In this blog post, Meet Kachy, pursuing M.A. in Business law from NUJS, Kolkata, opines upon if it makes sense for the Indian entrepreneurs to incorporate their holding company in another country.

India is rapidly turning into one of the world’s leading entrepreneurial hotspots and it is not difficult to see why. In an increasingly slow-growing world economy, India’s demographics and low base provide a large market with a potentially long growth runway making it one of the standout economic destinations.

The above mentioned macro-economic factors coupled with a largely young and fairly educated workforce and a growing aspiring consumer class make India an attractive market to experiment with new ideas, launch new products and create new businesses.

All these factors create a fertile environment for a new generation of Indian businesses to emerge.

The most fundamental factor in the success of any entrepreneur/start-up is the ability to fulfill an explicit or a hidden need with a good quality product or service

We see around us plenty of new ideas mushrooming each day, some of which will become very big someday and most of which will fail to take off the ground. While the most fundamental factor in the success of any entrepreneur/start-up is the ability to fulfill an explicit or a hidden need with a good quality product or service, this soon becomes a basic hygiene factor.

Once a product or a service is found to be relevant and meaningful as well as of a good quality, the future success of the company and its promoters is often dependent on their ability to understand and navigate the labyrinth of various compliance, regulatory and legal structures which govern their business.

One of the key factors governing the above is the domicile of the start-up and its corporate structure as they determine the regulatory framework which will govern the business (hereinafter referred to as company).

We will explore this question by going through the three key aspects of any startup/company –

1. Investing into the company
2. Operating the company
3. Exit/returns from the company

Before we delve any deeper, it would be prudent to state the base assumptions upon which the document is written. We assume that the situation we are discussing involves a resident, Indian operating company (hereinafter referred to as the “Opco”) which is operating a business in India and the question involves the domicile of the holding company (hereinafter referred to as the “Holdco”) of this operating company.

The operating company is the majority or completely owned by its holding company. The founder/promoter of the Opco and its underlying business are also assumed to be Indian citizens resident in India.

Investing into the Company

One of the key aspects of running a start-up and growing the business is to obtain investment from various strategic & financial investors. Due to the nature of how the global economy has evolved and how it currently operates most often, the subject matter expertise, the wealth and the patience/mindset required to invest and nurture a young business is available only outside the country either in the western markets or in wealthy Asian countries such as China, Singapore and Hong Kong.

Investment into an Indian company can be done by resident individuals/entities or non-resident ones.

• When the latter is an investor into any Indian company it is governed by the rules of foreign direct investment, as covered by the extant foreign direct investment policy at the time.

• As far the FDI policy is concerned, it treats individuals and body corporate/partnerships the same with regards to the FDI policy.

Hence, whether the Opco is receiving investment directly from a foreign individual or from a foreign domiciled Holdco, the same set of rules are applicable.

Any foreign investment into the Opco will be governed by the latest FDI policy circular.

The said circular defines in very clear terms –

1. The amount of foreign shareholding allowed.
2. The mode of investment.
3. The definition of a non-resident investor.

• Amount of Foreign Shareholding Allowed

• The government of India has defined the maximum thresholds of the foreign shareholding allowed in various sectors of industry.

For example, the government allows 100% FDI in ‘non-news and current affairs’ television channels but only 49% in ‘news and current affairs’ television channels.

• Mode of Investment

There are two approved modes of FDI into an Indian company –

• Automatic Route

Under the automatic route, the investor doesn’t require any approval from the government for its investment. It is possible that a particular sector could have automatic approval up to a certain level of investment beyond which government approval is required.

For example, investment up to 49% stake in any defense undertaking is covered under the automatic route but government approval is required for investment above 49%.

• Government Route

Under the government route, prior approval of the government is required for the investment to go ahead. This approval is provided by a body called the Foreign Investment Promotion Board (FIPB) which comprises of secretaries from ministries of finance, commerce & industries and external affairs.

• Definition of Foreign Investment

• Foreign investment into an Indian company includes both direct and indirect foreign investment.

• Direct investment means investment which has come from a non-resident entity directly into the target resident entity.

• Indirect foreign investment means that investment which has come from a non-resident entity into a resident entity which then further invests into the target resident entity.

If the investing resident entity is such that even after the non-resident investment it is still owned and controlled by an Indian person/entity then, the downstream investment into the Opco will not be considered as a foreign investment.

So, any decision about having a foreign-domiciled Holdco and attracting foreign investors will first have to be filtered through the above-described FDI rules and regulations.

If the underlying business proposed to be conducted in the Opco is such that the government doesn’t allow up to 100% FDI then the entire premise of having a foreign-domiciled Holdco can fall flat.

The next aspect which needs to be considered with regards to investing into the venture is that there are two broad types of investors in any company –

1. Promoters
2. Non-Promoters

We shall evaluate the given situation from both their perspectives:

• Promoter/Founder Investment

• The promoter/promoter group/founder (hereinafter referred to as ‘promoter’) is the person/group of persons who are central to the entrepreneurial venture.

