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Foreign Direct Investment in Limited Liability Partnerships in India

Sanskriti Rastogi and Akshay Gupta analyze the aspect of FDI being allowed in LLPs in India.
FDI: a tool to revive the economy!

There has been a lot of controversy regarding the government’s move to have allowed FDI (Foreign Direct Investment) in multi brand retail sector upto a cap of 51% as it is feared that it will completely wipe the Indian economy with small retailers struggling hard to compete with the foreign brands. On 24 November 2011, cabinet allowed 100% FDI in single brand retail, up from 51% earlier, and put a 51% cap in multibrand retail with riders . There has been mounting criticism for the same as the entire issue has hit a roadblock stuck in the political quagmire of our country. The debate has been looming large between the cock eyed optimists and hardnosed critics.

The government in recent years has liberalized the economy in pursuit of influx of foreign currency and to strengthen the economy. Also, the government has not allowed FDI in aviation industry upto a certain threshold. Last year (2010) was the year of allowing FDI in Limited Liability Partnerships in India, a new business model which the government seeks to capitalize and seek profits in a calibrated manner. The circular for the same was released by RBI on 11th May, 2011 and the same was incorporated in the consolidate FDI Policy of October 1, 2011.

The consolidated FDI policy was passed by the DIPP (Department of Industrial Policy & Promotion), Ministry of Commerce & Industry, Government of India on 1 October, 2011, suggesting certain changes. One of the key changes was FDI in LLPs (Limited Liability Partnerships) in India by way of insertion of a new paragraph 3.3.5, replacing the present paragraph 3.3.5. The press note by DIPP was released on 11th May, 2011 allowing foreign investment in such entities in a calibrated manner. The press note was preceded by a discussion paper dated 28th September, 2010.

The Intent and Objectives of the FDI Policy clearly states that: "It is the policy of the Government of India to attract and promote productive FDI in activities which significantly contribute to industrialization and socio-economic development. FDI supplements domestic capital and technology."

As the Indian economy battles sliding growth, costly credit rising inflation and a falling rupee, economists say this is the time to ease norms for foreign investors to attract global capital. Also, FDI will phenomenally help to revive the economy.

India’s economic condition: numbers speak the truth!

The economy started liberalization in year 1991. It opened up and the necessity was felt for integrating the Indian economy with world economy. A look at the latest statistics would reveal that India dips into a $1.5 trillion pool of FDI and has managed to draw in $ 132 billion by 2000. By comparison FDI flows into China clocked $105 billion in 2010 alone . From January to October, China’s FDI surged by 15.8% to $95 billion, almost equal to all of last year. In April 2010, the State Council launched new FDI development guidelines encouraging foreign companies to invest in sectors including service, high-tech and new energy . This can be attributed to the blanket which the government has provided barring the global foreign investment. However if India has to grow faster than it is doing now, it needs FDI. It takes investment of Rs. 4 in India to produce every extra rupee of income. Also it is important to note that our country invests more than it saves and imports more than what it exports. It adds up to 6% of the GDP of our economy.

The moot question that arises at this point is as to why our economy needs FDI. The answer to this question is simple. As already quoted, for making that extra one rupee we need an investment of Rs. 4 in the country. The country lacks the requisite funds to make that money. Thus we need investments from other countries. Every penny invested into the country means better processing of economic resources, employment generation which thus results into increasing the disposable income, thereby facilitating the improvement of the economy.

In the backdrop of such a scenario, the Government has been allowing foreign direct investments in various sectors with threshold limit. Since then, it has been liberalizing the economy in pursuit of a healthy foreign exchange striving hard to strike a tradeoff between the regulatory burden and foreign global capital inflow in our economy. However, the FDI in India has seen a considerable decline in the past couple of years. The recent data released by the Department of Industrial Policy and Promotion has pegged the reduction at 5% for the financial year ending 2009-10 and further decline of 25% for the financial year 2010-11. The position of China and USA on the same front is way different and so is the position of their economies. The recent data released by the UNCTAD regarding the inflow of FDI is declared to be over 43% and 6% for USA and China respectively. The decline in FDI can have considerable effects on the Indian economy.

