Summary: Limited liability partnerships (LLPs) have gained popularity in India as an attractive investment vehicle, particularly for non-resident investors. However, the current regulatory framework, specifically the Foreign Exchange Management Act (FEMA) and its associated rules, creates an uneven playing field for non-resident investors when exercising pre-emptive rights in LLPs. The pricing policies under FEMA, while designed to ensure fair market valuations, are not consistently applied to LLPs due to gaps in the regulations and reporting mechanisms. This can lead to non-resident investors being disadvantaged compared to resident investors when making additional investments in LLPs. To address this issue, the paper recommends amending the regulations to align the treatment of LLPs with that of companies, ensuring a more equitable environment for foreign investors.
Exercise of Pre-Emptive Rights in Indian Limited Liability Partnerships: An uneven playing field for non-resident investors
Introduction
Due in great part to their increased management and governance flexibility as well as their capacity to more tax-efficiently disperse earnings than conventional Indian firms, limited liability partnerships (LLPs) have become very popular investment vehicles in India. Once the Indian government loosened entity-specific foreign direct investment (FDI) limitations on LLPs, the attraction of LLPs to foreign investors noticed a notable increase post-2015.
Notwithstanding these seeming benefits, LLPs have not entirely fulfilled their promise as an investment vehicle in India, especially for non-resident investors. This paper explores some subtle aspects of India’s exchange control policies that might be causing this underuse. These legislative nuances become especially clear in situations when LLPs have a mixed composition of resident and non-resident investors while yet less noticeable in LLPs entirely controlled by non-residents.
When pre-emptive rights are used by resident and non-resident investors in LLPs or when additional money is sought, the complexity resulting from these statutory quirks is particularly evident. With an especially eye towards the unfair playing field established for non-resident investors, this paper attempts to clarify these nuances and their consequences for foreign investment in Indian LLPs.
Pricing Policies Under FEMA for LLPs and Companies
Published under the Foreign Exchange Management Act, 1999 (NDI Rules), the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 set particular pricing policies for non-residents subscribing to unlisted Indian enterprises. These rules require that the fair market valuation (FMV) of equity instruments offered to non-residents be either equal to or higher than their price. Conducted at arm’s distance and based on internationally accepted pricing approaches, this FMV is to be found.
Within the context of businesses, the price per share is calculated from the FMV of the whole company split by the total number of existing equity shares. By allowing non-resident investors to subscribe to a specified number of shares in a company, this calculating approach lets them acquire a contractually agreed percentage ownership for a contracted price either meeting or surpassing the per-share FMV. This adaptability also extends to follow-on investment rounds where non-resident investors exercise their pre-emptive rights, therefore preserving their shareholding and preventing dilution on a somewhat fair playing field.
Moreover, even if this price is less than the FMV, when businesses issue shares to current shareholders—including non-resident shareholders—under a rights issue, these shares can be offered to non-resident shareholders at the same price as offered to resident shareholders. This clause guarantees during rights issues equality between resident and non-resident owners.
But because of several holes in the NDI Rules and Form FDI-LLP(I), a form recommended by the Reserve Bank of India for reporting foreign investments in LLPs, the application of pricing rules for foreign investments in LLPs varies greatly. Whether through capital contribution or profit share acquisition, the NDI Rules mandate that foreign investments in LLPs must be made at a price either equivalent to or above the fair market value as decided upon by internationally recognised valuation standards.
Combining the NDI Rules with the information fields in Form FDI-LLP(I) indicates that non-residents making capital contributions to Indian LLPs should make those contributions 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 non-resident investor contribution against the whole past and present contributions in the LLP from all investors or partners. Although this strategy seems simple, in fact it causes certain difficulties especially with the exercise of pre-emptive rights by non-resident investors.
