Preparing for India’s proposed Foreign Investment Rulebook - From Instruments to Equity, From Downstream Tests to Control
Introduction : The Reserve Bank of India (“RBI”) had issued the draft Foreign Exchange Management (Foreign Investment) Rules, 2026 (“Draft Rules”) for public comments on 21 July 2026. On notification, they would supersede the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (“NDI Rules”). The exercise is in wake of the comprehensive review of the Union Budget 2026-27 and the RBI’s goal is a “simplified and principle-based framework, neutral as to investor and investor”.
The comments closed on 31 August 2026. While no notification for entry into force of the Draft Rules has been found, as of 5 November 2026, the NDI Rules, as amended, continue to apply, and the Fourth Amendment (notified on 2 September 2026 and published on 3 September 2026) introduces inventory based e-commerce only for exports of goods manufactured in India. Businesses should regard the NDI Rules as binding, and try to predict changes with the Draft Rules. The Draft Rules go beyond simply consolidating; they redefine foreign investment, alter the manner in which indirect investments are tested, and distinguish between policy and procedure. Legal Provisions summarizes the content of the Draft Rules, while Legal Analysis highlights points for potential clarification and refinement.
Legal Provisions
A. Scope and Architecture
The Draft Rules are drafted to be notified by the Central Government under section 46 of the Foreign Exchange Management Act, 1999 (“FEMA”) and are issued and administered by the RBI. They cover foreign investment in the equity of an “eligible investee entity” by a person resident outside India (“PROI”); a company, a limited liability partnership (“LPP”), an investment vehicle registered with SEBI, a registered partnership firm and a registered proprietary firm, but not investment in financial institutions in an International Financial Services Centre. Under Rule 4, the RBI administers the Rules and specifies payment and reporting requirements, while the Department for Promotion of Industry and Internal Trade (“DPIIT”) gives its interpretation of the foreign investment policy, which was proposed as Annexure II. Rule 5 restricts foreign investment which is not allowed under the Rules or directions listed in Annexure III, unless exceptions are given by RBI on application.
B. Data for Planning and Action
Four definitions in Rule 3 are central. First, “foreign investment” includes investment that is made directly by the foreign investor, or indirectly via a “foreign-controlled entity” (“FCE”) or a PROI owned and controlled by, or common ownership or control of, the foreign investor. Secondly, the term “ownership” refers to beneficial holding above fifty (50) per cent and “control” refers to the power to appoint more than fifty (50) per cent of the directors or to control the management or decisions of the company, including through voting or shareholders’ agreements which give the person ten (10) per cent or more of the voting rights. Third, an FCE is a resident company, LLP or investment vehicle owned or controlled by a PROI, as determined by sectoral regulators or, failing that, the law under which the entity is formed. Fourth, FDI is foreign investment of ten (10) per cent or more in a company or LLP, while investment below (10) per cent is considered as foreign portfolio investment (“FPI”).
C. Modes, Conditions and Pricing
Subscription, purchase, gift and pledge are allowed under Rule 6A while transfers to residents and selected equity swaps are allowed under Rule 7. The entry routes, caps and conditions of the policy, as well as requirement for SEBI registration for participation as a non-individual investor on Indian exchanges are required to be in compliance with Rule 8. Pricing follows SEBI guidelines for listed companies, Annexure I for companies listed on international exchanges, and otherwise an arm’s length pricing certified by a chartered accountant, merchant banker registered with SEBI or cost accountant. Annexure I covers direct listing abroad while the Annexures II and III appear only as headers.
Legal Analysis
A. From Listed Instruments to Accounting-Defined Equity
The NDI Rules regulate enumerated “non-debt instruments”, which are specifically identified. The Draft Rules instead question whether an instrument is an “equity” instrument, defined by the investee’s classification under applicable accounting standards. For hybrid instruments which may be classified differently for accounting and exchange-control purposes, it is simpler but ambiguous since Draft Rules do not state whether the investee’s classification will bind the RBI.
B. 10 per cent threshold considered uniformly
Under the NDI Rules, investment in an unlisted company is FDI irrespective of percentage, whereas the Draft Rules apply the ten per cent line uniformly to companies and LLPs. If the classification proposed by FEMA is adopted, then five (5) per cent stake in an unlisted company on FDI today, would become FPI, subject to applicable conditions. Three questions remain regarding the classification under FEMA; SEBI eligibility and registration of non-individual investors, whose treatment of unlisted holdings is left open in the Draft Rules; and the impact on an FPI when its unlisted holding reaches ten (10) per cent. On the last, Rule 8(1)(d) provides that exchange-traded FPIs reaching ten (10) per centcmay be “reclassified” as FDI, provided they meet the conditions for FDI, but does not mention the consequences of non-reclassification. The final Rules should be clear on it, rather than leave investors to assume automatic non-compliance.
C. Control and the FCE: Breadth and Ambiguity
The most consequential change replaces Rule 23 of the NDI Rules (downstream investment) with an ownership-and-control test. If a foreign investor owns or controls Indian Company A, then the investment of the foreign investor in Company A could also be foreign investment. Ownership and control are distinct tests and a company can be an FCE on either test. There are two features which create interpretative uncertainty. First, control consists of shareholders’ and voting agreements that give someone at least ten per cent of the votes. The test for a minority investor is not met by a ten per cent interest alone, but by contractual rights which give the minority investor the power to determine management or policy decisions. The final Rules should differentiate between rights of control and rights to protect investors. Second, FCE status is determined by sectoral regulators, or if not, by laws like the Companies Act, 2013, that has a similar definition of control, but which does not automatically mean FCE status. Rule 8(1)(a) applies FCE conditions only to sectors specifically prescribed in the foreign investment policy, but Annexure II has not been published with the draft.
