succession planning

In this article, Tushar Dey pursuing M.A, in Business Law from NUJS, Kolkata discusses Legal issues that arise in succession planning in large conglomerates.

Introduction

Privately-held or family owned businesses form a majority of large businesses in India. The most famous examples are business groups such as the Tata, Birla, Ambani, Godrej etc. Tellingly, 15 of the top 20 business groups are family-owned. Between them, they controlled nearly Rs. 26 lakh crore ($390 billion) of assets at the end of the 2016 Financial Year, which made up 84 per cent of the total assets of the top 20 business groups in India. While certain groups were major players in the economy even at the time of independence, others have emerged later and seen a meteoric rise. The sectors in which these businesses operate are also very diverse in range and nature – from textiles to petrochemicals to information technology.

However, a point of convergence for all businesses is the planning and implementation of a succession plan. As the founders and older establishment gradually pass on, their successors will take over the reins of business. But owing to certain cultural factors there is often great hesitation on part of the families to discuss succession plans. This is part of a larger trend in Asian business. Even though the absence of a well thought out succession plan may appear to be a non- issue, it is in fact perceived as a business risk by investors, especially foreign ones.

Such is the significance of lack of a succession plan that Morten Bennedsen, professor of family enterprise at Insead Business School, stated, “The single most important factor facing Asian family businesses is the issue of succession.”

A couple of high profile business groups such as Birla and Ambani have already faced serious succession issues when the older generation started dying. In 2013, a report in The Financial Times laid stress upon the need for greater awareness for succession planning because a large portion of wealth remained stuck in family businesses and needed to be effectively handed over to the next generation. Therefore, effective estate and wealth planning through which family owned businesses can make a smooth inter-generational transition, is the need of the hour.

The Objectives of Succession Planning

Business Succession Planning involves considered transfer of management and control of business from one generation to other. Succession planning normally has three objectives: to efficiently and fairly distribute assets from older to younger generations; to pass control of the business in a way that will ensure effective business leadership, and to maintain and promote harmony. Finally succession planning is about preserving and building a company’s net worth by successfully navigating between family membership, company management and business ownership. A succession strategy articulates how the process will be carried out as well as the purpose and values guiding the choices that have to be made.

The major objective of succession planning can be summarized as follows:

  1. Retaining Control: Retaining family control over business and managing overlap between family and business.
  2. Governance – Effective governance of family and business holdings
  3. Value – Maintaining Value of the business and individual shares of family members
  4. Conflict – Exit options and dispute resolutions

Major Legal Issues in Succession Planning

RESIDENCE AND DOMICILE

Generally, determination of ‘residence’ and ‘domicile’ forms an important first-step in succession planning. In everyday usage, both these terms are often mistaken to mean the same thing. In most countries, residence is relevant for the purposes of determining liability to income tax whereas domicile is relevant in the context of other taxes (such as estate duty or inheritance tax) and in the context of non-tax considerations such as applicability of succession laws (particularly, in case of movable property. In India, the basis for imposing Indian tax and exchange control regulations is the residence of an individual as opposed to domicile or citizenship. Domicile is important in cases of succession, whether testamentary (i.e. under a will) or intestate (i.e. where the person dies without leaving a will).

SUCCESSION LAW

Succession law in India is based on personal law i.e. the law is based on the religion followed by an individual.

HINDUS

Hindus are governed by the Hindu Succession Act, 1956, which codifies the law of intestate succession i.e. where the deceased dies without leaving behind a will. Pertinently, under the said Act, the term ‘Hindu’ includes persons professing the Buddhist, Jain, and Sikh religions as well. The Hindu Succession Act provides for a method of distribution of property in case of intestate succession. In such a scenario, the general principle is that property gets automatically vested in the legal heirs or it vests in the Hindu Undivided Family.

The Heirs of a Dead Intestate Hindu Male Inherit Property in the following order of preference,

  1. Class I heirs: Sons, daughters, widows, mothers, sons of a predeceased son, widows of a pre-deceased son, son of a pre-deceased sons of a pre-deceased son, and widows of a pre-deceased son of a predeceased son. It is important to note that all these heirs inherit simultaneously.
  2. Class II heirs: Father, Son’s / daughter’s son, Son’s / daughter’s daughter, Brother, Sister, Daughter’s / son’s son, Daughter’s / son’s daughter, Daughter’s / daughter’s son, Daughter’s /daughter’s daughter, Brother’s son, Sister’s son, Brother’s daughter. In Class II Heirs, an heir in a higher entry is given preference over an heir in a lower entry.
  3. In case there are no heirs in Class II, property will devolve upon the agnates (relatives through male lineage) of the deceased. If there are no agnates, the property will devolve upon the cognates (relatives through female lineage)

In case the rare case where there are no claimants the property gets vested with the state government.

