Foreign Exchange Management Act (FEMA): An overview

By Harish Khan 31 Minutes Read

Introduction

The Foreign Exchange Management Act (FEMA), enacted in 1999, is a key piece of legislation in India aimed at regulating foreign exchange transactions and facilitating a more liberalized economic environment. FEMA was introduced to replace the Foreign Exchange Regulation Act (FERA), reflecting India’s transition towards economic reforms and global integration. This comprehensive article explores FEMA in detail, covering its history, applicability, controlling authorities, salient features, objectives, and the key differences between FEMA and FERA.

When a business enterprise imports goods, exports products, or makes investments abroad, it engages in foreign exchange activities. Foreign exchange encompasses not only ‘foreign currency’ but also includes deposits, credits, and balances payable in any foreign currency. Additionally, it includes drafts, travelers’ cheques, letters of credit, or bills of exchange that are expressed or drawn in Indian currency but payable in any foreign currency, as well as those drawn by banks, institutions, or individuals outside India but payable in Indian currency.

The term ‘foreign exchange’ has been defined under section 2(N) of the Act, to mean foreign currency and includes deposits, credits, balance payable in foreign currency, drafts, travellers’ cheques, letters of credit, bills of exchange expressed or drawn in Indian currency but payable in any foreign currency. Any draft, travellers’ cheque, letters of credit or bills of exchange drawn by banks, institutions or persons outside India but payable in Indian currency has also been included in the definition of foreign exchange.[1]

The management of foreign exchange is crucial for modern business operations. FEMA (Foreign Exchange Management Act) facilitates external trade and payments while promoting the orderly development and maintenance of the foreign exchange market. The Act designates the Reserve Bank of India (RBI) as a key authority in administering FEMA. The RBI, in consultation with the Central Government, establishes the rules, regulations, and norms that govern various sections of the Act.

Foreign Exchange Regulation Act (FERA)

The Foreign Exchange Regulation Act (FERA) was enacted by the Indian Parliament in 1973 and came into effect on January 1, 1974. Its primary goal was to regulate foreign exchange and foreign securities transactions to conserve India’s foreign exchange resources and ensure their effective utilization for the country’s economic development. FERA applied throughout India and extended its jurisdiction to Indian citizens abroad, as well as to the branches and agencies of Indian companies and body corporates located outside India.

FERA established stringent regulations on foreign exchange transactions, controlling both the import and export of currency. Unlike other laws where all actions are permitted unless explicitly prohibited, FERA operated on the principle that nothing was allowed unless specifically permitted. This made the Act notably severe, with provisions for imprisonment even for minor infractions. Under FERA, individuals were presumed guilty until they could prove their innocence, contrasting with the typical legal principle of presumed innocence until proven guilty. Consequently, dealing with foreign exchange under FERA required meticulous compliance with legal requirements.

Over time, it became clear that FERA’s rigid regulations were a barrier to economic liberalization. The Indian government, recognizing the need for more flexible foreign exchange management in the context of economic reforms, drafted the Foreign Exchange Management Bill (FEMA) to replace FERA. The transition aimed to align with the liberalization of the Indian economy.

FERA was officially repealed by FEMA in 1999, which introduced a more liberalized framework for foreign exchange controls and reduced many restrictions on foreign investment. FEMA was implemented on June 1, 2000. To allow the Enforcement Directorate (ED) to conclude investigations into FERA violations detected before May 31, 2000, FERA was given a sunset clause of two years.

History and Development: Origins of FEMA

FEMA was introduced during a period of significant economic transformation in India. The early 1990s marked the beginning of economic liberalization, which included deregulation and opening up to foreign investment. Before FEMA, the Foreign Exchange Regulation Act (FERA), enacted in 1973, governed foreign exchange transactions in India. FERA focused on stringent controls to prevent capital flight and conserve foreign exchange reserves, reflecting the economic priorities of that time.

However, as India’s economy began to open up, the rigid controls of FERA became increasingly incompatible with the new economic environment. The 1991 economic reforms necessitated a shift towards a more flexible and investor-friendly regulatory framework. Consequently, FEMA was enacted in 1999 to align with global practices and support India’s integration into the global economy.

Transition to FEMA

The transition from FERA to FEMA marked a pivotal shift in India’s regulatory approach. FEMA aimed to liberalize and simplify foreign exchange regulations, supporting international trade and investment. Unlike FERA, which was characterized by stringent controls and penalties, FEMA introduced a more facilitative and flexible regulatory framework. The act was designed to balance regulatory oversight with the need to foster economic growth and global integration.