The promoter will want/have to invest a certain amount of funds in their own venture to ensure they have a good amount of control.

• If this is to be done via a foreign-domiciled Holdco, the promoter will need to transfer their funds abroad first into the Holdco which will then come back into the country into the Opco.

While this is definitely allowed, it is governed by another set of regulations called the Master Circular on Overseas Direct Investments, defined and updated by the Reserve Bank of India from time to time.

The above circular defines the limits of maximum investment which can be done in a year (USD 1 billion or 400% of net worth of the entity, whichever is lower) as well as the modus operandi and any other restrictions.

More importantly, these rules can restrict the flexibility that the promoter can have with respect to infusing funds into their own venture.

Hence, the promoter needs to have a very clear picture as to why they would want to invest via a foreign-domiciled Holdco as prima facie, there doesn’t seem to be any merit for them to be doing so.

• Non-Promoters

• As far as non-promoter investors are concerned, while the FDI, as well as, the ODI would apply as relevant, they could have valid reasons for wanting to invest via a foreign-domiciled Holdco.

• For non-promoter investors based in foreign locations, it might be easier and more attractive to invest directly into a Holdco which is domiciled in their home/preferred jurisdiction, leaving the hassle of foreign investment compliances for the Holdco/Opco to sort out.

The same would also apply when they are taking their money out during an exit. We will cover this aspect in more detail later in the article.

As a conclusion to the investing stage of the start-up and the benefits of having a foreign-domiciled Holdco, we can state the following:

• The suitability of a foreign-domiciled Holdco and consequently foreign direct investment into the Opco business will primarily be governed by the activities proposed to be carried out in the Opco.

If the extant FDI regulations are favorable to the underlying business of the Opco then this becomes a non-issue. But if the underlying Opco business is such that the extant FDI regulations do not allow majority foreign ownership then having a foreign-domiciled Holdco would not be advisable.

• Unless the promoter has a very strong reason to invest money via a foreign-domiciled Holdco, extant RBI regulations on FDI could create an additional layer of restrictions and compliances for the promoter to invest money into their own venture. Non-promoter investors, on the other hand, could be neutral between the two options and maybe even prefer the option to invest in a Holdco which is based in their home/favorable jurisdiction. Prima facie, this may not be a game changer either ways.

Operating the Company

Once the business has been set up with some initial capital, and hopefully some investor capital as well, the corporate structure should be such that it allows for hassle-free operations on a day-to-day basis. This is important because no promoter starts a business to spend all their time on completing compliances and worrying about the corporate structure. It is thus very important that the holding structure of the company is such that it minimizes the time and cost spent towards compliance and regulatory activities. We shall focus on this issue from a few different angles, namely:

• Operational Compliance

• As the business of the Opco will be conducted within the territory of India, it will be governed by the various compliances and regulations existing in India.

But if the Holdco is a non-resident entity then there will be additional compliances with respect to Foreign Exchange Management Act (FEMA) which governs the flow of currency in and out of the country.

• As a fundamental understanding, the Reserve Bank of India has a much lesser objection to foreign currency coming into the country than exiting out of the country. Having said this, FEMA compliances have to be done on both kinds of transactions, be it inflow or outflow, regardless of whether the flow is of an investment/capital nature or of an operational nature.

• The cost of these compliances is typically in the form of additional human capital resources as the business will need to either employ or hire professionals competent in completing FEMA transactions and ensuring compliance. This is not an easily available skillset as rules are continuously evolving and not all finance, legal and secretarial professionals have had exposure to the same.

• This is also important because FEMA non-compliances can often hold up transactions for months together and can come back to hit the business at any point in the future most often, during subsequent rounds of investing or during investor exits.

• Taxation

• As the Opco is a resident as well as the main business generating entity, it will be governed by the accounting and taxation rules existing in India. Hence, its earnings will be taxed at the usual Indian corporate tax rate, which can effectively be nearly 30%.

• Even if the Holdco is domiciled abroad it would have no effect on the corporate taxation of the Opco.

From an operational & on-going compliance aspect, it would not be advisable to have a foreign-domiciled Holdco.

Exiting the Company

One of the main reasons for new businesses to be formed and invested into is that the promoters and investors are looking to make outsized returns from betting big at an early stage into what they believe would be successful businesses of the future. While promoters can often start a venture out of passion for the underlying business and could even continue doing the same for many years, non-promoter investors are always investing from the perspective of generating returns, either for themselves or for their clients whose money they are managing.

Hence, one of the key points of discussion & negotiation in any such deal is the exit strategy of the business and the various exit options available to the investors. These options and rights can be materially impacted by the corporate structure of the business.

Below, we examine the question at hand and how it will impact the return of capital to the investors:

• Dividends

• Once the Opco has paid its income taxes and subject to the rules governing dividend distribution under the Companies Act 2013, it is free to pay dividends to the Holdco after withholding the dividend distribution tax.

