FDI in Retail: Development and the way ahead

Retail sector is one of the fastest growing sectors in India. Thanks to rapid urbanization and increased consumerism. Reports indicate that retail contributes almost nine to ten percent to India’s gross domestic product, and around seven to eight percent to employment, albeit retail sector in India is mostly unorganized comprising predominantly the ‘mom-and-pop’ stores. It is expected that Indian retail market will cross forty seven trillion Rupees by the year 2016-17, with a growth rate (compounded) of around fifteen percent. This growth rate is too attractive to be ignored whether by domestic investors or foreign or international investors. There has been tremendous amount of investment in retail sector by domestic players but foreign investment, to the contrary, seems to be limited. In the span of last fifteen years (i.e., from April 2000 to January 2015), the aggregate foreign direct investment (FDI) in retail sector (single-brand) has not even reached three hundred million US Dollar, whereas other trading activities have received more than seven and a half thousand million US Dollars. Service sector, on the other hand, tops the chart with more than forty two million US Dollar FDI during the aforementioned period. The question then arises as to what are the reasons for the limited FDI in retail sector. Reasons are numerous, such as the varied demographic and geographic divide in India, less evolved infrastructure facilities and logistics support. One such impediment is also the conscious policy decision of the government to restrict FDI in retail.

The policy framework on FDI in trading including retail activities is set out in the periodical consolidated FDI policy document (FDI Policy) issued by the Department of Industrial Policy and Promotion of the Government of India. FDI Policy segregates trading into the following three categories: (a) wholesale trading/cash and carry (WT), (b) single brand product retail trading (SBRT), and (c) multi brand retail trading (MBRT). FDI Policy defines WT as sale of goods for the purpose of trade, business and profession as opposed to personal consumption. The determining factor is not the size and volume of sales but is the type of customers to whom sales are made. However, the term ‘retail’ has not been defined in the FDI Policy. Simply speaking, retail is the sale of goods to the end consumer for final consumption. This has also been discussed in great length by the Delhi High Court in Federation of Associations of Maharashtra case ((2004) ILR 2 Delhi 530), which has also been referred to in subsequent cases before the Karnataka High Court and Delhi High Court itself.

Key Development in FDI Rules Governing Retail

FDI in trading activities has been allowed by the government in a phased manner:

1997

  • Up to one hundred percent FDI in WT was permitted under the government approval route.

2006

  • FDI in WT was allowed up to one hundred per cent under automatic route.
  • FDI in SBRT was allowed up to fifty one per cent under the government approval route in order to: (a) attract investments in production and marketing, (b) improve availability of goods to consumers, (c) encourage sourcing of goods/raw materials from India, and (d) enhance competition.
  • FDI in SBRT was made subject to, inter alia, the following conditions: (a) products should be of ‘single brand’ only, i.e., they should be sold under the same brand internationally, (b) products should be branded during manufacturing only, and (c) any addition to the list of products or products category would require fresh approval of the government.

2011

  • Another restriction was imposed on FDI in SBRT wherein only owners of the brand were allowed to invest.

2012

  • FDI in SBRT was allowed up to one hundred per cent with prior government approval.
  • FDI in MBRT was also permitted up to fifty one percent with prior government’s approval.
  • Certain conditions with respect to domestic procurement, etc., were introduced.

2013

  • FDI in SBRT was allowed up to forty nine per cent under the automatic route, and beyond forty nine per cent (up to one hundred per cent) under the approval route.
  • More than one entities owning the brand or under an agreement were allowed to undertake SBRT.

Current FDI Regime

Currently, FDI in WT is allowed up to one hundred per cent under automatic route. Various conditions that are required to be complied with by WT entities having FDI include: (a) WT entities can transact only with any of the following entities/persons – (i) holders of excise duty/sales tax/value added tax/service tax registration, (ii) holders of trade licenses such as a shops and establishment registration, etc., (iii) holders of permits/license for undertaking retail trade, and (iv) institutions/organisations registered as societies or public trusts for their self-consumption; (b) intra-group sale cannot exceed twenty five per cent of the total turnover of the WT venture; and (c) WT entity cannot open retail stores to sell goods directly to the consumer.

