Contribution — This article is written in collaboration with Sanketh Kamath — Manager, Transfer Pricing at B S R and Co, Chartered Accountants. Views personal.

The idea behind the Founder Mental Model series of blogs would be to provide current and prospective founders a map to navigate the complex path to starting up.

I saw a question on LinkedIn that asked — “More than 95% of Indian #saas business is registered in North America and every time I talk to founders, the sole reason they set up an Indian subsidiary is to facilitate salary payouts despite having the main business registered in the US. With solutions like Deel, Remote coming into picture, do we need the subsidiary set up?”

That’s a great question and one that needs some amount of delving deeper before we arrive at a “yes” or “no” answer. The short answer is that it depends. I know, you probably hate me for that, but hear me out?

Besides, the US IP laws offer stronger and (perhaps) faster ways to protect the patents/ business IPs. Also, we have seen start-ups citing better valuation prospects (due to higher capital availability) as another key reason.

Off late, there has also been an exodus of Web3 start-ups from India to Dubai due to lack of regulatory certainty on the space. Those start-ups would look at leveraging India for the R&D capabilities.

What are the various considerations for founders who are increasingly setting up their HQ or Holding companies in the USA, Singapore, British Virgin Islands, Cayman Islands etc to name a few.

If this is of interest to you, we can consider doing another deep-dive on the choice of hold-co (Holding company) jurisdiction (“a fancy way to say country, by us finance types”).The short answer there is depth of capital markets and proximity to a large customer base. You’ll need to wait for the longer answer.

  • Customer Preference — Customers are at the heart of everything an organization does. Here, it is no different. In case you have a sizeable customer base (over 15% of global) in India, make it a point to talk to a few (large) customers to understand their preference of whether they like to work with an organization billing them directly in INR and charging applicable taxes like GST etc or working with a US or any other entity charging them in USD and for the customers to figure out the vagaries of tax withholding, GST etc. “Investment in SaaS increased 170% over 2020 and is expected to reach $4.5 billion in 2021, accounting for 8% of the overall private equity and venture capital deal value in India.”, reports Bain and Company. This means that India will represent more and more of the global TAM.

Other large organizations like Amazon AWS / Google etc have a way around this problem of customers in India wanting to be billed through an Indian entity. Large companies typically have a vast reseller network through which they invoice to customers in specific locations, the resellers provide customers in their geography favorable credit terms (in some cases more than 45 days), INR denominated billing, free professional services etc. For an early stage start-up, getting to this level may take a few years and few hundred or even few thousand customers.

  • Employee Tax and Benefits — By being on the payroll of an EOR (Employer of Record) provider, the company is constrained in terms of the benefits and perquisites that it can offer its employees. By setting up an own subsidiary, these benefits (group health health insurance, company cell phone plan, car lease, group term life insurance etc) can be tweaked from time to time. As I think about this point deeply, I think this point would become less and less relevant as EOR service providers scale in operations, so take this one with a grain of salt.

The employee tax structuring referred to here could include stuff like a car lease plan, driver allowance, broadband allowance, new pension scheme to name a few. As the race for talent intensifies, the benefits that an organization provides will become a crucial part of the evaluation process when talented individuals decide to switch so this is an important consideration.

  • Cost — After a particular scale of employees (typically over 25+) the EOR services starts to become very expensive. So this is a great way to start, but for anyone with aspirations of becoming a billion dollar company, that would mean few hundred or even few thousand employees in India. With costs ranging from $200-$500 per employee per month, this stacks up really quickly. With the right networks and connections to appropriate accounting, payroll and compliance professionals, it come be done for significantly cheaper on its own. Think about what you’re optimizing for speed or cost and decide whether it makes sense to take this route to hire the early employees while the formal company / LLP set-up is under way.
  • Stock Options — Investors frown upon stock options being given to individuals who are not employees of the Company. Most Stock Option Plans carry an additional approval from the Preferred Shareholders in case of issue of stock options to non-employees. So technically an employee on an EOR provider isn’t equal to an employee directly employed by the Company or it’s wholly owned subsidiary. There is potentially a work-around here by amending the Stock Option Plan but might face pushback from investors depending on how conservative / aggressive they are. Also, as a founder you want to maximize your time in terms of running and scaling the business and have someone take over the Legal/Financial aspects. (Focus on what works, right?)
  • Real Estate — Most companies, regardless of how remote they are would still have the requirement for some real-estate in the form of co-working spaces, office spaces etc. Without having a legal entity in India, no landlord will be able to lease out space to these companies for any group activities, office style requirements (if any). While there has been a phenomenal rise of remote work, many organizations realize that they would also appreciate the option to enable in-person / team level catch-ups from time to time. These in-person meetings typically happen at co-working place in a city with a sizable population of the employee base. (This is typically a city like Bangalore, Mumbai, Chennai or Delhi)

There is an increased understanding of these structures but this is not a new model. EOR organizations like Velocity Global (2014) have been around for longer than Deel / Remote etc.

While we have covered the reasons to set up an Indian Subsidiary, below are some of the reasons to re-think that approach —

If you have no customers in India and India would not be a significant customer base and the presence is limited to less than 10–25 individuals, it may not be required to set up a full blown private limited company.
  • Transfer Pricing (“TP”) — The typical structure is that the US or non-India hold-co owns the IP (intellectual property) and assigns the India legal entity the task for developing the IP based on designs, customer inputs, high-level inputs provided by the US Hold-co. A common model for facilitating this type of a transaction where 2 related companies work together with teach other is called a “related party transaction”. Transfer Pricing is a set of international rules that define that while the US Hold-co and Indian Subsidiary are “related”, the price at which they perform transactions should be as per global and local transfer pricing regulations.

For a risk mitigated, captive R&D and such similar service providers, TP requires that the India legal entity perform a cost-plus billing to the US Hold-co(where the Indian subsidiary invoices all the operating cost like salary, consulting cost, rent, utility etc and adds on a mark-up that typically ranges from 12%–20%) on a periodic basis. Aligning with the ‘risk-mitigated’ characterization, the cost-plus billing arrangement typically ensures that the India Subsidiary remains profitable anddue to this cost-plus billing arrangement, the India Subsidiary will almost always be profitable and be subject to tax in India that ranges from 25–33%. All the while, without making any profits at a group (overall)level as the below table illustrates.

Most likely, the tax paid in India would be tax creditable (reduce tax instance in the US as and when the group becomes profitable) but due to the timing mismatch there would be a large outflow for Indian income tax owing to the transfer pricing requirement. Given the abundant availability of capital, entrepreneurs are willing to take bolder and bigger bets which means profitability will remain elusive and the tax above becoming a sunk cost.

India Transfer Pricing Litigation landscape — India has come a long way since the India TP regulations kicked-in. The field officers continue to remain aggressive — and this, frankly, is isn’t a new knowledge for MNCs which have been in India, through Sub-co(s), for generations now — they tend to mitigate/ manage the TP litigation risks through bilateral routes enabled under Tax Treaties. For start-ups, their economies-of-scale simply would not justify opting such bilateral ‘strategies’ — and even going through the actual domestic litigation process, which often is time consuming and expensive, is not be feasible. As a start-up, it is ideal to channel time and efforts in building products/ services, creating market etc. — and not tangle itself in unwarranted TP litigations, which in India could go up to 10–12 years before any reasonable finality is attained.

Disclaimer — This post is for informational purposes only and is not intended to be treated as tax, legal or professional advice. The reader is requested to get the counsel of a qualified professional and the above information is illustrative in nature to provide the reader a high-level introduction to the topic being discussed.

This post was first published on Medium.