Externalisation: Many Indian Startups are Choosing to have their Holding Entity Outside India

Indian companies have been facing issues in doing business, without any ease. Compliances have become complex and are becoming harder to meet all the compliances though there is full intent in complying with the various laws. While foreign direct investment has been eased, obtaining the registration number for such investment by Reserve Bank of India (RBI) takes quite some time, even though all these filings are now online. Without these registration number, the secondary sale of shares is difficult. Investment by early-stage resident Indian angels is subject to issues of valuation by merchant banker, with prior approval for the proposed investment by the Inter-Ministerial Board of Certification or valuation is proven to the satisfaction of tax officer. Else, there is a possibility that the investment can be taxed as income.

Offshore entities

Many startups have global businesses. Startups that get selected for global accelerator programs are asked to have a holding company, primarily in the USA.

Restrictions on Exit Price (Put Option), under the Foreign Direct Investment Policy, the Indian entities cannot determine or assure the exit price to its non-resident investors. This restriction would impact where the investors require optionality clauses, which allows investors to sell their shares at a predetermined price after a predetermined period.

The new disruptive, technology companies find it easier to find exits such as Initial Public Offer, become attractive targets for acquisition/ merger. It is also believed that there is an inherent premium to valuation in being a non-Indian company.

Running a global business from India is most Indian entrepreneurs dream. However, the above and many other factors are making the Indian promoters to move their holding entity ie., the value-creating entity outside of India.

These and many other factors are the triggers for the promoters to move their holding entity outside of India (“externalize”). The Indian legislations are not easy to comply even during externalization.

Incorporation of an Offshore Entity

Firstly, the Founders are required to incorporate an offshore entity as per the governing law in the host country. The Founders shall also consider the restrictions/compliances under Liberalised Remittance Scheme (LRS) as notified by RBI.

LRS facilitates Indian resident individuals to remit funds abroad for permitted current or capital account transactions or combination of both without prior approval of RBI. While the RBI has relaxed the individuals from seeking approval, it is pertinent to note that the outward remittance towards the share capital of overseas entity is allowed only in case if such entity is an operating entity and not have any step-down subsidiary. Further, LRS does not permit remittance towards incorporation of an entity.

Incorporation of Indian Subsidiary

Should the promoters wish to have a wholly owned subsidiary in India, (assuming there is no LRS), the subsidiary will primarily operate as a cost center, wherein the intellectual property is with the holding company. The employees of the subsidiary are eligible for ESOP of the holding company. The services agreement between the holding and subsidiary company should adhere to the transfer pricing regulations. Every care has to be taken to ensure that there is no round-tripping of funds. 

If an Investment is Raised

If the promoters had raised investment in the Indian entity earlier, then externalizing to ensure that the economic interest of the investors are protected has to be undertaken with care. There are processes such as transfer of shares, swap of shares that can be considered, while ensuring that the valuation of the Indian entity is an important matter to evaluate from tax perspective.

Some of the matters to consider is customer revenue, intellectual property, ESOP granted to employees etc.

The ODI Regulation as prescribed by the RBI is applicable in case of acquisition/transfer of shares of an offshore entity from Person Resident in India to Person Resident outside India[1] or vice versa.

Intellectual Property (IP) Licencing Agreement

If the Indian subsidiary enters into any customer agreements, then it is essential that the Indian subsidiary is appointed as a distributor or reseller or is a licensee of the IP in order to have the rights to sell the products to customers.

Applicability of Place of Effective Management (POEM) under Income Tax Act 1962

For the purpose of identifying the tax incidence, POEM plays a key role. POEM considers amongst other aspects, determination of active business outside India; identifying key persons where management and commercial decisions are taken and determination of place where those decisions are taken; location of the meeting of the Board; location of the head-office of the company and the like. However, POEM is applicable to those companies whose total turnover during the year is more than INR. 50 Crore.

We are witnessing many Indian startups move out of India and it is time that Indian regulators pay attention to actually ease doing business in India.

Author: Ashwin Bhat, Junior Partner

[1] Definition of Person Resident in India and Person Resident outside India is as captured under section 2(v) and 2(w) of the Foreign Exchange Management Act, 1999

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