D. Policy Decoupling and Unsettled Annexures
The Draft Rules should allow for procedure changes through DPIIT without the need for the core policy (Annexure II) to be amended. This could reduce predictability. If Annexures II and III are not included, businesses will not be able to fully evaluate the implications of the framework. The impact would bring in the accompanying transitional arrangements, which have no transitional relief beyond the paragraph for pre-supersession activities in the Draft Rules. Policy action is swift: Press Notes No. 2/2026 and the amendment to the Press Notes in May 2026 have linked the beneficial ownership in the land-border regime to the Prevention of Money-laundering (PML) regime, allowing investors to include non-controlling beneficial ownership of up to ten (10) per cent of land-bordering countries under the automatic route, subject to reporting. Annexure I adds direct-listing conditions, such as eligibility criteria and divestment in case an FPI on an international exchange achieves a ten (10) per cent.
Relevant Case Laws
These decisions state principles relevant to interpreting the proposed framework; none decides the Draft Rules.
In Vodafone International Holdings B.V. v. Union of India decided on 20 January 2012, the Supreme Court explained that the transaction should be looked at as a whole, holding structure with commercial substance are legitimate and an entity with no commercial substance and merely designed to circumvent the tax, may be set-aside. It did not rule on FEMA, but the rationale provided might guide review of multi-layered FCEs.
In IDBI Trusteeship Services Ltd. V. Hubtown Ltd., a single judge of the Bombay High Court, in a summary suit on a corporate guarantee, issued an unconditional leave to defend holding the routed foreign investment to be a colourable device that violated the FEMA and FDI policy. The Supreme Court set aside the order on 15 November 2016. It considered the stages one by one, and concluded that nothing prima facie FEMA infraction stood against the defence made at the stages and that repatriation of funds would require RBI permission, and granted leave only after depositing or securing ₹418 crore. There was no final ruling on FEMA compliance.
Vijay Karia v. Prysmian Cavi E Sistemi SRL: Supreme Court upheld the enforcement of foreign arbitral award against a challenge by FEMA with respect to pricing issues, holding that a rectifiable FEMA breach cannot violate the fundamental policy of Indian law, since FEMA permits post-facto permission or condonation.
In GPE (India) Ltd. V. Twarit Consultancy Services Pvt. Ltd., the Court, accepting the RBI’s affidavit that a compensatory damage is a current account transaction, did not find any bar to action, the RBI had stated that a violation of the rules on share-issue or transfer is actionable unless compounded. Failure to comply with pricing requirements does not invalidate a contract, but does subject the contractor to penalty on adjudication, subject to compounding.
Practical Implications
Indian companies with foreign ownership or control may carry foreign-investment classification into downstream investments, so deal teams should conduct ownership chain mapping, review investor rights for control, and test hybrid instruments for structuring. FEMA-compliance representations, approval-related conditions precedent or pre-closing valuation certification become more significant for documentation. For compliance, Rule 9 makes the onus joint, so investees cannot treat compliance as the investor’s concern alone, and RBI directions and DPIIT instruments must both be monitored. A readiness checklist follows:
Map each foreign holding against the ten (10) per cent threshold and identify unlisted holdings that may result in a shift from FDI to FPI.
Identify Indian entities which constitute more than fifty (50) per cent ownership or control by non-residents, since these may be FCEs.
Review shareholders’ and voting agreements for rights that could constitute control.
Conduct a test of each instrument against the definition of equity based on accounts.
Identify and eliminate conflict of interest in valuation and certification for arm’s-length pricing arrangements.
Confirm that non-individual investors are registered with SEBI on Indian exchanges.
Track Annexures II and III, DPIIT clarifications and RBI directions on reporting.
Record the commercial rationale of each step to withstand substance-over-form scrutiny.
Review contracts for change-in-law and regulatory-compliance clauses.
Reassess FDI/FPI classification whenever there is a change in the shareholding or voting rights.
Conclusion
The Draft Rules move away from an instrument-by-instrument rulebook to an equity-based, control-centred structure. A shorter rulebook does not mean lighter regulation: the definition of equity, control and FCE will now determine outcomes that have been previously determined in a list.
The final Rules can be improved by adding 5 refinements. First, the definition of control should make it clear whether the ten (10) per cent reference is a threshold or an illustration, and distinguish between investor protection rights from substantive control. Second, there is a need to include transitional provisions to protect structures validly placed under the NDI Rules. Third, Annexures II and III should be published for consultation with the core text. Fourth, the Rules should specify the relationship between accounting classification and RBI’s supervision of hybrid instruments. Fifth, the interplay between the uniform threshold and SEBI’s FPI framework, along with the implications of Rule 8(1)(d), should be addressed. Until then, businesses should not wait for the final Rules to begin reassessing their structures: early identification of ownership, control and instrument-classification issues will help prevent regulatory surprises when the framework takes effect.
Author: Aastha Agarwal in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at Khurana & Khurana, Advocates and IP Attorney
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