This article summarizes the Discussion Paper (DP) released on 28 September 2010 on ‘Foreign Direct Investment in Limited Liability Partnerships’ issued by the Department of Industrial Policy & Promotion (DIPP) of the Government of India (Gol). Even though there may be benefits in organizing one’s business as a Limited Liability Partnership (LLP), both from commercial and tax perspectives, there has been a lack of clarity on the foreign direct investment (FDI) policy in case of foreign investments in an LLP. The DIPP has sought to address this with the release of a DP on this subject. The DP brings out the various differences between an LLP and a company form of structure, the inherent advantages of an LLP, the consequent challenges on its regulation and also invites suggestions on the approach to be adopted for framing an appropriate FDI policy for foreign investments in LLPs. Comments and suggestions on the DP are invited on or before 31 October 2010.
The LLP Act, 2008 passed in January 2009 heralds LLP as a new corporate form of business and an alternative to the traditional partnership model, with unlimited personal liability on the one hand and a limited liability company with detailed compliance requirements and restrictions on the other. An LLP structure has features of both a partnership firm and a body corporate and, therefore, helps businesses organize and operate in a flexible, innovative and efficient manner. An LLP structure has the following key features:
The various attributes of the LLP structure such as lower compliance costs, flexibility in operations, better control over management and limited liability make it an attractive alternative.
However, the use of an LLP structure for foreign investments into India was uncertain as there was no clarity on the FDI policy of the Gol. Hence, with a view to formulate FDI policy in case of LLPs, the DIPP has come out with a DP on FDI in LLPs.
From a tax perspective, the Indian Tax Law (ITL) considers LLP as a partnership firm. Accordingly, its income is taxed at the entity level and is excluded from taxation at the partner level. Also, minimum alternate tax, presently levied at 18% (plus surcharges resulting in an effective tax rate of 19.93%) on book profits when tax payable under other provisions is lower, does not apply to an LLP. Furthermore, dividend distribution tax, levied at 15% plus surcharge on profit distribution of a company, does not apply when an LLP distributes its profits to its partners. It would also be useful to note that there may be some disadvantages as well if a business is organized as an LLP as some of the provisions of the ITL are currently designed to apply only to a company and not to an LLP (e.g. in-house weighted deduction for scientific research expenditure, amortization of certain preliminary expenses, availability of tax holiday in certain sectors etc.). These are some of the significant differences in taxation of businesses organized as an LLP as compared to a business organized as a company. From a foreign investors perspective, the ‘single tier’ taxation system and the absence of tax on distribution of profits is likely to be of specific interest while evaluating the alternative options for setting up business operations in India and the pros and cons of an LLP structure. However, foreign investors who may want to convert their current corporate entities into LLPs may need to specifically examine the tax consequences that may arise from such a conversion. This tax treatment of an LLP broadly continues under the proposed the Direct Taxes Code 2010 that is expected to be effective from 1 April 2012.
Issues on induction of FDI in LLPs
Depending on the sector in which FDI is being inducted, the present FDI policy permits foreign investment in Indian companies under: (i) Automatic route (ii) Approval route. However, foreign investment is not permitted in firms or proprietary concerns without prior approval from the exchange control regulatory authority. There are no specific provisions addressing LLPs and, hence, the following five issues have been identified for analysis:
Ownership :The FDI policy prescribes caps on the level of the FDI and prohibits foreign ownership in specified sectors. It also lays down procedures for determining the level of foreign ‘ownership’ and ‘control’ in a corporate entity. However, the same concept cannot be applied in case of an LLP as the LLP Act, 2008 envisages flexibility for partners to decide on the manner in which they wish to contribute capital, extract profits, participate in voting and limit their liabilities. Every partner of an LLP has two rights attached to the partnership interest, one being an ‘ownership’ right and the other being the right of ‘management and control’. A transfer in the ownership right need not necessarily affect the right of management and control. It is, thus, challenging to set norms for ascertaining ownership and control of an LLP.
One suggestion is that foreign ownership could be determined with reference to profit sharing percentages, which is similar to determining beneficial interest in the shareholding of companies on the basis of rights over dividends. Another view is to determine ownership with reference to capital sharing percentage. This view has been opposed on the ground that partners’ capital could be in different proportions compared to their profit or loss sharing ratios due to a variety of reasons such as differences in the time of entry, differences in the withdrawal patterns etc.
Valuation :-The LLP Act, 2008 provides that every capital contribution shall have a monetary value, though valuation guidelines have not been prescribed as yet. One can consider adopting the discounted cash flow method, similar to valuation in case of companies, but after taking into account various factors such as extent of capital contribution, share in profits, extent of voting rights, extent of liability sharing and share in proceeds on liquidation. This would require adequate disclosure requirements on the part of an LLP. The exchange control regulatory authority has prescribed guidelines in case of an unlisted company and it needs to be considered as to what extent these guidelines can be applied to LLPs.
Control :-In case of companies, the FDI policy defines control as the ability to appoint majority of the Board of Directors (BoD). However, the LLP does not have a comparable BoD to facilitate determination of control.
As the LLP Act, 2008 does not prescribe the manner of management it is left to the partners of an LLP to agree upon specific aspects related to powers of partners, voting rights, meeting of partners etc. Thus, it is possible to confer management decisions/control on a few identified partners, including non residents, irrespective of their capital holdings. Furthermore, a partner in an LLP can transfer its economic interest without transferring its share in the LLP. Therefore, ascertaining ‘control’ can be extremely challenging and, hence, the right to take majority decisions may not be relevant in the context of LLPs for determining control.
Treatment of downstream investments :-As per the FDI Policy for companies, all downstream investments by an investing or investing-cum-operating company, which is owned or controlled by non-resident entities, are to be considered as indirect foreign investments. The issue is whether similar treatment can be accorded in the case of LLPs.
Treatment of non-cash contributions:-As per the LLP Act, 2008, a partner can contribute in both cash and non-cash forms to the LLP. As per the existing FDI policy for companies, prior approval is required for non-cash considerations, which is the subject matter of a separate discussion paper. The issue involved is whether similar rules can be applied to LLPs.
Issues for consideration:-In the above background, some of the issues raised for consideration are detailed below:
Comments :-Absence of clarity on foreign investments in LLPs had come in the way of LLPs being considered as an effective alternative business structure for foreign investors. The DP released by DIPP suggests that the Gol is open to considering foreign investments in LLPs and is, therefore, a positive step in this direction. Comments on this DP are invited on or before 31 October 2010 and it is, therefore, important that businesses actively engage with the Gol in putting forth their points of view. It is expected that the Gol would shortly, thereafter, come out with policy guidelines for FDI investment in LLPs, after giving due consideration to the public comments. Foreign investors setting up or having business operations in India may find it useful to evaluate the LLP option for structuring their presence in India, if the Gol policy gives a favorable consideration to this issue.