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Summary: Recommendations of expert committee to reverse flipping of Indian startups

‘Flipping’ refers to the process of transferring the entire ownership of an Indian startup entity to an overseas entity, accompanied by the transfer of all data and IP hitherto owned by the Indian company.

The expert committee set up in March 2023 to identify a roadmap to encourage Indian startups that have flipped abroad to relocate to India submitted its report on August 25.

The report, submitted to the International Financial Services Centres Authority (IFSCA), lays out over thirty recommendations across a range of domains such as taxation, infrastructure, company law, dispute resolution etc. to encourage startups that have flipped abroad to relocate to the International Financial Services Centre (IFSC) in Gujarat International Finance Tec-City (GIFT City).

What is flipping: “Externalization or flipping refers to a process of transferring the entire ownership of an Indian startup entity to an overseas entity, accompanied by a transfer of all IP and data hitherto owned by the Indian company. It effectively transforms an Indian startup (company) into a 100% subsidiary of a foreign entity, with the founders and investors retaining the same ownership via the foreign entity, having swapped all shares,” the report explained.

Why do startups flip abroad: “The committee examined several push-pull factors are responsible for Indian founders flipping to overseas jurisdictions. In the preferred jurisdictions overseas, startup founders are able to benefit from favourable business and regulatory regimes, ease of doing business, tax incentives, better IP protection and higher valuation for their ventures with easier access to capital. In several instances, foreign investor influence has also been a major factor for Indian startups to flip overseas,” the report stated.

What’s the harm to India from flipping: “The externalization/flipping of startups impacts the Indian economy in several ways. One, a direct consequence of flipping is the brain drain of entrepreneurial talent from India. Young, skilled, and innovative founders relocate to overseas jurisdictions, which results in a loss of human capital, and stalling of innovation and technological advancements within the country. Two, the flipping of startups results in value creation in foreign jurisdictions rather than in India. Homegrown innovative ideas and disruptive technologies contribute to the startup ecosystem and economic growth of other countries. It also results in the loss of Intellectual Property and Tax Revenue for the country,” the report laid out.

Recommendations of the expert committee to reverse flipping

The expert committee laid out recommendations across twelve broad areas to bring back the flipped startups to India and prevent further flight of Indian innovation to overseas jurisdictions.

These recommendations were framed by taking into consideration the models followed by Singapore, the Netherlands, and Delaware, the report said.

The committee focused on making the IFSC in Gujarat’s GIFT City the preferred destination for reverse flipping given the several advantages that IFSC offers to the Indian startup community “including flexibility to transact in foreign currency, hassle-free movement of capital and investments, business-friendly regulatory environment, reduced compliance burden, attractive tax regime & financial incentives, access to vibrant and growing PE/VC ecosystem as well as access to world-class FinTech Hub.”

I. Company Law and Regulatory Issues

  1. Make establishing Holding Companies easier: Holding Company (HoldCo) structures are corporate structures that exist to own and control other group companies and centralize administration across diverse companies within the same group. They have emerged as the preferred option in today’s startup landscape but the process in India to set up HoldCos is complex and time-consuming. It is recommended to institute a simplified incorporation process and procedure to establish HoldCos in GIFT City.
  2. Simplify the process for incorporation of companies: Incorporation of a company in India, especially with foreign shareholders, is a time-consuming process. It is recommended to design and implement a “Common Application Form” to consolidate company incorporation and approval under one form with the International Financial Services Centres Authority (IFSCA) serving as the single point nodal office. Furthermore, all applications should be processed by a dedicated desk for IFSC at the Ministry of Corporate Affairs.
  3. Relax certain compliances under the Companies Act, 2013: The current regulations require the submission of specific information to the registrar within specified timeframes. For example, a company making any allotment of securities should file with the Registrar a return of allotment within 15 days from the date of the allotment. This can be burdensome. It is recommended to grant exemptions or relaxations to IFSC companies on such types of filings by making some of the filings part of annual reporting instead.
  4. Increase limit under Liberalised Remittance Scheme: Under the Liberalised Remittance Scheme (LRS), there is a limit of USD 250,000 per financial year for foreign outward remittances without RBI approval. It is recommended not to club investment in IFSC under LRS with other activities like medical treatment, education, etc. and to permit an additional limit of USD 250,000 for investment in IFSC.
  5. Ease overseas investment restrictions by AIFs and Mutual Funds: Investments made by Indian AIFs (Alternate Investment Funds) and Mutual Funds in overseas securities are subject to limits of $1.5 billion and $7 billion respectively. Investments in GIFT City entities are considered overseas investments as well, thus subjecting them to the same limits. It is recommended to exclude entities domiciled in GIFT City from these limits set by RBI in order to ensure that Indian residents can participate in the capital raises by entities in GIFT City.

