LEGAL REGIMES GOVERNING FOREIGN DIRECT INVESTMENT (FDI) IN HOST COUNTRIES

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1 LEGAL REGIMES GOVERNING FOREIGN DIRECT INVESTMENT (FDI) IN HOST COUNTRIES SRIJANEE BHATTACHARYYA SLAUGHTER AND MAY Type: Published: Last Updated: Keywords: Legal Guide November 2012 November 2012 Foreign Direct Investment, FDI, governance.

2 This document provides general information and comments on the subject matter covered and is not a comprehensive treatment of the subject. It is not intended to provide legal advice. With respect to the subject matter, viewers should not rely on this information, but seek specific legal advice before taking any legal action Any opinions expressed in this document are those of the author and do not necessarily reflect the position and/or opinions of A4ID Advocates for International Development 2012

3 Introduction Foreign investment can be generally understood as the transfer of capital to a country, commonly referred to as the host country, by a non-resident entity. FDI is one form of foreign investment characterised by a certain degree of influence and control over assets in the host country. It is distinguished from the provision of cross-border bank loans and portfolio investment (where there is no active involvement in the management of the enterprise, for example, shareholdings in the host country s companies through managed funds). There is however no detailed, authoritative and universal legal definition of what constitutes direct investment. The test for the existence of a sufficient degree of control and influence varies in scope depending on applicable law in a particular jurisdiction and some jurisdictions do not make distinctions between different forms of foreign investment. Therefore, when dealing with a particular legal regime governing FDI, it is important to check how FDI is defined. The Organisation for Economic Co-operation and Development (OECD) has recognised the need to agree a standardised definition of FDI for the purposes of compiling statistics and has produced its own Benchmark Definition of FDI 1 to which the International Monetary Fund (IMF) refers in its Balance of Payments Manual 2. The OECD s Benchmark Definition states that a key characteristic of FDI is the presence of a lasting interest in an enterprise, consisting of a long-term relationship and a significant degree of influence, and considers ownership of at least 10% of the voting power to be evidence of such influence. Methods of making FDI Common ways of making FDI into a country are through: the creation of a new subsidiary and/or manufacturing base in the host country (often referred to as greenfield FDI ); mergers and the acquisition of existing businesses in the host country; participation in joint ventures; or re-investment of profits into projects in the host country. Advantages and disadvantages of FDI for the host country Studies conducted on the impact of FDI on a host country show that it can have both positive and negative effects depending on factors such as its purpose, quantity, source, 1 OECD Benchmark Definition of Foreign Direct Investment, Fourth Edition, f 2 Balance of Payments and International Investment Position Manual, Sixth Edition

4 4 target and the policy environment 3. An increase in FDI may be associated with improved economic growth due to the influx of capital and increased tax revenues for the host country. Host countries often try to channel FDI investment into new infrastructure and other projects to boost development. Greater competition from new companies can lead to productivity gains and greater efficiency in the host country and it has been suggested that the application of a foreign entity s policies to a domestic subsidiary may improve corporate governance standards. Furthermore, foreign investment can result in the transfer of soft skills through training and job creation, the availability of more advanced technology for the domestic market and access to research and development resources 4. The local population may be able to benefit from the employment opportunities created by new businesses. However, there has been concern over the environmental impact of unregulated FDI and the depletion of natural resources, for example, the overconsumption of water by largescale commercial projects. Host countries can also cede control of vital industries to foreign investors unless protective measures are in place. Although FDI is generally seen as a longer-term investment there are fears over the risk of volatility that comes from liberalising domestic industries and the increased exposure to global markets. Local businesses may suffer due to the pressure exerted by larger multinational competitors with significant competitive advantages. Legal and regulatory factors affecting FDI in host countries Law and regulation can be key determinants of the quantity and quality of FDI received and legal regimes governing FDI can incentivise and encourage beneficial FDI, whilst preventing or at least minimising damage to the national economy and resources 5. Generally, these legal regimes are made up of a number of components, including: 3 Magnus Blomström and Ari Kokko, The Impact of Foreign Investment on Host Countries: A Review of the Empirical Evidence (1997) World Bank Policy Research Working Paper /additional/ _ pdf; Foreign Direct Investment for Development: Maximising Benefits, Minimising Costs (2002) OECD Robert E. Lipsey, Home and Host Country Effects of FDI (2002) NBER Working Paper No Foreign direct investment, the transfer and diffusion of technology, and sustainable development (2010) UNCTAD Angathevar Baskaran & Mammo Muchie, Foreign Direct Investment and Internationalization of R&D: The Case of BRICS Economics (2008) Diiper Research Series Working Paper No. 7 Moses M. Ikiar, Foreign Direct Investment (FDI), Technology Transfer, and Poverty Alleviation: Africa s Hopes and Dilemma (2003) ATPS Special Paper Series No Jean-Yves P. Steyt, "Comparative Foreign Direct Investment Law: Determinants of the Legal Framework and the Level of Openness and Attractiveness of Host Economies" (2006). LL.M. Graduate Research Papers. Paper 1