In case of a Hindu Undivided Family, which is a joint family and is often, used as an unincorporated business vehicle, the interest of a deceased Hindu male devolves by survivorship upon other surviving members, and not as per the rules of succession as discussed above. An exception to this is the scenario where the deceased has disposed off his interest in the Hindu Undivided Family through a will.

Traditionally, the Hindu woman’s estate was limited in nature. By virtue of an amendment to the Hindu Succession Act in 2005, any property possessed by a Hindu female, is held by her as absolute property and she is given full power to deal with it and dispose of it by will as she likes. In case of death of a Hindu female, property devolves firstly, upon the sons and daughters (including the children of any pre-deceased son or daughter) and the husband; secondly, upon the heirs of the husband; thirdly, upon the heirs of the father; fourthly, upon the heirs of the father, and lastly, upon the heirs of the mother.

MUSLIMS

Under Muslim law, the heirs of the deceased intestate Muslim inherit a fixed share of the property. The son receives double the share of the daughter. The wife is entitled to one-eighth of the estate of the deceased. In case there are only daughters, they receive two-thirds of the estate and the remainder goes to the deceased brother or his son/s. If the deceased is a Muslim woman, the husband will inherit one – fourth of the property. In case the deceased’s parents are alive, they too will inherit a specified share.

Three Major Ways to Plan Succession

1) Family Settlement

One of the effective ways to plan a succession is via a family settlement. This takes place during the lifetime of the owner of the business.Shareholding of various family members may be re – arranged so as to ensure effective control by major shareholders and consequent maintaining of the health of the business.

While such an arrangement may be oral, it is advisable to have it reduced in writing and then registered under the provisions of the Registration Act. Registration will ensure a formal record of the arrangement and prevent any disputes from arising later. Family settlement may also be ordered by the Court but no separate registration is required in such a case.

A settlement must be bonafide in nature and a fair and equitable division or allotment of properties must be made between the various members of the business family. Furthermore, a family settlement must be voluntary. It must not be vitiated by factors such as inducement, fraud, coercion or undue influence. A family arrangement may be made in order to maintain harmony or bring about peace among family members.

Judicial decisions make it amply clear that the validity of the family arrangement does not depend upon whether or not the rights claimed by any disputing family members are sustainable in law.

A family settlement is also an excellent method to avoid tax. Where a settlement is reached in order to avoid disputes within the family and maintain good relations between family members, any transfer of assets between them does not attract capital gains tax liability as per section 47 of the Income-tax Act, 1961

In CIT v. Ramanathan 245 ITR 494, in a family dispute, an assessee was supposed to receive a certain amount of money and some specified lands in exchange for half of his shareholding in some companies. This arrangement allowed the assessee to avoid payment of Capital Gains Tax because the High Court agreed with the assessee’s contention that agreements were in pursuance of a family settlement and hence capital gains from these transactions could not be assessed to Capital Gains Tax.

2) Wills

Since large family owned business conglomerates in India now have up to three living generations, leaving assets to devolve upon heirs as per intestate succession can create friction between family members and may prove undesirable, and even harmful, for crucial and profitable decision making. With multiple heirs to a large business group, the division of property by way of a will is the preferable solution to avoid any possible squabbles and complications between family members. Though a will, the family patriarch may, if he wishes, bequeath property to heirs or certain other persons as well.

The Procedural aspects of Creation and Execution of Wills are provided under the Indian Succession Act, 1925. Section 2(h) of the said Act defines the term ‘Will’ as under:

“The legal declaration of the intention of the testator, with respect to his property, which he desires to be carried into effect after his death.”

A will, therefore, gives effect to the wishes of the deceased (called testator) with respect to his property. However, for a will to take effect, it must be proved in court. There are certain other rules which are applicable in accordance with the Indian Succession Act – testator must be of a sound mind while making the will; a will obtained by fraud, coercion or importunity which takes away the testator’s free agency, is void. A probate i.e. copy of a Will certified under the seal of a Court of competent jurisdiction with a grant of administration to the estate of the testator, proves that the will is genuine. A probate is required for claiming immovable assets spread across different states. An executor named in the will administers the estate of the deceased in accordance with the will, and is authorised to do so by the court.

In case a person dies intestate, an administrator is appointed by the court to administer the estate. An administrator is also appointed if the will is invalid, or an executor has not named in the will or is unable/ unwilling to act. The document issued by court granting authority to an administrator is known as “Letters of Administration”.

While under Hindu Law, a testator can dispose off his entire property by way of will, Muslims can dispose off property by will only to the extent of one – third of the total estate. More than this may be disposed of by will only if the heirs of the testator agree.

