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Zia Mody – Evolving Legal Landscape for Family Businesses

Investment Outlook , Published Feb 17, 2019

Zia Mody

Zia Mody

Founder and Managing Partner at AZB & Partners.

Two legal themes are likely to lead to better governance practices and financial management by Indian family businesses over the next few years.

Overview

Business families will talk more about business succession planning than before, particularly if an estate tax is introduced. Secondly, the implementation of the Insolvency and Bankruptcy Code, 2016 will make business families increasingly cognizant of the importance of personal wealth planning as well as the impact of promoter debt obligations on personal finances.

According to reports by Credit Suisse and Bain earlier this year, Indian family-run businesses were ranked as some of the world’s best companies for shareholder value.

These companies outperformed their peers in other regions, as well as non-family owned companies over the last decade and a half. At the same time, 2018 has been the year of the NPA crisis, with periodic reports of large-scale loan defaults by prominent promoters and family businesses, with RBI numbers indicating that the loan default margin doubled over the period of a year.

Considering this background, two legal themes are likely to feature strongly over the next few years..

The first is the Indian estate tax. Broadly, this is a tax levied on the inheritance of wealth by the next generation. As it is targeted at the redistribution of wealth, the rates levied tend to be higher than income tax. Although India does not currently have an estate tax in place, it is expected to come in at some stage. The significance is that globally, estate tax regimes are not restricted to liquid assets. Illiquid assets such as family business shareholdings are also included in the estate. If a similar model is adopted in India which is likely, then considering that a majority of businesses in India are family owned, the introduction of such a tax could create cash flow difficulties for the family, and hurt the business, if a plan is not put in place in advance.

As we wait for the law to come in, several business families have already started planning for a trust and other structures in anticipation of the tax. This is likely to continue shaping the way family businesses are held and managed in India in the years to come.

A second key theme is the impact of implementation of the Insolvency and Bankruptcy Code, 2016 (“IBC”). Historically, it has been a common practice for promoter families to co-mingle business and personal assets, and plough back all proceeds back into the business. While this sort of single-minded, long-term focus on the business may have created value, it also meant that good governance practices were not given sufficient importance due to the conflation of business with family finances. The IBC brought about a shift in approach, by introducing a creditor favourable regime and making it difficult for companies to practice ever-greening of their business loans. A recent Supreme Court ruling also held, for example, that personal guarantors cannot benefit from the imposition of moratorium during the insolvency process and therefore continue to be subject to independent and co-extensive liability under the IBC.. As a consequence, business families are increasingly cognizant of the importance of personal wealth planning, and the impact of promoter debt obligations on personal finances. It is likely that in the years going forward, these developments will lead to better governance practices and financial management by Indian family businesses.

The significance is that globally, estate tax regimes are not restricted to liquid assets.

On a related note, business families are talking more about business succession planning than they have ever before, and this will be a continuing theme going forward as well, particularly if an estate tax is introduced. Changing family circumstances such as increasing global families, children studying abroad, daughters playing stronger professional roles and some public high-value disputes are compelling families to think about the relationship of the family with the business in a more structured fashion. Greater thought is going into how family businesses can be managed in a seamless fashion even after the demise of the patriarch, how capability may be built in the next generation or how professionals may add value. Overall, the statutory push to get women directors on board is salutary. And this will surely be good for the economic landscape.

The investment outlook cannot fail to evaluate whether development is inclusive and leading to positive socio-economic growth at the grassroots. Philanthropy has received a fillip due to companies being required to make corporate social responsibility contributions under law. Social business investments

forever-appreciating

have also seen an increase over the last decade, and this will hopefully fulfill a dual mission of socio-economic development that is sustainable and not grant dependent. Indian families, in making these investments, extend their family legacies beyond the board room. It is an investment approach that is made across asset classes including venture capital, private equity, social impact bonds, and social venture funds. Such impact investment globally is set to cross over USD 465 billion by 2020. A recent study with KPMG showed that the market is estimated to grow by 16% through to 2020.

I believe the path to this journey by Indian family businesses will soon reach maturity. And that will lead to a more mature separation of roles between family members of management and ownership with less friction and the obvious resultant accretive positive value creation.

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