II. Tax-Related Issues and Proposals

  1. Eliminate tax burden on the relocation of offshore holding company to GIFT City: To incentivize the movement of offshore holding companies into GIFT City, efforts should be made to ensure tax neutrality, “so as to not trigger adverse tax consequences for the offshore holding companies and their stakeholders” that are relocating to India. Measures to support this include no tax for the offshore holding company on relocation, no tax for the shareholders of the offshore holding company on relocation to GIFT City, grandfathering of existing investment of the holding company, allowing carry forward of losses despite the change in ownership, reduced compliance obligation for the investors of the offshore holding company, etc.
  2. Provide participation exemption for GIFT City holding company on capital gains tax: Business-friendly jurisdictions like the Netherlands and Luxembourg provide something called “a participation exemption” regime, which reduces the tax burden on HoldCos on certain types of investments in subsidiaries. Currently, no such exemption is available in India, which means “holding companies will have to bear capital gain tax on their exits from their strategic investments that may potentially lead to double taxation on the same income within the group and therefore putting a damper on the total takeaway returns for their end investors.” It is recommended to introduce a participation exemption mechanism in line with global standards to provide for exemption on capital gain tax for HoldCos based in GIFT City provided the investment by these HoldCos fulfil certain criteria.
  3. Reduce tax rates on the sale of shares held by GIFT City holding company: The applicable tax implications on the sale of shares held by the GIFT City holding company in any Indian subsidiary should not be disadvantageous as compared to the tax implications, had no relocation taken place. For example, when a non-resident company sells shares in an unlisted Indian operating company, a 10 percent tax is applicable, but when an Indian company sells shares in an unlisted company it is subject to a 20 percent tax. When an offshore holding company relocates to GIFT City, it would be considered an Indian resident company for tax purposes and be subject to the 20 percent tax as opposed to the 10 percent tax had no relocation taken place.
  4. Exempt dividend income received from subsidiaries from taxes: Countries like Singapore and Luxembourg exempt HoldCos from tax with respect to dividend income earned from subsidiaries. There is no such exemption in India with respect to dividend income earned by an Indian holding company from its overseas subsidiaries. It is recommended that dividends received by a GIFT City holding company from investment in its overseas subsidiaries or Indian subsidiaries should be tax-exempt, subject to meeting prescribed conditions.
  5. No adverse tax implications for foreign subsidiaries of GIFT IFSC holding company: In case of relocation of an offshore holding company to GIFT City, there should be no adverse tax consequences for the foreign subsidiaries of such GIFT City holding companies merely because it’s managed from India via the holding company. Under the Income Tax Act, such foreign subsidiaries will normally be considered Indian companies because they are managed from India and are subject to tax obligations in India on their global income. To avoid this, an express clarification that the Place of Effective Management (‘PoEM’) clause under the Income Tax Act will not be triggered merely because the holding company is based in GIFT City should be made.
  6. Exempt GIFT City entities from angel tax: Angel tax provisions subject an unlisted company to a tax liability for money received that results in the issuance of shares that exceed the Fair Market Value (FMV) of the company. Additionally, shares issued to non-resident investors cannot be below the FMV of the shares. As a result, the only tax-efficient option for a company would be to procure investment at the exact FMV of the shares, which may have a detrimental impact on the valuation of the company and might deter foreign investors from investing in India. To encourage the flipping of offshore holding companies into GIFT City and to encourage greenfield set-up of companies in GIFT City, angel taxation provisions should not apply to GIFT City holding companies.
  7. Reduce the burden of transfer tax levied by offshore jurisdiction: For startups reverse-flipping into GIFT City, the foreign country might subject them to tax obligations. To reduce the burden of these tax obligations, the Indian government may allow the entity to carry forward losses or provide the entity a 20-year tax holiday instead of the existing 10-year holiday.
  8. Exempt entities from stamp duty: When the offshore entity flips into IFSC, the entity will have to pay stamp duty for the set-up of the company in India, transfer of assets, etc. It is recommended to provide stamp duty exemption for entities looking to relocate to GIFT City.

