Externalization: Can the government halt the trend?

By Rajesh Begur, ARA LAW
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Externalization is the strategy of incorporating holding companies in offshore jurisdictions for tax optimization and operational stability.

With India’s growth story gaining significant traction in the international marketplace, the prospect of Indian entities setting up offshore holding companies, especially in the e-commerce sector, has become increasingly alluring considering challenges associated with India’s complex tax and regulatory regimes. The allure is further augmented by the ease of operating from more business-friendly jurisdictions and the possibility of attracting financing overseas.

Advantages

Rajesh Begur
Rajesh Begur

One of the major triggers of externalization has been the uncertainty in the current Indian tax regime that has been bought about by ambiguities pertaining to the application of general anti-avoidance rules as well as moves such as the government’s attempts to apply retrospective taxation on indirect transfers of Indian assets. Further, the high rates of corporate tax, dividend distribution tax, taxation on transfer of shares and minimum alternate tax under the Indian tax laws have added impetus to companies seeking to externalize from the standpoint of mitigating tax risks.

The above factors are compounded by the scepticism with which investors view India’s current foreign exchange laws, which allow limited exit options to foreign investors. In particular, the perceived prohibition on enforcing “put options” and pricing-related restrictions add to the risk exposure of investors.

Also, with the recent advent of the Companies Act, 2013, risks from increased director liability, statutory minimum pricing norms (other than under the Foreign Exchange Management Act, 1999), etc., are sought to be mitigated by companies flipping overseas. Further, the relatively slow and long winding process of enforcing contractual rights in India is viewed as a deterrent for investing in Indian domiciled entities. Even though mechanisms are available for alternative dispute resolution in India, they are not necessarily viewed as efficient and effective modes for timely resolution of disputes.

In addition to the above, externalization offers a wider base of potential investors and greater access to global capital markets, thereby making fund-raising easier and more convenient, leading to better realization of business potential and higher valuations. Further, investment in offshore holding companies provides investors with immunity from the risks involved with exposure to currency fluctuations and erosion of investment value due to the depreciating Indian rupee.

Challenges

Even with externalization, India’s fast changing exchange control regulations and tax laws may still bring companies externalized overseas under their ambit. The introduction of the principle of “place of effective management” under the Finance Bill, 2015, whereby a company will be considered as “resident” in India if its place of effective management, at any time in that year, is in India, may have the effect of offshore entities falling within the Indian tax net.

Further, mirroring ownership of Indian entities in the overseas holding companies presents added challenges considering the requirement of regulatory approvals for transfer or swap of shares for non-cash consideration. Additionally, any acquisition of shares of Indian domiciled entities by overseas holding companies would require structuring from the tax and pricing/exchange control perspective. Also, the transfer of securities involved in the corporate inversion may be construed as an “indirect transfer” and might attract potential tax liability under the Income Tax Act, 1961.

Conclusion

The government has of late focused on bringing about “ease of doing business” in India. Towards this, it has proposed steps such as reduction of corporate tax from the current 30% to 25% over four years and amendment of the Arbitration and Conciliation Act, 1996, in order to restrain high tax rates and counter slow enforcement of contractual rights. To attract more foreign funding, it has taken steps to ease investment norms in the online retail sector. The government has also allowed offshore listing of Indian companies without the requirement of listing on domestic stock exchanges. Although conditions attached to such listing, such as the ability to list only 51% of shares and repatriation of funds if not utilized overseas within 15 days, may curtail such listings.

Despite these initiatives, more needs to be done to streamline the legal and regulatory framework in India and the government will need to take continuing and successive steps, and not actions in isolation, towards creating a level playing field from the perspective of taxation, regulatory, corporate and other factors. It will also have to streamline the approval process for investments and reduce barriers to exit by foreign investors in order to arrest the trend of externalization and flight abroad of Indian companies.

Rajesh Begur is the managing partner of ARA LAW, a first-generation law firm with offices in Mumbai and Bengaluru.

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