Chapter 12: Foreign Exchange Management Act, 1999 (FEMA)

The Foreign Exchange Management Act, 1999 (FEMA) is the central legislation governing cross-border capital flows, external trade, and foreign currency transactions in India. While the Reserve Bank of India (RBI) administers FEMA in consultation with the Central Government, its provisions directly regulate foreign portfolio investment, foreign direct investment, and offshore borrowings.

Core Classification: Current Account vs. Capital Account

FEMA bifurcates all foreign exchange transactions into two constitutional domains:

1. Current Account Transactions (Section 5): Transactions that do not alter the external assets or liabilities (including contingent liabilities) of a person resident in India or outside India:
   • Foreign trade payments for goods, short-term banking credit, travel expenses, education remittances, medical treatment, and dividend/interest payouts on securities.
   • Freedom of Remittance: Current account transactions are broadly free and permitted unless specifically restricted under the Foreign Exchange Management (Current Account Transactions) Rules, 2000.
2. Capital Account Transactions (Section 6): Transactions that alter the assets or liabilities (including contingent liabilities) outside India of persons resident in India, or assets and liabilities in India of persons resident outside India:
   • Inward and outward foreign direct investments, portfolio investments in equities and debt, acquisition of immovable property, External Commercial Borrowings (ECBs), and overseas direct investments.
   • Regulatory Control: Capital account transactions are prohibited unless specifically permitted by general or special permission of the RBI or Central Government.

Foreign Direct Investment (FDI) represents long-term strategic foreign capital in Indian companies.

The Two Inward Investment Routes

• Automatic Route: Inward foreign investment does not require prior approval from the Government of India or the RBI. The Indian company simply files the requisite Form FC-GPR (Foreign Currency - Gross Provisional Return) with the Authorized Dealer bank within thirty (30) days of share allotment.
• Government Approval Route: Foreign investments in sensitive sectors or exceeding automatic caps require prior approval from the Government of India, processed through the Foreign Investment Facilitation Portal (FIFP) administered by DPIIT (Department for Promotion of Industry and Internal Trade) and the concerned administrative ministry.

Prohibited Sectors for Foreign Investment

Under the consolidated FDI Policy and FEMA Non-Debt Rules, FDI is strictly prohibited in:

1. Lottery business (including government/private lotteries, online lotteries);
2. Gambling and betting (including casinos);
3. Chit funds and Nidhi companies;
4. Trading in Transferable Development Rights (TDRs);
5. Real estate business or construction of farmhouses (development of townships, commercial construction, roads, bridges, and investments in REITs/InvITs are expressly excluded from the prohibition and permitted);
6. Manufacturing of cigars, cheroots, cigarillos, and cigarettes of tobacco or tobacco substitutes;
7. Activities/sectors not open to private sector investment (atomic energy, railway operations).

Eligible Capital Instruments & Pricing Guidelines

• Eligible Instruments: Equity shares, Fully and Compulsorily Convertible Preference Shares (CCPS), Fully and Compulsorily Convertible Debentures (CCDs), and share warrants.
• Non-Debt Pricing Guidelines: The price of equity instruments issued to a person resident outside India cannot be lower than the Fair Market Value (FMV) determined by an independent Chartered Accountant or SEBI-registered Merchant Banker using internationally accepted pricing methodology (such as Discounted Cash Flow - DCF).

FEMA provides specialized investment channels for Non-Resident Indians (NRIs) and overseas institutional venture funds.

Portfolio Investment Scheme (PIS) for NRIs and OCIs

Non-Resident Indians (NRIs) and Overseas Citizens of India (OCIs) can purchase and sell shares and convertible debentures of Indian listed companies on recognized stock exchanges through the Portfolio Investment Scheme:

• Must operate through a designated Authorized Dealer (AD) bank branch holding an NRE (Non-Resident External - repatriable) or NRO (Non-Resident Ordinary - non-repatriable) account.
• Individual Ceiling: Up to 5% of the total paid-up equity capital or paid-up value of each series of debentures.
• Aggregate Ceiling: The aggregate investment by all NRIs/OCIs cannot exceed 10% of the paid-up capital of the Indian company (can be raised up to 24% by passing a special resolution in the company's general meeting).

Foreign Venture Capital Investors (FVCI) Regime

An FVCI registered with SEBI under the SEBI (Foreign Venture Capital Investors) Regulations, 2000 enjoys unique regulatory exemptions under FEMA:

• Can invest in equity, debt, or hybrid instruments of unlisted Indian Venture Capital Undertakings (VCUs) in infrastructure, biotechnology, IT, nanotechnology, and seed tech.
• Exemptions: FVCIs are exempt from standard entry and exit pricing restrictions applicable to FDI investors, allowing them to acquire or sell unlisted securities at mutually negotiated commercial terms.

In October 2019, the Central Government and RBI overhauled foreign investment regulations by bifurcating debt and non-debt instruments.

Foreign Exchange Management (Non-Debt Instruments) Rules, 2019

Framed and administered by the Ministry of Finance (Department of Economic Affairs - DEA):

• Governs all foreign investments in equity instruments of listed and unlisted Indian companies, capital participation in LLPs, units of Alternative Investment Funds (AIFs), Real Estate Investment Trusts (REITs), and Infrastructure Investment Trusts (InvITs).
• Establishes sectoral caps, performance conditions, pricing guidelines, and transfer restrictions between residents and non-residents.

Foreign Exchange Management (Debt Instruments) Regulations, 2019

Framed and administered by the Reserve Bank of India (RBI):

• Governs foreign portfolio investments in debt securities: Central Government Securities (G-Secs), State Development Loans (SDLs), Corporate Debt securities, Commercial Papers, and Municipal Bonds.
• Voluntary Retention Route (VRR): A dedicated investment window introduced by RBI to encourage long-term, stable debt investment. FPIs committing to retain at least 75% of their investments in India for a minimum period of three (3) years enjoy exemption from standard macro-prudential concentration limits (such as single-issuer caps).