Overview of the Foreign Exchange Management Act (FEMA)

The Foreign Exchange Management Act (FEMA) came into effect on June 1, 2000, replacing the earlier Foreign Exchange Regulation Act (FERA). FEMA was designed to modernize and streamline the regulatory framework for foreign exchange transactions, reflecting India’s shift towards economic liberalization and a more open market economy. Its primary goal is to consolidate and amend existing laws related to foreign exchange, facilitating external trade and payments while promoting the orderly development and maintenance of the foreign exchange market in India.

Objectives of FEMA

FEMA’s enactment aimed to achieve several key objectives:

1. Consolidation and Amendment of Laws: FEMA sought to update and unify the legal framework governing foreign exchange transactions, bringing clarity and coherence to the regulatory environment.

2. Facilitation of External Trade and Payments: One of the central aims of FEMA was to simplify and encourage international trade and financial transactions, thereby integrating India more fully into the global economy.

3. Promotion of Market Development: FEMA was also intended to support the orderly development and maintenance of India’s foreign exchange market, ensuring that it operates efficiently and transparently.

The Act is structured into 49 sections (including sub-sections) and is organized into seven chapters, providing a comprehensive legal framework for foreign exchange management.

Highlights of FEMA 1999

FEMA is characterized by its transparency and flexibility, contrasting sharply with the more restrictive measures of FERA. Key highlights of FEMA include:

1. Regulation of Capital Account Transactions: Under FEMA, only capital account transactions are subject to regulation by the Reserve Bank of India (RBI). This focus on capital account transactions allows for a more controlled approach to managing significant financial flows.

2. Permissibility of Current Account Transactions: Current account transactions, which involve routine business and personal transactions, are generally permitted under FEMA. However, there are specific restrictions and exceptions to this general rule. For instance:

• Remittances Related to Lottery Winnings: Such transactions are prohibited under FEMA.
• Income from Gambling or Hobby Activities: Remittances arising from activities like gambling or other hobbies are subject to restrictions.
• Purchase of Lottery Tickets and Sweepstakes: Payments for these are not allowed.
• Export Commissions and Equity Investments: Payments related to equity investments in foreign joint ventures or wholly-owned subsidiaries of Indian companies require prior permission.
• Dividend Remittances: Companies with dividend balancing requirements must comply with specific regulations.
• Telephone Call-back Services: Payments for call-back services are regulated.
• Interest on Non-Resident Accounts: Remittances of interest income from non-resident accounts are subject to certain restrictions.

Applicability of FEMA

FEMA is applicable across a wide range of foreign exchange transactions and entities, ensuring comprehensive regulation. Key areas of applicability include:

1. Territorial Applicability

FEMA extends to the whole of India. This means that all transactions and regulations outlined under FEMA are applicable to the entire Indian territory, including its states and union territories.

2. Applicability to Overseas Entities

FEMA’s scope includes not only transactions and entities within India but also extends to branches, offices, and agencies located outside India if they are owned or controlled by a person resident in India. The residential status of an individual is crucial for regulating the flow of foreign exchange between individuals of varying residency statuses. Under the Foreign Exchange Management Act (FEMA), 1999, specific limits are set for the transfer or transmission of foreign exchange based on residency.

According to Section 2(v) of FEMA, 1999[2], a “Person Resident in India” includes:

I. Individuals residing in India for over 182 days during the previous financial year, except:

• Those who have left India for employment, business, or other reasons indicating an intention to stay abroad indefinitely.
• Those who have arrived in India for employment, business, or other reasons indicating an intention to stay in India indefinitely.

II. Entities registered or incorporated in India, such as companies.

III. Offices, branches, or agencies in India owned or controlled by individuals or entities residing outside India.

IV. Offices, branches, or agencies outside India owned or controlled by individuals or entities residing in India.

This extension ensures that Indian residents’ foreign operations are also regulated under FEMA. Here’s a breakdown:

Branches, Offices, and Agencies Outside India:

• Ownership or Control: FEMA applies to Indian individuals or entities that own or control branches, offices, or agencies situated outside India. This means that if an Indian resident has a foreign branch or office, the operations and transactions of such branches are subject to FEMA regulations.
• Regulatory Oversight: Indian entities and individuals with overseas operations must ensure compliance with FEMA’s provisions, even if the transactions occur outside Indian borders.

