Introduction
The process of Delaware Flip is when an international company creates an American holding company for various purposes may it be Tax regulations, gaining American Venture Capital. The consequence of this Flip is that the international company will be owned by the newly born American Company.[1]
America has the biggest investors also the world’s biggest Stock exchange (New York Stock Exchange, NASDAQ)[2] Although American Venture Capital Funding can be obtained by Non – American Startups or companies, in this interconnected world governed by laws, these laws change with the change in Jurisdiction thus making it mandatory for American VCs to abide by the regulations of different jurisdictions for Investing. American venture Capitalists believe that the return on investments (ROI) from foreign investments will be inferior as compared to local or domestic investment. These particular hurdles discourage many American VCs from going ahead with the funding, but if the company is entirely owned by an American Company particularly situated in Delaware it becomes comfortable due to the comprehensive corporate regulations of Delaware in America also Delaware is one of the best places for incorporating a company as it provides level playing field or neutral ground. It also further benefits the investors from a tax perspective if the company is a particular jurisdiction for these reasons investors prefer jurisdictions that are similar to the US (Delaware) like the Cayman Islands or Singapore.
Why Delaware is preferred for the Flip?
Delaware is a popular jurisdiction for the registration of a company not specifically limited to the US but Internationally as well. One of the main reasons for the said jurisdiction is as follows:
- The Delaware Corporation’s shareholders can act based on a simple majority vote on the other hand many jurisdictions require either super-majority or unanimous consent.
- The rules and regulations of the finance and governance of a firm are substantially flexible and predictable.
- An act as complex as a Merger can get the consent of a simple majority of shareholders, irrespective of the consent of minority shareholders.
- The above-said points are more than enough for attracting a huge number of investors.
- Another advantage is the ease with which you can get listed on many stock exchanges just because you are a US-based company.[3]
How to do a Delaware Flip?
The typical process starts with the formation or incorporation of a Delaware company which is taxed under subchapter C of the American Internal Revenue Code (Delaware C Corp) and transfer of all Intellectual property to this new company. And now to transfer the ownership of the Indian company to the newly incorporated Delaware C company. This is achieved by executing a share for share exchange of the Indian company for the shares of the new Delaware company based in America.[4]
But this is not as easy as it sounds various essential considerations have to be reviewed as the ownership of the company is changing jurisdictions (To US) even when the higher management which takes the big decisions in the company are India, In this article, we will exclusively focus on the Indian regulatory challenges that may arise during the flip.
Indian Regulatory Perspective
The first big roadblock when it comes to Indian Jurisdiction is the Foreign Exchange Management Act (FEMA). The technical term for flip has not been explicitly defined in the FEMA or even by the RBI but the general idea of transferring all the Indian company-owned assets to another jurisdiction out-off India is frowned upon. The process of round-tripping – to hide the source of income or money by transferring it outside India below the name of Overseas direct investment (ODI) and then under the disguise of Foreign Direct Investment (FDI) bringing the same money back has been banned by the provision under Foreign Exchange Management Act, 1999 (FEMA), as well as Reserve Bank of India (RBI), has taken various steps for regulating said activities on various occasions.[5]
But if an Indian entity is keen on investing in a foreign company and wants to invest through ODI, currently it has to seek approval from the RBI, in a recent circular released by RBI it has decided to tighten the regulations around Overseas Direct Investment But ease up on round-tripping which means that the RBI is seeking to liberalize the rules and regulatory framework of the Foreign Direct Investment and Overseas Direct Investments structures.[6]
What the regulator is trying to emphasize is that it is fine with Indian companies investing in a foreign entity that already has investments in India provided that the purpose is not tax evasion or avoidance.
