other capital instruments involved in cross-border transactions between residents (Indian entities or individuals) and non-residents (foreign entities or individuals).

This blog delves into the importance of valuation under FEMA, explores the regulations for Foreign Direct Investment (FDI) and Overseas Direct Investment (ODI), and highlights the benefits of accurate valuations in this context.

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Why Valuation Matters Under FEMA

FEMA emphasizes fair pricing in cross-border transactions to:

• Prevent Capital Flight: Accurate valuations help curb practices like under-invoicing exports or over-invoicing imports, sometimes used for illegal capital outflow.
• Ensure Transparency: Fair valuations promote transparency in foreign exchange transactions, fostering trust and stability in the Indian financial market.
• Protect Investors: Accurate valuations safeguard investors from paying an inflated price for shares or capital instruments of Indian companies.

Understanding FDI and ODI Valuations

Foreign Direct Investment (FDI): When a foreign entity invests directly in an Indian company, the RBI mandates valuation of the shares or capital instruments involved. Here’s what you need to know:

• Minimum Price: The valuation report sets the minimum price (floor) at which the Indian company can sell its shares or instruments to the foreign entity.
• Valuation for Listed Companies: For shares of listed companies, valuation is based on the relevant SEBI guidelines, typically reflecting market prices.
• Valuation for Unlisted Companies: For unlisted companies, the valuation must be conducted by a qualified professional like a Chartered Accountant, SEBI-registered Merchant Banker, or Cost Accountant. They use internationally accepted methodologies like market price, income approach, or discounted cash flow (DCF) method.

Overseas Direct Investment (ODI): When an Indian entity invests in a foreign company (Joint Venture or Wholly Owned Subsidiary), valuation plays a crucial role here too:

• Maximum Price: The valuation report sets the maximum price (ceiling) at which the Indian entity can invest in the foreign company.
• Valuation Process: Authorized Dealer (AD) banks play a key role. They can recommend valuers like Merchant Bankers or Registered Valuers to determine arm’s length pricing for the investment.

Key Point: All valuation reports for FDI/ODI transactions have a validity period of 90 days. The transaction must be completed within this timeframe.

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Who Can Conduct Valuations under FEMA?

The professionals authorized to conduct valuations under FEMA depend on the type of company involved:

• Listed Companies: Valuation is based on existing market prices as per SEBI guidelines.
• Unlisted Companies: A Chartered Accountant, SEBI-registered Merchant Banker, or Cost Accountant can conduct the valuation using internationally accepted methodologies.
• ODI Transactions: The AD bank, based on their assessment, can recommend valuers like Merchant Bankers or Registered Valuers to determine arm’s length pricing.
• Swap of Capital Instruments: For complex transactions like swaps of capital instruments, valuation requires the expertise of a SEBI-registered Merchant Banker or an Investment Banker recognized by the appropriate regulatory authority in the foreign country.

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Eligibility for Business Valuation/ Share Valuation Under FEMA

1. Accepted Instrument: The valuation must involve a recognized financial instrument like shares or debentures.
2. Valuation Methodology: The valuation process and procedures must adhere to internationally accepted standards.
3. Discounted Cash Flow (DCF) Method: This method may be used for valuation purposes (not mandatory).
4. Transfer Pricing: The transfer price of the instrument should follow international valuation principles.

Documents required for Business Valuation/ Share Valuation Under FEMA

• Consent Letters: Signed by both the transferor (seller) and transferee (buyer).
• Share Purchase Agreement: An agreement outlining the terms of the share transfer.
• Shareholding Pattern: Documentation showcasing the equity participation breakdown before and after the transfer, categorized by resident and non-resident investors.
• NRI Transfer (if applicable): If the transferor is a Non-Resident Indian (NRI), provide RBI approvals proving repatriation/non-repatriation status of the shares. Sale proceeds will be credited to a non-resident rupee account.
• Valuation Certificate: A certificate from a qualified professional (either a Merchant Banker or a Chartered Accountant who has passed the Companies Act 2013 valuation exam) indicating the fair value of the shares.
• Undertaking from Transferee: A document confirming the transferee’s adherence to all pricing guidelines.
• No Objection Certificate (NOC)/Tax Clearance: NOC or tax clearance certificate issued by the Income Tax Authority or a Chartered Accountant.