As discussed above, FDI in SBRT is allowed to under automatic route up to forty nine per cent, and under government route up to one hundred per cent. In addition, the following conditions, inter alia, are also applicable to FDI in SBRT: (a) only owners of brands, or entities with agreements with owners of brand are allowed to carry out SBRT; (b) in case of FDI beyond fifty one per cent, goods representing thirty per cent of the of the total goods purchased are required to be sourced from India, preferably from micro/small/medium enterprises, village and cottage industries, artisans and craftsmen; (c) the aforementioned sourcing requirement is required to be complied with as an average of five years’ total value of the goods purchased beginning from 1st April of the year during which first tranche of FDI is received and, thereafter, on an annual basis; and (c) entities with FDI and carrying out SBRT are prohibited from carrying out retail trade by way of e-commerce. In addition, certain disclosures are required to be made to the Reserve Bank of India for FDI up to forty nine per cent, and application for approval be made to the Secretariat for Industrial Assistance in the Department of Industrial Policy and Promotion for FDI more than forty nine per cent.

FDI in MBRT is limited to fifty one per cent under the approval route. The conditions attached to FDI in MBRT are more stringent than the ones attached to FDI in SBRT such as: (a) the minimum capitalization requirement of one million US Dollars; (b) at least thirty per cent of the products purchased are required to be sourced from Indian micro, small and medium industries and agricultural/farmer cooperatives wherein total investment in plant and machinery (at the time of installation, and without providing for depreciation) does not exceed two million US Dollars; (c) the aforementioned sourcing requirement is required to be complied with as an average of five years’ total value of the goods purchased beginning from 1st April of the year during which first tranche of FDI is received and, thereafter, on an annual basis; and (d) retail outlets can be opened only in cities with population of more than one million or any other city as the state government may allow, (each includes an area up to ten kilometers of the municipal/urban agglomeration of such cities); (d) retail outlets can only be set up in the areas conforming to the master/zonal plan; (e) proper provision for transport connectivity and parking is also required to be made; and (f) entities with FDI and carrying out MBRT are prohibited from carrying out retail trade by way of e-commerce. In addition, the biggest roadblock to FDI in MBRT is that all the aforementioned is subject to the state governments allowing setting up of MBRT outlets at their discretion. Thus far, not even half of the total number of states and union territories in India have given their consent for allowing setting up MBRT outlets within their jurisdiction.

Structuring Options for FDI in Retail

The traditional structures for foreign players to sell their goods in India have either through franchise agreements or distribution agreements. However, lately, the FDI has been routed in the retail sector in India via two major routes:

Downstream Investment by Indian Companies

In this structure, an Indian joint venture entity (having foreign investment but not being owned and controlled by such foreign investor(s)) further invests in an entity that carries out retail activities. Since the entity investing in the retail entity is not owned and controlled by foreign resident(s), the FDI structure is exchange control and FDI Policy compliant.

Front-end and Back-end Structure

Another model that various entities have used in the past is to have back-end and front-end structure. Under this structure, the back-end entity carrying out WT receives foreign investment and has back to back supply arrangements with the front-end retailing entity. The front-end entity in turn sells the goods to front-end customers. However, this structure is not very tax efficient. Further, such wholesale supply by the back-end entity to the front-end entity is restricted to twenty five per cent of the total turnover of the back-end entity if the front-end entity is a group company of the back-end entity.

It is important to note that the regulators have not looked at both the abovementioned structures favorably, and have perceived them as ways to circumvent the exchange control norms and FDI Policy.

The Road Ahead

FDI in retail has always been a delicate subject both on the political front and on the economic front. While the government has indicated that it does not have any reservations to retailing of goods produced/manufactured by entities having FDI, FDI in pure retailing entities is not free from reservation. Further, the regime around FDI in SBRT and MBRT are also on different pedestals. While rules governing FDI in SBRT have undergone significant liberalization, rules governing MBRT are not conducive for the amount of investment that any entity would be required to make in the capital intensive sector such as MBRT. International majors like IKEA and Decathlon (both active in SBRT) have already received government nod for carrying out SBRT in India. Some of the recent reports indicate that the government is open to further liberalization of FDI rules concerning SBRT by allowing multiple formats of retails by FDI entities, and also relaxing the domestic procurement norms that has been a great cause of concern for a lot of investors.

Any further liberalization of FDI rules around MBRT will take much time. The new government has been quite clear on its stand on FDI in MBRT. The government feels further liberalization of the FDI regime in MBRT will have large scale economic and social impact on India and, therefore, the time has not come yet for further liberalization of FDI in MBRT.

In any case, the revised FDI Policy of the government is expected soon, and it would be interesting to see what changes to FDI in SBRT and MBRT will be rolled out this year.

Disclaimer: The views of the authors are personal, and should not be considered as those of the firm.

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Ganesh Prasad and Rishabh Bharadwaj

Ganesh Prasad is partner, Khaitan & Co and Rishabh Bharadwaj is associate, Khaitan & Co.

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