[Shubh Gautam is a fourth year B.A.LL.B (Hons) student at Chanakya National Law University, Patna]
Indian startups and new age companies are jumping on the bandwagon of ‘flipping’ their business. This trend has been addressed by the Foreign Exchange Management (Overseas Investment) Rules, 2022 issued on August 22, 2022 (forming a part of the new overseas investment regime). The new overseas investment rules and regulations have ushered a liberal investment regime in India which will contribute to improving the ease of doing business.
Several amendments and improvements have been brought over the old regime. For startups, the most significant one is the permission given to Indian entities to invest in foreign entities which have a subsidiary in India. This permission effectively provides a relaxation to Indian entities to flip their business.
What is a Flip?
A ‘flip’ structure or a round-tripping structure refers to a corporate inversion of a company. The company incorporates a holding company in a foreign jurisdiction with a favourable environment for business and the shares of the company are transferred to the holding company. In effect, the company becomes a wholly-owned subsidiary of the foreign company.
When a company flips, it changes its domicile. For instance, when an Indian start-up with its business in India flips through a holding company incorporated in the USA, its business remains intact in India, but it becomes a USA-based company.
The choice of foreign jurisdiction is based on several factors, considering the present and future needs of the business. Some markets are more mature and consolidated in terms of providing easy access to capital, conducive legal compliances, liberal tax and regulatory regimes, and well-developed intellectual property (IP) and data protection laws. The USA, the United Kingdom, Singapore and Maturities are some of the popular jurisdictions where companies prefer to flip.
The primary consideration for the flip is easy access to capital and a conducive business environment. With limited investment options in India, startups have started to realise the importance of capturing global attention for broadening their investment pool. The holding company acts as a vehicle for investment so that the partners and other investors can focus on bringing investment to the holding company.
Investors in the USA might be reluctant to invest in India for reasons such as regulatory hurdles, foreign exchange implications and a general apprehension of investing in a foreign country. However, their attitudes may change while putting their money in a company incorporated in their country. Foreign domicile opens up the prospect of launching an IPO in the foreign country, thus making it easier to access the larger public capital market. Chances of merger or acquisition with foreign companies also increase. In addition, developed markets provide access to facilities such as incubators and advisors as a part of the wider business ecosystem. These factors contribute to the growth and success of a startup.
Companies with robust IP regimes prefer to transfer their IP abroad for better protection, control and valuation. Through a flip, the ownership of the IP is passed on to the foreign holding company which is protected by the IP laws of the foreign country. Additionally, jurisdictions with developed privacy and data security laws (such as EU) are lucrative destinations for startups looking for safer flow of data. Hence, there are sufficient compelling reasons for companies in India to flip to a foreign jurisdiction.
The Old and the New ODI Regime
A flip results in an investment made outside India in a holding company. This investment is then redirected to India in the Indian subsidiary of the holding company. There is a flow of investment in both directions. This is why a flip is often called a ‘round-trip structure’. When investment is directed outwards, it triggers regulations on overseas direct investment (ODI). While an investment directed inward triggers regulations for foreign direct investment (FDI).
For most cases, a foreign entity is free to invest in India. This is, however, subject to conditions such as entry routes, sectoral caps and pricing guidelines under the FDI policy. Restrictions on inward flow of investment is a discussion for another day.
In the context of ODI, the old regime was marked with regulatory uncertainty and ambiguity. For instance, a key consideration for an Indian party to invest in a foreign entity is that the foreign entity should be engaged in a “bona fidebusiness activity”. In the old regime, there was no clarification on what constituted a bona fide business activity. This had led to unnecessary confusion and uncertainty in getting approvals from the RBI.
The new ODI regime defines “bona fide business activity” to mean any business activity permissible under any law in force in India and the host country. This definition is broad enough to include all businesses that are legal in India and the foreign country in question.
In the earlier regime, flip structures were neither expressly prohibited nor permitted. In cases where there were ambiguities, companies were advised to seek prior approval from the RBI. The RBI, after considering the commercial nature of the activity, could grant or refuse permission to go ahead with the activity. The RBI had been of the view that flip structures were not bona fide business activities. As a result, it disallowed round-tripping. In an FAQ published by the RBI, it prohibited Indian entities from setting up an Indian subsidiary through an offshore company.
The new regime has changed this position. It expressly permits an Indian entity to invest in a foreign entity which has a subsidiary in India. A significant restriction on such investments is that the overall structure should not result in more than two layers of subsidiaries.
Welcoming the Change
The report of the High-Level Advisory Group chaired by Surjit S. Bhalla has made the observation that a blanket prohibition under the garb of ‘round-tripping’ of funds may affect legitimate business activities. The report also finds the apprehensions of RBI misplaced and is instead of the view that attracting foreign investment in India through the route of round-tripping structures would contribute to the growth of our economy.
The new rules and regulations have made India’s ODI policy more liberal, predictable and easily comprehensible compared to the earlier regime. Certain compliance requirements have been reduced and general approvals through automatic route have been increased. It can be said that ambiguities still exist in relation to the definition of control, regulation for ODIs in foreign startups and the layers of subsidiary concept. However, the overall change brought by the new regime is a welcome move.
India is one of the fastest-growing startup destinations. By permitting flip structures, the new ODI regime has opened up a huge opportunity for Indian startups to deepen investment by foreign portfolio investors and foreign nationals. Improved access to funding will ensure that innovative ideas are not nipped in the bud for the lack of investment.
– Shubh Gautam