Companies Act 2013 Requirements:

• Form SH-4: This form, duly signed by both transferor and transferee, is mandatory.
• Form FC-TRS: This form may also be required depending on the specific transaction.

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Framework of Valuation under FEMA

The Foreign Exchange Management Act (FEMA), 1999, establishes a framework for fair and transparent valuation of shares and capital instruments involved in cross-border transactions between residents (Indian entities or individuals) and non-residents (foreign entities or individuals). This framework safeguards against capital flight, protects investors, and fosters trust in the Indian financial market.

Objectives:

• Prevent Capital Flight: Accurate valuations help curb practices like under-invoicing exports or over-invoicing imports, sometimes used for illegal capital outflow.
• Ensure Fair Pricing: The framework promotes fair market prices for shares and capital instruments in cross-border transactions.
• Protect Investors: Accurate valuations ensure investors don’t pay an inflated price for Indian assets.
• Maintain Transparency: Fair valuations foster transparency in foreign exchange transactions, building trust in the financial system.

Valuation Principles:

• Fair Value: FEMA emphasizes determining the fair value of shares or instruments. This refers to the estimated price achievable in an arm’s length transaction between willing buyers and sellers in an orderly market.
• Internationally Accepted Methodologies: Several internationally recognized valuation methodologies are used, such as:
  • Market Price Method: Utilizes the prevailing market price of similar shares or instruments traded on a recognized stock exchange.
  • Income Method: Considers the future income generation potential of the shares or instrument.
  • Discounted Cash Flow (DCF) Method: Estimates the present value of the expected future cash flows from the shares or instrument.

Valuation Process:

1. Appointment of Authorized Person: The resident entity involved in the transaction appoints an authorized person to conduct the valuation. These can be:
   • Chartered Accountant
   • SEBI-Registered Merchant Banker
   • Practicing Cost Accountant
2. Selection of Valuation Methodology: The chosen professional selects the most appropriate methodology based on the specific circumstances of the transaction and the nature of the shares or capital instruments.
3. Data Collection and Analysis: The authorized person gathers relevant financial information about the company, the industry, and the broader market environment.
4. Valuation Report: The authorized person prepares a comprehensive report documenting the valuation process, the methodology used, the rationale behind the valuation estimate, and their qualifications.

Regulations and Guidelines for Business Valuation / Share Valuation Under FEMA:

• FEMA (1999): The core act establishes the foundation for foreign exchange management.
• Foreign Exchange Management (Non-Debt Instruments) Regulations (2019): Provide specific guidelines for valuation of shares and capital instruments in cross-border transactions.
• RBI Notifications: The RBI periodically issues notifications and updates regulations related to valuation under FEMA.
• Pricing/Valuation Guidelines: Specify the valuation approach for different scenarios:
  • Issue by Indian Company/Transfer to Non-Resident:
    • Listed Company: Price as per SEBI guidelines.
    • Unlisted Company: Fair value using internationally accepted methodologies, certified by a qualified professional.
  • Transfer from Non-Resident to Resident:
    • Listed Company: Price as per SEBI guidelines.
    • Unlisted Company: Fair value using internationally accepted methodologies, certified by a qualified professional.
  • ODI Transactions: AD bank can recommend valuers to determine arm’s length pricing.
  • Swap of Capital Instruments: Valuation required by SEBI-registered Merchant Banker or a recognized foreign Investment Banker.

Compliance and Enforcement:

• FEMA regulations carry penalties for non-compliance, including fines and potential legal proceedings.
• The onus of ensuring accurate valuation lies with the resident entity involved in the transaction.

