All you need to know about Externalisation of Businesses

Ankit Mishra

12 Jul, 2023

In the era of globalisation and digitisation, businesses are offered a lot of variety to run operations across the globe. The digital revolution has already cut down the borders and trade barriers that once hindered their expansion strategies. However, the legality of running a business internationally should be followed according to the varying law of the land.Aside from the secretarial and tax-based benefits of externalising business, it provides a better opportunity for the businesses from the fundraising perspective. This process connects the Indian companies with possible foreign investors who feel safe investing in a company that is keen to establish a holding company in a foreign land. This not only diversifies the portfolio of the Indian entity but also provides it with better opportunities in the international market. This article aims at demystifying the meaning and concept of the Externalisation of business with the process, advantages and challenges it possesses.

What is the Externalisation of businesses?

Externalisation is a process to systematically incorporate holding companies in an offshore jurisdiction, allowing them to enjoy benefits on taxation, secretarial and financial aspects of the business. Many companies employ this strategy to make good of the relaxations offered by countries that are relaxed in terms of secretarial and regulatory norms. Also referred to as a ‘Flip’, this concept is a favourite amongst the growing start-ups to take their business internationally.

In the Indian context, there are various benefits of externalising business activities to an offshore holding company, like mitigating currency fluctuation risk and better enforceability of business functions. This is the primary reason that the major private equity players, tech companies and other portfolio companies find this process very attractive to this process externalisation of their businesses.

Case Study (Flipkart India Private Limited)

To explain it with an example, Indian e-commerce giant Flipkart in the year 2011 did the exact thing as FDI was not allowed in the online retail sector at that point in India. Bansal’s set up a company in India by the name of Flipkart Online Services and then went on to establish an ultimate holding company by the name of Flipkart Private Limited in Singapore. Flipkart India Private Limited was established in 2011 and is a subsidiary of FPL. The FOS entirely transferred its business to the Singapore-based entity in 2011, completing the process of externalisation of business,

Benefits of Externalisation in the Indian Context

• Put Options are an essential exit strategy for investors; however, the enforceability of the same has been a profound conundrum in India. RBI and SEBI have made those options illegal in India, which makes investing in India poorly paid for foreign investors. The put options allow the investors to exit in advance when they feel that stock prices are about to fall. Hence Externalisation of an Indian entity can make it more lucrative to foreign investors as they will be able to put forth these put options for the capital. 
• The process of greater access to global markets and a wider base of potential investors makes raising funds easier and more convenient. Many companies prefer going on international stock exchanges like NYSE and Nasdaq without going public in India.
• The currency risk posed by the Indian rupee can be evaded by investing in dollars from the offshore holding company. Many companies have carried out this exercise in order to manage currency fluctuations.
• Foreign Countries have a relaxed investment environment in comparison to India.
• It protects from enhanced director’s liability, pricing norms and other segments of the Companies Act.
•  Companies that operate globally possess a more significant advantage in expanding in different jurisdictions.
• Foreign countries provide better infrastructure and supply chain-oriented solutions to businesses, which also counts in favour of externalising business operations.

Risks/challenges posed by Externalisation

Round tripping

Round tripping essentially means coming back domestic money as FDI into the country; It is a prohibited practice under the FEMA, 1999¹, and the RBI has time to time, taken up the matter to curb this suspicious activity. Foreign countries allow tax concessions whilst carrying out business activities which is why many entities park their money in such jurisdictions. This money is then invested in a company of that jurisdiction which is brought in as FDI into India. This vicious cycle is adopted to evade taxes by individuals. Round tripping is a challenge that plagues the adaptability of externalisation as this activity can be turned into an offence of money laundering.

POEM (Place of Effective management)

The place of effective management (POEM) is a concept that emerged after the Finance Bill of 2015, under which any company whose place of effective management falls in India that all its foreign incomes would also be taxed according to Indian Laws. Externalisation was, in the way, sought as a loss by the exchequer, and the POEM was introduced to curb this process to get rid of money laundering.

Regulatory approvals

 In Share Swapping 

The basic challenge faced by any entity is the transfer or swap of shares from the Indian entity to the foreign holding. This process requires regulatory approval, which cannot be easily granted once it realises the basic aim behind swapping is to hold shares in the Indian Company. Such transfer of securities may be construed as an indirect transfer and attract a potentially hefty tax liability under the Income Tax Act of 1961.

Procedure of Externalisation

The process of externalisation of business is quite complex and is carried out in multiple ways, the following steps can be taken by the entity for a successful externalisation of their business.

Step 1:  The first step is to incorporate a company in India. The entity should not be a complex corporate structure, ideally a start-up.

Step 2:  Incorporation of a holding company in any other country like Singapore or Dubai. The shareholding of the newly found holding entity is as same as the Indian entity.

Step 3:  The foreign holding company has to incorporate a wholly-owned subsidiary company in India. An Indian company manages the operations of this business for its cost-effectiveness.

Step 4:  With a Transfer agreement, the subsidiary company established takes over the operation of the start-up company established primarily. It enables a smooth and legal transition of the business function to the subsidiary company.

Step 5: The start-up is thus dissolved, and the subsidiary company takes over the business whilst having its original jurisdiction in the country where the shareholding was mirrored.

Conclusion

The Government of India has emphasized promoting the ‘Ease of Doing Business in the country, the corporate tax rate has been slashed, and various statutes have been amended to bring about the change necessary for increased public participation. To attract more FDI into the country, investment norms have been relaxed in many industries. To boost AI and Fintech industry, regulatory sandboxes have been developed in order to test the new products before launching them in the market. Double taxation avoidance agreements have been signed with many countries to ensure no round-tripping of funds into the country. These initiatives have boosted the spirit of entrepreneurship in the country. Still, there is a long road ahead before the time that India can compete with the business environment of foreign countries.

Read our Article: Facilitation of External Trade – Export of Goods and Services

1. https://en.wikipedia.org/wiki/Foreign_Exchange_Management_Act