“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.
Externalisation, or setting up of offshore holding companies for Indian assets, continued to attract both private equity players and their portfolio companies, especially in the tech space. Some of the major reasons for doing so include tax benefits at the time of exit, avoiding Indian exchange control issues, mitigating currency fluctuation risk, better enforceability of rights, etc.
Further, from a fund-raising perspective, it offers Indian companies to connect with the global and larger investor base that appreciates the business potential and values them from global perspective as against the domestic.
Some other benefits of externalisation are enumerated below:
- Mitigating currency fluctuation risk that may arise from investing directly in a domestic company vis -a vis a US based company.
- Ring fencing potential liabilities from India tax and regulatory standpoint for the investors.
- Relaxed investment environment.
- Protection from enhanced director liability, statutory minimum pricing norms, etc under Companies Act, 2013.
- Restrictions on put options by Indian authorities and enforceability of such options in contracts have been a bone of contention and accordingly the investors also push companies to be global.
- Global companies have a greater advantage when they want to expand in multiple jurisdictions.
- Option to raise fund through overseas listing
- Offshore jurisdictions provide for better infrastructure and government policies aligned to business growths as against revenue collections.
- When should a flip be considered?
Commercial reasons and stringent Indian tax and regulatory considerations are key consideration for an externalisation exercise. From a tax standpoint, flipping the ownership offshore may entail substantial tax leakage, and to that extent it is advisable if the flip is undertaken at early stages before the value is built up in the Indian company.
In some cases, companies are choosing to wait until the business model is viable and they have been able to secure customers in various territories. This makes it easy to flip the structure in territory where customer base is substantial. However, there have been challenges at the later stage particularly due to high tax incidence to mirror the shareholding structure outside India. Further, there are tax costs associated with moving the IP outside India and there are regulatory challenges on moving the key Promoters outside India.
3.1 Exchange control
An Indian resident can acquire the shares of a foreign company under the following routes:
- Non-resident can transfer shares held in a foreign company by way of gift to a resident – freely permissible transfer
- Non-resident funds outside India, funds that were acquired/earned when the resident was a non-resident in India
- Right shares
- ODI route for companies / other entities (with prior RBI permission)
Round tripping concerns: residents’ funds, if any, should not be remitted back into India (not applicable in a “gift” scenario)
In case of exit, RBI approval may be required if the acquirer is an Indian resident to invest in the foreign company.
- From a regulatory standpoint, one of the challenges is to replicate the Indian ownership in the overseas holding company, 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 overseas holding company is to hold shares in the Indian company. Indian companies may be restricted from acquiring shares of the overseas holding company on account of the overseas holding company likely qualifying as a financial services company and Indian individuals may be restricted to acquire shares of the overseas holding company under the new exchange control norms since overseas holding company will not be an operating company. The extent of operations to be evidenced remains ambiguous. Overseas holding company’s acquisition of Indian shares will also need to be carefully structured as the overseas holding company will not be permitted to acquire Indian shares at below fair market value from an Indian tax and exchange control perspective.
- Under the liberalized remittance scheme, remittances cannot be made for investment in companies outside India for reinvestment into India. It is relevant 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. This is to avoid round tripping transactions.
- Under foreign direct investment (‘FDI’) regulations, a company whose significant beneficial ownership is deemed to be situated in India, will not be considered as an FDI company even though the investment has come from outside India.
3.2 Income – tax
- Issue of shares in a foreign company to be at fair market value (book value could be considered)
- Gift of shares, i.e., shares issued below the fair market value could result in taxability under section 56(2)(x) of Income-tax Act, 1961 in the hands of the promoter
- Issuance of shares as gift in the foreign company to non-residents may also get taxed subject to evaluation of relevant treaty benefits
- Fair market value to be determined as per Rule 11U and Rule 11UA of the Income-tax Rules, 1962
- Promoters/ Indian residents are required to disclose their interest in foreign company in their personal tax return
- Non-residents may be subject to capital gains tax on exits if the foreign holding company derives value substantially (more than 50 percent) from assets in India based on the period of holding
- For non-residents / foreign companies – shares held for up to 24 months may get taxed at 40 percent and upon sale of shares held for more than 24 months at 10%
- Residents will get taxed at 20% (long term) / corporate tax rate or slab rate (short term) based on period of holding
- Over the years, India has introduced various anti-avoidance measures embedded into its tax, regulatory and corporate laws.is the choice of jurisdiction for the holding company considering the general anti -avoidance rules that disregard the holding company structure if it is found lacking commercial substance.
- Further, guidelines on place of effective management (‘POEM’) could result in an overseas company being considered a tax resident in India if the key managerial functions and decisions are taken in India.
- Popular jurisdictions
It is an extremely efficient and economically and politically stable jurisdiction with strong rule of law and a fair and reasonable tax regime, a responsive, well-educated financial regulator and a government that supports the free market, a vibrant fundraising landscape, as well as it has access to some of the most advanced and high-quality banking and financial services. These factors make Singapore suitable for a variety of business purposes.
Singapore may also be suitable for holding structures. In fact, a significant number of business groups operating within Asia-Pacific, choose Singapore as their holding headquarters. This is particularly common when they are trying to attract venture capital. Often startups opt for a Pte. Ltd. Holding Company.