Lacunae in NDI Guidelines and Form FDI-LLP(I) Affecting Pre-Emptive Rights
Although the Limited Liability Partnership Act, 2008 (LLP Act) does not specifically address this element, LLPs have the freedom to indicate contributions or profit shares as notional units or shares, therefore acknowledging this in the LLP agreement signed among the partners. The NDI Rules or Form FDI-LLP(I) have not included this enabling clause, hence the regulatory structure suffers a major vacuum.
Pre-emptive rights primarily serve to guarantee that, proportionate to their current shareholding, an investor’s shareholding does not become diminished without an equal opportunity to fund the LLP. Pre-emptive rights are fundamentally based on the need that the pricing or value given to every investor for additional fund-raising be consistent, therefore guaranteeing a level playing field among investors. But especially for non-resident investors, the present legislative environment for LLPs does not offer this degree of fair field.
Though apparently small, the subtle change in the NDI Rules and Form FDI-LLP(I) not recognising a per instrument or unit FMV has a major unintentional consequence when non-resident partners of an LLP exercise their pre-emptive rights, especially in LLPs with a mix of resident and non-resident partners. When one compares the results of more investments in LLPs against corporations, this problem becomes clear.
Imagine this: “NR” is a non-resident investor and “R” is a resident investor in an LLP called “ABC LLP.” At first, both NR and R each contribute INR 1 million at the time of ABC LLP’s founding, each owning a 50% interest or profit share. Following establishment, ABC LLP’s overall contribution comes out to be INR 2 million. ABC LLP has a worth of INR 4.5 million after a year of business and needs further INR 2 million to grow its activities. NR and R choose to provide ABC LLP additional INR 1 million each.
Due to the gaps in the NDI Rules and Form FDI-LLP(I), this is not the case in an ideal scenario, so creating an unfair playing field for NR, the non-resident investor. These further contributions by NR and R, made in equal proportions should result in both parties retaining their 50% interest or profit share in ABC LLP.
When one compares the results of this situation for both investment structures, it is clear how different investing in an LLP is from a business is. Regarding the LLP, the first capital injection yields 50% interest to every member. But in the additional capital infusion following one year, Form FDI-LLP(I), which computes prorated FMV and does not consider a per instrument or per unit FMV, calls for NR (being a non-resident) to spend at least INR 1.25 million to keep a 50% shareholding in the LLP. This is so since NR had before invested INR 1 million in the LLP and the prorated FMV for a 50% profit share is INR 2.25 million. R, the resident investor, on the other hand, has freedom to pay just INR 1 million to keep its 50% profit share.
NR’s post-investment profit share or interest will thus drop to 44.44% on a cumulative basis in the LLP if she invests INR 1 million in the LLP in this next funding round (total contribution of INR 2 million, on a total valuation of INR 4.5 million). This result obviously hurts the non-resident investor, who cannot keep their proportional ownership without making greater capital investments than their resident relative.
By contrast, the results would be much different and more fair if the investment were made in a corporation instead of an LLP. The first capital infusion would produce NR and R each obtaining 100,000 shares at INR 10 per share, for a total of 200,000 shares and a 50% stake each. With the company valued at INR 4.5 million and the further capital infusion following one year, the FMV of every share would be INR 22.5. Complying with the Pricing Guidelines, NR and R would each invest INR 1 million and get 40,000 new shares at an issue price of INR 25 per share—above the FMV of INR 22.5.
Under this situation, NR and R would keep their 50% shareholding in the company since, following the fresh issue, each of them owns 140,000 out of a total of 280,000 shares. Unlike the case with the LLP, this result generates an equal playing field for both resident and non-resident investors.
The main distinction is in the calculation and reporting style of the investments. Regarding the corporation, Form FC-GPR (used for foreign investment reporting) notes the FMV of every share at the moment of subsequent issuing. By investing at an issue price over the FMV per share, this lets NR follow Pricing Guidelines. NR and R have same shareholding percentages since the same number of shares are issued at the same price.
