It is once rightly said by Justin Mateen, “An idea is just an idea. When and how you execute that idea is what will define the outcome.”

It is the promoter(s) of a company who conceive an idea, develop it, executes the plan for incorporation and setting up of the business. The incorporation of a company and commencement of business in India involves costs.  These expenses are pre-incorporation/pre-operative expense which includes consultant costs or procuring any material for the business. The pre-incorporation/ pre-operative expenses and the investment by foreign entities in Indian companies are regulated by the authority i.e., Reserve Bank of India (“RBI”) as per the provisions laid down under the Foreign Exchange Management Act, 1999 (“FEMA”), FEMA (Non-Debt Instruments) Rules, 2019 (“NDI Rules”) and the regulations/circulars notified by RBI.

What are pre-incorporation and pre-operative expenses?

The explanation of ‘pre-incorporation’ and ‘pre-operative expenses’ was earlier provided in the erstwhile regulation, i.e., FEM (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017, and the same explanation is now provided in ‘Master Directions – Foreign Investment in India’ (“Master Direction”).

As per Master Direction, ‘pre-incorporation / pre-operative expenses’ will include amounts remitted to the investee Company’s account or to the investor’s account in India (if it exists) or to any consultant or attorney or to any other material/ service provider for expenditure relating to incorporation or necessary for commencement of operations. It is interesting to note that the explanations ‘pre-incorporation’ and ‘pre-operative’ expenses are not explained separately; therefore, both terms can be used interchangeably. However, in general parlance, the pre-incorporation expenses are expenses which are incurred by the promoters prior to the incorporation such as payment towards statutory fees for the incorporation, consultancy fees and other related expenses, whereas the pre-operative expenses could be those expenses that are incurred by the promoters after incorporation, but before the commencement of the business.

Once the above expenses are incurred by the foreign promoters the option for them is available to get the pre-operation/pre-operative expense converted into equity instruments. NDI Rules and Master Direction regulate the conversion of expenses into equity instruments, subject to the conditions specified therein. Further, pre-incorporation expenses can be reimbursed by the Indian companies, subject to the conditions laid down in the “Master Direction – Other Remittance Facilities”.

Conversion of pre-incorporation/pre-operative expenses into equity:

As per provisions laid down under NDI Rules and Master Direction, wholly owned subsidiaries in India (which are operating under a sector permitted for 100% FDI under automatic route and there is no FDI linked performance conditions) are allowed to convert the pre-incorporation/pre-operative expenses (incurred by foreign holding entity) equivalent to the limit of 5% of the authorized capital or USD 500,000 whichever is less, into equity shares/preference shares/convertible debentures/warrants (“equity instruments”) without the RBI approval. However, the conversion of the expenses into equity instruments and the reporting of the issuance of equity instruments should be done within the prescribed time period from the incorporation.

The term wholly owned subsidiary (“WOS”) is neither defined under FEMA regulations nor under the Companies Act, 2013 (“Act”). However, the term “subsidiary” has been defined under Section 2(87) of the Act which means the company in which the holding company (i) controls the composition of the Board of Directors; or (ii) exercises or controls more than one-half of the total voting power either at its own or together with one or more of its subsidiary companies.

In similar terms, WOS are those companies which are completely controlled by the holding company through 100% share capital/ voting power.

Reimbursement of pre-incorporation expenses:

The reimbursement of the pre-incorporation expenses to foreign entities (other than individuals) by the Indian companies is regulated by ‘Master Direction on Other Remittance Facilities’. As per the provisions, pre-incorporation expenses equivalent to the limit of 5% of the investment brought in India or USD 100,000, whichever is higher, can be reimbursed to the foreign entities without taking approval from the RBI.

While the provision with respect to the conversion of expenses into equity instruments is linked with the authorized capital of the Indian company, the reimbursement of the pre-incorporation expenses can be done basis the investment amount brought in India.

From the above provisions, it may be concluded that while Indian companies are allowed to reimburse pre-incorporation expenses to foreign parties, only WOS are allowed to issue its equity instrument in lieu of its pre-incorporation/pre-operative expenses to the foreign holding company. Therefore, it becomes relevant for Indian companies to appropriately classify the expenses into pre-incorporation and pre-operative expenses, before planning the settlement of the expenses.