LLPs: A new business vehicle

The government entered into a series of negotiations to tap the potential by allowing FDI in LLPs (Limited Liability Partnership) in India. The LLPs as business vehicle provides an attractive proposition of limited liability. It offers a great relief to the partners, particularly professionals like Company Secretaries, Chartered Accountants, Cost Accountants, Advocates and other professionals. These professionals may also form multi-disciplinary LLPs to meet the changing economic environment . Also, it combines the advantages of the Partnership firm and a company form of business enterprise. The LLP Act came into force in year 2009. It created new opportunity for service sector to bloom.

The exact need for the LLP has been articulated in the Limited Liability Partnership Bill, which was tabled in Rajya Sabha on 15 December, 2006.It states:

"With the growth of the Indian economy, the role played by its entrepreneurs as well as its technical and professional manpower has been acknowledged internationally. It is felt appropriate that entrepreneurship, knowledge and risk capital combine to provide a further impetus to India's economic growth. In this background, a need has been felt for a new corporate form that would provide an alternative to the traditional partnership, with unlimited personal liability on the one hand, and, the statute-based governance structure of the limited liability company on the other, in order to enable professional expertise and entrepreneurial initiative to combine, organize and operate in flexible, innovative and efficient manner."

The LLP as an idea was first conceived by Naresh Chandra (2003) & J. J. Irani (2005) committee; however the concept paper was developed by MCA (Ministry of Corporate Affairs) in 2006. LLP Bill, 2006 was introduced in the Rajya Sabha on December 2006. Revised Bill was introduced in the Rajya Sabha on 8 October & passed in the same month. LLP Bill, 2008 was passed by Lok Sabha on 12th December, 2008 and it got President’s assent on 9 January, 2009. It was finally notified in year 2009.

It is important to note that India’s LLP Act is borrowed from that of U.K. & China. The structure is more or less the same. However, it is distinct in its tax treatment. The LLPs in India are not taxed in hands of the partners and the LLP which is a separate legal entity is taxed separately. Also, it benefits immensely as it is not liable to pay all kinds of taxes which a company has to pay. This gives all the more reasons to companies for converting into an LLP form. A peek into the background would reveal that "Handoo & Handoo", legal consultants were the first to convert into an LLP, wherein every partner would have limited liability in year 2009 just after the LLP Act was notified.

The need for LLP structure was realized by the Indian government and as a result of the same, the LLP act was passed in the year 2008. The LLP has a lot of benefits over the traditional partnership firms or a company. Thus as soon as it was allowed, there was a huge spur in the firms and companies converting themselves to LLP. The procedure for conversion will be in accordance. Provisions of clause 58 and Schedule II to Schedule IV to the LLP Act provide procedure in this regard.

There are many things which a company might take into account while converting itself into an LLP. It is held that the government may exempt partnership firms and limited companies from paying stamp duty while converting into limited liability partnerships (LLPs). The intention is to adopt a provision similar to Section 394 of the Companies Act, which allows high courts to waive off stamp duty while approving amalgamations and restructuring of companies involving transfer of assets. Hence, paying a stamp duty is not mandatory for conversion. As far as capital gain tax is concerned in the Union Budget of 2010- 2011, it has been expressly declared that in relation to LLPs, while converting a private company or unlisted public company into LLP, capital gain tax exemption will be available subject to the following conditions being satisfied.

  • The total sales, turnover or gross receipts in business of the company do not exceed sixty lakh rupees in any of the three preceding previous years;

  • The shareholders of the company become partners of the LLP in the same proportion as their shareholding in the company;

  • No consideration other than share in profit and capital contribution in the LLP arises to partners;

  • The erstwhile shareholders of the company continue to be entitled to receive at least 50 per cent of the profits of the LLP for a period of 5 years from the date of conversion;

  • All assets and liabilities of the company become the assets and liabilities of the LLP; and

  • No amount is paid, either directly or indirectly, to any partner out of the accumulated profit of the company for a period of 3 years from the date of conversion.

The Finance Bill, 2009 rests the taxation woes of an LLP to rest. It has been proposed to tax LLPs on the lines similar to general partnerships under Indian Partnership Act, 1932, i.e. taxation in the hands of the entity and exemption from tax in the hands of its partners. The Finance Bill, 2009 has accorded a "limited liability partnership" and a general partnership the same tax treatment. Consequent changes in the Income-tax Act, 1961 like (i) the word ‘partner’ to include within its meaning a partner of a limited liability partnership, (ii) the word ‘firm’ to include within its meaning a limited liability partnership and (iii) the word ‘partnership’ to include within its meaning a limited liability partnership as these terms have been defined in the Limited Liability Partnership Act, 2008 have also been proposed in the Finance Bill, 2009.

