Deferred Consideration in FEMA: How to Structure Staggered Payments

Why Deferred Consideration Matters in Cross-Border Indian Deals

Under Rule 9(6) of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 — commonly called the "18/25 Rule" — no more than 25% of the total consideration in a cross-border share transfer involving an Indian company can be deferred, and that deferred portion must be paid within 18 months of the transfer agreement. The remaining 75% or more must be paid at or before closing, with no flexibility to exceed either limit under the automatic route.

However, India's Foreign Exchange Management Act (FEMA) and the Foreign Direct Investment (FDI) framework impose specific constraints on how and how much consideration can be deferred. These rules apply whenever shares of an Indian company are transferred between a person resident in India and a person resident outside India — covering both inbound and outbound transactions.

Understanding these constraints is essential because a payment structure that violates FEMA's deferred consideration rules exposes the parties to RBI enforcement action and penalties of up to three times the amount involved under section 13 of FEMA, and typically has to be regularised through compounding or unwinding of the arrangement.

The 18/25 Rule: FEMA's Core Framework

The foundational rule governing deferred consideration in cross-border share transfers is contained in Rule 9(6) of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules). This provision, commonly referred to as the "18/25 Rule," establishes two hard limits:

• Amount cap: No more than 25% of the total consideration may be deferred
• Time cap: The deferral period cannot exceed 18 months from the date of the transfer agreement

The remaining 75% or more must be paid at or before closing. There is no flexibility to exceed either limit under the automatic route — any deviation requires prior RBI approval, which is rarely granted for standard commercial transactions.

What Counts as "Total Consideration"

The total consideration for purposes of the 25% cap includes all forms of payment — cash, share swap value (at fair market value), and any other financial instruments used as consideration. It does not include non-compete payments or consulting fees structured as separate agreements, though the RBI may look through such arrangements if they appear designed to circumvent the 25% cap.

When the Clock Starts

The 18-month period runs from the date of the transfer agreement (i.e., the share purchase agreement or SPA), not from the date of closing or the date of actual share transfer. This distinction is critical because in complex cross-border deals, the gap between SPA execution and closing can be 3-6 months due to regulatory approvals (CCI, SEBI, RBI). If the SPA is signed in January but closing occurs in June, the buyer has only 12 months remaining for the deferred payment — not 18.

Three Permitted Payment Mechanisms Under Rule 9(6)

Rule 9(6) of the NDI Rules permits three specific mechanisms for structuring the deferred portion of the consideration. Each serves a different commercial purpose. The deferred-payment and escrow routes are variants of the same 25%/18-month deferral window, while the indemnity route applies where 100% of the consideration is paid upfront — the caps cannot be stacked across mechanisms to exceed 25% in aggregate.

Mechanism 1: Deferred Payment

The buyer pays up to 25% of the consideration on a deferred basis — meaning the payment is held back and released upon satisfaction of specified conditions or simply at the end of the deferral period. This is the simplest structure and is typically used when:

• The buyer wants a straightforward holdback against warranty and representation breaches
• The parties have agreed on specific milestones or performance targets
• The deal involves purchase price adjustment mechanisms (working capital adjustments, net debt adjustments)

The deferred amount must be paid in full within 18 months. Partial releases during the deferral period are permitted (e.g., 10% at 6 months, remaining 15% at 12 months), provided the full 25% is settled within the 18-month window.

Mechanism 2: Escrow Arrangement

The buyer deposits up to 25% of the consideration into an escrow account held by a third-party escrow agent (typically a bank). The escrow amount is released to the seller upon satisfaction of agreed conditions, or returned to the buyer (in whole or part) if indemnity claims are validated.

Key requirements for FEMA-compliant escrow arrangements:

• The escrow account must be opened with an Authorized Dealer (AD) bank in India
• The escrow agreement must be captured in or referenced by the share purchase agreement
• The escrow amount cannot exceed 25% of total consideration
• The escrow period cannot exceed 18 months from the SPA date
• The escrow must be closed out within the 18-month window — amounts due to the seller released and any agreed refunds returned to the buyer; it cannot be extended under the automatic route

Mechanism 3: Indemnity by Seller

If the buyer pays 100% of the consideration upfront, the seller may furnish an indemnity for an amount not exceeding 25% of the total consideration for a period not exceeding 18 months from the date of full payment. This structure is used when the seller wants immediate liquidity but the buyer wants downside protection.