Singapore operates a full imputation tax system – corporate profits are only taxed once in Singapore. Consequently, dividends received from Singaporean subsidiaries are not taxed at the holding level and there are no withholding taxes when distributing dividends either to residents or non-residents. There are no withholding taxes on interests either but royalties and certain technical service fees paid to foreign corporations may be subject to a 10% and 17% tax, respectively, if no exemption applies and the tax rate is not reduced under a tax treaty. Recently, Singapore also published availability of credit on dividend distribution income tax paid on dividends from subsidiaries in India.
Pre-2017 investments in India are grandfathered and exempt from capital gains exemption tax. Further, the treaty between India and Singapore continues to provide exemption on transfer of capital interest in an Indian LLP.
Singapore is also a preferred jurisdiction for IP holding. There are concessionary tax rates on royalty income and other IP income subject to certain conditions. Singapore has concluded tax treaties with over 80 countries and is commercially a very attractive place to carry out operations particularly in South east Asia.
The Netherlands is one of the jurisdictions that have concluded more tax treaties with other jurisdictions worldwide. This made the Dutch BV a common structure as an ‘intermediate’ holding company to access Dutch tax treaty benefits and thus reduce the consolidated tax burden of a given group structure.
It must be noted that with the advent of general anti avoidance regulations in India and around the world, a shell intermediate holding structure may not work. However, from India perspective, there are several benefits that Dutch holding may enjoy which are currently not enjoyed by several other jurisdictions.
Participation exemption is available on dividends received and also as per India – Dutch treaty, certain capital gains tax exemptions apply on transfers to non-residents. The treaty also provides capital gains exemptions on business reorganisations.
Dutch entity is also attractive particularly when a large customer base is from European markets. Due to the Most Favoured Nation clause, possible to explore a lower dividend distribution tax rate as well as availability of credit in Netherlands may be explored.
While US does not have the most favourable tax treaty network, it is still a very attractive jurisdiction from an externalisation perspective particularly for tech companies seeking global presence, valuation and access to many funds and investors.
Registering a Delaware entity is an attractive option from investment perspective and several large multi-national and listed companies are mostly a Delaware registered entity. The Delaware LLC is the most flexible type of business entity offered by any state or country in the world. This is the reason why the LLC (Limited Liability Company) has become the entity of choice among many legal, accounting and business professionals. A Delaware LLC provides significant benefits such as:
- The structure of the company and the rules that govern the members of the company are contained in a contract called the LLC Operating Agreement, which is drafted by the members of the LLC. This means the terms and rules of each LLC can be tailored to accommodate the specific needs and preferences of an LLC. This is the biggest benefit of an LLC over any other form of business entity. This power is called freedom of contract.
- Asset protection against the creditors for the LLC
- Limitation on member’s personal liability in the event of business failure
- Beneficial tax treatment – founders can choose whether to be taxed as partnership, an S corporation or a C corporation or a sole proprietorship
- Simple to form
- Low annual fees and maintenance
- Owner protected through Delaware privacy laws
- Current flip structures – key issues
- The most common type of flip structures earlier days involved the acquisition of shares of an overseas holding company by shareholders of the Indian company. The foreign company then acquires shares of the domestic company from the shareholders of the domestic company. However, with government tightening the noose on such structures due to shareholders keeping the investments outside India resulting in ‘treaty shopping’ and ‘round tripping’ issues, such structures are no longer viable.
- Substance over form is the key to any structuring which is often overlooked by the new age start-ups who are focused on business viability, investor interests and customer acquisition that they do not focus on the key prerequisites for flipping a structure.
- RBI has been proactive in sending notices and doing inquiry on such structures and government has been vocal about the need to comply with various conditions like overseas company be engaged in a bona fide business activity, and/or that the overseas company cannot have a step-down subsidiary. Complex structures may need to be implemented to bring a flip within the paradigm of the Indian regulatory framework.
- Externalization transactions are typically cost-intensive, primarily because they involve assessment of and compliance with regulatory requirements across multiple jurisdictions. Further, various aspects of the restructuring may result in tax incidence in the hands of the company and its shareholders and will need to be carried out in a manner as to minimize tax leakage.
- Flip structures are always complex and building up a business rationale is a key to implementing such structures. Further, flipping a structure would not just mean changing the holding company jurisdiction but also assignment of IP which could also be complex as IP favourable jurisdictions may be different from investor preferred jurisdictions.
- Key points to consider while flipping a structure
- Undertake an analysis on where the IP is to be situated
- Location / preference of Promoter for business presence
- Type of customer – Indian vs global
- Location of investor
- Objectives of business – IPO vs sale
- Valuation of business
- Future funding and acquisitions
- Value creation at the holding company level e.g. by way of moving key managerial functions, direct contracts with customers, assignment of IP – undertaking all such steps to ensure the entity being perceived global rather than global
- Flexibility for Promoters / key managerial personnel to relocate to the holding company jurisdiction
- Incorporation of overseas holding company with foreign sourced income
- Obtaining RBI approval while investing in an overseas holding company with step down India subsidiary
- At a later stage of business, if a flip is considered, it may be better to undertake the same through a formal court approved / NCLT route such as cross border merger, demerger process
This material and the information contained herein prepared by Algo Legal is intended to provide general information on a subject or subjects and is not an exhaustive treatment of such subject(s). Algo Legal is not, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision. Algo Legal shall not be responsible for any loss whatsoever sustained by any person who relies on this material.
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