Insights Into FDI In India

Wednesday, October 23, 2013 - 10:07

The Editor interviews Rahul Patel, Partner in King & Spalding’s Corporate Group and Rajat Sethi, Partner in the New Delhi office of S&R Associates. Mr. Patel’s practice focuses on mergers and acquisitions, joint ventures, strategic corporate transactions, and general corporate work. A significant portion of Mr. Patel’s practice focuses on cross-border transactions, particularly transactions involving Indian companies. Mr. Sethi’s practice covers mergers and acquisitions, foreign investment, joint ventures, private equity, venture capital, corporate governance, regulation and distressed assets matters.

Editor: Foreign direct investment (FDI) in India has been opened up in many areas, but left restricted in others. Where is it still limited, and what is the rationale behind this decision? 

Patel: In August 2013, the FDI policy was liberalized with respect to several sectors, such as in telecom services where FDI up to 100 percent has been permitted (previously 74 percent). However, in a number of sectors, FDI remains restricted for different reasons – for example, (i) uplinking of news and current affairs TV channels and publication of newspapers and periodicals dealing with news and current affairs are still regarded as “sensitive sectors,” and restricting FDI is believed to be a way to regulate content; similarly, defence is a restricted sector in the interests of national security; (ii) investment in multi-brand retail continues to be restricted due to strong political  opposition; and (iii) FDI in the insurance sector, while proposed to be increased from 26 percent to 49 percent, is pending the approval by parliament of the Insurance Laws (Amendment) Bill, 2008.

Editor: Last year at about this time, the Indian government announced a change to its policies on FDI in multi-brand and single-brand retail trading. Would you outline these policies?

Patel: First, some background. Previously, India prohibited FDI in multi-brand retail trading at any ownership level and FDI was only permitted up to 51 percent in single-brand retail trading. In November 2011, the Indian government proposed an increase in the FDI limit for single-brand retail trading to 100 percent and allowing up to 51 percent FDI in multi-brand retail trading. That proposal produced considerable backlash so the Indian government limited its liberalization policy to only permit FDI up to 100 percent in single-brand retail trading, subject to the prior approval of the Foreign Investment Promotion Board (“FIPB”) of the Indian government and certain other conditions. FDI in multi-brand retail continued to be prohibited until September 2012, when FDI up to 51 percent was finally permitted in multi-brand retail, with the prior approval of the FIPB and subject to various conditions that (a year later) appear to have had an unfortunate chilling impact on the attempt at liberalization. FDI in single-brand retail trading was, on the other hand, further liberalized in August 2013 when FDI up to 49 percent was permitted under the automatic route, with FDI in excess of 49 percent and up to 100 percent requiring FIPB approval.

Editor: What are the conditions for 100 percent foreign ownership in single-brand retail companies, and how successful have single-brand retailers been thus far?

Patel: The following must occur:

  • The products to be sold must be of a “single-brand” only;
  • They must be sold under the same brand internationally;
  • “Single-brand” retail would cover only products that are branded during the manufacturing process;
  • The foreign investor, whether or not the owner of the brand, is permitted to undertake single-brand retail trading in India for that specific brand, directly or through a “legally tenable agreement” (e.g., a license or franchise agreement) with the brand owner;
  • In respect of proposals involving FDI in excess of 51 percent, at least 30 percent of the value of goods purchased must be sourced from India, preferably from small industries, village and cottage industries, artisans and craftsmen. This sourcing requirement will initially need to be met as an average of the total value of goods purchased over five years commencing from April 1 of the year during which the first tranche of FDI is received. Thereafter, such requirement will need to be met annually; and
  • Applications for FDI in excess of 49 percent would need to specifically indicate the product/product categories which are proposed to be sold under a “single-brand,” and any additions to the products/product categories would require a fresh approval.   

Sethi: Since 100 percent FDI in single-brand retail trading has been permitted, there has been significant interest from foreign retailers who are keen to capitalize on the large Indian market. The FIPB has since approved the applications of companies across various product lines – IKEA, Fossil, Decathlon and Le Creuset, to name a few. The 30 per cent sourcing requirement has been a stumbling block for a number of companies, including IKEA. Though the Indian government has modified the requirement to make it somewhat less stringent (the sourcing should preferably be from small scale/cottage industries/craftsmen and is to be initially complied with over a five-year period), it remains of concern to numerous companies.      

Editor: Please describe the limitations on investments under the multi-brand investment policy, especially the requirement that retailers obtain 30 percent of the procurement value of manufactured/processed products from “small industries.”

Sethi: FDI of up to 51 percent in multi-brand retail is permitted subject to FIPB approval and the following conditions:

