Economic Survey makes a case for startups to shift domicile to India, calls it 'reverse flipping'

The Economic Survey has made a case for startups to shift domicile to India and has recommended regulatory action and "solution –focused strategies" that will discourage startups from moving abroad in the search of a conducive regulatory environment.

The Survey observed that many Indian firms are establishing headquarters abroad, particularly in locations with favorable legal and tax systems. The survey notes that the process of "Flipping" refers to transferring the full ownership of an Indian company to a foreign entity, along with the transfer of its IP and data. This effectively converts the Indian firm into a 100 percent subsidiary of the foreign entity, with its founders and investors retaining ownership through the foreign entity by exchanging all shares.

As per the survey, startups often "Flip" early on due to commercial, tax, and personal considerations of their founders and investors. While, some companies "Flip" because their main market is overseas, others do so due to investor preferences or to access capital markets for better valuations and funding opportunities. In the past, better IP protection, tax treatment of licensing revenue, and flexible corporate structures have also been reasons for "Flipping".

Looking at reversing the trend of entrepreneurs leaving India, the survey says that reversal of ‘flipping’ can be achieved through collaboration among government agencies and other stakeholders.

The survey has recommended the following measures to accelerate ‘Reverse Flipping’:

Simplifying the process for grant of "Inter-Ministerial Board (IMB) certification" for start-ups.

Further simplification of taxation of Employee Stock Options (ESOPs).

Simplifying multiple layers of tax and uncertainty due to tax litigation.

Simplifying procedures for capital flows: Many countries, such as US and Singapore, have easier corporate laws, with lesser restrictions on the inflow and outflow of capital and treatment of hybrid securities.

Facilitating improved collaboration and partnerships with established private entities to develop best practices and state-of-the-art start-up mentorship platforms.

Exploring the incubation and funding landscape for start-ups in emerging fields like social innovation and impact investment.

In recent years, the startup community has called for simplification of tax policies on employee stock ownership plans, more favorable laws on capital movement, and equal tax treatment for both listed and unlisted companies.

The Economic Survey's observations come amid discussions in the startup community about the costs of moving a company back to India. PhonePe, a decacorn that recently relocated to India, described the process as a "stiff shock."

PhonePe's CEO, Sameer Nigam, stated that at least 20 unicorns are interested in moving back to India if the regulatory and tax environment improves. He explained that moving back to India is treated as a capital gains event for existing investors and requires a fresh valuation and payment of taxes, which resulted in "a loss of Rs 8,000 crore ($1.1 billion) for PhonePe's investors".

He also pointed out that early-stage startups face the challenge of convincing employees to accept a reset of their stock options, as well as the risk of losing accumulated losses in tax savings. Nigam stated that the Indian law needs to change to make it more attractive for startups to move their domicile to India.

The survey highlights India's booming startup scene, placing it among the largest in the world. Indian startups generated over 900,000 direct jobs in 2022, a 64 percent increase from the average of the previous three years, as per the survey. Nearly half of startups hail from Tier 2 and Tier 3 cities, demonstrating the abundant potential at the grassroots level. Although government support has made starting a business easier, start-ups still face challenges like funding, generating revenue, limited access to supportive infrastructure, challenging regulations, and complex tax structures.

The Survey noted that, destinations like Singapore and the UAE have designed their policies and tax structures to attract companies to establish holding companies and regional headquarters by offering tax benefits for dividends received by a subsidiary. In Singapore, there are no taxes on dividends paid to resident or non-resident shareholders. The UAE also doesn't impose withholding taxes. The Netherlands provides participation exemptions on dividends and capital gains for companies meeting certain shareholding thresholds, however, these exemptions are not available in India and relocating existing structures to India triggers capital gains tax. However, the abundance of capital through the thriving private equity and venture capital ecosystem, changes in rules against round-tripping, and the advancement of India's capital markets have slowed down the practice of "flipping" and have encouraged companies to consider "reverse flipping".

2023 is expected to be a challenging year for the global economy, and startups are navigating tough waters as well. Venture capital investments dropped to $24 billion in 2022, down from the record $35 billion in 2021, which can be seen as a reset for all metrics. Investors are now demanding profitability and rethinking valuations following the decline of newly-listed tech companies.

Unicorns such as Byju's, Bharat-PE, Swiggy, Sharechat and Meesho have all reported substantial losses, leading to a shift away from growth at any cost. To improve unit economics and conserve cash, many highly-funded, high-value startups have had to lay off employees. Over 20,000 workers were let go by Indian startups at last count.