In A First, Economic Survey 2022-23 Advocates For Reverse Flipping Of Indian Startups

Nearly 20% of Indian unicorns have headquarters outside the country, and PhonePe’s recent massive tax bill for redomiciling to India shows just how expensive it can be to have an HQ in India. But the Economic Survey 2022-23 for the first time has spoken about how to ease their way back to India, talking about steps to accelerate reverse flipping of Indian startups.

Whether this is a hint of things to come in tomorrow’s Union Budget 2023 is unclear, but chief economic adviser V Anantha Nageswaran and his team have outlined some measures that could be taken to arrest flipping and easing regulations to re-establish Indian HQs.

Flipping, or in other words registering a headquarters outside India, is all too common among some of the highest valued startups in the country. But often, this is also a requirement by investors, who often cite India’s complicated tax and tax litigation system as a primary reason for forcing startups to register abroad, while carrying out operations in India.

Economic Survey Looks To Reverse Flipping Trend

The Economic Survey calls these reasons “short-term gains in the dynamic, uncertain geopolitical world”, however, startups have legitimate reasons to not have HQs in India, given some of the reasons that have been cited by companies such as PhonePe in recent weeks.

Among the six steps presented in the Economic Survey 2022-23 are measures such as simplifying the process for grant of “inter-ministerial board (IMB) certification” for startups, simplification of taxation of employee stock options (ESOPs) and reducing friction by simplifying the “multiple layers of tax and uncertainty due to tax litigation”.

The survey also recommends easing the procedures for capital flows citing the example of geographies such as US and Singapore, that “have easier corporate laws, with lesser restrictions on the inflow and outflow of capital and treatment of hybrid securities”.

Hybrid securities include convertible bonds as well as convertible preference shares, which pay dividends at a fixed or floating rate and can be exchanged for shares at a later date. This is typically used by startups when selling equity to investors.

The chief economic adviser further called for improved collaboration and partnership opportunities with established private entities to develop best practices and boost mentorship of startup founders, as well as improving India’s startup incubation and funding landscape in emerging fields like social innovation and impact investment.

Siddarth Pai, founding partner of 3one4 Capital, believes the Economic Survey’s talking about aiding reverse flipping is a pivotal moment for the Indian startup ecosystem.

“Flipping is eroding the value created by the Indian startup ecosystem. India is a land of startups, not subsidiaries. Indian startups looking to go global from India must be allowed to do so. While India has made tremendous strides in incorporating and closing a company, issues still exist during a startup’s lifecycle.” – Siddarth Pai, founding partner of 3one4 Capital

Pai pointed out that non-residents are taxed at half the rate as residents from a capital gains perspective, while M&As in India require NCLT approval, which can take anywhere between 12-18 months, which is an impossibly long period of time. “Acknowledging this issue is the first step – hopefully they (authorities) can create a scheme to onshore Indian startups back to India and allow India to truly benefit from the value its citizens create,” Pai told Inc42.

Why Startups Flip Outside India

Data compiled by Inc42 shows that 20 out of the 108 unicorns in India are headquartered overseas. A whopping 75% of these are based in the US, and a majority come from the enterprisetech sector i.e SaaS startups.

Like Pai points out, “The ability to make and receive payments in USD, which is a cornerstone of the SaaS segment, is still a logistical nightmare in India.”

It’s not just unicorns that are HQ’ed abroad, but also hundreds of early-stage startups who are also registered overseas, largely due to investor pressure. The most frequently cited example is Y Combinator, which first came under pressure in 2020 for seemingly forcing some startups to register in the US, if they wanted to secure the funding deal.

Given the higher volume of investments in Indian startups by the Silicon Valley-based early-stage investment giant, this condition has definitely attracted criticism As per an Inc42 analysis, Y Combinator has invested in 217 Indian startups since 2005, of which 205 have headquarters outside the US.

Y Combinator is just one example, but it’s not uncommon to see this among other foreign investors backing Indian startups. Inc42 had covered the issue in detail in December 2020, which saw several investors and industry bodies talking about this pressure to HQ outside India.

Speaking to Inc42 then Sanjeev Bikhchandani, executive vice chairman of the digital behemoth Info Edge that owns Naukri, Jeevansathi, Shiksha and 99acres, called forced flipping “institutionalised transfer of wealth”.

At the time, Bikhchandani had said, “So you have a bunch of foreign investors who tell our best young startups that they will invest in their companies provided they shift their company domicile overseas. The reason being that they do not want to be subject to Indian laws, taxes and government rules except to the minimum extent required (because) they say they do not trust the Indian government and the legal system.”

Others have pointed out that the ownership of the startup, the intellectual property (IP) it builds and all its data shifts overseas, but startups build their products in India using less expensive human resources and also sell to customers in India. This results in India losing out on tax dollars, since the business pays the bulk of its taxes in the domiciled country.

PhonePe’s $900 Mn Reverse Flipping Bill 

In January 2023, PhonePe CEO Sameer Nigam flagged challenges for startups eye reverse flipping to India, claiming 20 unicorns would move their HQs to India if regulations were eased.

He also said that there are too many challenges for Indian startups in the reverse flipping process. PhonePe’s move to redomicile in India is said to have cost its investors almost $900 Mn in taxes, which was treated as a restructuring event. PhonePe had to take the step to list on Indian stock exchanges.

“I hope things will get easier. If you want to move from any other market to India as a domicile it is treated as a capital gains event for existing investors so they have to make a fresh mark to market valuation, you have to pay tax on the delta,” PhonePe chief Nigam said.

Like the Economic Survey 2022-23, Nigam also highlighted issues around ESOPs during the reverse flipping process, where the vesting period for employee stock options was reset.

PhonePe raised a mammoth $350 Mn funding from General Atlantic and other investors at a valuation of $12 Bn, soon after moving its headquarters to India and separating itself from ecommerce startup Flipkart.

In the wake of PhonePe’s troubles, several investors have pointed out that not many Indian startups can afford to spend so heavily in reverse flipping to Indian, and also the fact that they might not get the investor go-ahead to pull off such a move.