[Ojasav and Deesha are students at National Law University, Jodhpur.]
The recent growth of India's startup ecosystem can be attributed to a combination of favorable government policies and incentives. This convergence has led to an increase in the number of entrepreneurs who seek to externalize or “flip” their company structure, relocating their holding company to countries such as Singapore, the United States, the United Kingdom, the Netherlands, etc., as their businesses expand globally. This process of externalization is driven by various factors, including easier access to international financing, regulated markets, a structure familiar to private equity investors, and the opportunity to list on foreign stock exchanges.
Previously, there were no strict regulations regarding flip structures in India. However, the country's economic climate has improved due to a new investment system, which has been made possible by the relaxation of restrictions on foreign investment. The previous system has undergone several modifications and enhancements, with the most significant one allowing investments in foreign companies that have a presence in India. Given the current state of the investment regime in the country, it is crucial to assess the effectiveness of this legislative change of permitting startups to undertake flip structure under the Foreign Exchange Management (Overseas Investment) Directions 2022 (OI Directions).
For this, the authors examine the concept of flip structures and explore the reasons behind their increasing popularity. They then focus on the position of flip structures within the new overseas investment regime. The authors also analyze the legislative steps taken and provide their opinion on the matter. Finally, the article will conclude with a suitable summary.
Flip Structure: An Overview
A “flip” structure, also known as a round-tripping structure, involves a corporate inversion where a company establishes a holding company in a foreign jurisdiction that offers favorable business conditions. The company's shares are then transferred to the holding company, effectively making the company a wholly-owned subsidiary of the foreign entity.
The primary factors driving the adoption of flip structures are financial accessibility and a conducive business environment. Given the limited investment opportunities in India, companies have realized the importance of attracting global interest to expand their pool of funding. The holding company serves as an investment vehicle, allowing partners and investors to focus on attracting investment specifically to the holding company.
Furthermore, a share exchange is typically carried out during a flip process. Shareholders of the local company exchange their shares for shares of the foreign holding company once the Indian business owners establish it. As a result, the shareholders of the domestic company also become shareholders of the foreign holding company. To simplify the complexities of a stock swap, a flip structure may be utilized, wherein the shareholders of the Indian business purchase shares in the overseas holding company, and the overseas holding company acquires all shares of the Indian company from the shareholders.
Consequently, the benefits of easier access to funding, stable regulations, familiarity with the structure for private equity investors, and a favorable platform for public listing in foreign jurisdictions provide compelling reasons for Indian companies to relocate to foreign jurisdictions.
The New Regime
By virtue of Regulation 3 of the OI Directions, an Indian resident may make or transfer any investment or financial commitment outside India under general permission/automatic route, subject to the Foreign Exchange Management (Overseas Investment) Rules 2022 (OI Rules) and Foreign Exchange Management (Overseas Investment) Regulations 2022 (OI Regulations). Consequently, foreign investment in a foreign entity engaged in a bona genuine commercial activity may be made directly or through an SDS/special-purpose vehicle. This must be read in conjunction with Rule 9 of the OI Rules, which states that “any investment made outside of India by an Indian resident must be made in a foreign entity engaged in a bona fide business activity, either directly or through a step-down subsidiary or a special-purpose vehicle, subject to the limits and conditions set forth in the specified legislation.”
The rules contain a provision emphasising that the structure of a foreign entity's subsidiary or step-down subsidiary must meet the structural criteria of a foreign entity. In addition, the explanation offered in the rule defining bona fide business activity fills the void left by the absence of a definition in the previous regime. The term “bona fide business activity” refers to any commercial activity permitted by the laws of India and the host country or host jurisdiction.
The Reserve Bank of India (RBI) has retained control despite liberalising the regime by stating that, if necessary, it may stipulate the ceiling for the aggregate outflows during a financial year on account of financial commitment or overseas portfolio investment and also stipulate the ceiling above which the amount of financial commitment by an Indian resident in a financial year shall require its prior approval. Thus, the legislators have achieved a balance in the new investment environment.