The indemnity can be backed by:

• A bank guarantee from the seller's bank
• A corporate guarantee from the seller's parent company
• Warranty and Indemnity (W&I) insurance — increasingly common in India deals since 2023

The critical point: in an indemnity structure, the full consideration is paid at closing. The 25% cap applies to the maximum indemnity exposure, not to a payment holdback.

Pricing Compliance: The Hidden Constraint

Deferred consideration does not exempt the transaction from FEMA's pricing guidelines. Under the NDI Rules, the total consideration — including the deferred portion — must comply with the applicable valuation norms:

This means the total deferred consideration, when finally paid, must result in a per-share price that is at or above the fair value floor (for outbound sales) or at or below the fair value ceiling (for inbound purchases). A FEMA-compliant valuation report from a SEBI-registered merchant banker or a chartered accountant is required at the time of the SPA, setting the benchmark price.

Purchase Price Adjustments and FEMA

Purchase price adjustment (PPA) mechanisms — such as working capital adjustments, net debt adjustments, or earn-out payments — add complexity to pricing compliance. The final adjusted price must still fall within the FEMA pricing floor/ceiling. If a downward PPA takes the per-share price below the fair value floor, the transaction may violate FEMA pricing guidelines even if the parties commercially agreed to the adjustment.

Practical solution: build a pricing buffer into the base consideration so that even after maximum downward PPA, the per-share price remains above the FEMA floor.

Earnout Structures: The Regulatory Grey Area

Earnout payments — where additional consideration is paid based on the target company's future performance — are common in global M&A but create significant FEMA challenges. The core issue: earnout payments are, by nature, deferred consideration. If the earnout amount plus any other deferred consideration exceeds 25% of total consideration, the structure violates the 18/25 Rule.

Structuring Earnouts Within FEMA Limits

• Cap the earnout at 25% minus any other holdback: If the escrow holdback is 10%, the maximum earnout is 15% of total consideration
• Set the earnout period within 18 months: Earnout periods of 2-3 years (common globally) are not FEMA-compliant under the automatic route
• Define total consideration as base + maximum earnout: By including the maximum possible earnout in "total consideration," the 25% cap is calculated on a larger base, providing more headroom
• Seek RBI approval for longer/larger earnouts: For transformative M&A transactions, parties may apply to the RBI for a relaxation of the 18/25 Rule, though approval timelines of 3-6 months are common

January 2025 RBI Update: Downstream Investment Clarification

On January 20, 2025, the RBI updated its Master Direction on Foreign Investment in India and inserted a Note in the preamble to paragraph 9 (Downstream Investment). Before that update there was no such Note, and it was unclear whether Foreign-Owned or Controlled Companies (FOCCs) — i.e., Indian companies that are themselves controlled by foreign investors — could use the payment mechanisms of Rule 9(6) when making downstream investments in other Indian companies.

The Note records that, on the guiding principle of downstream investment, the arrangements available for direct investment under the NDI Rules — investment by way of swap of equity instruments or equity capital, and the "payment arrangements/mechanism as per Rule 9(6) of the Rules" — "shall also be available for the purpose of downstream investment", provided the transaction does not circumvent Rule 23 of the NDI Rules, including the restrictions on use of borrowed funds for downstream investment. That proviso is not decorative; it is the operative limit on the concession, and it is set out below.

A drafting point worth knowing before you read the source: the Master Direction never uses the abbreviation "FOCC". The Note speaks of downstream investment generally — investment by an Indian entity or an investment vehicle into another Indian entity that is treated as indirect foreign investment for the investee. "FOCC" is market shorthand for the entity making that investment, not a defined term in the Rules.

Practical Impact — and Its Limits

Before January 2025, many advisors structured FOCC downstream acquisitions conservatively, requiring full upfront payment to avoid regulatory risk. The Note opens up the following, on Rule 9(6) terms:

• Up to 25% of the consideration in a downstream acquisition can be held back on a deferred basis and settled within 18 months of the transfer agreement
• The escrow route is available as an arrangement — subject to the caveat on the escrow account below
• An indemnity by the seller can be used in an Indian-to-Indian share transfer where the buyer is an FOCC
• Swap of equity instruments or equity capital travels across on the same footing — the Note names it alongside the Rule 9(6) mechanisms

Three limits sit on top of that, and each of them bites:

