FEMA penalty cannot rest on inapplicable borrowing rules or unpleaded downstream investment allegations
FEMA penalty proceedings were analysed on whether funds received as FDI against equity and preferential capital could be treated as borrowing under the Borrowing and Lending in Rupees Regulations, 2000. The tribunal found that the regulations presuppose an actual rupee borrowing transaction and that equity inflows do not become borrowing merely because the funds were later used onward. It also noted that downstream investment, Regulation 14 and Section 6(3)(e) could not sustain the penalty where the show cause notice did not properly plead those bases and the alleged onward deployment was to a society, not an Indian company. The penalty orders were therefore set aside.
Issues: (i) Whether the penalty could be sustained under the borrowing and lending in rupees regulations when the funds received were FDI towards equity and preferential capital and not borrowing. (ii) Whether the impugned order could validly rest on downstream investment, Regulation 14 and Section 6(3)(e) of FEMA, 1999 when those bases were not properly pleaded in the show cause notice and the recipient was a society, not an Indian company.
Issue (i): Whether the penalty could be sustained under the borrowing and lending in rupees regulations when the funds received were FDI towards equity and preferential capital and not borrowing.
Analysis: The material on record showed that the inflows were received as foreign direct investment against equity and preferential capital. The borrowing and lending in rupees regulations apply to borrowing in rupees by a person resident in India from a non-resident, and therefore presuppose a borrowing transaction. The Court found that the case did not involve borrowing by the appellant company; the subsequent use of FDI funds could not convert equity capital into a borrowing transaction. On that footing, the reliance on the rupees-borrowing regulations was misplaced.
Conclusion: The penalty could not be upheld on the basis of Regulation 4 and Regulation 6 of the Borrowing and Lending in Rupees Regulations, 2000, and this issue was decided in favour of the appellants.
Issue (ii): Whether the impugned order could validly rest on downstream investment, Regulation 14 and Section 6(3)(e) of FEMA, 1999 when those bases were not properly pleaded in the show cause notice and the recipient was a society, not an Indian company.
Analysis: The show cause notice did not clearly allege contravention of Regulation 5 or Regulation 14 of the transfer or issue of security regulations, nor did it disclose the factual foundation necessary to sustain an allegation of prohibited FDI in a service sector entity or downstream investment. The Court noted that downstream investment under Regulation 14 contemplates indirect foreign investment by one Indian company into another Indian company by subscription or acquisition, whereas the alleged onward deployment of funds was to a society under a management arrangement. The invocation of Section 6(3)(e) was also found inapposite because the case was not one of borrowing or lending in rupees in the statutory sense. The Court further held that the order could not be sustained on a basis beyond the scope of the notice and the disclosed material.
Conclusion: The findings on downstream investment, Regulation 14 and Section 6(3)(e) could not support the penalty, and this issue was also decided in favour of the appellants.
Final Conclusion: The impugned penalty orders were set aside because the alleged contraventions were not made out on the facts and the regulatory bases relied upon were either inapplicable or beyond the scope of the show cause notice.
Ratio Decidendi: A penalty under FEMA cannot be sustained where the regulatory provision invoked does not fit the nature of the transaction and where the adjudication is founded on allegations or statutory bases not properly disclosed in the show cause notice.
TaxTMI 
AI Drafter ✕
TaxTMI 