3. Contraventions Committed Outside India

FEMA’s applicability includes contraventions committed outside India by individuals or entities to whom the Act applies. This provision ensures that any violations of FEMA regulations by Indian residents or entities, irrespective of where the contravention occurs, are subject to enforcement and penalties under FEMA. Key aspects include:

• Global Reach: Indian residents and entities are held accountable for their compliance with FEMA even when their activities or violations occur outside India.
• Jurisdiction: Enforcement agencies in India can take action against Indian residents or entities for violations committed abroad, ensuring that the regulations governing foreign exchange transactions are consistently upheld.

4. Emphasis on “Owned or Controlled”

The Act places significant emphasis on the terms “owned or controlled,” which broadens its applicability. It means:

• Ownership: If an Indian resident or entity has ownership of a branch or office abroad, that entity is bound by FEMA regulations.
• Control: Control over a foreign entity or office, even if the ownership is not direct, brings the entity under FEMA’s regulatory scope. Control implies having the power to direct or influence the decisions and operations of the entity, which could be through shareholding, managerial positions, or contractual agreements.

Salient Features of FEMA

FEMA incorporates several key features that define its role in managing foreign exchange transactions. Here’s a detailed look at these features:

1. Investments by Non-Residents in India and Overseas Investments by Indian Residents:

• Foreign Investments in India: Non-residents are allowed to invest in Indian assets, businesses, and securities, subject to regulations set by FEMA. These investments must adhere to the conditions outlined by the Reserve Bank of India (RBI) and other relevant authorities.
• Indian Investments Abroad: Indian residents can make investments outside India, including in foreign securities, real estate, and businesses. These investments are regulated to ensure compliance with FEMA’s provisions and any restrictions imposed by the RBI.

2. Permissible Transactions on Current Account:

Current Account Transactions: Transactions related to the current account, which include trade in goods and services, travel, and other day-to-day transactions, are generally permitted under FEMA. However, they are subject to reasonable restrictions that may be imposed by the RBI or the Central Government to manage the balance of payments and maintain financial stability.

The term “current account transaction” is defined under section 2(J) of the Act as any transaction that is not classified as a capital account transaction. It includes payments related to foreign trade, other current business activities, services, and short-term banking and credit facilities conducted in the normal course of business. It also covers payments for interest on loans, net income from investments, and remittances for the living expenses of parents, spouses, and children residing abroad, as well as expenses related to foreign travel, education, and medical care for the same.[3]

The Act permits the purchase and sale of foreign exchange for current account transactions through authorized persons. However, the Central Government, in consultation with the Reserve Bank, has the authority to impose reasonable restrictions on these transactions.

3. Control over Capital Account Transactions:

Capital Account Transactions: These transactions involve investments and financial flows that affect the country’s capital account, such as borrowing and lending between residents and non-residents, and foreign direct investment. The RBI and Central Government have control over these transactions to ensure that they align with the country’s economic policies and financial regulations.

A ‘capital account transaction’ is defined under sec 2(E) of the Act as any transaction that changes the assets or liabilities, including contingent liabilities, of persons residing in India with respect to their assets or liabilities outside India, or alters the assets or liabilities of persons residing outside India with respect to their assets or liabilities within India.[4] This definition encompasses the transactions outlined in Sub-section (3) of Section 6 of the Act.[5]

4. Requirement for Realization of Export Proceeds and Repatriation:

Export Proceeds: Exporters are required to realize and repatriate export proceeds to India. This means that payments received for exports must be brought into India and converted into Indian currency as per the regulations. This requirement helps in managing the country’s foreign exchange reserves and ensuring that funds generated from exports are available for domestic use.

5. Dealing in Foreign Exchange through ‘Authorized Persons’:

Authorized Persons: Transactions involving foreign exchange must be conducted through entities recognized as authorized persons, such as Authorized Dealers, Money Changers, and Offshore Banking Units. These entities are authorized by the RBI to handle foreign exchange transactions and ensure compliance with FEMA regulations.

6. Adjudication and Compounding of Offenses:

• Adjudication: The process of adjudication involves determining the liability for violations of FEMA regulations. The adjudicating authority assesses the nature and extent of the violation and imposes penalties or other corrective measures.
• Compounding: Compounding refers to the settlement of offenses by paying a monetary penalty instead of facing criminal prosecution. FEMA allows for the compounding of offenses to provide a means of resolving violations without lengthy legal proceedings.

7. Investigation of Offenses by Directorate of Enforcement:

Directorate of Enforcement: This agency is responsible for investigating offenses under FEMA, including violations related to foreign exchange transactions. The Directorate has the authority to conduct searches, seizures, and gather evidence to enforce compliance with FEMA regulations.