5 5 regional free trade agreements; multilateral and bilateral investment treaties; specific investment legislation and regulations; and elements of domestic commercial, antitrust, intellectual property, tax, labour and environmental laws. Common features of legal frameworks Key characteristics of legal regimes governing FDI include: Incentives to invest Many countries have introduced fiscal incentives such as tax holidays, reductions in employer contributions, allowances for skills training and waivers or rebates on corporation and export taxes. Host countries have also provided loan guarantees and subsidies to encourage investment. In areas where development is particularly needed, certain states have created special enterprise zones. For example, in the Philippines various special economic zones dealing with particular investment priority areas such as information technology services and agro-industrial manufacturing have been created and are regulated by the Philippine Economic Zone Authority. In such a zone, a registered export manufacturing enterprise could be eligible for an income tax holiday of between 3-6 years depending on the type of project it is undertaking. On expiry of the tax break, the rules grant such enterprises an exemption for all national and local taxes, only requiring them to pay a 5% special tax on their gross income 6. Investor protection measures Typically FDI regimes contain provisions prohibiting differential treatment of foreign investors, limiting the circumstances in which expropriation of foreign assets is permitted and protecting foreign investors rights to property. It is common for host countries to be obliged under these rules to provide fair compensation when expropriation takes place. For example, Uganda has enacted the Investment Code Act Part V of this Act deals with the protection of foreign investments and section 27 states that compulsory acquisition of any of the investor s interests or rights in an enterprise licensed under the legislation or its property must be in compliance with the Ugandan constitution and the fair market value of the interest or right must be paid in compensation. The Act also requires the compensation to be freely transferable it is explicitly exempted from the Ugandan Exchange Control Act s 6 A summary of the fiscal incentives available in these special economic zones can be found here: A summary of the non-fiscal incentives available in these special economic zones can be found here:

6 6 restrictions 7. In addition, alternative dispute resolution procedures are important for foreign investors to ensure independent adjudication where disputes arise. Agreements often oblige parties to undertake arbitration at the International Centre for the Settlement of Investment Disputes to resolve their disputes. Protective measures, approval criteria and notification requirements Host countries are keen on retaining control of strategic industries. Their FDI regimes often reflect this by prohibiting investments in key protected industries and placing limits on the extent of foreign ownership of certain sectors. Requirements to obtain prior approval from or notify government, regulatory or other public authorities are common. For example, the Indian FDI regime works on a tiered system. FDI is not permitted in prohibited sectors such as lotteries, gambling and betting, atomic energy and railways. Other sensitive industries have a cap on foreign ownership and/or are subject to the investment receiving government approval (for example, FDI in print media in India requires government approval and there is a 26% limit on investment 8 ). These categories of restricted and prohibited activities are not fixed and there has been a gradual liberalisation of the FDI policy in India notably in the retail sector where earlier this year the Indian government approved reforms allowing foreign investors to own up to 100% of single-brand businesses 9 and more recently cleared plans to allow foreign businesses to buy an equity stake of up to 51% in multi-brand retail businesses 10. Compliance with free trade agreements The extent to which legislative tools can be used to control FDI can be limited by free trade agreements and trade liberalisation measures. One example of this is the WTO s Agreement on Trade Related Investment Measures which prevents its members from discriminating against foreign products in favour of domestic goods through policies such as local content requirements 11. Similarly, the inclusion of most favoured nation clauses in investment treaties and agreements require host countries to treat all foreign investors from states designated as most favoured nations identically. These rules may be used to stop host countries from applying export restrictions or local employment conditions targeted at foreign investment alone. 7 The Investment Code Act Investment Policy Review Uganda (2000) UNCTAD 8 Consolidated FDI Policy, effective from 10 April 2012, Department of Industrial Policy and Promotion, Ministry of Commerce and Industry

7 7 Conclusion As the importance of FDI to the global economy increases, there is a growing need for stable and well-tailored FDI regimes that promote national well-being and sustainability. Using the normative power of the law is one way to achieve this. Although this guide aims to provide a general introduction to FDI regimes in host countries, in practice, legal regimes regulating FDI are today characterised primarily by their heterogeneity. Whilst the search for a universal definition of FDI and a unified regulatory regime continues, it is important to check carefully the current state of the law in the jurisdiction concerned. This might involve looking at documents that the country has produced specifically for investors, or seeking legal advice as appropriate. One advantage of this constant development and increasing legalisation of FDI frameworks is that it provides opportunities for a wide range of stakeholders to influence policy in this area at both the international and national level. Individuals as well as organisations such as NGOs and trade associations can, through activities such as lobbying law-makers, participating in consultations on draft bills and contributing to impact assessments, shape not just the direction but the technical aspects of the rules governing permitted FDI in their respective countries.

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