  • The foreign investor must invest at least US$100 million in FDI.
  • At least 50 percent of the total FDI brought in in the first tranche of US$100 million must be invested in “back-end infrastructure” within three years.  Back-end infrastructure includes capital expenditure on activities such as processing, manufacturing, distribution, design improvement, quality control, packaging, logistics, storage and warehousing. Expenditure on land cost and rentals will not be counted for purposes of back-end infrastructure. Subsequent investment in back-end infrastructure may be made by the company as needed, based upon its business requirements.     
  • At least 30 percent of the procurement value of manufactured/processed products purchased must be sourced from Indian micro, small and medium industries, which have a total investment in plant and machinery not exceeding US$2 million.  This refers to the value of the plant and machinery at the time of installation (without providing for depreciation). It has also been clarified that the “small industry” status will be reckoned only at the time of first engagement with the retailer and, even if the US$2 million threshold is exceeded during the relationship with the retailer, the relevant industry would continue to qualify as a “small industry”. Sourcing from agricultural and farmers’ cooperatives will also be considered in this category. The 30 percent sourcing requirement is calculated as a percentage of the average of the total value of manufactured/processed products purchased in the five years commencing on April 1 of the year during which the first tranche of FDI is received.  Thereafter, it will need to be met on an annual basis.
  • The Indian retail company is required to confirm compliance by self-certification and the investors are required to maintain accounts duly certified by statutory auditors.
  • Retail sales outlets may be established only in Indian cities with a population of more than 1 million or any other cities as per the decision of the respective state governments and may cover an area of 10 km around the municipal/urban agglomeration limits of such cities.
  • The establishment of the retail sales outlets must be in compliance with applicable state/union territory laws and regulations, such as the Shops and Establishments Act.
  • Fresh agricultural produce, including fruits, vegetables, flowers, grains, pulses, fresh poultry and fishery and meat products, may be sold unbranded. The Indian government will have the first right to procurement of agricultural products.
  • Companies receiving FDI are prohibited from engaging in any form of retail trading (single or multi-brand) by means of e-commerce.

Editor:The joint venture between Wal-Mart and Bharti was recently called off, with Wal-Mart purchasing Bharti’s 50 percent stake in the Indian wholesale venture. It has been reported that the regulatory framework you described may have played a role in this decision. Would you elaborate on this?

Patel: In addition to the termination of the wholesale cash-and-carry venture with Wal-Mart buying-out Bharti’s stake in the joint venture, news reports also indicate that Bharti will acquire the compulsorily convertible debentures held by Wal-Mart in Cedar Support Services (the holding company of Bharti’s retail venture). The retail venture was investigated in March 2013 for violation of the FDI norms (news reports suggest that it has since been found that there was no violation). Based on news reports, it appears that the 30 percent sourcing requirement became a significant roadblock for Wal-Mart’s plans to expand into multi-brand retail.  Under these regulations, the Indian government is mandating that large global retailers plug the very smallest business partners into their procurement, logistics and sales systems.  Setting aside the practical problems this creates – such as identifying, negotiating and reaching acceptable contractual terms with reliable small and local businesses – the economics will be very difficult to make work for the foreign retailer.  In other countries, these large retailers will leverage their ability to establish significant, multi-location and long-term agreements with sophisticated and reliable third parties to get comfortable that an appropriate return on their investment can be achieved.  Under the Indian regulations, these factors are harder or impossible to achieve and the ability to make an acceptable return becomes even more difficult to accomplish.

Editor: In February 2013, authorities in the state of Tamil Nadu put a stop to the construction of a Wal-Mart warehouse, becoming the first state to strongly resist the new retail policies. What role do Indian states play with respect to enforcing or resisting national policy?

Sethi: The “sealing” of Wal-Mart’s proposed warehouse in Tamil Nadu was stated to be due to the absence of necessary building approvals and permits. While the ostensible reason was unauthorized construction, policy-level concerns were expressed by traders and other stakeholders in Tamil Nadu regarding the entry of foreign retail giants into Tamil Nadu.  

With respect to multi-brand retail, the implementation of the FDI policy has been left to the discretion of each individual state. As on date, 12 states/union territories in India have agreed to allow FDI in multi-brand retail. States such as West Bengal, Kerala and Tamil Nadu continue to oppose the policy. The economic and social benefits that could be expected from foreign investment in the retail sector, such as job creation, increased competition and a consequent reduction in prices and better supply chain and logistics, are viewed with skepticism in such states.

Editor: In July, Mauritius responded that it would address India’s concerns that its double tax avoidance agreement (DTAA) with the island nation was being abused. What was the problem, and has the DTAA been revised?

Sethi: The DTAA between the two countries provides that capital gains arising in India from investments into India from Mauritius can only be taxed in Mauritius. Since Mauritius does not tax capital gains, Mauritius became an attractive destination for foreign investors to route their investments into India. A revised DTAA is under negotiation and has not been finalized as yet.

Editor: U.S. companies entering the Indian retail space may encounter heightened FCPA risks. What are some best practices for mitigating this?

Patel: You are correct. Some of the basic provisions of the retail regulations (such as the foreign/domestic joint venture structure mandated for multi-brand retail and the back-end infrastructure investment and small industry procurement conditions) present areas for heightened FCPA compliance risk.  U.S. companies should consider precautions to mitigate their FCPA compliance risks associated with proposed Indian retail investments, including:

  • thorough due diligence on their domestic multi-brand retail partners and close monitoring of the business and third-party relationships;
  • developing joint venture agreements that include or require compliance certifications for anti-corruption laws and provide meaningful access to the venture’s books and records;
  • education and training of joint venture personnel covering anti-corruption laws and policies;
  • thorough due diligence surrounding, and the establishment of compliance safeguards and reporting mechanisms with respect to the identification, negotiation and execution of the back-end infrastructure investments, focusing on relationships with possible foreign officials and third party agents utilized in this process; and
  • putting in place compliance safeguards and reporting mechanisms with respect to the Indian government’s FDI approval process and the Company’s self-certification process under the FDI policy.

 

Please email the interviewees at rpatel@kslaw.com or rsethi@snrlaw.in with questions about this interview.