The terminology 'Externalisation', 'Offshoring' or 'Flipping' have become common parlance in the Indian start-up ecosystem. For more than a decade now, these terms are known to denote a process whereby a company incorporated in India and having operations in India (the "Indian Company"), sets up its holding company in a foreign jurisdiction (the "Holding Company") and consolidates its investors, assets, values or customers, off shore. While motivations to externalise may differ from one entity to another, the usual suspects are, access to global markets, offshore listing of shares, tax benefits, better valuations, avoiding regulatory hassles in home jurisdictions, or simply, receipt of larger monies from global funds.
2. WHY EXTERNALISE?
2.1. Regulatory ease or clarity
The regulatory regime in India limits the scope of certain businesses depending on the political and economic sentiments in relation to such businesses. For example, businesses engaged in crypto currencies, news (global and Indian), drones, online gaming, are susceptible to either a strict regulatory regime or worse, uncertainty in terms of regulation. Hence, companies engaged in such sectors often house such businesses in other jurisdictions which provide a safer harbour.
2.2. Ease of raising funds
All foreign investments in India are subject to and are governed by the Foreign Exchange Management Act, 1999 ("FEMA"). In order to raise funds from abroad, an Indian Company is required to adhere to various sector based conditionalities along with investment-based restrictions under FEMA, as well as compliance and permission-based requirements, which can be challenging sometimes. For example, the government may not look at investments from certain bordering countries favourably and accordingly, restrict incoming investment from such countries, or the urge to protect local players in some sectors may lead to stringent norms or regulations for foreign investments therein. In such cases, many companies find it easier to raise funds from persons resident outside India, in foreign jurisdictions. Further, more avenues are available in the global market for such entities, including regular and venture debt from foreign lenders at better terms (including lower interest rates).
2.3. Strategic considerations
Sometimes the global supply and demand dynamics in specific industries often provide a larger customer base in foreign jurisdictions, or companies are able to derive higher value while placing their product or service in such foreign markets.
2.4. Valuation advantage and shielding from exchange rate risks
Companies may be able to receive a higher valuation for its business when pegged to a similar business in a global market, which is generally denominated in a higher value currency. Further, in externalised structures, it is possible to hedge such investment against exchange rate risks involving the Indian rupee.
2.5. Listing with access to global capital
The norms around listing shares in India are still stringent and listing shares of an Indian company abroad has its own challenges. Thus, another advantage of an externalised structure is greater access to public market listings and access to retail investors who invest on global stock exchanges, such as NASDAQ, HKEX, and NYSE. Some industry experts also maintain that stocks in specific sectors or segments may fetch much better valuation in jurisdictions aboard.
2.6. Other exit opportunities
Pricing guidelines under FEMA, particularly under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (the "Non-Debt Rules") restrict an Indian company from providing any assured exit price to any foreign investor in relation to any investment in such company. Hence, there is no scope for an Indian company to provide any foreign investor with a guaranteed fixed return or equivalent on such investor's investment. However, structures associated with exit options dependant on fixed returns by way of put options, buy-back, redemption or otherwise, are feasible in other jurisdictions.
In comparison to India, other jurisdictions may offer better taxation rates, flexibilities, or subsidies for a company in terms of business, operations, and investments. Such tax advantages generally comprise of beneficial corporate taxation rates, rates in case of capital gains, transfers, dividend distribution, and buyback.
3. HOW TO EXTERNALISE?
3.1. There are several restructuring options which get discussed every time a company decides to offshore. Amongst these, the common approaches comprise of the following steps:
- Step 1. Setting up or acquiring (through transfers) a Holding Company in the agreed foreign jurisdiction;
- Step 2. Incorporating a wholly owned subsidiary of the Holding Company in India (the "New India Company");
- Step 3. Capitalising the Holding Company to ensure that the existing stakeholders of the Indian Company being externalised, acquire shares in the Holding Company. This can be by way of transfers, gifts, employee stock options ("ESOPs"), new subscription, share swap, replicating the shareholding (and existing rights) of such stakeholders in the Holding Company, or a combination of any of these.
- Step 4. Transferring the business or assets of the Indian Company to the New India Company to continue operations, by way of a business transfer, asset transfer, or by merger or amalgamation.
- Step 5. Winding-up, or liquidating the Indian Company or buying-back its securities.
4. WHAT TO CONSIDER WHILE EXTERNALISING?
4.1. While taking the plunge to externalise, the decision makers grapple with several considerations in relation to selection of a befitting jurisdiction, housing of the intellectual property, customers, contracts, or talent pool, relocation of the promoters to the preferred jurisdiction to raise investments, analysis of the risks pertaining to valuation leakage or adverse tax consequences on the company and its stakeholders, analysis of regulatory hassles or ease of doing their business (now or in future), or availability of any tax benefits. Apart from the multitude of commercial considerations, externalisation also requires detailed analysis of several legal considerations, including the ones listed below.
4.2. Remittances made from India by any resident stakeholders for purchase of shares in the Holding Company will be governed by FEMA, and particularly by the Foreign Exchange Management (Overseas Investment) Rules, 2022 (the "OI Rules"), the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (the "OI Regulations") and Foreign Exchange Management (Overseas Investment) Directions, 2022 (the "OI Directions") (the OI Rules, the OI Regulations, and the OI Directions, collectively the "OI Legal Framework"). The following will have to be considered in this regard.