A few tax benefits that a LLP structure enjoys above a company includes the following:-

  • 10% exemption is given in case of surcharge.

  • Tax payment is lower than a private limited company which pays a 33.99% tax on profits.

  • Tax will be imposed only on 40% of the income since the firm would be allowed to pay 60% to the partners as remuneration. So there will no double taxation of the income.

  • Further there is no requirement to fill dividend distribution tax.

  • Deemed dividend under section 2(22)(e) need not be paid.

  • No carry forward or set off under section 79 in case of major change of ownership.

  • Share of profits at the hands of the partners of the LLP is exempt from tax.

The reasons for converting can be many. Some of them can be lower compliance costs, greater flexibility in operations, better control over management, no restriction on the number of partners and limited liability. Also the LLP structure envisaged under the Act is flexible in terms of the statutory requirements like maintenance of minutes etc. The audit of an LLP having a capital of less than 25 lakhs or turnover less 40 lakhs is not required by law .Also, any individual or even a body corporate can become a partner in an LLP. Thus the companies are attracted towards changing the structure of their firms or company.

The advantages of allowing FDI in entrepreneurial projects carried out through the LLP model would encourage small entrepreneurs in India to explore business ventures with foreign investment/collaboration. Other than professionals and small entrepreneurs, the LLP structure may also be preferred by small businesses. Additionally, foreign entities having project offices in India could consider reducing risk by using the LLP structure. Further, any structure where different members want to control different segments and also bear full responsibility for their acts, could conveniently use the LLP structure. This includes infrastructure project SPVs where different partners bring in different expertise into the project.

The 11th May, 2011 Circular. Good or Bad?

  • Investment Rules:

    FDI will be allowed only in LLPs which are engaged in the sector where 100% FDI is allowed through automatic route and where no performance linked restrictions, like minimum capitalisation, etc., is imposed. An Indian company having FDI can invest in a LLP, provided that both the investing company and investee LLP are engaged in sector where 100% FDI is allowed through automatic route and where no performance linked restrictions, like minimum capitalization, minimum area norms, lock in, entry route restrictions, caps etc, are imposed. Since FDI in LLP’s will not be permitted in activities that have FDI-linked performance conditions, such as construction development. There remains a big question mark on the future of such business enterprises.

    A big question which remains to be answered is whether this restriction would also cover a sector like wholesale trading, where one of the conditions under operational guidelines is that wholesale trading to group companies should not exceed 25% of the total turnover of the wholesale venture?

    Also, are the minimum capitalization norms prescribed for FDI in Non-banking Financial Companies (NBFCs), a “performance” condition, thereby restricting FDI in LLPs engaged in the 18 permissible NBFC activities?


  • Restrictions:

    No FDI in LLP is allowed, if the investee LLP is engaged in agricultural/plantation, print media or real estate. The FII (Foreign Institutional investors) & FVCI (Foreign Venture Capital Investment) have been prohibited to invest in LLPs. It is important to note here that FIIs are allowed for portfolio investment wherein the main intention is to invest and seek gains out of it. The aim is not to create a lasting relation with the entity in which investment is made. This shows that there is a lot of uncertainty as the FIIs might not want to invest and even withdraw the principal amount throwing the Indian economy into turmoil.

    Also an LLP cannot possibly think of invoking ECB (External Commercial Borrowing). Availing of ECB might increase the possibility of a huge debt flowing into the country which would erode the economy.

    LLPs with FDI cannot make downstream investments. Downstream investment in general parlance means that an Indian company which is owned by a foreign company invests in another Indian company. It is an indirect foreign direct investment. This condition acts as an embargo on the conversion of the Joint Venture Companies or Wholly owned subsidiaries to make any downstream investment.

    Also, in LLPs it is very difficult to understand the concept of ownership & control. Under the FDI policy for companies, a foreign investor would own an Indian company if he owns more than 50% of the share capital of the company. Such an approach may not be apt for an LLP as the LLP Act provides flexibility for partners to decide the manner in which they wish to contribute to the capital for the LLP.

