Introduction
In recent years, limited liability partnerships ("LLPs") registered under the Limited Liability Partnership Act, 2008 have gained significance since they possess the advantages of being a separate legal entity and having limited liability, akin to a company, while also offering the operational flexibility and reduced compliance burdens associated with a partnership - making them an attractive hybrid business structure.
However, despite its unique advantages and the growing popularity, LLPs face significant challenges when navigating the complexities of foreign investment. One such challenge is structuring a cross-border transaction having an element of purchase price adjustment (such as for working capital) or deferred consideration (i.e. when a portion of the purchase consideration is proposed to be held back / paid at a later date, contingent on certain conditions being met).
Given the increasing interest in LLPs, it is important to understand how these entities are treated differently under the Foreign Exchange Management Act, 1999 and the rules and regulations made thereunder ("FEMA") as compared to companies, particularly in relation to purchase price adjustments and deferred consideration.
In this article, we analyse the law governing purchase price adjustments and deferred consideration as provided under FEMA in the context of LLPs in comparison to companies and the commercial impact of such distinction.
FEMA law on deferred consideration
With effect from May 20, 2016, by way of a notification, the Reserve Bank of India ("RBI") permitted deferred consideration in transactions involving a transfer of shares between a resident and a non-resident subject to: (i) such amount not exceeding 25% of the total purchase consideration; and (ii) the payment of such amount being made within 18 months of the date of the transfer agreement ("18/25 Rule")1. Following the same 18/25 Rule, the deferred consideration/ purchase price adjustment can also be operationalized through an escrow arrangement between the buyer and the seller. In addition to the 18/25 Rule, it is mandatory that the total consideration finally paid for the shares is compliant with the applicable pricing guidelines under FEMA.
This law has now been laid down in Rule 9(6) of the FEMA (Non-debt Instruments) Rules, 2019 ("NDI Rules").
Restriction on deferred consideration in case of LLPs
While FEMA permits deferred consideration in case of companies (subject to the 18/25 Rule and pricing guidelines), it does not extend the same flexibility to LLPs, creating a regulatory gap in case of cross-border transactions involving LLPs.
The 18/25 Rule mentioned above is only applicable in case of transfer of 'equity instruments'. Under Rule 2(k) of the NDI Rules, 'equity instruments' mean equity shares, convertible debentures, preference shares and share warrants issued by an Indian company and do not cover partnership interests of an LLP.
Investments in LLPs can be done by way of contribution to the capital of the LLP or acquisition or transfer of profit shares of an LLP. Given that the mechanism for purchase price adjustments and deferred consideration in case of LLPs is not expressly authorised under FEMA (like the 18/25 Rule for companies), and since no person resident outside India is permitted to make any investment in India, save as otherwise provided for under FEMA – it can be concluded that deferred consideration and purchase price adjustments are not permitted under the automatic route for LLPs when a transaction is between a resident and non-resident.
Commercial impact on cross-border transactions involving LLPs
On account of such restriction on LLPs, a cross-border transaction involving LLPs cannot provide for the following structuring options without RBI approval:
- Purchase price adjustments:
This is a mechanism adopted by parties to adjust the final purchase consideration based on any changes in the financial condition of a target between the date the target was initially valued and the date of closing. In such cases, typically, the adjustment of the purchase price takes place post the closing of the transaction.
From a buyer's perspective, purchase price adjustments provide protection to the buyer against any decrease in the valuation of the target in the interim period. On the other hand, from a seller's perspective, the purchase price adjustment mechanism ensures that the seller is adequately compensated in case there is any increase in the valuation of the target within such period.
In case of transfer of equity instruments of a company between a resident and a non-resident, such adjustment of purchase price is permissible, subject to the 18/25 Rule and the total consideration finally being paid as per applicable pricing guidelines. However, given that such provision is restricted only to companies, post-closing purchase price adjustments in case of transfer of partnership interests of an Indian LLP between a resident and non-resident is not permissible under the NDI Rules without RBI approval. - Deferred consideration:
In deals involving deferred consideration, such as earn-outs, a certain amount of the purchase consideration may become payable only upon the fulfilment of certain pre-determined milestones. These payments would not be possible in case of cross-border transactions involving LLPs unless RBI approval is received.
From a practical perspective, obtaining RBI approval for the above instances may lead to delays.
The restriction on deferred consideration/ purchase price adjustments for LLPs in case of cross-border transactions may result in potential investors being apprehensive to enter into transactions involving LLPs, since this would involve additional complexity, compared to investments in Indian companies. These strict rules create a disadvantage for LLPs compared to companies where foreign investment is involved.
The parties could explore alternatives for deferment of the purchase consideration/purchase price adjustment, such as structuring the transaction between residents only or only between non-residents (since these regulatory restrictions are applicable only in case of a transfer between a resident and a non-resident) or structuring deferred consideration through other methods which are not part of the purchase consideration (such as payment of management incentives/ fees to sellers). However, any structuring would need to be explored cautiously and undertaken in a manner that complies with applicable law, including FEMA, and may not always be commercially viable and tax efficient.
While the parties may consider converting the LLP into a company, commercial, tax and other considerations (such as the time, process and costs of conversion, the additional compliances for a company in comparison to an LLP, etc.) would need to be borne in mind. As per the NDI Rules, an LLP having foreign investment, engaged in a sector where foreign investment up to 100% is permitted under the automatic route and where there are no foreign direct investment linked performance conditions, may be converted into a company under the automatic route i.e. where no approval under FEMA will be needed. If the LLP is converted into a company, then deferred consideration/ purchase price adjustments would be permissible subject to the 18/25 Rule and pricing guidelines. In such a case, alternative structures could also be explored (such as issuance of redeemable preference shares of the converted company to the resident sellers). However, conversion of an LLP to a company may not always be workable solution.
Conclusion
While the current regulatory framework prohibits deferred consideration and purchase price adjustment for LLPs under the automatic route, the same is permissible for companies subject to the 18/25 Rule and pricing guidelines. To enhance the business environment in India, promote ease of doing business and boost the attractiveness of LLPs, it may be prudent for the legislature to extend the flexibility accorded to companies to LLPs as well.
Footnote
1 The 18/25 Rule also deals with indemnity payouts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
