Reverse Flipping Through An Inbound Merger
(Dewansh Raj and Archisman Chatterjee are 4th-year students at National Law University Odisha)
Introduction
The ministry of corporate affairs issued a notification on September 9 2024 which introduced amendments to the CAA rules. The amendment now allows the merger between foreign holding company and it Indian wholly owned subsidiary to fall under the fast track merger scheme under section 233 of the Companies Act (‘the act’). Section 233 of the act allows the company which meet the criteria mentioned in the section to eliminate the requirement of obtaining approval of the NCLT.
For a merger between a transferor foreign company that is incorporated outside India and is a holding company and a transferee Indian company, which is its wholly owned subsidiary (WOS), prior approval of the Reserve Bank of India (RBI) has to be obtained, thus doing away with the process of deemed RBI approval.
Further, the Indian WOS have to file an application with the Central Government under Section 233 of the Act, read along with Rule 25 of the Companies (Compromises, Arrangements, and Amalgamations) Rules (CAA Rules). Additionally, if the foreign firm is established in a nation that borders India by land, the Indian WOS shall make a declaration in Form CAA 16 during the making of the application through the fast-track merger process. This requires the Indian WOS to detail if prior sanction under the Foreign Exchange Management (Non-debt Instruments) Rules (NDI Rules) is required for the merger proposed.
Understanding The Difference: ‘Flipping’ To ‘Reverse Flipping’
The world of global startups is fast-evolving, and with it, the rising trends of “flipping” and “reverse flipping,” are becoming common parlance in the Indian entrepreneurial ecosystem. These terms refer to just a few of the many potential strategic decisions around domicile and operational headquarters of a startup, influenced by opportunities to attract investment, regulatory environments, or access to market.
Many Indian startups have followed the practice of “flipping,” which refers to the process of a company that was incorporated in India restructuring and laying the foundation of a holding company in a global jurisdiction like the United States or Singapore. This strategy was largely informed by a few factors:
Capital Access: Indian startups providing timely access to capital expected a favorable end. Venture capital and foreign private equity firms preferred to invest in countries that had stable regulatory environments and laws that were conducive to investors. By basing themselves in either the U.S. or Singapore, startups had the potential to access a network of international lenders which were generally more amenable to investing in an understood legal framework.
Regulatory Environment: To the layman, India was traditionally considered to have a complex regulatory climate and was not conducive to the requirements of rapid scaling of startups. The challenges spanned from stringent foreign exchange limits and bureaucracy to sudden changes in policies. By moving to more business-friendly jurisdictions, startups were far better positioned to actually face these issues head on.
Exit Options: There was a general belief that a listing on an international stock exchange, say NASDAQ or NYSE, was likely to be more lucrative with higher valuations, increased liquidity, etc. This potential for highly lucrative exits made flipping desirable for early stage startups aiming for an IPO.
There were challenges to implement this strategy, however, as it involved keeping two distinct entities one anchored in India for operational activities and the other abroad for holding purposes with the consequent manipulation of administrative nuances and the patching up of operational costs. Besides, following up with many legalities inevitably proved expensive in terms of legal and accounting resources.
Rationale Behind Reverse Flipping
However, in the Indian context the major reason for these companies to reverse flip is to get access to the Indian capital markets and go for an IPO. They expect to make huge returns on the Indian capital market more than in any other country, thanks to the recent trends. Further under the provision of the income tax act the transfer of a capital by the amalgamating company is not chargeable. Moreover the transfer by a shareholder of a capital asset being shares held in amalgamating company is also not chargeable subject to the transaction meeting the definition of amalgamation.
Given India’s law that only local company can only list on India’s exchanges, the prohibition on dual listings, and the poor track record of such companies listing elsewhere, it seems that the IPO-bound startups are returning home to ensure a proper exit to their investors.
Furthermore, industry sources claim that when it comes to important operational permits, like those needed by fintechs, India’s central bank and other regulators favour domestic companies over their international competitors.
Foreign Jurisdiction Compliance For Outbound Mergers
Having undertaken an examination of the Indian laws governing inbound mergers, it becomes essential to recognize the laws which are prevalent in the country of foreign jurisdiction involved in an outbound merger when viewed from the lens of the foreign company.