Permitting the Flip Structure: An Analysis
The bright side
Under the previous ODI regime, there was regulatory ambiguity and uncertainty. For instance, in order for an Indian party to invest in a foreign entity, the foreign entity had to be involved in a “bona fide business activity.” However, there was no clear definition of what constituted a legitimate economic operation, leading to confusion and uncertainty when seeking approval from the RBI. On the contrary, the OI Directions define “bona fide business activity" as any economic activity permitted by the laws of both India and the host country. This definition is broad enough to encompass all legal enterprises in both India and the foreign country in question.
Under the current regime, Indian entities are expressly authorized to invest in foreign entities with Indian subsidiaries, subject to certain restrictions, including a maximum of two levels of subsidiaries in the corporate structure. Compared to the previous regime, the new rules have made India's ODI policy more liberal, predictable, and understandable. Some compliance requirements have been reduced, and more general permissions are granted automatically. Challenges remain regarding the definition of control, regulation of ODIs in international startups, and the concept of subsidiary layers. Nevertheless, the overall shift brought about by the current regime is a positive development in light of following benefits:
Increased capital for investment
Allowing foreign investors to invest in Indian startups can significantly increase the availability of capital. This infusion of funds can help startups scale their operations, develop innovative products or services, and expand their reach in the market.
Access to global markets
Foreign investment can provide startups with access to international markets, networks, and distribution channels. This exposure to global markets can help startups expand their customer base, increase exports, and foster international collaborations, ultimately contributing to their growth and success.
FDI can facilitate the transfer of advanced technologies, research and development capabilities, and innovation-driven practices to Indian startups. This exposure to cutting-edge technologies can foster technological advancements and enable startups to create more innovative and globally competitive products or services.
Foreign investors often bring valuable industry expertise, technical know-how, and best practices that can benefit Indian startups. This knowledge transfer can enhance the capabilities and competitiveness of local entrepreneurs, leading to the overall growth and development of the startup ecosystem.
The dark side
As much as the above considerations are relevant, the following also assume significance.
First, when an Indian company becomes a wholly-owned subsidiary of a foreign corporation, the Indian government loses its ability to tax future capital gains, profits from public listings, and operational profits, resulting in economic and national losses.
Second, flipping poses a security risk as vital information and potential value derived from associated intellectual property are compromised.
Third, the Indian government may have security concerns regarding the source of funding for these companies if they are headquartered outside of India, particularly in the event of future hostile actions.
Fourth, flipping benefits international investors who seek to capitalize on India's thriving economy without physically entering the country, potentially leading to a cycle of asset resale that bypasses India's interests.
Fifth, as these privatized businesses list overseas, there will be reduced liquidity in Indian public equities markets, and foreign investors can profit from India's resources and growing economy without adhering to local regulations.
However, despite these drawbacks, the discussed advantages and the need for a liberalized approach outweigh the cons. The significant loss of foreign investment and other obstacles were more detrimental. Therefore, the new regime is a positive development, but caution should be exercised in its implementation.
Indian startups are considering externalization as a viable method to expand their businesses. However, before opting for externalization, they carefully evaluate the regulatory and compliance consequences, including foreign investment rules, tax regulations, fair pricing mechanisms, and intellectual property considerations. Successful flip structures take all these aspects into account and align their structures accordingly. In the wake of the COVID-19 impact on the Indian economy, legislators aimed to strike a balance between conflicting requirements by establishing an investor-friendly system and revitalizing the economy through investment rules and regulations.
The new ODI regime, by permitting flip structures, has opened up significant potential for Indian startups to attract international portfolio investors and foreign investments. Improved access to funds will prevent innovative ideas from being hindered by capital constraints.
Furthermore, according to the Economic Survey 2023, Indian startups are choosing to relocate or redomicile within India. This involves reverse flipping, where the corporate headquarters are moved from outside of India to locations within the country. Recent examples include the relocation of the headquarters of Indian fintech unicorn PhonePe from Singapore to Bengaluru. These developments indicate positive progress, reflecting the efforts of lawmakers in creating an investor-friendly environment and stimulating the economy through investment rules and regulations. However, it is crucial to address the significant risks posed by the permissible flip structures and expedite legislative measures to establish a more comprehensive overseas investment regime.
 Ritesh Dwivedi, Indian Startups: Analyzing Their Vulnerabilities and Prevailing Challenges, 6, SMS J. of Entrepreneurship & Innovation, pp 61-79, (2019).