Flip structures under the new overseas direct investment framework

Flip structures involve the creation of a foreign holding company to which the ownership of an existing Indian company or operating entity is transferred. This effectively restructures the business so that the foreign entity becomes the parent company, while the Indian entity operates as its subsidiary.

Flip structures are recognised for their ability to accelerate growth, attract foreign investment, and enable expansion into global markets. While these structures offer significant advantages, the previous overseas investment regime (the ‘Erstwhile Regime’) imposed strict limitations on such arrangements. This highlighted the need for reforms to streamline these structures, facilitating ease of business and accelerating the flow of foreign investments into Indian startups.

To address this, the Indian government had set up a high-level advisory committee to recommend changes to the foreign direct investment rules, and to legitimise flip structures under the Indian law. As a result, the Indian government and the Reserve Bank of India (RBI) notified the revised rules, regulations and directions applicable to overseas investment by Indian entities and individuals (i.e., Foreign Exchange Management (Overseas Investment) Rules 2022 (OI Rules), Foreign Exchange Management (Overseas Investment) Regulations 2022, and Foreign Exchange Management (Overseas Investment) Directions 2022 (collectively the New Regime).

The New Regime, inter alia, aims to facilitate the ease of doing business in India, incorporates changes to permit Indian startups to adopt flip structures, and also allows access to funds of global markets.

In the recent past, flip structures have gained popularity among Indian startups, and some startups have actively adopted such flip structures to infuse funds. This article discusses the amendments introduced under the New Regime and its impact on flip structures adopted by startups in India.

Use and benefits of flip structures

Indian startups adopt flip structures to establish wholly-owned subsidiaries, replicating the shareholding to act as an investment vehicle for the startup, such that the investment received offshore is utilised by the startups for operations in India.

Popular in jurisdictions like Singapore, United States of America, and United Kingdom, these structures bypass India's strict exchange controls, enabling operations in India and facilitating higher valuations through listings on foreign stock exchanges. These flip structures also help Indian startups to achieve higher valuation by listing their securities over foreign stock exchanges. Considering these factors, flip structures are advantageous to Indian startups.

Round tripping and other restrictions under Erstwhile Regime

A flip structure offers various benefits, but it also triggers compliance requirements under India's overseas investment regime and foreign direct investment (FDI) laws. This is because, under such a structure, the Indian startup invests funds abroad (into its offshore entity) and receives investment from outside India (via funds raised by the offshore entity and redirected to India).

Consequently, a flip structure may give rise to round tripping, where an Indian founder invests in the foreign company, which in turn invests in India or already holds investments in India.

The Erstwhile Regime neither allowed nor prohibited round tripping in India. Accordingly, the RBI had an unrestricted discretion in approving transactions involving round tripping. The RBI had clarified in its FAQs that Indian entities are prohibited from setting up an Indian subsidiary through an offshore company.

Though the Erstwhile Regime was governed basis the RBI’s decisions, the OI Rules lay down the general principles applicable to overseas investment under automatic rule, and provide that overseas investment by a resident Indian must be in a foreign entity which is engaged in bona fide business activity, either directly or indirectly through its step-down subsidiary. While the restriction under the law seems reasonable, lack of a defined criteria in relation to bona fide business activity marks it with regulatory ambiguity.

Given that there was no clarification in relation to the meaning of the term, the RBI continued to exercise unrestricted discretion in granting approvals and considered that entities in round tripping are not engaged in bona fide business activity, which also led to a plausible conclusion that round tripping was prohibited.

Relaxations on round tripping under New Regime

To tackle the restrictions/ambiguity in relation to round tripping, the New Regime, inter alia, provides for wide ranging changes.

For Indian startups interested in flip structures, the following relaxations are key:

Bona fide business activity: The New Regime defines ‘bona fide business activity’ as any activity permissible under Indian and host jurisdiction laws, adding clarity for investments in foreign companies with multiple subsidiaries. However, ambiguities regarding the scope of Indian laws, including state-specific differences (e.g., online gaming) and whether holding companies qualify as bona fide businesses still persists.

Round-tripping structures: The New Regime permits round tripping, subject to the restriction that such structures are limited to two layers of subsidiaries. While the relaxation facilitates ease of doing business for Indian startups globally and enables them to downstream investment and revenues of the foreign company to their Indian subsidiaries, the limitation in relation to round tripping being limited to two layers of subsidiaries requires further clarification.

There is ambiguity on whether the two layers of subsidiaries are to be construed from the India leg or the global leg. If the former scenario is intended, then the Indian entity may be allowed to have investments till two layers before investing back in India, i.e., the foreign entity and one of its step-down subsidiary outside of India.

On the contrary, if the latter scenario is intended, then the Indian entity can invest up to two layers of further investment, before investing back in India, i.e., the foreign entity, its step-down subsidiary, followed by another step-down subsidiary outside India. Such investment will not require any prior approval from the RBI.

While the New Regime does not explicitly specify how to calculate the two layers of subsidiaries, the RBI’s Master Direction on Reporting under the Foreign Exchange Management Act 1999, which provides instructions for filing Form FC, clarifies that the levels of step-down subsidiaries should be determined by treating the foreign entity as the parent.

Therefore, a step-down subsidiary directly under the foreign entity is considered a first-level step-down subsidiary. Similarly, a step-down subsidiary of the first-level step-down subsidiary is regarded as a second-level step-down subsidiary, and so on.

Emergence of flip structures for startups: A positive move

Despite certain ambiguities under the New Regime, the relaxations and steps taken by the Indian government will be instrumental in allowing Indian startups to flip their structures offshore. This will help attract more foreign investments and boost the global expansion of Indian startups.

Further, while flip structures offer enormous growth in the funding of these startups, a comprehensive analysis of the foreign market and corporate structuring, particularly from an Indian exchange control regulations standpoint, is essential. This is to suit the goals of the investors and compliance with applicable Indian laws. That said, Indian startups should also analyse corresponding tax implications which may arise in relation to such restructuring.