For instance, in Singapore, Sections 210, 212, and 215 of the act categorically prescribe that an amalgamation must be approved by the requisite majority as per the statute and the same has to be sanctioned by the High Court. Further, Singapore follows a voluntary merger control regime, meaning companies do not have a duty to solicit prior approval from the Competition and Consumer Commission of Singapore (CCCS). However, the authority has the discretion to proceed to initiate investigation after the transaction has been completed.
It is crucial to note that in the Cayman Islands, the entity which is dissolving is under the requirement of satisfying the domestic ‘Registrar of Companies’ with regard to certain points pursuant to which the merger would lead to the dissolution. Firstly, that it is not restricted by any ‘charter document’ of the company which could be referred to as the Memorandum of Association or Articles of Association in the Indian context, secondly, the company has no pending liquidation/winding up petition which is pending against it in any jurisdiction other than the one where the merger is proposed to take effect. Additionally, the entity is also necessitated to convene a board meeting in order to formally sanction and approve the draft plan of the merger. Subsequently, the company would have to produce all the documents which are relevant for issuing a ‘strike off’ certificate which in turn would clearly indicate the dissolution of the entity under Cayman law.
The Mauritius framework allows reverse flips but the same are subjected to Section 247 of the Act which lay down the procedure for “short-form amalgamations” and the same has to fulfil certain criteria. Firstly, when any company and another company or companies that are wholly owned by it would enter into an amalgamation. Secondly, where separate companies, two or more in number intend to amalgamate when they are wholly owned by the same companies. Under the laws of Delaware for outbound mergers, it is essential to show that the both the foreign and the domestic entity has taken approval from the board of directors and the shareholders through a resolution.
Nevertheless, it also specifically provides that if the entity which emerges from the merger is a foreign entity, they would be obligated to ensure compliance with the domestic law of delaware. Given all of these factors, there is a greater chance that timeframes will be delayed because of the regulatory ambiguity that exists in the two jurisdictions. Therefore, the success of internalisation through a cross-border merger would rely on the authorities’ permissions and careful consideration of the deadlines and procedures for completing such structures in all relevant jurisdictions.
Given these factors, there is a higher likelihood of delays in timelines due to prevailing regulatory uncertainty across both jurisdictions. Therefore, if internalization is pursued through a cross-border merger, its success will rely on obtaining necessary approvals from authorities and adhering to the timelines and procedures required for completing such structures in all applicable jurisdictions.
Inbound Merger V. Share Swap: The Better Option
Another method which is sometimes adopted by companies undertaking a reverse flip involves a share-swap agreement. It is effected by the issuance of shares to the shareholders of the foreign entity in exchange for shares of the newly formed Indian entity. Consequently, the investors of the foreign holding company will acquire direct ownership of shares in the Indian company, which in turn would make the Indian company the holding company of the foreign entity.
Such an issuance of equity shares to the investors of the foreign company (persons resident outside India) in exchange for a swap of the equity shares of the foreign company is required to comply with the provisions of the Non-Debt Instrument rules. Additionally, any such transaction would also have to comply with the sectoral caps for investments, pricing guidelines issued by RBI and other reporting guidelines as may be applicable. Further, such an entity would also be required to comply with Press note 3 and secure approval from the government of India if it shares a border with India or the beneficial owner of any investment resides in any country sharing a border with India.
However, a share swap arrangement has a certain set of challenges as opposed to the mode of an inbound merger. Under a share swap arrangement, individuals would be taxed on the basis of the difference between the present value of the shares of the Indian entity and the price at which the shares of foreign entity were acquired. On the other hand, if the flip is executed through the mode of an inbound merger, then the individuals holding the shares of the foreign entity which is merging with the Indian entity can claim a tax exemption under the exemptions provided in relation ‘amalgamation’ under Income Tax act.
Despite the promising investment environment, inbound mergers in India continue to suffer from a host of challenges that impact the efficiency as well as success of the transaction. The big challenges include the following:
As mentioned previously, businesses must comply with a large number of policies and regulations in order to make for a smooth transition back to India. Another major challenge lies in navigating India’s complex tax regime, especially when it comes to repatriation of assets and risk of double taxation. Corporates moving to India will need to adhere to the complex tax provisions on capital gains, immediate transfer pricing and the GST. The government did announce a couple of tax incentives including in GIFT City but more reforms need to take place when it comes to elements like corporate governance, regulatory approvals and cross border merger regulations.
