FEMA vs. Income Tax Residency: What Indian Founders Must Know Before Incorporating in the US

For Indian founders setting up a US entity, FEMA residency is the single most important factor that determines how you can hold shares in that entity. Whether you can hold shares directly as an individual, or whether you need to hold them through an Indian LLP, comes down entirely to your status under FEMA not under the Income Tax Act, and not based on your citizenship.

This distinction is widely misunderstood, and the consequences of getting it wrong are significant.

FEMA and Income Tax Define Residency Differently

India has two separate laws that determine residential status - the Foreign Exchange Management Act (FEMA) and the Income Tax Act (ITA). They serve different purposes and operate on different timelines.

The Income Tax Act is a revenue law. It determines what income is taxable in India. Residential status under the ITA is calculated at the end of the financial year, based solely on the number of days spent in India between April 1 and March 31. If you spent 182 days or more in India in a given financial year, you are a tax resident for that year. If you spent less than 182 days, and less than 365 days across the preceding four financial years, you are a non-resident.

FEMA is a regulatory law. It governs cross-border transactions  including the ability to invest in a foreign entity, hold shares in a US company, remit money abroad, and maintain NRE accounts. FEMA residency is not calculated annually. It changes from the specific date you depart or arrive in India, based on the purpose of your stay. A person who has been in India for more than 182 days in the preceding financial year is considered a FEMA resident unless they leave India for employment, for business, or with the intention of remaining outside India for an uncertain period, in which case they become a FEMA non-resident from the date of departure itself.

The critical point is this: for the purpose of incorporation and share ownership in a US entity, it is your FEMA status that governs not your income tax status.

What FEMA Residency Means for Shareholding in a US Entity

Under FEMA's Overseas Investment Rules 2022, any investment made by an Indian resident in a foreign entity constitutes an Overseas Direct Investment (ODI) and must comply with specific RBI regulations. This includes routing the investment through an Authorised Dealer (AD) bank, obtaining a Unique Identification Number (UIN) for the foreign entity, and filing an Annual Performance Report (APR) each year.

A FEMA resident individual can technically make an ODI directly -  the 2022 regulations provide express permission for resident individuals to invest directly in overseas entities, up to USD 250,000 per financial year under the Liberalised Remittance Scheme (LRS). However, there is a significant restriction that makes direct shareholding complicated for most startup founders: a resident individual cannot acquire control in a foreign entity if that entity subsequently sets up a subsidiary or step-down subsidiary abroad. For a US C-Corp that intends to have an Indian subsidiary, which is the most common structure for Indian-founded startups, this restriction effectively rules out direct shareholding by a FEMA resident individual.

This is why most Indian-resident founders hold their shares in the US entity through an Indian LLP rather than directly. The LLP makes the ODI into the US entity, holds the shares on behalf of the founder, and is the entity that undertakes the associated FEMA compliance. The restriction on step-down subsidiaries does not apply to an Indian LLP in the same way it does to a resident individual, making the LLP the cleaner and more compliant vehicle for holding shares in a US entity that also has Indian operations.

The Difference Between Being a FEMA Resident and a FEMA Non-Resident

If you are a FEMA non-resident, meaning you have relocated outside India for employment, business, or an indefinite period, the picture changes significantly. A FEMA non-resident is not subject to the ODI rules in the same way. They can hold shares in a US entity directly as an individual, without routing through an LLP or an AD bank, because they are no longer considered a person resident in India under FEMA.

This is where the confusion between FEMA and income tax residency becomes consequential. A founder might believe that because they relocated to the US six months ago, they are no longer subject to Indian regulations on foreign shareholding. That may be true under FEMA -  if they left with the clear intention of remaining abroad indefinitely, they became a FEMA non-resident from the date of departure. But if they still spent more than 182 days in India in the same financial year, they remain a tax resident under the ITA and their global income continues to be taxable in India for that year.

The two classifications are independent. One governs what transactions you can make and how you can hold shares. The other governs what income gets taxed. A founder who is a FEMA non-resident but an income tax resident in the same year has different obligations under each law simultaneously.

Determining Your FEMA Status Before You Incorporate

The question of whether you need an LLP to hold shares in your US entity depends on a straightforward assessment of your FEMA status at the time of incorporation.

If you are currently living and working in India with no definitive plan to relocate, you are a FEMA resident. In this case, holding shares directly in a US C-Corp that will have an Indian subsidiary is not permissible under FEMA ODI rules, and the LLP route is the appropriate structure. Each founder typically incorporates their own Indian LLP, which then makes the ODI into the US entity and holds the shares.

If you have already relocated outside India -  for employment, to run your business, or with the intention of remaining abroad and that relocation is substantive and not temporary, you are likely a FEMA non-resident from the date of departure. In this case, you can hold shares in the US entity directly as an individual, without the LLP structure. However, this needs to be assessed carefully, as the date of departure, the purpose of the move, and the nature of your ongoing ties to India all factor into how FEMA characterises your status.

If you are in transition spending time in both countries, or planning to relocate but have not yet done so definitively your FEMA status is still that of a resident, and the LLP structure applies until the relocation is established.

Final Thoughts

The decision of whether to hold US entity shares directly or through an LLP is not a structural preference. It is a compliance requirement determined by FEMA. Getting this wrong, whether by holding shares directly when you are a FEMA resident or by assuming the income tax rules govern your share ownership, creates violations that are difficult and expensive to unwind.

Most founders only discover these issues when they are already incorporated, sometimes years into running the business. At that point, rectifying the structure involves voluntary disclosure to the RBI, potential penalties, and a significant amount of back-and-forth with Authorised Dealer banks. The costs, both financial and in terms of time, are avoidable if the assessment is done upfront.

If you are an Indian resident founder in the process of incorporating a US entity, it is worth getting clarity on your FEMA status before you finalize the shareholding structure. Book your call today at Inkle Incorporate.