Overseas Direct Investment and the Two Layer Rule

[By Vansh Gupta & Mehar Kaur Arora ]

The authors are students at Gujarat National Law University.



Overseas Direct Investment (ODI) means acquisition of any unlisted equity capital or subscription as a part of the Memorandum of Association of a foreign entity, or investment in 10% or more of the paid-up equity capital of a listed foreign entity, or investment with control where investment is less than 10% of the paid-up equity capital of a listed foreign entity. RBI identified that entities having their subsidiaries in India and outside India would use round tripping to siphon-off funds by providing inter-corporate loans to their subsidiaries and evade tax liability leading to a ban on the practice unless undertaken for legitimate purpose with the approval of RBI. However, the ban could disincentivise foreign investment by Indian entities due to compliance burden and cost. In order to create a balance between the need for regulatory oversight and to facilitate ease of doing business, the new ODI Rules introduced the layering restriction. Although the layering restriction is expected to expand the horizon of growth for Indian entities, further clarity is required with respect to the understanding of layers and the exemption provided to certain entities.

Overseas Direct Investment is allowed in a company engaged in Bona fide business activity only. An activity that is legal as per the laws of India and the host country is considered a bona fide business activity. Though the definition brings about a level of lucidity, there are certain reservations. For instance, it is not clear what repercussions does the term “law in force in India” have. It is possible that certain activities, lacking a central law, might be legal in some states, while not permitted in other states.

This article explores the complexities of the ODI framework, the layering restriction, and the need for further clarity and harmonization of definitions to balance regulatory oversight and ease of doing business in India.

Layering restriction and the base entity for calculation of Layers:

Rule 19(3) of the New ODI Rules states that, “no person resident in India shall make financial commitment in a foreign entity that has invested or invests into India, at the time of making such financial commitment or at any time thereafter, either directly or indirectly, resulting in a structure with more than two layers of subsidiaries.” Hence, investment into foreign entities is not permitted if it results into a structure of more than two layer of subsidiaries. However, the confusion arises when determining how to calculate the layers, specifically whether to consider an Indian entity as the foundation or a foreign subsidiary. For instance, an Indian company ‘X’ makes investments in a foreign company ‘Y’, which in turn has two more layers of subsidiaries ‘G’ and ‘H’ which invest in India. Now if H is counted as a layer with respect to the Indian entity, it will be considered as the third layer, and therefore triggering the layering restriction.

Clause 20(2) of the ODI Directions clarifies that foreign entity should be taken as the base for calculation of the number of layers of subsidiaries. The instructions for Form FC under the Master Direction – Reporting under the Foreign Exchange Management Act 1999, which state that the level of Step Down Subsidiary shall be calculated by treating the foreign entity as the parent, provide yet another confirmation in favor of foreign entities.

Defining “Subsidiary” and the threshold for “Control”:

Department of Corporate Affairs has time and again proposed steps to ensure that ‘subsidiary route’ is not used to siphon-off funds and to prevent the misuse of the complex corporate structure to bypass the restrictions. Hence, it was recommended to introduce a statutory cap on the number of layers of subsidiaries permitted for a holding company. However, there is a notable disparity between the definitions of “Control” and “Subsidiary” in the OI rules and the Companies Act. Rule 2(y) of the ODI Rules defines a subsidiary as a company in which a foreign company has ‘control’.

“Control” refers to the right to appoint majority of directors or control of the management exercisable individually or with person acting in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements that entitle them to 10% or more of voting rights. However, the definition of control under Section 2(27) of the Companies Act, 2013 is silent on the 10% threshold. On the contrast, a 50% threshold is mentioned for a company to qualify as a ‘subsidiary’ of a holding company under Section 2(87) of the Companies Act. Setting the threshold at 10% rather than over 50% for determining subsidiary status under the ODI Rules expands the scope to encompass a greater number of foreign entities. This ensures that they are subject to the restrictions on the number of subsidiary layers. Otherwise, companies could have easily invested substantial funds in another entity while maintaining ownership below 50%, allowing them to siphon funds to foreign entities without scrutiny.

It is important to highlight that the definition of control is inclusive in nature and can cover other scenarios where an entity may not have 10% shareholding but may influence policy decisions of the company by certain exclusive veto powers or by any other means.

Horizontal layers of subsidiaries:

The definition of “Control” further talks about indirect control by the Holding Company. To illustrate A is a holding company having a subsidiary B and C. B further has control in C. Therefore, A may not directly control C but exercise an indirect control by virtue of B. Since there is no restriction in layers of subsidiaries in horizontal propagations, a company is allowed to make as much investment as it wants into enterprises at horizontal level.

Further, the first proviso to Rule 2 of Companies (Restriction on number of layers) Rules, 2017 provides and allows an Indian entity to acquire a foreign entity having more than two layers if it is permitted under the laws of that country since Indian law cannot have extra-territorial application. This causes concern since an Indian entity may invest in foreign entity and form multiple layers thereby redirecting the funds to the host country. The ODI Rules shall not govern such transaction since Rule 19(3) is silent on the subjection of such a transaction to layering restriction. So by allowing such exceptions, has the Ministry of Finance unknowingly augmented the outward flows from the Indian economy?

There is no restriction on the nature of the country in which the overseas investee company is incorporated, it is plausible that a domestic entity invests in an overseas entity situated in a country where there are insufficient safeguards to prevent money laundering. To address these concerns, it is inevitable that RBI issues guidelines regulating such investments by abstaining investments in countries, which have deficiencies in dealing with money laundering.

ODI framework is to have prospective application. Therefore, holding companies that already have more than two layers of subsidiaries, in accordance with the laws of the host country, are allowed to maintain their existing structure even after the rules come into effect. However, they are prohibited from adding any additional subsidiaries, including horizontal ones.

Once an ODI, always an ODI

When an investment made by an Indian firm in an entity abroad is designated as an ODI, it will remain such even if it drops below 10% of the paid-up equity capital or the investor loses control in the foreign entity. This says a lot about the seriousness of the Indian government to regulate transactions involving multiple subsidiaries. While the government wants to encourage investment and ease of doing business, it doesn’t want it at the cost of tax evasion and money laundering.

It is essential that the foreign entity, in which the Indian entity invests, has investments back in India for the ODI framework to be applicable. This might defeat the purpose of the framework to prevent siphoning-off funds as the companies may choose to invest in the host country, thereby causing significant outflow of funds from the Indian economy.


The ODI framework, introduced by the RBI in 2022, is a significant development in the Indian foreign investment landscape. The framework aims to balance the need for regulatory oversight with the need to facilitate ease of doing business. The layering restriction, which is one of the key features of the ODI framework, is designed to prevent the misuse of complex corporate structures to siphon-off funds.

The introduction of layering restrictions holds potential benefits for the regulation of fund transfers. However, to ensure effective implementation, it is necessary to clarify various aspects, including the calculation of layers, the definitions of “Control” and “Subsidiary,” and the treatment of horizontal layers and transactions involving foreign entities with more than two layers. The ODI framework’s prospective application, along with the commitment to treating investments as ODI regardless of their equity capital percentage or loss of control, underscores the government’s seriousness in regulating transactions involving multiple subsidiaries.

Overall, the ODI framework is a step in the right direction. However, further clarity and harmonization of definitions are needed to ensure that the framework is effective in preventing the misuse of complex corporate structures.


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