8. Appeal Provisions:

• Special Director (Appeals): Appeals against the orders of adjudicating authorities can be made to the Special Director (Appeals). This provision allows individuals and entities to challenge decisions and seek a review of adjudication orders.
• Appellate Tribunal: Further appeals against the decisions of the Special Director (Appeals) can be made to the Appellate Tribunal. This tribunal provides an additional layer of judicial review and ensures that decisions are fair and in accordance with FEMA’s provisions.

Similarities between FERA and FEMA

The similarities between FERA and FEMA include:

• Regulatory Bodies: Both FERA and FEMA maintained the Reserve Bank of India (RBI) and the Central Government as the primary regulatory authorities overseeing foreign exchange transactions.
• Extraterritorial Jurisdiction: FEMA retained the principle of extraterritorial jurisdiction that was established under FERA, allowing for the regulation of foreign exchange activities beyond India’s borders.
• Enforcement Agency: The Directorate of Enforcement continued to be responsible for enforcing the provisions of the law, including conducting searches and seizures, under both FERA and FEMA.

Difference Between FEMA and FERA

The Foreign Exchange Regulation Act (FERA) and the Foreign Exchange Management Act (FEMA) represent different approaches to regulating foreign exchange transactions. Here’s a detailed comparison:

BASIS FOR COMPARISON	FERA	FEMA
PROVISIONS	FERA comprised 81 sections and was notably more complex in its structure.	FEMA is much simpler compared to FERA, consisting of only 49 sections.
FEATURES	FERA included provisions for the presumption of negative intention (mens rea) and for holding individuals accountable for abetment or aiding in the commission of an offense.	FEMA excludes the presumptions of mens rea (criminal intent) and abatement (aiding in the commission of an offense) that were present under FERA.
NEW TERMS IN FEMA	FERA did not provide definitions for terms such as Capital Account Transaction, Current Account Transaction, Person, and Service.	FEMA provides detailed definitions for terms such as Capital Account Transaction, Current Account Transaction, Person, Service, and others, offering greater clarity compared to its predecessor, FERA.
DEFINITION OF AUTHORIZED PERSON	In FERA, the definition of “Authorized Person” was narrow under Section 2(b).	The definition of “Authorized Person” under FEMA has been expanded to include banks, money changers, offshore banking units, and other similar entities.
MEANING OF “RESIDENT” AS COMPARED WITH INCOME TAX ACT	The definition of “Resident” under FERA differed significantly from the definition used in the Income Tax Act.	The provisions of FEMA are now consistent with the Income Tax Act regarding the definition of the term “Resident.” FEMA has adopted the criteria of “In India for 182 days” to determine residency status. As a result, an individual classified as a non-resident under the Income Tax Act, 1961 will also be considered a non-resident for FEMA purposes. However, an individual deemed a non-resident under FEMA may not necessarily be classified as a non-resident under the Income Tax Act.
PUNISHMENT	Under FERA, any offense if classified as a criminal offense was subjected to imprisonment as per the provisions of the Code of Criminal Procedure, 1973.	Under FEMA, the offense is treated as a civil offense, punishable primarily by a monetary penalty. Imprisonment is prescribed only if an individual fails to pay the imposed penalty.
QUANTUM OF PENALTY	Under FERA, the monetary penalty imposed could be as high as five times the amount involved in the offense.	Under FEMA, the quantum of penalty has been significantly reduced to three times the amount involved in the offense.
APPEAL	An appeal against the order of the “Adjudicating Officer” under FERA was taken to the Foreign Exchange Regulation Appellate Board and could subsequently be reviewed by the High Court.	Appeals against the orders of the Adjudicating Authority and the Special Director under FEMA are first heard by the Appellate Tribunal and can subsequently be reviewed by the High Court.
RIGHT OF ASSISTANCE DURING LEGAL PROCEEDINGS	FERA did not include any explicit provisions allowing defaulters to seek legal assistance.	FEMA expressly recognizes the right of an appellant to seek assistance from a legal practitioner or a chartered accountant.
POWER OF SEARCH AND SEIZE	FERA granted broad powers to a police officer of at least the rank of Deputy Superintendent of Police to conduct searches.	Under FEMA, the scope and power of search and seizure were significantly curtailed and were confined to officers of the Enforcement Directorate.
COMPOUNDING OF OFFENCES	FERA did not allow for the compounding of offenses.	FEMA permits the compounding of offenses, allowing for the settlement of violations through financial penalties rather than criminal prosecution.
TRANSACTIONS	Under FERA, all foreign exchange dealings required prior permission from either the Reserve Bank of India (RBI) or the Central Government.	FEMA allowed current account transactions to proceed without requiring prior permission, while certain capital account transactions still needed special authorization from the Reserve Bank of India (RBI).