• The Rule 23 proviso. The Note applies only where the transaction does not circumvent Rule 23 of the NDI Rules, expressly including the restrictions on the use of borrowed funds. Paragraph 9.3.6 of the Master Direction requires the Indian entity making a downstream investment that is treated as indirect foreign investment for the investee to bring in the requisite funds from abroad and not to use funds borrowed in the domestic markets. A deferred consideration structure funded or serviced out of domestic rupee borrowing is outside the concession.
• No FEMA escrow account. Paragraph 7.10.1 of the Master Direction permits a person resident outside India to open an escrow account in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016. A downstream acquisition is a transfer between two residents, so no party to it can open that account. The Note makes the escrow arrangement available; it does not create a FEMA escrow account for a domestic buyer, and in practice the escrow is an ordinary domestic one.
• Different reporting. Because the transfer is resident-to-resident, FC-TRS is not the form. The Master Direction on Reporting under FEMA, 1999 requires an Indian entity or investment vehicle making a downstream investment that is treated as indirect foreign investment to file Form DI with the Reserve Bank within 30 days from the date of allotment of equity instruments. That trigger is worded for allotment rather than for a secondary transfer, and the Reporting Master Direction prescribes no per-tranche Form DI obligation for deferred downstream consideration — do not assume one exists. Settle the mechanics with the AD bank.

This is particularly relevant for conglomerate structures where a Singapore holding company owns an Indian holding company (FOCC), which in turn acquires subsidiaries across India.

LLPs: A Regulatory Gap

While FEMA permits deferred consideration for transfers of equity shares in companies, the same flexibility does not extend to Limited Liability Partnerships (LLPs). The NDI Rules do not provide an equivalent of Rule 9(6) for transfers of LLP interest involving foreign partners.

This creates a practical problem: foreign investors acquiring or exiting LLP interests must pay/receive the full consideration at closing. No escrow, no holdback, no indemnity mechanism is available under the automatic route. Parties seeking deferred consideration in LLP transactions must apply for prior RBI approval on a case-by-case basis — a process with uncertain timelines and outcomes.

For this reason, deal advisors often recommend converting an LLP to a private limited company before undertaking a cross-border transaction, to access the more flexible FEMA framework available for companies.

Tax Implications of Deferred Consideration

Deferred consideration has direct income tax consequences for both the buyer and seller in cross-border Indian transactions.

Capital Gains Tax on the Seller

When a non-resident seller transfers shares of an Indian company, the transaction is subject to capital gains tax in India. The tax liability arises in the year of transfer (when the SPA is executed and shares are transferred), not when the deferred consideration is actually received. This means:

• The seller's capital gains are computed on the full consideration (including the deferred portion) in the year of transfer
• The buyer is required to withhold tax under section 393(2) of the Income-tax Act, 2025 (Table, Sl. No. 17; section 195 of the Income-tax Act, 1961) on the total consideration at the time of payment
• If the deferred consideration is paid in a subsequent financial year, the buyer must withhold tax at that time, potentially at a different rate if tax treaty benefits apply

Forms 145 and 146 (formerly Forms 15CA and 15CB) Requirements

Every payment of deferred consideration to a non-resident triggers the Form 145 filing requirement; Form 146 is additionally required where the taxable remittance exceeds INR 5 lakh and no assessing-officer certificate is held — which covers most deal payments. Form 146 (chartered accountant's certificate) must certify the applicable withholding tax rate, DTAA benefits claimed, and the nature of the remittance. Form 145 (online declaration) must be filed before the AD bank processes the outward remittance.

Interest on Deferred Payments

If the SPA provides for interest on the deferred consideration (compensation for time value of money), the interest component is treated as income in the hands of the seller and may attract additional withholding tax. The interest rate should be at arm's length to avoid transfer pricing scrutiny if the buyer and seller are related parties.

Reporting and Documentation Requirements

Every cross-border share transfer involving deferred consideration triggers specific FEMA reporting obligations.

FC-TRS Filing — One Per Tranche

The FC-TRS form (Foreign Currency Transfer of Shares) must be filed with the AD bank within 60 days of the transfer of the equity instruments or of the receipt/remittance of funds, whichever is earlier. It must disclose the total consideration, the deferred component, the escrow/indemnity arrangement, and the timeline for deferred payments.