3) PRIVATE TRUSTS

Due to frequent changes to taxation and regulatory systems in India, an increasingly preferred vehicle for succession planning by large businesses is the Trust. A trust ensures separation of ownership and control. Assets managed via a trust are easier to protect and maintain, and the interests of family members also remain protected.

Trusts may be either public or private in nature. While public trusts are created mostly for charitable purposes, private trusts are created by families to care for wealth for their heirs.  Establishing a trust entails the transfer of property (trust property) by the owner (settlor/ donor) to a person (trustee) who holds it for the benefit of another person (beneficiary). The Indian Trusts Act, 1882, defines a “trust” as “an obligation annexed to the ownership of property, and arising out of a confidence reposed in and accepted by the owner, or declared and accepted by him, for the benefit of another, or of another and the owner.” Furthermore, private trusts may be either specific or discretionary. In case of the former, interest of each beneficiary is pre – defined. The latter may, however, either specify all the beneficiaries or provide an indicative list of beneficiaries, which may even be changed later. In this case, discretion is granted to the trustees to decide the manner or ration in which the distribution can be made between the beneficiaries.

A trust of immovable property is created by virtue of a trust deed signed by the creator of the trust or the trustees and duly registered. It may also be created by the will of the owner of the property or of the trustees. A similar procedure is followed for creation of trust of a movable property. Alternately, for a movable property, ownership of the property must be transferred to the trustee.

A trust should be designed carefully in order to guarantee control over all group assets, separation of economic interest from management control, simple income and assets distribution, and safety of assets from potential claims by creditors.

Exchange Control Laws

In India, exchange control laws are applicable to investment (equity/debt/otherwise) by non-residents (as defined for the purposes of such exchange control laws) in businesses and properties in India and vice versa (i.e., investment by residents in businesses and properties outside India). Exchange control laws also govern remittance of funds by residents and non- residents from India. From a succession planning perspective, this consideration becomes critical where family members, businesses, properties, etc., are spread in different jurisdictions. For example, if an Indian resident is considering setting up an offshore trust, he may be able to contribute only up to USD 250,000 per financial year into the trust, unless he has any accumulated funds outside India (earned when he not an Indian resident) or if his family members or friends are also willing to make contributions into the trust, etc. In case of persons who have been living outside India for a significant period of time and return back to India, they are generally allowed to retain funds outside India which they earned or acquired while they were non-resident. However, once they remit such funds to India, generally, limitations applicable to Indian residents in relation to remitting funds outside India get triggered.

Therefore, to the extent succession planning objectives can be achieved, often, there is a preference to create separate succession planning structures – (i) for Indian assets with Indian residents as beneficiaries and (ii) for offshore assets with non-residents as beneficiaries, with both structures operating in parallel and in such a manner that effectively similar benefits are given to beneficiaries under both trusts.

Taxation Issues in Succession Planning

ESTATE DUTY

Estate Duty in India was introduced in 1953 under the Estate Duty Act, 1953 (“Act”) with the object of imposing estate duty on property passing or deemed to pass on the death of a person. Estate Duty was abolished on June 16, 1985. The government cited excessive administrative costs as against the actual tax yields (only about 20 crores) as the primary reason for abolishing estate duty. Consequently, estate duty was not payable in respect of the estate of a person who died after March 16, 1985. It is anticipated that the government may consider re-introduction of estate duty in India, though there has been no formal announcement or other communication by the government in this regard.

Taxation of Family Settlement

In case a Family Settlement or a Family Arrangement is arrived at to avoid continuous family friction and to maintain family peace amongst the family members there would be no “Transfer” in terms of Capital Gains, hence no tax liability as per section 47 of the Income-tax Act, 1961.

Conclusion

No one goes through the work, risk, and sacrifice of starting a business without hoping it will last. Building value that endures is the dream that motivates entrepreneurs. Yet in many businesses, too little of that work goes into determining who will take over when the founders leave the stage. For a business, working without a succession plan can invite disruption, uncertainty, and conflict, and endangers future competitiveness. For companies that are family owned or controlled, the issue of succession also introduces deeply emotional personal issues and may widen the circle of stakeholders to include non-employee family members. Succession planning is a complex process that draws upon many business disciplines. Many privately held businesses display solid professionalism and enviable profits in their daily operations, yet fail to properly plan for and complete the transition to the next generation of leaders. An unprepared new management group, or even a poorly managed transition to competent management, can trigger significant loss in value. A lot of effort goes into every part of succession planning. None of it would be necessary if business lifespan and human lifespan aligned perfectly. The whole point of succession is to determine how one of those processes will continue after it disengages from the other. All of which is a clinical-sounding way to express a deeply personal thought: Business succession planning is about what persists of your effort, your stamp, your principles, and your hard work after you are no longer there to continue to shape it.

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