Focusing on the past outlook of RBI where it strictly prohibited any company with a round-tripping structure that was set up for tax efficiency or anything else But now it is trying to keep a liberal view towards ODI and FDI, a good example for it is that of SPAC (Special Purpose Acquisition Company) which is a shell company listed on the stock exchange, with the single purpose of acquiring a private company, indirectly making the private company Public without even applying for an Initial Public Offering (IPO). But even the incorporation of a special company runs into many hurdles due to the regulations of RBI of the matters stated above. [7]
The next difficulty faced by Delaware Flip is from the Income Tax Act, 1961, during the process of flipping the step of exchange of shares has to be scrutinized by Section 50CA and Section 56(2)(x) and lastly capital gains if applicable.[8]
Another step was taken by the Indian government for minimizing the loss of money due to the Flip by introducing Placement of Effective management (POEM). This concept was introduced by the Finance Act 2015. It is almost impossible to avoid taxes in India if the company does not have more than half of its business outside the jurisdiction of India. As per the rules, if the place of management is situated in India, the company will be treated under its jurisdiction meaning its entire income will be taxable in India.[9]
An excellent example of Flip is – Flipkart (Before it was acquired by US-based Walmart), The flip was performed in October 2011, the founders of Flipkart incorporated a company called Flipkart Online Services Pvt. Ltd (FOS) in the Jurisdiction of India in 2007. After which the company decided to go for FDI (Foreign Direct Investment). But due to the prohibition of FDI in the online retail market at that time, Flipkart. Pvt. Ltd (FPL) was set up in Singapore. This company as of 2020 has three WOS in Singapore. These three companies have stakes in five Indian companies one of which is Flipkart India Pvt. Ltd. (FIPL), Flipkart Online Services Pvt. Ltd (FOS)transferred its business to FIPL in 2011 thus completing the Flip.[10]
Conclusion
After the COVID-19 pandemic started the economies all around the world suffered badly, as India and other countries started recovering to the point they were before the Indian Government is trying its best to bring India Up in rankings of ease of doing business so that the economy recovers fast. Such was the step taken by the regulatory authorities of India when the corporate tax was reduced from 30% to 25% and RBI eased on regulations of round-tripping so that foreign investors find Indian markets more attractive.
But also Delaware Flip is not for every company looking for funding due to the obvious disadvantages of tax implications and complications in regards to the Income-tax Act, 1961 and also awaiting approval of RBI in certain cases of ODI.
Recently with the current trend of Blockchain and cryptocurrency the State of Delaware has passed the Delaware Blockchain Initiative which will make changes in the Delaware corporate law to track shares of issuances and transfers on distributed ledgers. This could bring a paradigm shift in the very foundation of the corporate and Financial Sector and Infrastructure.[11]
Lastly, we can say despite all these attempts made by the Indian Government for curbing companies from flipping and transferring to tax friendly countries with ease of regulation, it is but inevitable.
References:
[1] CNK RK & Co Chartered Accounts, Arkayandarkay, How to do the Delaware Flip, https://www.arkayandarkay.com/how-to-do-the-delaware-flip/
[2] EasyTrade, The Top 10 Stock Exchanges in the world, 21st Sep 2021, https://easytrade.io/news/the-top-10-stock-exchanges-in-the-world/
[3] Diva Rai, Ipleaders, Do you know about the Delaware flip, September 30, 2020, https://blog.ipleaders.in/do-you-know-about-the-delaware-flip/
[4] Supra note 1, para 4
[5] RBI, Circular on Overseas Direct Investments, (Updated as of September 19, 2019), https://www.rbi.org.in/scripts/FS_FAQs.aspx?Id=32&fn=5#_Can_Indian_corporates
[6] Payaswini Upadhyay, Bloomberg | Quint, RBI To Tighten Rules On Overseas Direct Investment, Ease Up On Round-Tripping, https://www.bloombergquint.com/law-and-policy/rbi-tightens-rules-on-overseas-direct-investment-but-goes-soft-on-round-tripping
[7] Julie Young, Investopedia, Special Purpose Acquisition Company (SPAC), October 16, 2021, https://www.investopedia.com/terms/s/spac.asp
[8] Aneri Dani, Taxsutra Database, Valuation Rules for Sections 50CA and 56(2)(x) – So Close Yet So Far!, May 29, 2017, https://database.taxsutra.com/articles/eb7d1deb2feb1c0f097079b44a3c4d/expert_article#:~:text=The%20Finance%20Act%202017%20introduced%20section%2050CA%20and,market%20value%20computed%20as%20per%20prescribed%20guidelines%20%28%E2%80%98FMV%E2%80%99%29.
[9] Deepansh Guwalani, IndiaCorpLaw, Analysis of “Externalisation” under Indian Law, May 14, 2018, https://indiacorplaw.in/2018/05/analysis-externalisation-indian-law.html
[10] id at para 7
[11] Andrea Tinianow, Harvard Law School, Delaware Blockchain Initiative: Transforming the Foundational Infrastructure of Corporate Finance, Thursday, March 16, 2017, https://corpgov.law.harvard.edu/2017/03/16/delaware-blockchain-initiative-transforming-the-foundational-infrastructure-of-corporate-finance/
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