Analysis of “Externalisation” under Indian Law

[Deepansh Guwalani is a 4th Year Student at ILS Law College, Pune]


“Externalisation” is a strategy of incorporating holding companies in offshore jurisdictions to enjoy certain benefits which the home country does not offer. The strategy is employed by companies to move their corporate structures away from the Indian tax and regulatory regimes.

How it is done

The process of externalisation can be carried in numerous complex ways. A typical corporate structure would be as follows:

Step 1: A start-up company is incorporated in India. This takes place in the initial days of the company i.e. before expansion is envisaged when the promoters have usually not assessed the complex corporate structures.

Step 2: A holding company is incorporated in some other country like Singapore. The shareholding of the start-up is mirrored here.

Step 3: This holding company incorporates a wholly-owned subsidiary (WOS) company in India. The business is usually run in India through an Indian company due to cost-effectiveness.

Step 4: The subsidiary company assumes the business of the start-up through a Business Transfer Agreement and becomes the operating company.

Step 5: The start-up ceases to exist.

Case in point: Flipkart (before the Walmart acquisition)

Flipkart carried out exactly the same exercise in October, 2011. Bansals, the founders of the company, set up an entity called Flipkart Online Services Pvt. Ltd (FOS) in India in 2007. Soon, they decided to bring in foreign direct investment (FDI). Since, FDI was not allowed in the online retail sector at the time, Flipkart Pvt. Ltd. (FPL) was set up in Singapore (the ultimate holding company) which today has three wholly owned subsidiaries in Singapore. These companies, in turn, have stakes in five Indian companies, including Flipkart India Pvt. Ltd. (FIPL), the wholesale cash-and-carry entity. FOS transferred its business to FIPL in 2011 and thus completed the process of externalisation.

Why go global?

Restrictions on put options

Put options are an exit strategy for investors. These optional clauses are incorporated in the shareholders’ agreement which allows investors to sell their shares at a predetermined price after a predetermined period. The investors usually employ this when they are expecting a fall in the stock price so that they are able to exit in advance. However, the validity and enforceability of put options has always been a bone of contention from an Indian securities law and exchange control perspective. These restrictions deter foreign investors and thus give impetus to go global.

Retroactive taxation on indirect transfers

Indirect transfer primarily means the transfer of underlying assets located in a jurisdiction through the transfer of an intermediate holding company located in a different jurisdiction. The controversy with respect to taxation of indirect transfer of assets located in India came into the limelight in the landmark Vodafone case. In this case, the Vodafone group purchased the Indian business of Hutchison group through the purchase of a single share of a Cayman Islands company. The Supreme Court rejected the argument of the Indian revenue authorities that such transaction of indirect transfer of Indian business is taxable in India. Following this, Indian tax laws were retrospectively amended by way of the Finance Act, 2012. After the retrospective amendment introduced by the Finance Act, 2012, India taxes the capital gains arising to a non-resident on transfer of shares of a foreign company if such shares derive their value substantially from the assets located in India. Externalisation offers protection from such taxation since the ultimate holding company in a different jurisdiction can be acquired in a cost-effective manner.

Strong investor base

Externalisation offers a wider base of potential investors and greater access to global capital markets, thereby making fund-raising easier and more convenient, leading to better realization of business potential and higher valuations. This is similar to a few companies in India have hitherto preferred to tap the global capital markets (NYSE and Nasdaq) without going public in India.

Currency fluctuations

By investing in dollars in the offshore holding company (OHC), foreign investors can be immune from the currency risk. In the international context, other companies have carried out similar exercises.

Dividend distribution tax

The holding company will get a tax credit for the dividend distribution tax (DDT) borne by its Indian Subsidiary Co. This, however, depends on the double taxation avoidance agreement between India and the concerned foreign country and the domestic laws of both the countries.

ABC Inc. (tax resident of USA) owned 99.99% in ABC Pvt. Ltd., its Indian subsidiary company. ABC Inc. would be able to claim a tax credit for the DDT borne by its subsidiary company.


Round tripping

Round tripping” of FDI is where domestic funds come back into India as FDI money without any incremental flow of funds into the country. Tax concessions allowed in the foreign country encourage individuals to park money there. The money will be invested in a company formed there (e.g., Mauritius) and later this company will be taking back the money as foreign direct investment into the home country (India).

The moment the Indian subsidiary is funded by the OHC, the round-tripping issues clearly emerge. Round-tripping is prohibited under the Foreign Exchange Management Act, 1999 (FEMA) and the Reserve Bank of India (RBI) has from time to time taken actions against such suspicious activities.

Place of effective management

To curb (only to some extent) the loss to the exchequer by the externalisation of Indian businesses, the new concept of ‘place of effective management’ has been introduced. To determine the residential status of foreign companies, the Finance Act 2015 introduced the concept of place of effective management (POEM). If a company’s place of effective management is India, it will be treated as an Indian resident and its global income will be taxable in India. The intent is to target shell companies created for retaining income outside India although real control and management of affairs is located in India. Although guiding principles have been released to clarify the meaning of “place of effective management”, ambiguity is still prevalent. This may bring OHC under the Indian tax ambit.

Regulatory approvals

From a regulatory standpoint, one of the challenges is to mirror the Indian ownership in the OHC, especially since swap of shares or transfer of shares for consideration other than cash requires regulatory approval, which may not be forthcoming if the regulator believes that the primary purpose of the OHC is to hold shares in the Indian company. Also, the transfer of securities involved in the corporate inversion may be construed as an “indirect transfer” and might attract potential tax liability under the Income Tax Act, 1961.


The Government has lately focused on bringing about “ease of doing business” in India. Towards this, it has proposed steps such as reduction of corporate tax from the current 30% to 25% over four years and amendment of the Arbitration and Conciliation Act, 1996, in order to restrain high tax rates and counter slow enforcement of contractual rights. To attract more foreign funding, it has taken steps to ease investment norms in the online retail sector. The government has also amended the double taxation avoidance treaties with Mauritius and Singapore to curb round tripping.

Despite these initiatives, considering the challenges faced by India Inc., the need to move away from India for growth seems inevitable in current times.

Deepansh Guwalani

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