Tax Implications of Reverse Flipping in India

Over the past decade, various fast-growing Indian companies have chosen to domicile or register abroad through a process known as “flipping.”

This move, driven by the inability of Indian-domiciled companies to list overseas, involved transferring their entire capital, intellectual property, and data to an overseas entity.

Recently, there has been a significant increase in “reverse flipping,” where companies re-integrate ownership and value back to India. In a reverse flip, the shares of foreign and Indian shareholders, originally held by the foreign holding company, are swapped for shares in the Indian company. Subsequently, the foreign companies or offshore holdings are dissolved or merged into the Indian entity, with all shareholders at the offshore level now holding shares in the Indian company.

Reverse flipping can be executed in two primary ways: an in-bound merger of the foreign company with an Indian company or a share swap, where foreign company shareholders receive shares in the Indian entity.

The tax implications in the foreign entity’s country of residence must be separately analysed. In India, both these methods have distinct tax implications :

Tax Implications for In-bound Merger

1. 1. Capital Gains Tax Exemption: The transfer of capital assets from the foreign holding company to the Indian company, as well as the transfer of shares by non-resident shareholders in exchange for shares in the Indian company, are not taxable as capital gains under Sections 47(vi) and 47(vii) of the Income Tax Act, 1961 (“ITA”). However, this exemption is conditional on meeting the requirements of Section 2(1B) of the ITA. If these conditions are not met, the transactions will be subject to capital gains tax in India unless applicable tax treaties assign taxing rights solely to the country of residence of the holding company or its shareholders.
   2. Tax Losses: The holding company’s tax losses can be carried over to the Indian company, subject to the conditions of Section 72A, ITA. If the holding company is involved in trading or service businesses, it may not qualify as an ‘industrial undertaking’ under Section 72A(7)(aa) of the ITA, preventing the Indian company from absorbing these tax losses.
   3. Change in Shareholding: If the shareholding of the Indian company changes, and shareholders who held at least 51% of the voting power prior to the merger do not continue to hold the same post-merger, it could result in the lapse of carried-forward tax losses under Section 79 of the ITA. There is legal divergence on whether the 51% beneficial holding test should be applied to the ultimate beneficial owner or direct shareholding. Section 79 does not apply to startups recognised by the Government of India.

Tax Implications for Share-swap Arrangements

1. 1. Share Swap as Exchange: The swapping of shares of the holding company for shares in the Indian company is considered an ‘exchange’ and thus a ‘transfer’ under Section 2(47)(i) of the ITA.
   2. Capital Gains Tax on Foreign Shareholders: Foreign shareholders are subject to capital gains tax in India under Section 9(1) of the ITA on the transfer of holding company shares if these shares derive value from assets located in India. Tax treaties may provide relief by assigning taxing rights to the investor’s country of residence. The taxable gains are the difference between the value of the new Indian company’s shares and the holding company’s shares at the swap date, subject to fair valuation.
   3. Impact on Carried-forward Losses: Similar to the in-bound merger, changes in the shareholding of the Indian subsidiary could affect the carry-forward and set-off of losses under Section 79 of the ITA, with considerations around ultimate beneficial ownership versus direct shareholding.
   4. Capital Gains Tax on Holding Company: For the holding company, the transfer of shares of the Indian subsidiary to the new Indian company is not taxable as capital gains under Section 46(1), ITA. For the new Indian company, the market value of these shares on the distribution date is taxable under the ITA. Accumulated profits are taxed as ‘deemed dividends’ under Section 2(22)(c), ITA, while the excess is taxed as capital gains under Section 46(2), ITA. This transaction may also require reporting under Indian transfer pricing laws.
   5. Additional Considerations: Reporting requirements, the dissolution of the holding company, the company’s eligibility to list its shares on an Indian exchange, and the tax implications in the holding company’s country of residence need separate examination.
      

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Author: Kritika Krishnamurthy