All you need to know about Externalisation

How is externalization carried out?

The externalization process can be carried out by any form of company. However, mainly startups carry out the flip process to secure benefits of favorable regulatory incentives offered by other countries. Externalisation is carried out in the following way:

1. An entity (Start-up) is first incorporated in India. Usually, promoters of a start-up would consider incorporating an entity with all the regulatory compliances carried out in India.
   
   
2. In the next step, a holding company is incorporated in another jurisdiction outside India. Usually, start-ups prefer jurisdictions such as Singapore and USA to carry out the flip processes. At this stage, the terms and conditions of the shareholder’s agreement would be a replica of the one which is made with the Indian company.
   
   
3. After this, the foreign holding company (HC) would incorporate a wholly-owned subsidiary (WOS) in India. The Indian WOS is usually run by the Indian company due to ease of business and cost-effectiveness.
   
   
4. The Indian WOS becomes an operating company through a business transfer agreement.
   
   
5. In the final step, the entity (Start-up) ceases to exist.
   
   
6. With this, the foreign holding company would become the parent company to the Indian WOS.

Why go for Flips?

One of the main questions which you may ask is why Indian start-ups go for a flip at an early stage. The following reasons depict why an Indian start-up go for the process of externalization:

• To secure a large investor base- By flipping the Indian start-up would get access to a wider investor base consisting of foreign investors as well as Indian investors.

• More infrastructure and government incentives- This is one of the main reasons why Indian companies go for flips. Other countries offer more infrastructure and investment-friendly terms which are more aligned with the goals of the company.

• Avoids any form of currency fluctuation- There are currency fluctuations when a foreign investor invests in an Indian company. To reduce or mitigate such fluctuations, foreign investors prefer to invest in an offshore holding company to be immune from any form of currency risk and benefit from the value of appreciation of the Indian company.
  
  
• Restrictions on Put Options- ‘Put Options’ is a term that is widely used in shareholders’ agreements. Usually, this option comes into the picture when an investor is selling their respective shares. This option would state that specific shares must be sold at a pre-determined price after a particular pre-determined period. The regulatory enforcement of ‘Put Options’ in India is a controversial area.

• Expansion- The whole objective of an externalization exercise is to expand your business to another location. After incorporating in another country, it would be easier to comply and expand to other jurisdictions with limited compliance.

• Reducing Tax and Regulatory Compliance- Many companies want to reduce their overall tax liability. Once a company is incorporated in India, there are various regulatory compliances that must be carried out. Along with this, there are annual compliance requirements that must be followed by the Indian company. To reduce their overall burden, companies prefer carrying out an externalization exercise.

• Raising investment through listing- By carrying out the process of externalization, the Indian holding company can easily raise investment from listings abroad. Classic examples of successful flips include Wipro which is listed in global capital markets such as the New York Stock Exchange (NYSE) and NASDAQ.

When should a company go through the process of Externalisation?

Externalisation is carried out with the main objective of the commercial viability of the business. In many cases, a flip is only considered when it is feasible for an enterprise to expand overseas. Promoters would look into the type of customers they are serving after an externalization process. However, if a flip is carried out at a later stage, then the tax incidence would be more on the company.

Risk Pertinent to Flips

The following are the risks pertaining to flips:

• Costs- It is very costly to carry out the process of externalization as there are multiple cross-border related compliances that must be carried out by the company. Fluctuated costs can diminish the overall profits of the company.
  
  
• Intellectual Property- Companies that utilize the flip process are not just shifting from one jurisdiction to another jurisdiction, but there is a complete transfer of all the associated intellectual properties (IP) of the company.

• Round Tipping- Round tripping is a transaction where funds are transferred from one country to another and transferred back to the origin country for purposes of reducing and evading tax liability in the home country. Hence round tipping is a form of Foreign Direct Investment (FDI), which is any form of foreign investment in India. As per the guidelines of the Foreign Exchange Management Act, 1999 and the Reserve Bank of India (RBI) round-tripping is not permitted in India. In a round-tripping transaction, money is invested in a country say Mauritius for a particular period before it is got back into India.

• The objective of Flipping- Many startups in India are more concentrating on the type of customers they will serve once the flipping process is completed. They are not looking at the bigger picture and objective of carrying out the flipping exercise.

Conclusion

Flipping is a restructuring exercise carried out by a startup to avoid various regulatory norms in India. Foreign investors are more favourable when a company carries out a flipping exercise, as there is no form of foreign exchange fluctuation. Moreover, an investment in the company by a foreign investor may be a condition after the company has carried out a successful flip. Flipping has its advantages to the foreign holding company as well as foreign investors who are funding the company.