Uneven Ground: The Difficulties Pre-Emptive Rights Provide for Non-Resident Investors in Indian Limited Liability Partnerships
Introduction
Because of their flexibility in management and governance as well as their capacity to distribute income more tax-efficiently than conventional firms, Limited Liability Partnerships (LLPs) have become rather popular in India as an investment vehicle. Following 2015, when the Indian government loosened entity-specific foreign direct investment (FDI) restrictions on LLPs, this attractiveness grew among overseas investors. Notwithstanding these benefits, LLPs have not really realised their potential as a preferred investment vehicle in India, especially among non-resident investors.
This paper looks at certain subtle changes in India’s exchange control rules that can help to explain LLP underutilisation as an investment vehicle. These subtleties show themselves in cases when LLPs combine resident and non-resident investors and are less noticeable in LLPs totally owned by non-residents. Particularly in light of pre-emptive rights, this study focusses on the quirks in pricing rules for foreign investments in LLPs and the gaps in statutory forms for reporting such investments, so generating an unfair playing field between resident and non-resident investors.
Pricing Policies Under FEMA for LLPs and Companies
Pricing rules mandated under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) demand that equity instruments issued to non-residents be either equal to or more than the fair market valuation (FMV) of such instruments when non-residents subscribe to shares in unlisted Indian companies. Arm’s distance and internationally approved pricing techniques help to ascertain this FMV.
The price per share for businesses is determined by the FMV of the whole business together with the total outstanding equity shares. Long as it is at or above the per-share FMV, non-resident investors can subscribe to a certain number of shares to obtain a contractually agreed percentage ownership in the company for a stipulated fee. This adaptability also extends to follow-on investment rounds when exercising pre-emptive rights, therefore giving non-resident investors a fairly level playing field to stop dilution of their shares.
On the other hand, certain gaps in the NDI Rules and the form of Form FDI-LLP(I), recommended by the Reserve Bank of India for reporting foreign investments in LLPs, cause separate pricing rules for foreign investments in LLPs to operate. According to the NDI Rules, foreign investments in LLPs made through capital contributions or profit share acquisition must be paid at a price either equal to or higher than the fair market value as per internationally accepted valuation criteria.
A combined interpretation of the NDI Rules and the information fields in Form FDI-LLP(I) indicates, however, that non-residents making capital contributions to Indian LLPs should do so at or above the prorated FMV of the LLP. Calculated as the FMV of the whole LLP, this prorated FMV is based on the percentage of contribution made by the non-resident investor against the overall past and present contributions in the LLP from all investors/partners.
Lacunae in NDI Guidelines and Form FDI-LLP(I) Affecting Pre-emptive Rights
Although the Limited Liability Partnership Act, 2008 (LLP Act) is vague on this point, LLPs allow their members to indicate contributions or profit shares as notional units or shares, thereby acknowledging in the LLP agreement signed among the partners. The NDI Rules and Form FDI-LLP(I) have not, however, included this facilitating clause.
Pre-emptive rights seek to guarantee that an investor’s shares does not become diminished without an equal opportunity to fund the LLP, pro rata to its current investment. Pre-emptive rights are fundamentally based on the need of a level playing field, so the valuation or price paid to every investor for a further fund raise should be consistent.
Though ostensibly benign, the absence of a per instrument/unit FMV in the NDI Rules and Form FDI-LLP(I) has major unforeseen implications when non-resident partners exercise their pre-emptive rights in LLPs including a mix of resident and non-resident partners.
To show this problem, consider the following:
Owning 50% interest or profit share each, NR (a non-resident investor) and R (a resident investor) each contribute INR 1 million at the incorporation of ABC LLP. ABC LLP’s valuation after a year is INR 4.5 million; it needs another INR 2 million for development. NR and R choose to donate extra INR 1 million apiece.
Fairly speaking, these additional donations made in equal measure should cause NR and R to retain their 50% interest/profit share in ABC LLP. But the NDI Rules and Form FDI-LLP(I) include lacunae that cause an unfair playing field for NR, the non-resident investor, which would not have happened had the investment vehicle been an Indian firm instead of an LLP.
Under the peculiarities of Form FDI-LLP(I), if NR invests INR 1 million in a later funding round, NR would get a post-investment profit share/interest of only 44.44% on a cumulative basis in the LLP (total contribution of INR 2 million on a total valuation of INR 4.5 million). This is so as Form FDI-LLP(I) does not consider a per instrument/per unit FMV and computes the prorated FMV of NR. NR, being a non-resident, would thus have to make minimum INR 1.25 million investments to keep a 50% stake in the LLP.
On the other hand, if the investment vehicle were a corporation, NR would be able to retain a 50% stake for the same amount of further investment (INR 1 million) and the same FMV of the organisation (INR 4.5 million) during a further capital raise while nonetheless following the Pricing Guidelines. This is so because the form FC-GPR, used for reporting foreign investments in businesses, notes the FMV of every share at the time of the next issuing, therefore enabling a more fair handling of resident and non-resident investors.
Suggestions and Final Thought
Several remedies might be taken into account to solve the problems underlined in this article:
Some LLPs provide non-resident investors excessive profit shares in comparison to their money or contributions made. The Reserve Bank of India does not, however, allow such disproportionate profit sharing in favour of non-resident investors—though it is allowed if it benefits resident investors.
Changing the NDI Rules and Form FDI-LLP(I) to acknowledge the capacity of Indian LLPs to issue units This strategy is not unique since the NDI Rules already let foreign investors own pooled investment vehicles including mutual funds, Alternative Investment Funds, Real Estate Investment Trusts, or Infrastructure Investment Trusts. Changes of consequential nature should be done to guarantee that investors can subscribe to LLP units at or above their FMV. This will alleviate the issues brought up in this essay and provide a level playing field for foreign investment.
Changing the LLP Act, NDI Guidelines, and Form FDI-LLP(I) to allow rights issuing by LLPs, same like corporations. corporations and LLPs are not fundamentally different from one another that calls for such flexibility that exists for corporations but not for LLPs.
These steps should assist LLPs become more popular as a choice of investment vehicle and support the government’s goal of improving India’s business environment’s simplicity. Particularly with regard to the exercise of pre-emptive rights, India can make a more appealing and fair environment for foreign investment in LLPs by tackling the present differences in the treatment of resident and non-resident investors in LLPs.
The suggested adjustments would provide more freedom and justice in the valuation and pricing of investments by closely matching the regulatory structure for LLPs with that of businesses. This would not only help non-resident investors but also improve the general attractiveness of LLPs as an investment vehicle for both home and foreign investors.
Moreover, these changes will assist the efforts of the Indian government to draw outside capital and enhance the economic environment of the nation. Through the LLP structure, India may inspire more foreign involvement in its expanding economy by eliminating pointless obstacles and levelling the playing field.
To fully realise the possibilities of this company structure in India, the present regulatory environment for foreign investments in LLPs must be filled in order otherwise. Policymakers can make sure that LLPs become a more practical and appealing choice for both resident and non-resident investors by following the advised modifications, therefore helping India’s economic development.
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