Many fintech startups in India have established foreign holding companies (HoldCo) to attract investment from offshore venture capital and private equity funds. They take advantage of favorable foreign regulatory regimes, better intellectual property protection, easier access to capital and product markets, and the option of overseas listing. This process, commonly known as “Flipping,” involves transferring ownership and intellectual property from an Indian company to an overseas entity, which becomes the HoldCo for the Indian entity.
While flipping is generally considered easier during the early stages of an entity’s life cycle, there are also challenges associated with this structure. Fintech startups in India, operating as subsidiaries of foreign entities, often face difficulties in partnering with regulated entities such as banks, NBFCs (Non-Banking Financial Companies), and insurance companies. Their foreign ownership and control can hinder obtaining licenses and registrations.
Recently, Indian startups have gained comparable valuations to those in foreign jurisdictions. The Indian government’s ease of doing business initiatives and relaxed listing norms in Indian stock exchanges have prompted startup founders to consider “Reverse Flipping.” This involves shifting their company’s domicile back to India. One reason for reverse flipping is to list the company on Indian stock exchanges, which have a large number of retail individual investors willing to buy shares of startup companies. As a result, the trend of reverse flipping has gained traction, with up to 20 Indian startups, including PhonePe, exploring the option.
The Economic Survey 2022-23, for the first time, called for steps to facilitate the return of Indian startups. It suggested six measures to accelerate reverse flipping, including simplifying ESOP (Employee Stock Ownership Plan) taxation, streamlining tax processes, improving inter-ministerial board certification, and easing capital flow restrictions. The survey also emphasized collaboration with startups to establish best practices and enhance India’s startup incubation and funding landscape.
While reverse flipping may prima facie seem desirable for a startup looking for listing, given its increasing popularity and a comparatively more supportive regulatory environment developing in India, it is important for entities, their managements and participating shareholders to evaluate several legal and commercial considerations that may arise while shifting their domicile back into India.
Some of these considerations include:
1. Structuring the internalisation
Choosing the right structure that aligns with India’s legal, regulatory, and tax requirements is crucial. One common approach is an inbound/cross-border merger of the HoldCo with its Indian subsidiary, where the Indian entity becomes the surviving company. This involves the foreign entity merging into the Indian entity, with the assets and operations eventually owned and controlled by the Indian entity. Shareholders of the foreign entity receive shares of the Indian entity as consideration.
Compliance with the merger regulations of the jurisdiction where the HoldCo is incorporated is also essential. Some foreign jurisdictions have straightforward procedures, while others may have restrictions on outbound mergers or significant tax implications. For example, in Singapore, an outbound merger with an Indian entity may require prior approvals and clarifications from regulators. Consideration of these factors may result in delays due to regulatory uncertainties in both jurisdictions. Successful cross-border mergers depend on approvals from authorities and adherence to timelines and procedures in all relevant jurisdictions.
Founders and promoters of the foreign HoldCo typically receive employee stock options (ESOPs) or similar incentives. However, Indian regulations do not allow ESOPs for local company promoters. Startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) are exempt from these restrictions, but entities considering inbound mergers may not satisfy DPIIT eligibility. In an inbound merger, promoters’ ESOPs may need restructuring to comply with legal and tax requirements.
The debts of the HoldCo become those of the Indian entity upon merger. Borrowing must adhere to Indian laws regarding loans from overseas lenders within two years. During this period, the Indian entity cannot remit funds to repay such loans. If the HoldCo has foreign subsidiaries or investments, they become overseas investments of the Indian transferee company after the merger, subject to FEMA (Foreign Exchange Management Act).
2. Tax implications
If the reverse flip occurs through an inbound merger, shareholders of the foreign amalgamating entity may claim exemption from capital gains tax arising from the transfer. This exemption is subject to the transaction qualifying as an “amalgamation” under the provisions of the Indian Income Tax Act, 1961.
3. Regulatory consideration
In-bound mergers must comply with the Companies Act, 2013, Foreign Exchange Management Act, 1999 (FEMA), and its regulations, including the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, and the Foreign Exchange Management (Cross-Border Merger) Regulations, 2018 (cross-border regulations).
An In-bound merger has to be approved by the National Company Law Tribunal (NCLT), which is a time-consuming process. The amalgamating entities have to obtain board, shareholder and creditors approvals, and prepare requisite documentation, including the valuation report and financial statements, to file with the NCLT. The scheme has to be approved by the stipulated majority of the shareholders and creditors of the entity in India. The NCLT will usually direct that notice be given to government agencies, such as the income-tax authorities, the Reserve Bank of India and the Competition Commission of India, any of which may make representations and raise objections.
Under Rule 25A of the Companies (Compromises, Arrangements and Amalgamations) Rules 2016, prior approval of the Reserve Bank of India (“RBI”) is required for In-bound mergers. In this regard, the RBI framed the Cross Border Regulations which provides that merger transactions in compliance with these regulations shall be deemed to have been approved by RBI, and hence, no separate RBI approval should be required. In other cases, cross-border merger transactions shall require prior RBI approval.
According to the Cross Border Regulations, issuance or transfer of securities to a person resident outside India by way of an in-bound merger will have to be undertaken in accordance with the pricing guidelines, entry routes, sectoral caps, attendant conditions and reporting requirements for foreign investment as laid down under Foreign Exchange Management (Non-debt Instruments) Rules, 2019, along with due regard to the provisions of the recently enacted Foreign Exchange Management (Overseas Investment) Rules, 2022.
A prior approval from the Government of India/RBI may be necessary if the internalized entity operates in a sector that falls under the “approval route” as outlined in India’s Consolidated Foreign Direct Investment (FDI) Policy. Additionally, the entity must consider whether the internalization will trigger the need for intimation/approval from the Competition Commission of India (CCI). Therefore, a comprehensive analysis of all required regulatory and sectoral approvals in both India and the host countries of the offshore entity is essential when assessing the structure and timelines for internalizing into India.
In conclusion, the attractive valuations in the Indian market and the potential economic benefits and job opportunities associated with internalizing the domicile back to India make the trend of “reverse flipping” significant. The government is actively promoting this trend and has established the expert Padmanabhan committee to provide recommendations on encouraging startups to relocate. If these efforts succeed, more startups and investors may choose to re-domicile and list in India.
About Author: CS Dhaval Gusani who is founder of DVG and Associates, Company Secretaries, Mumbai. He can be reached at firstname.lastname@example.org.