III. Listing of Startups on IFSC exchanges

  1. Reduce barriers to listing of start-ups on IFSC stock exchanges: The current conditions to list startups on IFSC stock exchanges such as having an operating revenue of $20 million and a pre-tax profit of $1 million act as significant barriers. Relaxations or exemptions should be provided from these conditions to allow the start-ups to raise capital from the market.
  2. Issuance of Indian depository receipts (IDR) on the Indian stock exchange: Indian depository receipts (IDR) allow Indian investors to indirectly invest in the foreign company’s equity but issuance of IDR is subject to certain conditions such as a minimum average market capitalization and a track record of profitability that might hinder a company from issuing IDRs. It is recommended to relax these conditions. Further, it is recommended to allow IFSC-based custodian banks to issue IDRs on behalf of companies as opposed to only allowing overseas custodian banks. These liberalised IDR guidelines will make it easier for Indians to invest in foreign entities as well as allow foreign companies to tap into the Indian market and attract capital from Indian investors.

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IV. Peripheral Issues

  1. Exempt GIFT City entities from deemed gift tax: Relocation of holding companies in IFSC should be exempt from the “deemed gift tax” provision under section 56(2)(x) of the Income Tax Act subject to certain conditions similar to that provided for investment funds. Deemed gift tax is an anti-abuse provision to tax transfers that take place at less than FMV. Basically, the provision states that if any property is transferred at zero value or at a price less than its FMV, then the difference between the FMV and the transaction price is taxable as income in the hands of the recipient.
  2. Allow deferment of ESOP taxation: Employee Stock Ownership Plans (ESOPs) are important tools for employee retention and compensation. The Indian regulatory regime does not permit the issuance of ESOPs to vendors or promoters, so when the offshore entity flips its holding into India, the vendors or promoters holding ESOPs will have to offload their ESOP holding or convert them into shares. It is recommended that the taxation for this be deferred because the tax paid might turn out to be a dead cost if the startup fails and the shares become worthless.
  3. Lay down tax regime for Convertible Notes: Currently, the Income Tax Act, does not deal with the taxability of Convertible Notes (CNs). It is recommended to lay out a tax regime and valuation mechanism for CNs and to treat CNs similarly to other convertibles.
  4. Lower personal tax rates for non-resident individuals: Countries like Singapore, Hong Kong, UAE, Caymans Island and Switzerland, are popular for entrepreneurs because of low personal tax rates. India currently imposes a personal tax rate of 30% plus surcharge and cess making it comparatively higher than other competitive jurisdictions. To boost the relocation of non-resident high-skilled professionals and employees to India, the country should lower its personal income tax rates for such individuals to less than 20%.

V. Other Regulatory Issues

  1. Allow ODI for GIFT City entities: Overseas Derivative Instrument (ODI) regulations do not permit an IFSC entity to have subsidiaries outside of IFSC. Because of this, resident individuals cannot hold ODIs (Overseas Derivative Instruments) in startups that have flipped their offices back to India and have set up their HoldCos in IFSC but have subsidiaries outside of IFSC. It is recommended to allow ODIs in entities in IFSC that have Indian subsidiaries.
  2. Exempt mergers from NCLT approvals: Flipping back to India might require mergers and acquisitions (M&As) that are normally subject to approvals from the National Company Law Tribunal or the RBI. To encourage flipping, it is recommended to exclude mergers involved in reverse flipping from the purview of NCLT and other complex processes.
  3. Facilitate smoother and faster exits: A company might decide to wind down for many reasons but winding up of a company is a “herculean task” currently. The Ministry of Corporate Affairs introduced the Fast Track Exit Mode to speed up this process, but there is still a lot of friction in this process compared to foreign jurisdictions such as the US where it can be done in a day. It is recommended that the exit process from India should be rationalized and improvised. No Objection Certificates (NOCs) from all concerned departments should be given in an expeditious manner and the timelines associated with the same must be bought down. A fast-track option should be made for IFSC entities that want to wind up, as an alternative to the process in the Insolvency and Bankruptcy Code, 2016.

VI. Dispute Resolution

  1. Set up special courts and arbitration centres: There are currently over 43 million cases pending in courts in India. To combat the delays and procedural complexities with the court system in India, it is recommended to establish special courts in GIFT IFSC (similar to the court system in Dubai International Financial Centre) that can provide a faster, simpler and more efficient dispute resolution mechanism for Companies Law and Intellectual Property Rights related matters. Additionally, an international arbitration centre at GIFT City should be modelled based on international standards for adjudication of disputes on the lines of the Singapore International Arbitration Centre, or the London Commercial Arbitration Centre.
  2. Set up advance ruling authority to address questions on regulations: Since regulations governing the IFSC are still evolving, the establishment of an advance ruling authority to address any regulatory questions that entrepreneurs and investors may have is recommended. “It would be helpful if such Authority was comprised of retired Supreme Court judges who would receive remuneration as per international standards and perquisites for tax and other important legal purposes.”

