India Tax and advisory, business entry and consulting services

How to do the Delaware Flip

Start-up CEOs are accustomed to the word flip, they must after all flip roles, flip assets, and flip shares to be able to sustain and grow their fledgling businesses. For certain companies there is another play on the word flip that is increasingly very relevant. This is the Corporate structural flip, from an India head quartered company to a US head office. Since often the US state of choice is Delaware (DE) this structure is also called the Delaware Flip.

This note attempts to understand the need, mechanism, and impact of such a transaction from an Indian regulatory perspective.

The need for a Delaware Flip

Despite the increasingly globalized, interconnected nature of the world economy, there exist variances in investor rights and regulations across the world. Some jurisdictions have the right mix of de-regulations as well as checks and balances to be empowering to the entrepreneurs as well as providing security to the investors. Further, given the structure of the investors themselves it may be beneficial for them from a tax perspective to invest only in entities incorporated in certain jurisdictions.

It is for these reasons that investors prefer to therefore invest in entities situated in either the US or similar jurisdictions ( Singapore, Cayman Islands). For the rest of this note we shall discuss only the Delaware Flip since that is the most widely

The Mechanics of the Flip

The Flip alludes to the incorporation of a Delaware entity and the transfer of all Intellectual property (IP) to the said entity and the transfer of ownership in the existing Indian entity to the new Delaware company, thereby completing the flip. This however looks simpler than it is. There are multiple issues that can arise, particularly when the Indian company has been in operation for a while or has any of the following, significant assets, investors, revenues, customers.

Important considerations

Foreign Exchange Management Act ( FEMA )

The biggest regulatory challenge to the Delaware flip emanates from the round tripping prevention provisions of FEMA. While round tripping has never been explicitly defined by the RBI, it is understood to the act of cloaking the source of dubious money by first taking it out of India as overseas direct investment (ODI) and then subsequently bringing it back to India as Foreign Direct Investment (FDI). You see how this structure has parallels with the mechanism discussed earlier? This similarity is the root cause of most problems with the flip.

To add insult to injury, the RBI in a September 2019 modification to its FAQs on ODI added the following line item.

Q: Can an Indian Party (IP) set up a step-down subsidiary/joint venture in India through its foreign entity (WOS/JV), directly or indirectly through step-down subsidiary of the foreign entity?

A: No, the provisions of Notification No. FEMA 120/RB-2004 dated July 7, 2004, as amended from time to time, dealing with transfer and issue of any foreign security to Residents do not permit an IP to set up Indian subsidiary(ies) through its foreign WOS or JV nor do the provisions permit an IP to acquire a WOS or invest in JV that already has direct/indirect investment in India under the automatic route. However, in such cases, IPs can approach the Reserve Bank for prior approval through their Authorized Dealer Banks which will be considered on a case to case basis, depending on the merits of the case.

This ensures that the transaction must be very carefully structured since the golden rule around regulations is “What Cannot Be Done Directly Cannot Be Done Indirectly”

Income Tax Act

From an income tax perspective, the exchange/issuance of shares as the case might be has to be examined from the perspective of section 50CA, Section 56(2)(x) and capital gains if any.

Other points to consider

Once completed the founders also have cope with the provisions of the Place of Effective Management (PoEM) rules. In short, the rules mandate that the place of residence and therefore the taxable jurisdiction of a foreign entity will lie in India if significant business decisions, and management of the company also reside in India. Delaware flip entities with founders in India will have to be very careful of the repercussions of this provision and how it affects their business on an on-going basis.

Writing off Indian investors, one tragic side effect is the additional layer of compliances imposed for Indian investors. Per the amended ODI regulations, that we alluded to earlier, these investments can be made only with prior permission of the RBI adding a layer of compliance and uncertainty for Indian/India based investors.

Comments are closed.