  • Contributions:

    It is further clarified that foreign capital in LLPs in open sectors shall only be permitted by way of cash consideration received from overseas through an inward remittance through normal banking channels or through debits to the NRE (Non-Resident (External) /FCNR (Foreign Currency (Non-Resident) Accounts) account of the foreign investor maintained with an authorized dealer bank in India, thus contribution through consideration other than cash has been specifically excluded. There is no clarity on whether capital contribution through Non-resident Ordinary (NRO-When an Indian National/PIO resident in India leaves for taking up employment, etc. outside the country, his bank account in India gets designated as NRO account) can be done or not. Under Clause 32 of the LLP Act, "a contribution of a partner may consist of tangible, movable or immovable or intangible property or benefit to the LLP, including money, promissory notes, and other agreements to contribute cash or property and contracts for services or to be performed". This effectively means that a partner may contribute in a LLP "cash & non-cash". However, as per the existing FDI policy, issue of shares for consideration other than cash requires prior FIPB approval.


  • Designated Partner

    If a LLP has FDI, then it can have a designated partner which is a company incorporated under the Companies Act, 1956 (Indian) and not any other body like LLP or trust. For such LLP, the designated partner in order to be resident in India should satisfy the requirements prescribed in Foreign Exchange Management Act, 1999. the designated partner "resident in India", as defined under the 'Explanation' to Section 7(1) of the LLP Act, 2008, would also have to satisfy the definition of "person resident in India", as prescribed under Section 2(v)(i) of the Foreign Exchange Management Act, 1999.

    The designated partners are liable for compliances with LLP and subject to penalty if any. Conversion of a company with FDI into a LLP will be allowed only if the above conditions have been met and prior approval of the Foreign Investment Promotion Board/Government has been obtained for the conversion.


  • Valuation:

    The press release containing the policy announcement does not mention any pricing norms for FDI in LLPs. For example, the extent of contribution in the partnership capital, the share of profits, the extent of voting rights does factor in such provisions. In case of a company, the prevailing policy and FEMA regulations stipulate that the issue price of shares issued to a foreign investor, should not be lower than the fair value determined in accordance with DCF (Discounted Cash Flow) valuation methodology, in case of an unlisted company, and valuation in terms of SEBI (ICDR-Issue of Capital & Disclosure Requirement) Regulations, for listed companies . Nothing has been prescribed by DIPP for LLP on this front. However by virtue of a new notification (dated 11th July, 2011) which says that LLPs can now be listed, the valuation procedure that of listed companies can be adhered. In absence, of explicit guidelines for the same, it is difficult to test the viability of an investment.


Conclusion

The Indian economy is propelling itself in the currents of increased globalization and is capitalizing a great deal on the global investments. It is breaking free from the shackles of the closed and conserved economy and trying to make its mark on international footing along with other countries. Such moves will not only strengthen the economy but will also foster international relations. Allowing foreign investments in the wake of such a light is definitely a right step.

The current multi brand retail sector cap of 51% will strengthen the economy as it will bring in new technology, working style and generate employment for population of our country. It is not a threat to the domestic retailers as it will give them strong back hand support with operational efficiency. As far as the FDI in LLPs is concerned, we can understand that the restrictions put are understandable as the government doesn’t want to get stumbled under regulatory burden. The fact that LLP cannot raise ECB (External Commercial Borrowings) and not make downstream investments restricts its usage in specific cases particularly in the Infrastructure sector/other high leveraged sector. However, such restrictions are logical as the government doesn’t want huge inflow of debt in the Indian economy.

The detailed procedural guidelines are awaited for notifying the necessary amendments in the FDI policy, as also providing some clarity on the open areas. The valuation method as has been previously discussed is not clear. In absence of such important guidelines, it is not likely that the investor might want to put in money in LLPs in India.

LLP per se is an extremely attractive business model. Allowing FDIs in LLP in sector wherein 100% investment is allowed makes it a cherry on the cake. As the service sector such as Chattered Accountants and Law Firms will be able to scale up the infrastructure and provide tremendous exposure, such an initiative will definitely prove to be boon. The major problem which remains to be battled is the loosely worded provisions that have created a scope of lot of uncertainty which might open floodgates of litigation battle in future. The RBI and FIPB must quickly come out with detailed guidelines so that the uncertain nature can be done away with. It requires a little more effort for this initiative to be able to live up to its expectation. It remains to be seen if the circular dated 11th May, 2011 would mark the beginning of influx of foreign investments in LLPs in India or pass of as just a temporary move.

SANSKRITI RASTOGI is a final year student and AKSHAY GUPTA is a fourth year student at Gujarat National Law University, Gandhinagar.
 
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