Holding Vehicle -Company or an LLP? - Part 1

INTRODUCTION

Promoters are often required to make a choice, as to the ownership structure of businesses i.e. whether to hold shares in an operating company directly or through a Holding Company, or through a Limited Liability Partnership (LLP).  The Company and LLP vehicles are quite different and one obviously needs to test them in each situation; the results can be surprising at times and the widely acknowledged leverage of LLP of upstreaming profits without cost, may not be the sole factor to make a choice.

So, what makes the choice complex? The answer is not the tax & regulatory implications, but the objectives which often change over time and which differ from case to case. It then becomes crucial to test the holding vehicle for sustainability rather than short-term benefits, especially given that holding structures are not easily reversible or flexible.

First of all, one needs to distinguish between whether the holding is of a family or of a corporate group or of an MNC and whether one is talking of outbound or inbound. In this article, what is sought to be addressed is the holding structures for Indian companies either by Indian families or Indian groups and the key focus is a company vis-à-vis an LLP structure.

CAN AN LLP BE A PURE HOLDING VEHICLE AT ALL?

The general impression is that an LLP incorporated with a purpose of holding investments is not permissible statutorily. This issue surfaced when some LLPs intended for the sole purpose of investments faced registration resistance. The regulator’s discomfort vis-à-vis LLPs may possibly have emanated from the fact that Companies engaged in the business of holding investments are regulated by the Reserve Bank of India (RBI) and such LLPs, if permitted, would not be regulated. This perception would stay as such, until MCA or RBI brings in any clarification or amendment.

The second aspect is to test if the Limited Liability Partnership Act, 2008 (LLP Act) prohibits an LLP in nature of a holding vehicle. Section 11(1)(a) of the LLP Act, requires that, for incorporation as an LLP, two or more persons should associate for carrying on a lawful business. So, the question is, whether an LLP for the purpose of holding investments in not a business?  The issue is debatable; the doubt persists because of practical challenges in incorporating an LLP if it is with the sole purpose of holding investments. However, the practical answer if there is a business carried on/ intended to be carried on by the LLP, there should not be any issue in the LLP also holding group investment(s).

ACCEPTANCE OF AN LLP VIS-À-VIS COMPANY

LLPs, as a concept, was introduced in India, in the year 2008, with the introduction of the Limited Liability Partnership Act 2008 (‘LLP Act’). Since the last 10 years, the law around LLPs has gradually evolved and is still not matured. For instance, with initial introduction of the LLPs, Foreign Direct Investments (FDI) were not permitted but eventually the FDI policy accommodated LLPs. There are still some areas where LLPs receive a differential treatment. From a tax perspective, the Law is still evolving – for instance, conversion of a Company into an LLP in a tax neutral manner is permitted for very small-sized Companies. The absence of tax neutrality in all but very small situation has been a major deterrent in grants of LLPs.

While tax & regulatory framework is one side of the acceptance, external stakeholders have also not welcomed LLPs; for instance, banks/ financial institutions still indicate discomfort in lending to LLPs. Regulatory authorities like state utilities still do not permit LLPs to submit bids or tenders in some cases. Some HR professionals have also raised perception-based concerns for large operating businesses being housed in LLPs, indicating that it may not manifest a serious business set-up and it may be difficult to attract talent. While all of these acceptance issues may not be directly relevant for LLPs as holding vehicles, one also needs to be mindful of these aspects.

A Company is governed under the Companies Act, 2013 (Cos Act) and various granular aspects are regulated by the Cos Act. The LLP Act still does not provide (and justifiably so) strong granular regulatory details. An LLP can provide for an equally strong internal governance through its partnership deed and yet, external stakeholders may not rate LLPs on par with companies, as it will be a matter of internal governance between partners, as opposed to regulations per law. 

COMPANY vis-à-vis LLP AS HOLDING VEHICLE:

In order to evaluate a company vis-à-vis an LLP as a holding vehicle, it is first important to recognise that the situation can be different for a corporate group holding other companies, or a family holding, since the considerations are very different.  In relation to a family holding, quite often, a holding vehicle (usually a company) is a choice partly due to the ability to ‘bind’ family members in a company holding.

In relation to a corporate group, there is very often a historical situation of layered holdings; let’s say Company H, a family Holdco having promoted say, Listco 1 and Listco 1 is holding a significant stake in Listco 2.  This enables individual members of the family not being able to sell the shares to any external party, but also has the downside of the family members being locked in to a large extent. Also, when Listco 1 holds Listco 2, it enables the family to control Listco 2 without necessarily holding a majority stake; say holding in Listco 1 is 60% and Listco 1 holds 60% in Listco 2, promoters can control Listco 2, though holding is only 36% on a ‘see through’ basis.

As per section 186 of the Companies Act (CA), 2013, a company cannot make investment in subsidiary companies beyond two layers of investment companies, whereas in the LLP Act, there is no such restriction. Further, a company only holding investments in a group company may be classified as an NBFC subject to income test and asset test given in NBFC regulations. If such company classified as an NBFC, then NBFC (or CIC) regulations also need to be followed, whereas an LLP is not covered by NBFC regulations. (of course, if the NBFC qualifies to be a CIC, the regulatory compliance is lesser). In case of a company, voting rights depend upon number of shares held by the promoters; however, voting rights in an LLP can be defined in the LLP agreement. In case the LLP agreement is silent, then each partner has one vote.

TAXATION ISSUES:

Promoters would usually to receive dividend income from the operating company(s) through a holding vehicle. First, the holding vehicle will receive the dividend and then the issue is of extracting earnings from holding vehicle.

Extraction of earnings of operating companies:

Promoters would usually to receive dividend income from the operating company(s) through a holding vehicle. In case of a company, the holding company will receive the dividend from the operating company and then holding company will distribute earnings to promoters. Such distribution by a holding company to its shareholders (i.e. promoters) is subject to Dividend Distribution tax (DDT) at an effective tax rate of 20.56% as per section 115O of the ITA. However, when dividend is received from the subsidiaries, there is an upfront exemption for DDT.

In case of an LLP, the holding LLP will receive dividend from the operating company(ies) and then the promoters will receive share of profit from the holding LLP. Such share of profit received by promoters (being partners) from an LLP is exempt u/s 10(2A) of ITA. However, dividend received by the holding LLP in excess of INR 10 Lakhs is taxable at the rate of 11.65% u/s 115BBDA of the ITA, whereas the dividend received by a domestic company, on which DDT is paid, is exempt u/s 10(34) of the ITA.

The above tax implication is illustrated by following example:

Scenario 1: An operating company O is wholly owned by company H which, in turn, is wholly owned by promoters of the group. H has no other business.

Scenario 2: An operating company O is wholly owned by LLP L which, in turn, is wholly owned by promoters of the group. L has no other business.

Assuming the turnover of company O exceeds INR 250 crores and income of company O is INR 100 crore, tax implication and net income received by promoters are as follows:

                                                                                                                                          (INR in Crores)

On a plain vanilla basis, it would be seen that, whether the holding vehicle is an LLP or a company, it does not affect the outcome of tax. In both the cases, promoters receive the same amount of the after-tax income. However, in a situation where a holding company does not declare any dividend and retains profit (and usually, the position is that a holding company will not declare the full amount as dividend) a company holding vehicle is better than an LLP holding vehicle from the tax point of view.

However, one cannot choose a holding vehicle only on the basis of tax implications on extraction of earnings of subsidiaries; other factors such as funds extraction, borrowings, listing implications are equally important for decision making and those factors have been specifically dealt with in the second part of this article.

This article has been co-authored by Bhavik Gandha, Katalyst Advisors LLP.