In addition to regulatory hurdles, there are also commercial complications, including shareholder agreements and employee stock options. Reverse flips usually necessitate changes to the shareholder agreement and a reissuance of stock options to employees. Foreign stock option replacements with Indian-compliant Indian options may upset employees if new options prove less appealing. This can leave employees feeling disengaged, and raises risks in an environment where retention is vital, and talent is the lifeblood of an early stage startup. Companies, therefore, need careful management of such transitions to reduce attrition and keep the workforce balance.
Since compliance with these diverse laws and regulations can be a lengthy process, the government has recently amended the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016, to streamline the process for startups getting ready for an IPO when they return to India. This amends the existing law not only removes the requirement of approval by the NCLT but also reduces the processes time by 52%.
Working through a merger in this situation could be complex—ideally for companies from different cultural backgrounds, such as when a foreign company acquires an Indian entity, the integration of the organizational cultures, leadership styles, and business practices may not be easily manageable. Diverse corporate governance structures, decision-making models and employee work culture can cause resistance to change among employees, compromising the existing post-merger synergies. For successful integration, this necessitates paradigm shifts in change management strategies such as communication and the convergence of leadership.
The amendment marks a landmark step by the government in inviting the foreign companies back to India. The step has significantly streamlined the process of the and removes important roadblock of the permission of NCLT for reverse flipping. This would allow companies to execute the process faster without relying on courts for their sanction.
The newly introduced Rule 25A(5)(i) outlines that an approval is mandatory RBI in order for companies to merge or amalgamate. On the other hand, under Rule 25A(1), this requirement has always existed and is nothing new. It is relevant to point out that the deemed approval from RBI sought after ensuring compliance with Foreign Exchange Management (Cross Border) Regulations will stay in place and continue to operate, and as a consequence, no additional RBI approval would be necessary for a fast track merger.
Further, under Rule 25A(5)(ii), an transferee entity based in India would have to comply with the provisions of Sec. 233 of act and Rule 25A(5)(iii) requires such a company to mandatorily apply to the central government under sec. 233 of the act. The usage of the word ‘shall’ is the source of the confusion as sec. 233 allows the company to either opt for the court drive process under sections 230-233 of the act or apply to the central government.
However, the introduction of the new amendments hasmade it mandatory for companies who are looking to reverse flip has to go through the route of the central government and the court driven route is not available. Herein we refer to the rule of literal interpretation which means that the language utilized in a statute is the ultimate evidence of the intent of the legislature. In the present case, since the parent statute mentions the word ‘may’ as opposed to ‘shall’, the same cannot be overridden by rules framed under it.
However, companies will have more operational efficiency as a result of the accelerated process that avoids the NCLT, which will shorten the overall merger completion timetable from 8 to 12 months. In addition, reversal flipping is becoming more and more common in India. A large number of Indian subsidiaries, especially startups, are merging with their overseas parent corporations.
In October 2023, a caboodle of regulatory changes are coming into play, which introduces the possibility of the inbound merger and reverse flipping into our country-India. The omittance of NCLT approval appears to be good omens that erase the hurdles for uprooting companies abroad and reanchoring them by making compliance requirements less cumbersome. Not merely procedural, the change indicates an aggregate confidence in India’s budding economy, robust capital markets, and enhancement ease of doing business. Having said that, challenges remain. Reverse flip companies have to carefully deal with the issues of taxation, compliance, and operational restructuring.
Other regulatory hitches upon the RBI nod and those sectoral guidelines still can pose hurdles. Besides that, there needs to be a thoughtful integration of a seamless cultural and operational performance of the global businesses within the Indian ecosystem. Whether to reverse flip or use other mechanisms like share swaps in the end depends on a company’s long-term vision, market dynamics, and financial strategy. The long-term success of inbound mergers in India, as well as that of the broader startup ecosystem, would rely heavily on sustained regulatory reforms and investor-friendly policies, as it seeks to position itself as a destination of choice for global investments.
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