Enforcement Directorate Targets Firms Misclassifying Foreign Loans

The Enforcement Directorate (ED) has intensified scrutiny of companies misrepresenting foreign loans as export advances. This crackdown targets firms that have disguised cheaper foreign currency loans, referred to as External Commercial Borrowings (ECB), as advances from overseas buyers. In recent investigations, at least three companies were summoned by the ED to clarify why these claimed inflows were returned within a year.

The ED’s concerns stem from two key observations. First, the funds were sent directly from offshore branches of major foreign banks with a significant presence in India. This raises questions about why these banks would make advance payments for exports to steel traders and other businesses in Kolkata and Delhi without being engaged by any overseas buyers. Second, the money was often remitted back to these foreign banks within one to 18 months, citing reasons such as cancelled export orders due to quality issues or missed delivery deadlines.

Investigators suggest that the peculiar nature of these transactions and the rapid outflows support allegations that these funds originated as short-term, low-cost loans, which would typically violate ECB regulations. According to sources familiar with the situation, the ED is closely examining export transactions to ensure that foreign exchange inflows are not restructured to misrepresent the true nature of these financial dealings.

Moin Ladha, a partner at the law firm Khaitan & Co., emphasized the importance of compliance with ECB regulations. He noted that the minimum average maturity period for ECBs is typically between three to five years and that companies must meet specific end-use requirements, including monthly reporting on fund utilization and obtaining a loan registration number upfront.

Under the automatic route, ECBs are permissible only if the business is eligible for 100% foreign direct investment (FDI). While manufacturing companies may have some flexibility regarding maturity periods, trading or service firms cannot secure one-year ECBs. Such bridge loans are often utilized for acquiring local businesses, as domestic banks usually do not participate in acquisition financing.

Many of the questionable short-maturity ECBs were reportedly used to finance the acquisition of shares. The overarching intention among those manipulating the Foreign Exchange Management Act (FEMA) appears to be to classify capital account transactions, like ECBs, as current account transactions, such as advances for exports. This misclassification allows them to evade the stricter compliance requirements associated with ECBs.

Another tactic employed by some firms involves using trade credits, where a foreign seller of machinery or capital goods allows a buyer in India to make payments over three years. These methods have drawn increasing attention from enforcement authorities, prompting calls for stricter oversight to ensure compliance with international financial regulations.

As investigations continue, it remains critical for companies to adhere strictly to regulatory frameworks, ensuring transparency in their financial transactions and avoiding practices that could lead to severe penalties or legal repercussions.