Research and Articles

 

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• Critically examines key regulatory challenges and definitional ambiguity around ‘FDI-Linked Performance Conditions’, its inconsistent application, and the resulting compliance burdens on investors.

• Proposes policy reform measures to enhance regulatory clarity, reduce investor uncertainty, and align sector-specific conditions with India’s evolving economic priorities.

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Introduction

Foreign Direct Investment (“FDI”) continues to play a pivotal role in shaping India’s growth trajectory, contributing significantly to capital formation, technology transfer, employment generation, and global integration. In line with this strategic importance, India’s FDI policy, which is principally governed by the Foreign Exchange Management Act, 1999 and issued by the Department for Promotion of Industry and Internal Trade (“DPIIT”), seeks to strike a careful balance between encouraging foreign capital and safeguarding national interests in sensitive sectors.

To achieve this, the FDI framework classifies sectors into automatic and government approval routes and often prescribes specific conditions tailored to the sector's regulatory or developmental objectives. A particularly important subset of these sector-specific prescriptions is the concept of “FDI-linked performance conditions.” These are obligations which Indian investee companies and foreign investors must adhere to for bringing in FDI in certain sectors, ranging from minimum capitalization and lock-in periods to operational restrictions and export obligations. However, despite the growing relevance, this concept suffer from definitional vagueness and regulatory ambiguity.

This article aims to provide a comprehensive analysis of the concept, the current legal framework, its historical context, regulatory challenges, and the clarity that is required from the regulators.

Legal Framework

The term “FDI-linked performance conditions” is defined in the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”) as “sector-specific conditions specified in Schedule I of the NDI Rules for companies receiving foreign investment.”. Similarly, Clause 2.1.18 of the Consolidated FDI Policy Circular of 2020 dated October 15, 2020 (“FDI Policy”) defines the term as “sector-specific conditions for companies receiving foreign investment,” a definition that closely mirrors the one in the NDI Rules. These definitions, while seemingly straightforward, becomes problematic when applied practically. It raises the fundamental question of whether all sectoral conditions should be treated as performance-linked, or only those directly tied to business performance and the use of foreign capital.

This expression is relevant to several regulatory scenarios under NDI Rules. First, in the context of issuance of equity instruments against pre-incorporation or pre-operative expenses, a wholly owned subsidiary set up by a non-resident entity in India, operating in a sector that permits 100% FDI under the automatic route and does not involve FDI-linked performance conditions, is allowed to issue equity instruments against certain eligible pre-incorporation expenses incurred by the parent entity. Second, Indian companies that are non-operational and have not made any downstream investments may receive FDI under the automatic route for activities which do not have FDI-linked performance conditions. If such companies are into activities under the approval route and commence the business or make downstream investments, they must comply with applicable sectoral conditions. Third and most importantly, foreign investment in Limited Liability Partnerships (“LLPs”) is permitted only in sectors that allow 100% FDI through the automatic route and do not have FDI-linked performance conditions. Similar restriction applies to LLPs which are foreign owned or controlled and intending to make downstream investments or the LLPs with foreign investment which intend to convert into private limited companies.

Sectoral Analysis and Impact

Some of the sectors such as non-banking financial companies (NBFCs), Construction Development (including Townships, Housing, Built-Up infrastructure), Industrial Parks, Pharmaceutical in brownfield, Retail Trading impose clear FDI performance-based conditions such as minimum capitalization, minimum area to be developed, local sourcing, lock-in periods. These conditions relate directly to how the foreign investment is utilized and are therefore considered performance linked. On the other hand, sectors like wholesale trading, manufacturing, e-commerce, agriculture, plantation involve only compliance requirements such as licensing or regulatory approvals, which do not necessarily tie into the investor’s performance or obligations related to the FDI proceeds.

However, the current broad language of the definition creates confusion and results in these compliance-based sectors being erroneously treated as sectors having FDI-linked performance conditions.

Historical Clarifications

Between 2012 and 2015, the Department of Industrial Policy and Promotion (DIPP), which is now DPIIT, offered greater clarity on this matter through its annual consolidated FDI policies issued in those years. For instance, para 3.2.5 of the FDI policy issued for 2012 explicitly clarified that ‘FDI-linked performance conditions’ are the “conditions which are stipulated in the sectors such as Non-Banking Finance Companies or Development of Townships, Housing, Built-up infrastructure and Construction-development project etc.” This mean only the obligations like minimum capitalization, area development mandates, time-bound utilization of funds or of similar nature be construed as FDI-linked performance obligations. Apart from these, performance-linked conditions may also include requirements such as local sourcing, export obligations, R&D investment, technology transfer, infrastructure creation, or employment generation. These are fundamentally different from procedural or licensing conditions which are typically common in many sectors. A similar clarification was afforded in the subsequent FDI policies issued for 2013, 2014 and 2015 as well. This suggests that the government’s original intent was to differentiate between sectoral conditions that are compliance-based, and those that are performance-based.

However, the FDI policies issued thereafter including the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 lacked this clarity.

Regulatory Practice and Practical Challenges

Although the NDI Rules are issued by the Central Government and DPIIT is the policy-making body for FDI matters, the Reserve Bank of India (“RBI”) is responsible for administration of NDI Rules. Rule 2A of NDI Rules authorizes RBI to interpret rules for their effective implementation. However, when processing an FDI transaction, if there is uncertainty about whether the sector in question has FDI-linked performance conditions, the concerned Authorised Dealer Banks (“AD Banks”) have often directed stakeholders to seek clarification from DPIIT before processing the transaction, as this pertains to FDI policy.

There are instances where, as directed by AD Bank, clarification was sought for a sector like cash-and-carry wholesale trading sector and the DPIIT clarified that the conditions stated therein do not constitute FDI-linked performance conditions, thereby allowing LLPs to operate in that sector and accept foreign investment under the automatic route.

Concluding Thoughts

The existing ambiguity in the definition of FDI-linked performance conditions which is creating confusion and resulting in erroneous treatment of sectors with mere procedural and compliance-based conditions as the sectorshaving FDI-linked performance conditions has a significant impact on the ability of LLPs (and companies in few cases) to receive FDI in several high-potential sectors. Sectors such as wholesale trading, manufacturing, agriculture and allied activities, pharmaceuticals (particularly greenfield projects), and regulated financial services often fall into this grey area. As a result, only a limited number of sectors such as software development and business consultancy services, which have no sectoral conditions, remain fully open for LLPs and non-operational companies to attract foreign investment.

This misinterpretation causes additional scrutiny by AD Banks and unnecessary referrals to DPIIT which, in turn, slows down the investment timelines and increase compliance costs. This undermines investor confidence and is inconsistent with India’s stated goal of enhancing ease of doing business. It also disproportionately affects LLPs and start-ups seeking to raise FDI in sectors with nuanced conditions.

To address this, the definition of “FDI-linked performance conditions” in NDI Rules be revised to distinguish clearly between performance-linked and compliance-based sectoral conditions. The government should issue illustrative guidance or sector-specific clarifications to help identify which conditions fall into each category. Ideally, such guidance should be incorporated into the FDI Policy or annexed to the NDI Rules. Additionally, applying this clarification retrospectively would provide much-needed relief and certainty to investors who have made investments in good faith, based on their interpretation of the law. Such reforms would improve regulatory clarity, reduce delays, and ensure that India's FDI framework remains attractive to investors. This clarity is especially important given the noticeable increase in LLP registrations in recent years compared to companies, indicating a growing preference for LLPs as the preferred business structure in India.

 

Authors

- Chandrashekar K and Kishore Joshi

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