Regulation and Management of Foreign Exchange: Section 3

Under Section 3 of FEMA, no person is permitted to engage in the following activities without special authorization from the Reserve Bank of India (RBI):[6]

(a) Dealing in or Transferring Foreign Exchange or Foreign Securities: Engaging in transactions involving foreign exchange or foreign securities with any individual who is not an authorized person.

(b) Making Payments to Non-Residents: Making any payment to or for the credit of any person resident outside India in any manner.

(c) Receiving Payments from Non-Residents: Receiving payments otherwise than through an authorized person, by order or on behalf of any person resident outside India.

(d) Entering into Financial Transactions Related to Assets Outside India: Entering into any financial transaction within India as consideration for or in association with the acquisition, creation, or transfer of a right to acquire any asset outside India by any person.

Adjudicating Authority: Section 2(A)

Definition and Appointment: According to Section 2(a) of FEMA, the term ‘Adjudicating Authority’ refers to an officer designated to handle adjudication related to penalties under Section 13 of the Act. The Central Government has the power under Section 16 to appoint these officers. Such appointments are made through an official order published in the Official Gazette. These appointed officers are responsible for conducting inquiries and making decisions, ensuring that individuals alleged to have committed violations are given an opportunity to present their case.[7]

Appellate Tribunal: Section 2(B)

Function and Jurisdiction: The ‘Appellate Tribunal’ is defined as the Appellate Tribunal for Foreign Exchange, established to hear appeals against orders issued by adjudicating authorities and Special Directors (Appeals) under FEMA. The Tribunal provides a mechanism for reviewing decisions made by these authorities, ensuring that there is an opportunity for redress and proper legal recourse.[8]

Authorized Person: Section 2(C)

Role and Delegation: The Reserve Bank of India (RBI) is tasked with regulating foreign exchange transactions but cannot handle all transactions directly. Therefore, it delegates certain powers to ‘Authorized Persons,’ who are given the authority to deal in foreign exchange and foreign securities according to specific guidelines. Section 3 of FEMA mandates that all foreign exchange dealings must be conducted through Authorized Persons.[9]

Definition: Under Section 2(c) of FEMA, an ‘Authorized Person’ includes Authorized Dealers, Money Changers, Offshore Banking Units, and any other entity authorized under Section 10(1) to handle foreign exchange or foreign securities.[10]

Authorization: Section 10(1) grants the RBI the authority to designate individuals or entities as Authorized Persons. These entities are responsible for managing foreign exchange transactions in compliance with FEMA regulations.[11]

Categories of Authorized Persons

1. Authorized Dealers:

• Category I: Includes entities like commercial banks, State Cooperative Banks, and Urban Cooperative Banks, which can handle both current and capital account transactions.
• Category II: Consists of Full-Fledged Money Changers (FFMC) with a minimum net owned fund of INR 10 crore and a minimum operational period of 2 years. Regional Rural Banks (RRBs) can handle non-trade related current account transactions.
• Category III: Encompasses transactions incidental to foreign exchange activities undertaken by selected financial institutions and other authorized entities.

2. Authorized Money Changers (AMCs):

• Definition: Entities authorized by the RBI under Section 10 of FEMA to deal in foreign exchange for specific purposes.
• Functions: Includes issuing and encashing foreign currency travelers’ cheques and currency notes.

Duties and Responsibilities of Authorized Persons

• Adherence to RBI Directions: Authorized Persons must comply with directives issued by the RBI as stipulated under Section 10(4).[12]
• Periodic Returns: They are required to submit periodic returns or statements as mandated by the RBI.
• Declarations: Obligated to make necessary declarations as per Section 10(5).[13]
• Records Maintenance: Required to maintain and produce books of accounts and documents as per Section 12(2), ensuring transparency and accountability in their transactions.[14]

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[1] The Foreign Exchange Management Act, 1999, s. 2(N).

[2] Id., at s. 2(v).

[3] Id., at s. 2(J).

[4] Id., at s. 2(E).

[5] Id., at s. 6(3).

[6] Id., at s. 3.

[7] Id., at s. 2(A).

[8] Id., at s. 2(B).

[9] Id., at s. 3.

[10] Id., at s. 2(C).

[11] Id., at s. 10(1).

[12] Id., at s. 10(4).

[13] Id., at s. 10(5).

[14] Id., at s. 12(2).