A deferred-payment transfer is not covered by a single upfront filing. The Master Direction on Reporting under FEMA, 1999 provides that a transfer of equity instruments prescribed in Rule 9(6) of the NDI Rules — payment on a deferred basis — shall be reported in Form FC-TRS to the AD bank on receipt of every tranche of payment, and puts the onus of reporting on the resident transferor or transferee. Each tranche therefore carries its own FC-TRS, within its own 60-day window.

Do not import the opposite rule that governs the outbound side. The Reporting Master Direction's "two submissions" treatment of deferred consideration — the deferred part reported as a non-fund-based commitment and later reported again on conversion to equity capital — sits in Form FC under the Overseas Investment framework, and does not apply to inbound FC-TRS.

Where the buyer is an Indian entity making a downstream investment, FC-TRS is not the form at all: the transfer is resident-to-resident and the reporting is in Form DI, as set out in the January 2025 section above.

SPA Documentation Requirements

The January 2025 RBI update also added a Note to paragraph 7.9.1 of the Master Direction: a transaction intended to be undertaken using any of those arrangements "shall require the share purchase/transfer agreement to contain the respective clause and related conditions for such arrangement". In practice this means:

• The SPA must specify the total consideration and the deferred component
• The conditions for release of deferred consideration must be clearly documented
• The escrow terms (if applicable) must be referenced in or annexed to the SPA
• The indemnity terms must be set out in the SPA or a separate indemnity agreement referenced in the SPA

Oral or informal deferral arrangements — common in domestic transactions — are not FEMA-compliant and will be flagged during RBI audits.

Common Structuring Mistakes

Based on advisory experience across cross-border Indian deals, these are the most common errors in deferred consideration structuring:

1. Exceeding the 25% cap by combining escrow and earnout: Parties sometimes set up a 15% escrow and a 15% earnout without realizing these are both forms of deferred consideration subject to the aggregate 25% cap
2. Starting the 18-month clock from closing instead of SPA: The NDI Rules specify the transfer agreement date, not the closing date. This error can leave insufficient time for earnout measurement periods
3. Failing to update the valuation at payment: If the fair value has changed significantly between SPA and deferred payment, the per-share price may fall outside the FEMA pricing corridor. A fresh valuation should be obtained if there is a material change
4. Using deferred consideration structures for LLP transactions: The 18/25 Rule applies only to company share transfers, not LLP interest transfers. Attempting to defer LLP consideration without RBI approval is a FEMA violation
5. Not capturing the arrangement in the SPA: Post-January 2025, the RBI expects all deferred consideration terms to be documented in the principal transaction agreement. Side letters or undocumented arrangements are non-compliant

Warranty & Indemnity Insurance as an Alternative

Given the constraints of the 18/25 Rule, Warranty & Indemnity (W&I) insurance has emerged as an increasingly popular alternative in Indian cross-border deals. Under a W&I policy:

• The buyer (or seller) purchases an insurance policy covering warranty and representation breaches
• The insurer pays the claim directly, eliminating the need for escrow holdbacks
• The full consideration can be paid at closing, with insurance providing the downside protection
• Policy periods can extend beyond 18 months (typically 3-7 years), providing longer coverage than FEMA's escrow/indemnity window

Coverage is available from global insurers operating in India, with premiums quoted as a percentage of the policy limit, and W&I insurance is increasingly common practice in larger Indian deals.

Key Takeaways

• The 18/25 Rule is non-negotiable under the automatic route: Maximum 25% deferred, maximum 18 months from SPA date. Both limits are hard caps with no exceptions without prior RBI approval.
• Three mechanisms are available — deferred payment, escrow, or indemnity: Each serves different commercial purposes but all are subject to the same 25%/18-month limits. They cannot be combined to exceed 25% in aggregate.
• January 2025 RBI update extends these mechanisms to downstream investment: The Note added to the preamble to paragraph 9 of the Master Direction on January 20, 2025 makes the Rule 9(6) payment arrangements available for downstream investment, so a foreign-owned Indian company can use them when acquiring shares in another Indian company — provided the transaction does not circumvent Rule 23, including the bar on domestically borrowed funds. The escrow account of paragraph 7.10.1 stays with non-residents, and the reporting is in Form DI, not FC-TRS.
• Pricing compliance survives deferral: The total consideration (including deferred amounts) must comply with FEMA's fair value pricing guidelines. Build in pricing buffers to accommodate purchase price adjustments.
• Consider W&I insurance for larger deals: Insurance provides longer protection than the 18-month FEMA window and eliminates the need for escrow holdbacks, giving sellers immediate full payment.