EY Tax Alert

Foreign Direct Investment in Limited Liability Partnerships

4 October 2010

2 EY Tax Alert
Executive summary

This Tax Alert 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 (GoI). Even
though there may be benefits in organizing ones
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.

Background

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:

An LLP structure aims at providing the benefits
of limited liability of a company but allows its
members the flexibility of organizing their
internal management on the basis of an
agreement mutually arrived at, as in the case of
a partnership firm.

An LLP is a body corporate and a legal entity
which has perpetual succession and is separate
from its partners. The liability of its partners is
limited to their agreed contribution to the LLP.
Furthermore, the concept of joint and several
liability is done away with and no partner is
liable on account of independent or
unauthorized actions of the other partners.

The LLP Act, 2008 also has provisions
pertaining to maintenance of annual accounts,
corporate actions (such as mergers), winding up
etc.

The LLP Rules, 2009, inter alia, comprise
provisions and procedures pertaining to
incorporation, financial disclosures, conversion
into an LLP, compromise and arrangement or
reconstruction of an LLP.


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 GoI. 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

3 EY Tax Alert
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

4 EY Tax Alert
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:

Should FDI be permitted in LLPs at all?

Given the complexity of some of the issues
raised, would it be preferable to adopt a
calibrated approach to the induction of FDI in
LLPs? Initially, should FDI in LLPs be restricted
to sectors without caps, conditionalities or entry
route restrictions? Should FDI be allowed up to
100% in these sectors or should there
necessarily be an Indian partner? Should such
approval be confined to the government route?
Should LLPs be mandated not to make
downstream investments and should foreign-
owned or controlled Indian companies be barred
from investing downstream in LLPs? Should
investment by Foreign Institutional Investors or
External Commercial Borrowings be prohibited
for LLPs?

Should FDI policy treat LLPs akin to companies?
In such a case, how should the issues relating to
ownership, valuation, control, downstream
investment and non-cash contributions be
addressed? Should this be only through the GoI
approval route?

Will treating LLPs akin to companies under FDI
policy demand the stipulation of certain features
of the LLP agreement? Should this include
unambiguous specification of profit /loss
sharing percentage; congruence of legal and
economic ownership; timely notification of
changes including conversion from and to
companies/partnerships? Should it be mandated
that LLPs cannot have corporate bodies other
than companies registered under the companies
Act as partners? Is inclusion and coverage of
such issues in FDI policy warranted? Would the
consequent increase in the regulatory burden be
justifiable?

What additional regulatory safeguards are
required to enfold LLPs into FDI policy? Are
amendments to any existing regulations
required? Should the responsibility for periodic
monitoring of compliance with FDI stipulations
be allotted to a particular agency?

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
GoI 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
GoI in putting forth their points of view. It is
expected that the GoI 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 GoI policy gives a favorable
consideration to this issue.











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