Foreign Subsidiaries - Set-Up Tips to Avoid Later Problems - Part 1

Our clients often enter new markets by contract or investment -- what are some of the legal issues in establishing a new foreign company or investment that will have an important impact on operating the company and possibly later selling it? This is Part 1 of our two-part observations on this subject.

Taking India as an example, these observations are meant as a follow-up to our articles in the last several months on acquiring and investing in Indian companies. Though our focus here is on choices that can help US companies better operate and later sell their Indian companies, the lessons can be applied in other international markets.

These comments were inspired by our recent work on the sale of a US company’s Indian subsidiary and are also relevant to the many US companies in the process of restructuring their foreign operations, whether due to the changing economics of manufacturing in China or business process outsourcing in India, and recent examples of “on shoring” back to the US or moving production to a third country.

Though India is Now More Open to Foreign Investment, Set Realistic Time and Budget Expectations. Our earlier articles emphasized the current relatively open Indian approach to foreign investment, whether through acquisition or otherwise. However, in establishing, operating and later selling an Indian company, US companies can find Indian procedural formalities to be frustrating. This is also true for companies operating in other developing economies, though the procedural formalities may be less daunting in China and substantially improved in countries such as Korea which have graduated from the “developing” roster over the past several years.

The Indian Companies Act of 1956 and its regulations govern the incorporation, operation and winding-up of companies in India. Procedures for director identification numbers (DINs), recording new or resigning directors, making changes in share capital, issuing notices of meetings and for properly conducting meetings and recording minutes - all can challenge company management. Outside of the incorporation and ongoing corporate requirements, an Indian company will need several regulatory licenses and registrations, such as a possible “shops and establishment license,” value added tax registration, tax account numbers, import and export licenses if these activities will be engaged in, and industrial approvals based on national and local requirements. Some - not much different from the most developed economies. Others – somewhat more daunting and time-consuming.

A China consultant recently told me that he assumed that our work with US companies in India must be relatively easy as compared with China given this UK-based system and use of the English language. While India indeed has these advantages, this can cause US companies to greatly underestimate the timing and level of detail for doing business in India. While in some sense the legal framework continues to be more open to interpretation in China, the great attention to legal and procedural formalities in India within a system that is less precise than many assume creates a different type of challenge.

Appointing Directors - Take Into Account Practicalities and Local Rules. An Indian private company is required to appoint two or more directors. They do not need not be Indian nationals or residents, and meetings can be held outside of India.

So far, so good. A US company may make the assumption that two US-based directors are sufficient, though it is advisable to appoint at least one India-based director to be able to sign forms and take India-based actions. Some may then opt for at least one director based in the US and one in India, with a quorum of 2 directors.

Yet, to smoothly operate the company, it is important to have a quorum of directors available in the same place in order to conduct board actions. The Indian Companies Act does not allow meetings through teleconferencing or videoconferencing. In order to constitute a valid quorum for a meeting, at least two directors are required to attend a meeting in person, though the meetings can be in either India or elsewhere. What happens if a quorum in either India or the US is not available and a board action is needed? There are ways around this problem (involving resignations, reappointments and carefully-described minutes), but it is best avoided up front.

So You Want to Sell Your Indian Subsidiary? A Few Stock Transfer Issues. Indian government approvals or reporting of share transfers are generally not required for a transfer from one foreigner to another (such as the sale by a US parent to another US parent), yet additional steps are required for the transfer from an Indian resident shareholder to a non-resident.

An Indian private company must have at least two shareholders -- a US parent company can be one shareholder and another subsidiary can be the second. If a minimum single share is held by an Indian resident with the remainder held by the US parent company, complications may result if the Indian resident must then transfer the single share to a non-resident. For example, Reserve Bank of India rules require that a local bank certify that filings have been made and money received for the share transfer. For such a sale from a resident to a non-resident, a valuation of shares is generally also required as a measure of fair market value. (Can these issues be avoided through an asset transfer? Perhaps, though asset as opposed to stock sales are uncommon in India due to high asset transfer stamp duties.)

Is Holding the Indian Company Through an Offshore Holding Company Really Worth Considering? In our February 2008 article, we noted the advantages of acquiring an Indian company through a Mauritius holding company. US companies may believe that this sounds a little exotic and unnecessary and may prefer a more straightforward holding of the Indian company directly by the parent or a US-based special purpose subsidiary.

Let's say that despite your best expectations, its time to sell that Indian company sooner rather than later. For example, many US companies have found that their India-based costs have increased due to an increase in labor costs and also an increased value of the Rupee. If the company is sold after 1-year as part of a stock sale, a long-term capital gains tax of more than 20% will be imposed as a withholding tax that must be paid by the buyer. Holdings of less than 1-year would increase the tax to over 40%. Allocations of the purchase price between the sale of the stock and license fees may be possible, but not easy, and a US foreign tax credit may apply, but cannot always be used. (By the way, if the buyer is to hold part of the purchase price in escrow until certain conditions are met, the escrow amount is also subject to the withholding tax since the transfer takes place upon the transfer of the ownership of the stock, not a transfer of the consideration.)

Hiring Employees – Hope for the Best, But Set Realistic Termination and Non-Compete Expectations. In India as in any country, adjustments to contract language can help limit the chances of a dispute with an employee, particularly post-termination, as well as help protect confidential information accessed by the employee. In addition, some countries (as well as some US States) do not allow a non-compete to extend beyond the period of employment. This is the case for India - post-employment non-competes are not enforceable, though are routinely included in employment agreements.

Also, US companies understandably feel more comfortable with the law of their home state and local courts, though such a dispute resolution clause for a non-US employee would require a US company to first obtain a US judgment and then enforce it in another country – which can be a very uncertain process. We often prefer local arbitration which gives the US company the ability to seek an injunction in local courts pending the outcome of the arbitration.

If the time comes for a downsizing or termination of employees, also keep in mind mandatory employment laws in India that apply to non-managerial workers and those who earn less than defined amounts. These laws impose additional compensation, employment terms and termination requirements.

Part 2 of these observations follow (click here)