NDI Rules, 2019: Streamlining Foreign Investment in India

The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules) play a crucial role in governing foreign investments in Indian companies through non-debt instruments. These instruments encompass equity shares, convertible notes, and preference shares, representing a significant source of capital for Indian businesses. Here’s a deeper dive into the legal framework driving this process:

Legal Framework:

• Foreign Exchange Management Act, 1999 (FEMA): This act establishes the overarching framework for regulating foreign exchange transactions in India. The NDI Rules are derived from and operate within the ambit of FEMA.
• Foreign Exchange Management (Non-Debt Instruments) Rules, 2019: These rules supersede previous regulations and provide specific guidelines for foreign investment through non-debt instruments. Key sections include:
  • Section 2: Defines various terms used in the rules, such as “Foreign Direct Investment (FDI),” “Non-Resident,” and “Non-Debt Instruments.”
  • Sections 3 to 5: Specify different entry routes for foreign investment based on factors like investment size, sector, and control intent of the foreign investor. These routes can be automatic (approval not required) or require prior approval from the government or the Reserve Bank of India (RBI).
  • Sections 6 to 8: Outline the process for subscription and acquisition of equity instruments by foreign entities, adhering to designated entry routes and sectoral caps. Sectoral caps are limitations on the amount of foreign investment permitted in specific industries.
  • Sections 9 to 11: Define how foreign investors can repatriate their investment proceeds (principal amount and capital gains), subject to regulations and prevailing FEMA guidelines.
  • Sections 12 to 14: Specify various exit options available to foreign investors, including selling shares on a recognized stock exchange or buyback by the Indian company.

Benefits of NDI Rules:

• Simplified Procedures: The NDI Rules aim to streamline the process for foreign investment compared to previous regulations, facilitating faster and more efficient investment decisions.
• Increased Transparency: The rules promote transparency by clearly outlining the regulations and requirements for foreign investors.
• Enhanced Foreign Investment: By simplifying procedures and offering greater clarity, the NDI Rules aim to attract more foreign capital into India, fostering economic growth and development.

Transactions Requiring Valuation under FEMA

The Foreign Exchange Management Act (FEMA) mandates valuation for various cross-border transactions involving shares and capital instruments between residents (Indian entities/individuals) and non-residents (foreign entities/individuals). Here’s a breakdown of some key scenarios where valuation is required:

Foreign Direct Investment (FDI):

• When a foreign entity invests directly in an Indian company (equity capital, reinvestment of earnings, other capital).
• Valuation sets the minimum permissible price (floor) at which the Indian company can sell its shares or instruments to the foreign entity.

Overseas Direct Investment (ODI):

• When an Indian entity invests in a foreign company (Joint Venture or Wholly Owned Subsidiary).
• Valuation sets the maximum permissible price (ceiling) at which the Indian entity can invest in the foreign company.
• This can involve contribution to capital, subscription to a foreign company’s memorandum, or acquisition of existing shares through market purchase, private placement, or stock exchange.

Other Examples:

• Issue of Shares or Capital Instruments by an Indian Company to a Non-Resident: Valuation ensures fair pricing for the issuance.
• Transfer of Shares or Capital Instruments from a Resident to a Non-Resident: Valuation safeguards against underpricing of Indian assets.
• Transfer of Shares or Capital Instruments from a Non-Resident to a Resident: Valuation protects Indian entities from overpaying for foreign assets.
• Swap of Capital Instruments: Valuation is required for complex transactions involving swaps of shares or instruments, irrespective of the amount involved.

Things to Keep in Mind:

• Valuation reports for FDI/ODI transactions have a validity period of 90 days. The transaction must be completed within this timeframe.
• The specific authorized person qualified to conduct the valuation depends on the type of company involved (listed vs. unlisted) and the nature of the transaction (FDI vs. ODI).

Benefits of Accurate Valuation under FEMA

Accurate valuation under FEMA offers several advantages:

• Compliance with Regulations: Fair valuation ensures adherence to FEMA regulations and avoids potential penalties for non-compliance.