• The above rule is applicable regardless of whether the parent (Holdco) is domiciled in India or abroad.

• Exit via Sale of Shares

This is the primary mode of exit as well as the primary motivation for investors to invest in a start-up. There are two main ways to exit a private entity:

• Secondary sale to another private investor

• This involves selling the shares in the business to another private investor, preferably for a profit on the original investment made.

• Investors, especially foreign ones, could have a preference to invest via a foreign Holdco as it makes it very easy for them to offload their shares to another investor in their jurisdiction. While the underlying business will continue to run in India, the investors can get an easier exit as the incoming buyer will also not have to undertake any FEMA compliances which they might otherwise have to if the investment was made into a resident Holdco.

• Listing on a stock exchange via an IPO

• This involves offering the shares of the Holdco to the general public for investment and listing those on a recognized stock exchange. This provides a more permanent and much more liquid exit route for the investors, allowing them to sell down stake over time according to their preference.

• Listing requirements and regulations differ from place to place and are typically governed by the local securities market regulator. Due to the exponential increase in start-ups and their contribution to job & value creation, regulators in markets such as the USA have come up with a separate, lighter set of rules governing listing of start-up businesses.

This can make it attractive to have a foreign-domiciled Holdco which would find it much easier to list on an exchange abroad. Such an arrangement could provide tremendous liquidity to the Holdco shares and make the Holdco an attractive investment for the non-resident investor.

• Additionally, the abundance of growth-seeking capital, the scarcity of growth-generating businesses and a general culture of risk-taking in certain foreign markets can mean that often there is more appetite abroad to invest in early stage ventures in India.

This coupled with the above-mentioned point on ease of listing in foreign markets can make a foreign-domiciled Holdco an attractive entry funnel for interested investors abroad who can get access to a fast-growing Holdco without having to concern themselves with the various foreign exchange regulations and compliances.

• On the other hand, if the Holdco is a domestic entity, all is not lost. While there are certain formalities & documentations to be completed before a foreign investor can sell their shares and recoup their invested capital and any profits, as on date these are fairly well-established processes and approvals are not unreasonably delayed or held back.

• Similarly, SEBI is also continuously exploring facilitating easier listing norms for startups and has been working towards the same.

All considered this is definitely one aspect in which having a foreign-domiciled Holdco could be more beneficial to the businesses’ longer term prospects.

Why have a Holding Company?

The question at hand assumes that there is a holding company which needs to be domiciled either in India or abroad and the promoter is looking for advice on the same.

But it is also important for the promoter to understand whether we even need a holding company.

While there are benefits to having a Holdco (we shall enumerate a few later on in this article), there are costs involved in having a Holdco–Opco structure.

• First and foremost, there is the issue of the bloated share capital as shares will have to be issued at two levels.

To issue any shares, a company needs to have the requisite authorized share capital in place.

• This is obtained by applying to the RoC and paying fees which are in the form of an escalator.

For example- an infusion of Rs 50 Crs could entail registrar of companies (RoC) fees in the region of Rs 40-50 lacs whereas, an infusion of Rs 10 Crs would entail fees of only about Rs 5 lacs

While the business can issue shares at a premium to reduce these costs, issuing shares at a premium can be very restrictive with respect to the issuances of shares in future rounds of funding or even during a secondary sale.

• A Holdco-Opco structure also introduces multiple taxation incidences. As we have explored above in the section on exits, dividends and capital gains are taxed at each level which reduces the return of the investors and also makes the whole process very inefficient.

Does this mean there are no merits to having a Holdco-Opco structure?

No, there are situations where it makes perfect sense to have a Holdco-Opco structure. Some of which we list out below:

• If the Holdco to be structured as a parent for multiple businesses then, it makes sense to have this kind of a structure where the investors come in at the Holdco level and the Holdco management then allocates capital to various Opco entities.

This could add economies of scale to the group as Holdco can provide certain common management & administrative services to the various Opcos which don’t need to incur those expenses. It would also help the various Opcos in borrowing monies as the group size lends a certain level of stability to the business.

• As per the extant FDI rules, if a non-resident entity invests into a resident entity but only to the extent of 49% so that the investment receiving entity remains ‘owned and controlled’ by a resident, the receiving entity can then invest downstream into another resident entity as a domestic investor.

If such a scenario has to be played out then, it makes immense sense to have a Holdco-Opco structure but the Holdco investing directly into the Opco will have to be a resident entity which is owned and controlled by another resident entity.

Conclusion

I would not recommend an Indian entrepreneur to incorporate their holding company abroad unless most of the potential investors are abroad and insistent on the same or there are compelling case-specific reasons to do so.

A foreign-domiciled Holdco brings with it many layers of compliance and regulatory costs which is only in addition to the compliance and regulatory requirements arising out of running a business in India in the first place.

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