Monday 5 August 2013

FDI further liberalised: the last shot at retail?

The Indian economy is under pressure, the rupee is close to 62 and the Government must be seen to act. It is in this backdrop that we must look at last evening's Cabinet pronouncements. The Union Cabinet has confirmed the sectoral cap changes across sectors that were announced last week. It also released what we believe is the last set of clarifications from this pre-election Government on the multi brand retail side.



In this edition of the Retail Point of View - our fourth - we focus on the proposals from last evening that impact the retail sector. Our analysis is based on the Government’s press release while the legal notifications are awaited.


Multi brand retail: some operational relaxations


The Government has faced a Parliamentary approval and then a judicial validation for its September 2012 MBRT guidelines. What that means is that the Government is constrained from making any significant departures from its September guidelines. Within these constraints and as a response to intensive discussions with global retailers, the Government has now liberally interpreted 4 specific issues in relation to the policy:


· Most significantly, the Government has clarified that minimum investment in back-end infrastructure is basically to the tune of 50 million USD as only 50% of the first tranche of USD 100 million needs to be invested in back-end infrastructure within a span of 3 years. This is a relief for large scale retail operations, which entail investments in excess of 100 million USD. However, the limited scope and definition of eligible investment in back–end infrastructure has been retained. Further, no change has been made for niche and speciality stores, where self-owned back-end infrastructure is perhaps not a pre-requisite.


· The Government has also acceded to a request from the food retailers by permitting sourcing from agricultural co-operatives and farmer co-operatives as akin to sourcing from a SME. As raw agricultural produce, fruits and vegetables sourced from agricultural and farmer cooperative bodies would henceforth be counted, it would facilitate compliance with the mandatory 30% sourcing criteria.


· On the mandatory 30% sourcing requirement, the Government has enlarged the definition of small and medium enterprises (SME). The revised definition includes “an enterprise which has a total investment in plant & machinery not exceeding USD 2 million at the time of installation, without providing for depreciation”. Earlier, the investment size was capped at USD 1 million to qualify as an eligible SME. More pertinently, the SME status would be reckoned only at the time of first engagement with the retailer and the enterprise shall continue to qualify as a SME even if it outgrows the investment size of USD 2 million, during the course of its relationship with the said retailer. The policy does not spell a time period for which the SME status would continue to be beneficially conferred. Retailers could now be hopefully spared from the rigours of continuous evaluation of their suppliers as eligible SMEs and avoid periodic disruptions in supply chain.


· A dispensation has also been granted in respect of eligibility criteria for cities where retail sales outlets can be established. Earlier, the Government had restricted retailers by providing that retail outlets can be set up only in cities with a population of more than 1 million as per the 2011 Census. Now, the State Government has the discretion to allow any city within their State. While access to more cities may be favoured by the retailers, the impact on smaller local economies would become evident only in the longer term, once operations become widespread.


The Government clearly hopes that the above measures will somewhat suffice and at least one of the global players will commit an investment sooner than 2014. However, we believe that some of the vital issues covered in our previous edition[1] including establishing integrated retail structures with a pan India presence, freedom for brown-field activities, etc need to be addressed before meaningful investments are channelized into this sector, especially from players who are not already present in India in some form. The uncertainty emanating from all these issues, in all likelihood, will resolve only once the new Government is formed post elections.


Single brand retail: automatic approval up to 49%


FDI in single brand retail which is presently allowed up to 100% with prior Government approval has been brought under the automatic route so long as the foreign investment does not exceed 49%. It appears that automatic route cannot be availed of in case single brand retail trading involves sale of food products.


Automatic approval up to 49% is expected to facilitate investment flows as it guarantees easy and expeditious project implementation. Instead of spending a minimum of 2-3 months in processing a Government approval, investors can now simply ‘write the cheque’ under the automatic route. And thereafter, make necessary post-facto filings with the Reserve Bank of India (“RBI”) in relation to remittance of funds and issuance of shares. Brand owners may consider using this opportunity as a starting point to set up operations, explore and gain experience of doing business in India. A Government approval may be sought only when foreign shareholding is subsequently proposed to be increased from 49%.


On a critical note, inclusion of single brand retail on the automatic route is of limited benefit as it would only serve a foreign brand owner who is content with a 49% minority joint venture (while the Indian partner holds 51%). For more widespread inflow of foreign capital in single brand retail, the sector needs to be opened to financial investors including private equity funds and venture capitalists. Presently, foreign investment in single brand retail is confined only to a brand owner or an authorised brand licensee. This qualification criteria has not been diluted in any manner as the new regulations clearly specify that the brand licence agreement and the list of products sought to be retailed under the single brand need to be notified to the RBI under the automatic route. Policy conditions including definition of single brand also need clarity and refinement as discussed in our previous edition[2].


Broadening the definition of control


In another significant development, the Government has broadened the definition of ‘control’ for the purposes of the FDI policy. The concept of control is of relevance inter alia while computing indirect foreign investment in various sectors. Indirect foreign investment conceptually refers to downstream investment in India by an Indian company having foreign investment in it, and which is owned and controlled by non-resident entities.


By corollary, a downstream investment by an Indian company ‘owned and controlled’ by resident Indian citizens and/ or Indian Companies which are owned and controlled by resident Indian citizens is not viewed as an indirect foreign investment[3]. Whether this route could be explored to invest into restricted sectors such as retail, has been a subject matter of debate within the Government and the RBI. However, some regulatory consensus appears to have evolved on this matter as the RBI recently endorsed the DIPP Press notes vide its circular dated July 4, 2013, albeit after more than 3 years.


To ensure that the indirect foreign investment guidelines are not misused, the definition of control has been tightened. The extant definition of control was restricted to the right to appoint a majority of directors in a company. The new definition introduces some subjectivity by taking cognizance of control exercised on management and policy decisions through shareholder agreements and reads as "Control shall include the right to appoint a majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreements or voting agreements."


As recently witnessed in the Jet-Etihad deal, going forward, the Government could review shareholder agreements to investigate the extent of control exercised by the foreign shareholder in structures involving indirect foreign investment. Accordingly, where the foreign investor does not exercise control over the Indian investing entity and it can be demonstrated that the investing Indian company is ‘owned and controlled’ by resident Indian citizens and/ or Indian Companies which are owned and controlled by resident Indian citizens, the new guidelines possibly suggest that any downstream investment by such an Indian company would not be counted as an indirect foreign investment.

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