• Streamlined Transactions: Accurate valuations facilitate smooth FDI/ODI transactions by eliminating delays or disputes arising from unfair pricing.
• Protection for All Stakeholders: Fair valuations safeguard the interests of all parties involved:
  • Indian entities are protected from selling shares or instruments at undervalued prices.
  • Foreign investors are assured they are not paying an inflated price.
  • The Indian financial system benefits from increased transparency and stability in foreign exchange transactions.

Conclusion

Understanding and adhering to FEMA valuation guidelines is crucial for residents and non-residents engaging in cross-border transactions involving shares or capital instruments. Accurate and reliable valuations promote fair play, transparency, and ultimately contribute to a healthy foreign exchange environment that fosters economic growth and development in India.

Frequently Asked Questions about Valuation under FEMA

Q1. What is the purpose of valuation under FEMA?

Ans1. Valuation under FEMA ensures fair pricing of shares and capital instruments involved in cross-border transactions between residents (India) and non-residents (foreign entities). This helps prevent capital flight, protects investors, and fosters transparency in the Indian financial market.

Q2. What are the different types of transactions requiring valuation under FEMA?

Ans2. Several transactions require FEMA valuation, including:

• Foreign Direct Investment (FDI) by a foreign entity in an Indian company.
• Overseas Direct Investment (ODI) by an Indian entity in a foreign company.
• Issuance of shares or capital instruments by an Indian company to a non-resident.
• Transfer of shares or capital instruments between residents and non-residents.
• Swaps of capital instruments.

Q3. Who can conduct valuations under FEMA?

Ans3. The authorized professionals to conduct valuations depend on the type of company involved:

• Listed Companies: Valuation based on SEBI guidelines (typically market prices).
• Unlisted Companies: Chartered Accountant, SEBI-registered Merchant Banker, or Cost Accountant using internationally accepted methodologies.
• ODI Transactions: AD bank can recommend valuers like Merchant Bankers or Registered Valuers for arm’s length pricing.
• Swap of Capital Instruments: SEBI-registered Merchant Banker or a recognized foreign Investment Banker.

Q4. What are the key valuation methodologies used under FEMA?

Ans4. FEMA emphasizes internationally accepted valuation methodologies like:

• Market Price Method: Uses prevailing market price of similar shares traded on a recognized stock exchange.
• Income Method: Considers the future income generation potential of the shares or instrument.
• Discounted Cash Flow (DCF) Method: Estimates the present value of expected future cash flows from the shares or instrument.

Q5. What are the minimum and maximum price limits set by valuation under FEMA?

Ans5. Valuation for FDI/ODI transactions sets:

• Minimum permissible price (floor): The price at which an Indian company can sell shares/instruments to a foreign entity (FDI).
• Maximum permissible price (ceiling): The price at which an Indian entity can invest in a foreign company (ODI).

Q6. What is the validity period of a FEMA valuation report?

Ans6. Valuation reports for FDI/ODI transactions are valid for only 90 days. The transaction must be completed within this timeframe.

Q7. What are the consequences of inaccurate valuation under FEMA?

Ans7. Inaccurate valuation can lead to penalties, transaction delays, and even legal disputes for non-compliance with FEMA regulations.

Q8. What are the benefits of accurate valuation under FEMA?

Ans8. Accurate valuation offers several benefits:

• Ensures compliance with FEMA regulations.
• Facilitates smooth transactions by eliminating delays or disputes.
• Protects investors and Indian entities from unfair pricing.
• Promotes transparency and stability in the financial market.

Q9. Where can I find the legal framework governing valuation under FEMA?

Ans9. The key legal framework includes:

• FEMA (1999): The core act for foreign exchange management.
• Foreign Exchange Management (Non-Debt Instruments) Rules (2019): Specific guidelines for valuation of shares and capital instruments.
• RBI Notifications: Periodic updates and clarifications on FEMA valuation.

Q10. When should I seek professional help for valuation under FEMA?

Ans10. It’s advisable to seek professional help from qualified valuers authorized under FEMA, especially for complex transactions involving unlisted companies, ODIs, or swaps of capital instruments. They possess the expertise to ensure accurate valuation and compliance with FEMA regulations.