VII. Operational Issues

  1. Expand escrow mechanisms:  “An Escrow arrangement is a monetary instrument whereby an escrow agent holds liquid assets for the benefits of two parties who have entered into a contract.” While RBI permits escrow accounts in India, there are certain differences in the usage of escrow arrangements in India and globally. For example, the maximum tenure of escrow accounts in India is 18 months and they are non-interest bearing but globally these accounts have a tenure of 3 to 4 years and can accrue interest. It is recommended to streamline the usage of escrow arrangements in India such that the rules governing the same are in conformance with the global practice.
  2. Easen deferred consideration for M&As: Merger and Acquisition (M&A) agreements generally include a deferred consideration clause for due diligence findings, etc. This allows companies to pay a portion of the purchase price in the future. But in India, there are several issues for disbursing deferred consideration in case of transfer of equity instruments between a person resident in India and a person resident outside India. This includes requiring approval from RBI if the consideration is deferred over eighteen months and capping deferred consideration at 25% of the total purchase value. It is recommended to widen the tenure of deferment and increase the cap limit of deferred considerations.
  3. Provide automatic IMB approval for IFSCA registered Fintechs: The Inter-Ministerial Board (IMB) under the Department for Promotion of Industry and Internal Trade (DPIIT) validates and recognizes the startups, thus granting them government benefits that are available to the start-ups. Startups registering in GIFT City would be required to register themselves with IFSCA for setup and also with IMB to get the certification of an “eligible startup.” It is recommended that IFSCA explore an understanding with DPIIT and the IMB such that the approval of Fintech Companies by IFSCA is relied upon by the IMB to certify them as “eligible start-ups.”

VIII. Automation Challenges

  1. Automate administrative procedures that require human intervention: Despite attempts to simplify the business registration process in GIFT City, there are still areas that are complicated and time-consuming such as requiring wet ink signatures on certain documents, physical presence to register lease deeds, etc. It is recommended to introduce an automated framework in some of these areas including company registration and compliance, financial services and transactions, regulatory reporting, risk management etc.

IX. Infrastructure Issues

  1. Improve infrastructure in GIFT City: Currently, GIFT City has inadequate infrastructure facilities such as a lack of commute options, restaurant chains, bars, recreational facilities etc. “Quality infrastructure is a prerequisite for a business environment and the quality of life of the people to flourish.” Infrastructure can be improved by inviting more restaurants, bars, and global food chains to open up in GIFT City, increasing public transport options, setting up recreational centres, opening more shops, etc.
  2. Set up state-of-the-art incubation centres: GIFT City lacks a world-class incubation centre. It is recommended to set up such a centre with adequate infrastructure and availability of sectorial mentors to enhance the startup ecosystem in GIFT City. “A startup incubator is a program that helps startups in their early stages of development. It provides support services such as education, mentoring, funding, networking, and workspace.”

X. Intellectual Property related issues

  1. Improve IP protection: Companies face numerous challenges with respect to their intellectual property (IP) in India such as delays in the processing of patent and trademark applications, a lack of clarity on patenting new technologies such as software, an inadequate number of specialised benches for the protection of Intellectual Property, etc. It is recommended to form a committee to review the delay in granting patents and include software and business methods under patentable matters. It is also recommended to conduct various awareness campaigns where expert advice is provided to the applicants.

XI. Perception-related issues

  1. Create awareness about GIFT City and changes in regulations: There is currently a lack of understanding amongst investors and even entrepreneurs on the changes made to Indian regulations in the past few years as well as the benefits of GIFT IFSC. To tackle this it is recommended to engage with founders who have flipped overseas, hold meetings with investors who insist on flipping, take advantage of industry associations to promote GIFT City, hold town halls with the industry, etc.

XII. Capital raising

  1. Allow raising of capital through SAFE instruments, SPACs, VCCs and listing on offshore exchanges: Companies in India can typically raise money from debt from banks, issuance of bonds, issuance of shares in private placement, or issuance of shares in initial public offering (IPO). Startups are unable to raise funds from foreign stock exchanges which have wider investor participation or via certain new age methods such as Simple Agreement for Future Equity (SAFE) instruments, Special Purpose Acquisition Companies (SPAC), and Variable Capital Companies (VCC). It is recommended to frame regulations to allow and encourage entities in GIFT City to use such instruments and to also allow companies to raise capital through offshore stock exchanges.
  2. Modify Convertible Notes framework for more flexibility: Convertible Notes (CN) make it easier for start-up companies to raise investments and are popular because they provide the option to decide at a later date whether to convert the CN into equity or not. But in India, there is a restriction that the CN should repaid or converted to equity shares within 10 years. It is recommended to remove the time limit and to also allow CNs to convert into mandatorily convertible equity instruments rather than equity shares directly.

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