Form FDI-LLP(I) on the other hand emphasises the prorated FMV of the whole LLP instead of allowing this per-unit computation. This strategy unintentionally results in an unequal playing field since the non-resident investor must invest more than the resident investor to preserve the same proportion of ownership.
Non-resident investors trying to keep their proportional ownership in LLPs during next funding rounds find great difficulty in this difference in treatment between investments in corporations and LLPs. It essentially calls on non-resident investors to provide more money than their resident counterparts in order to preserve the same degree of ownership, therefore discouraging foreign investment in Indian LLPs.
Suggestions and Finish Notes
Several suggestions might be made to solve the problems mentioned in this article and establish a level playing field for foreign investors in Indian LLPs. These recommendations seek to close the treatment of investments in LLPs more closely with that of investments in corporations, so eradicating the present differences and rendering LLPs a more appealing investment vehicle for non-resident investors.
First, the NDI Rules and Form FDI-LLP(I) ought to be changed to acknowledge the capacity of Indian LLPs to create units. Under the NDI Rules, this recognition is not a new idea since they already let foreign investors own pooled investment vehicles including mutual funds, Alternate Investment Funds, Real Estate Investment Trusts, or Infrastructure Investment Trusts. Usually formed as trusts under the Indian Trusts Act, 1882, these bodies are Extending this idea to LLPs would help the regulatory system offer a more fair basis for appraisal and investment.
Changes of consequential nature should be done to guarantee that investors can subscribe to units of an LLP at or over their FMV. This change would eliminate the present differences by more closely matching the handling of investments in LLPs with those of corporations. Non-resident investors would be able to retain their proportional ownership in LLPs during next funding rounds without having to commit disproportionately more than their resident counterparts by allowing a per-unit FMV computation.
In addition, the LLP Act, NDI Guidelines, and Form FDI-LLP(I) could be changed to enable rights issues by LLPs, in line with those authorised for corporations. corporations and LLPs have no basic difference that would support the existence of this flexibility for corporations but not for LLPs. Including rights concerns for LLPs would give current partners—resident and non-resident alike—another way to keep their proportional ownership during fundraising cycles.
Allowing LLPs to provide disproportionate profit shares to non-resident investors compared to their capital or contributions was another idea that was thought about but decided to be unworkable due to legal restrictions. This strategy would have guaranteed that a non-resident investor may keep a 50% profit share in the LLP while its total investment in the LLP falls to a smaller percentage. Though such arrangements are allowed if they benefit resident investors, based on past experiences it is clear that the Reserve Bank of India does not allow such disproportionate profit sharing in favour of non-resident investors.
Following these suggestions will help to correct the present disparity in the treatment of resident and non-resident investors in LLPs, especially in relation to pre-emptive rights exercise and next financing rounds. These developments would make LLPs a more appealing and practical choice for foreign investment by more closely matching the regulatory structure with that of businesses, hence perhaps releasing major economic advantages for India.
For both resident and non-resident investors, these suggested actions should help make LLPs more appealing as a choice of investment tool. These developments will support the objective of the Indian government of improving the simplicity of doing business in the nation by building a more fair structure for foreign investment in LLPs. They would eliminate a major obstacle to international investment in LLPs, therefore enabling higher foreign direct investment in this industry.
In summary, even if LLPs have many benefits as an investment vehicle—more tax-efficient profit distribution and more management and governance flexibility—the current legal system unintentionally makes problems for non-resident investors especially in cases involving mixed resident and non-resident ownership. India can improve the attractiveness of LLPs to foreign investors by tackling these problems by means of focused changes to the NDI Rules and related forms, therefore fostering possible foreign direct investment and so supporting the national economic development.
Refining these regulatory subtleties will be essential in establishing a really equal playing field for all investors, regardless of residency status as India keeps positioning itself as an attractive place for global investment. The suggested adjustments will not only help non-resident investors but also improve the general appeal of the Indian market, therefore complementing the government’s more general economic goals and maybe resulting in higher foreign investment in many different spheres of the economy.
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