[By Ayush Singh Verma]
The Author is a student of Hidayatullah National Law University
Introduction
Recently, the Department for Promotion of Industry and Internal Trade released Press Note No. 2 (2025 Series) (PN2), which clarified the position regarding the issuance of bonus shares by Indian companies operating in Foreign Direct Investment (FDI) restricted sectors to their pre-existing non-resident shareholders. However, the position regarding pre-existing non-resident (PE NR) shareholders under the FDI policy regime remains uncertain, giving rise to the grandfathering dilemma. This article will explore the nuances of grandfathering under the FDI regulatory landscape in India by highlighting a gap in the framework regarding the permissibility of PE NR shareholders to hold stakes in companies operating in FDI-restricted sectors, especially the tobacco industry.
Background to Grandfathering
When new laws or regulations are enacted in a regime, they can be detrimental to a certain class of businesses or individuals who complied with the existing regime. Grandfathering seeks to resolve this issue by allowing such parties to function usually without any change being applicable to them. This is usually done by a grandfather clause, which provides that a section of rules or law would only be applicable to new businesses or activities. It was first introduced in the 1890s as a device to deny suffrage to African-Americans, as it conferred the right to vote only to those who had enjoyed the same before 1866-67.
Foreign Direct Investment is defined under the Consolidated FDI Policy Circular 2020 as “investment through capital instruments by a person resident outside India in an unlisted Indian company; or in ten per cent or more of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company” With regard to existing investment, the PN2 clarified that an Indian company engaged in FDI prohibited sectors or activities are permitted to issue bonus shares to its pre-existing non-resident shareholders. This provision is based on the condition that the shareholding pattern of such pre-existing shareholders should not change after the issuance of shares. The clarifications also provide that this provision will become effective from the date of issue of the applicable Foreign Exchange Management Act (FEMA) notifications. Although this move is much appreciated, the rules still do not clarify whether PE NR shareholders can continue to hold shares in companies engaged in the FDI restricted sector.
Gaps in Existing Framework
The regulatory gap lies in the fact that while the press note clarifies the position on the issuance of bonus shares, the regulatory framework is silent on the permissibility of holding shares by non-resident companies in restricted sectors. For instance, DPIIT via Press Note 2 of 2010 series changed the position regarding ‘Cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes’ where earlier, FDI in these activities were permissible for 100% under the Government Approval route. However, after the aforesaid press note, this sector was brought under the prohibited/restricted sector for FDI.
Regardless, what would happen to the non-resident shareholders already holding shares in tobacco manufacturing companies was not clarified. The best case in this regard is that of Godfrey Philips India Ltd. (GPI), which used to be a wholly owned subsidiary of Philip Morris International Inc. (PMI), a United States (US) based company, which is a leading cigarette manufacturer. In 2011, Modi Group acquired the majority stake in GPI, reducing the shareholding of PMI to 21%. Currently, GPI continues to hold a 25% stake in PMI despite its operations in an FDI-prohibited sector. This is a classic case of grandfathering, however, without any regulatory sanction or approval. Similarly, British American Tobacco Company (BAT) continues to hold 25% shares in ITC Ltd., another leading cigarette manufacturing company in India.
A notable mention of grandfather-like clause in FDI restricted sector is evident from Paragraph 1.2 of the Master Direction – Foreign Investment in India which provides that “An investment made by a person resident outside India in accordance with FEMA or the rules or the regulations framed thereunder and held on the date of commencement of NDI Rules i.e. October 17, 2019, shall be deemed to have been made in accordance with NDI Rules and shall accordingly be governed under it.” However, it still does not clarify the position with respect to investments made before 2010, when the tobacco sector was not restricted from FDI. These grandfathering instances, in light of the recent PN2, create a dilemma in ascertaining the position of such PE NR shareholders, where on one hand, they have investment in FDI restricted sectors, and on the other hand, there does not exist any grandfather clause under the FDI policy to allow such holdings. In the absence of a formal grandfather clause, circumvention can occur through mechanisms such as indirect control, proxy shareholding, or routing investments through layered corporate structures, enabling foreign entities to maintain de facto ownership or influence despite the formal FDI restrictions. This has the effect of circumventing FEMA provisions and increase the scope of illegal foreign investment in the tobacco industry.
Way Forward
The aforesaid gap in the regulatory framework justifies the need for including a grandfather clause in the FDI policy, which can determine the position of PE NR shareholders in FDI-restricted activities. For instance, a grandfather clause was introduced by the Finance Act of 2018 for investments made in or before 31 January 2018 in equity shares or an oriented mutual fund. This was done to exempt any income arising from the transfer of long-term capital assets of the same nature on which Securities Transaction Tax (STT) was already paid. In State of Manipur v. Surajkumar Okram, The Supreme Court ruled that “While repealing a statute, the Legislature is competent to introduce a clause, saving any right, privilege, liability, penalty, act or deed duly done and any investigation, legal proceeding or remedy arising therefrom, under the repealed statute.” This reasoning can be supplemented to conclude that the legislature is well within its powers to introduce a grandfather clause or saving of any right, even when it is substituting an older policy with a newer one. That is because substitution of an older policy has an effect of repealing it.
In 2018, the Indonesian Government introduced Regulation No. 14/2018, which established an 80% cap on foreign holdings in insurance companies. However, there was a grandfathering clause provided, which states that foreign shareholders who already hold more than 80% ownership at the time of enactment of the regulation are allowed to retain their existing holding, provided that they cannot increase their ownership further. Similarly, in 2019, when the FDI regulations were changed for the Digital Media sector, the DPIIT clarified that existing investments in this sector must be aligned with the new cap of 26%. The Indian government could also adopt a similar approach by either inserting a new clause in the consolidated FDI policy circular or by releasing a Press Note with detailed clarification regarding the position of PE NR shareholders in restricted sectors, especially the tobacco industry.
Conclusion
Grandfathering under India’s FDI regime is a ticking regulatory gap in development. Though, Press Note No. 2 (2025 Series) does clarify that bonus shares can be issued to PE NR shareholders, it does not go to the issue whether they will be able to hold on to their original investment in companies in sectors (e.g. tobacco), which are now under the ambit of sector-specific conditionalities (where FDI policy does not apply). Such a silence brings with it legal uncertainties and makes way for FEMA and FDI contravention. Cases of GPI and BAT in India are such dilemmas, which highlight the absence of formalized framework for ‘grandfathering’ the investments of this nature.
Applying Indian and international precedents, we can see that well-crafted grandfathering provisions can provide regulatory stability without sacrificing policy goals. Government needs to clarify through a FDI Policy amendment or Press Note on the status of PE NR investments made before sectoral prohibition. A simple and uniform grandfathering arrangement would not only reinstate investor confidence but also reinforce the legal sanctity of India’s FDI regime thus keeping it stable, fair and dynamic in modern times.