- Investment by promoters and resident
While persons resident in India, being individual natural persons, are allowed to make remittances abroad to acquire shares, there are several restrictions that apply. Under the OI Legal Framework, remittances by resident individuals are limited to USD 2,50,000 per financial year, including for the purpose of acquisition of shares abroad. Additionally, Schedule III of the OI Rules provide that in case an individual has 'control' over the foreign investee entity (in the example we are considering, the Holding Company) such foreign investee entity is prohibited from having a subsidiary or step down subsidiary. Most Holding Companies will be hit by this restriction, as the promoters will generally exercise control over the Holding Company and there will be a subsidiary in India (such as in the example we are considering, the New India Company).
The following alternatives are generally explored by resident individuals (including promoters) for ownership of shares abroad.
- Gift: Historically, this has been the most popular method for receipt of shares by resident individuals. However, the OI Rules now require that any gift of foreign securities from a person resident outside India to an individual resident in India may be made only in accordance with the Foreign Contribution (Regulation) Act, 2010 (the "FCRA"). The FCRA does not clarify the specific requirements and compliances for such a gift and hence, ambiguity exists, for which this option needs to be further analysed.
- ESOPs/ Sweat equity. A resident individual, being an employee or a director of an office in India or branch of an overseas entity or a subsidiary in India of an overseas entity or of an Indian entity in which the overseas entity has direct or indirect equity holding, may receive ESOPs or sweat equity shares offered by such overseas entity, subject to certain conditionalities specified in the OI Legal Framework. However, for a promoter resident in India, ESOPs may be unviable due to tax inefficiency and other commercial issues.
- Investment through an LLP structure: In light
of the OI Legal Framework, resident individuals may consider
investing through a limited liability partnership (a
"LLP") incorporated in India, subject to
the pricing guidelines, net worth requirement, and other
conditionalities that apply to such investment. This structure is
devoid of substance and could also be subject to regulatory
scrutiny from Indian authorities and may also involve adverse tax
implications for such resident individuals Further, the investors
in the Holding Company may not be agreeable with such indirect
shareholding as it may lead to difficulties in enforcing
contractual obligations on the promoters, including vesting and
claw back restrictions.
- Investment by Indian entities
Under the OI Legal Framework, resident Indian entities (including the LLPs as mentioned above) can invest abroad subject to the ceiling of 400% (Four Hundred Percent) of the net worth of such Indian entity, for the aggregate financial commitments, subject to other conditionalities that apply. Additionally, depending on the nature of the Indian entity, other limitations may apply as well, for example, investments by Venture Capital Funds ("VCFs"), and Alternative Investment Funds ("AIFs") registered with Securities and Exchange Board of India (the "SEBI") are subject to an overall cap of USD 1.5 Billion.
If for any reason a person resident in India is unable to invest in the Holding Company, parties use tracker rights with the investment retained in India, or grant shareholders' rights on a deemed shareholding basis abroad, or both. These structures may pose risks and complications at the time of an exit.
- Investment by non-resident entities and non-resident
Remittances by entities and individuals resident outside India being made from funds abroad will not fall under the purview of FEMA. Accordingly, such individuals and entities may directly invest in the Holding Company with funds maintained outside India, free from Indian regulatory requirements. Such investments would be subject to legal and tax implications applicable to the Holding Company.
4.3. Transfer of business, assets to the New India Company.
Generally, such transfer is done through a contract of business transfer on a slump sale basis or asset transfer, as feasible from a commercial and tax perspective. Given the time sensitivity, the option to merge or amalgamate the business through a court approved process is generally avoided. It is also important to determine which assets are to be transferred to the New India Company and the Holding Company depending on the requirement of value creation in India or abroad, for such asset classes. For example, it is common to assign the intellectual property to the Holding Company in case of technology companies.
4.4. Timing of externalisation.
Externalising at an early stage of the company growth may be beneficial as it is easier to replicate the shareholding pattern and also to undertake transfer of the business. This is due to lesser number of stakeholders, customers, vendors, workforce, assets, and even the monies involved. Re-structuring for a late stage company may be difficult, not just for the company, but also for its stakeholders (particularly the investors) as it leads to complex structures and tax leakages, and the company may not have the financial capacity to gross up such taxes. However, ironically, externalisations involve massive costs, including advisors' fees, government fees, stamp duties, taxes, which pose additional challenges for an early stage company.
Historically, externalised structures have been explored for several reasons including strategic ones like global outreach for customers and investors, foreign listings, and regulatory or tax benefits. With the new OI Legal Framework, while the orignal stigma of round tripping that plagued and raised questions on such externalised structures has been addressed, the tightening of legal norms requires additional and nuanced structuring for any Indian Company looking to externalise. Also, a shift in the trend could be expected with insistence and increased support from the Indian government for ease of doing business in India. With the recent internalisation of 'Phone Pe', Sameer Nigam, Phone Pe's co-founder urged the regulators to change the laws to incentivise companies to reverse flip1.
The choice of externalisation involves an in-depth analysis of the manner for its implementation in light of the complex legal, tax, and commercial implications it poses. Ultimately, it is for each company or business to independently evaluate the viability for externalisation, basis its factual matrix, and after giving due consideration to the benefits and challenges involved. It is best to exercise discretion and not look at it as a one size fits all solution. Only time will tell whether India will move towards externalisation or the other way, and all stakeholders are watching it play out with curious eyes.
1. Reference to video uploaded to Youtube by Phone Pe on January 25, 2023. Link: https://www.youtube.com/watch?v=MFjh0rp_dbM/
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