Author: Varsha Aithala
“India remains a high potential market with accelerated retail growth of 15-20 per cent expected over the next five years ((Hana Ben-Shabat, Mike Moriarty, Helen Rhim, Fabiola Salman, “AT Kearney: Global Retail Expansion: Keeps on moving”, http://www.atkearney.com/documents/10192/4799f4e6-b20b-4605-9aa8-3ef451098f8a; last accessed on October 3, 2012)).“
Organised or modern retail consists of chain stores owned or franchised by a central entity, or a single store that is larger than some cut-off point, typically consisting of various formats like hypermarkets, supermarkets and department stores. The Indian retail space consists of unorganised retailers owning small family managed outlets or the local kirana (the so-called ‘mom and pop’ stores), mainly selling food and other essential consumer goods. Presently, organised retail at USD 28 billion constitutes only 6-7% of the total retail sales in the country which is projected to grow to USD 260 billion by 2020, according to a study conducted by the Confederation of Indian Industries and the Boston Consulting Group ((Pierre Mercier, Rune Jacobsen, Andy Veitch, “Retail 2020: Competing in a Changing Industry”, a report by the Confederation of Indian Industries and the Boston Consulting Group dated August 9, 2012, https://www.bcgperspectives.com/content/articles/retail_digital_economy_retail_2020_competing_in_changing_industry/; last accessed on October 3, 2012)).
AT Kearney’s Global Retail Development Index of 2012 observes that internationally, private equity firms are providing significant investment in the retail sector ((Supra note 1. The report states that of the 29 retail investment transactions completed in 2011, most were as a result of private equity funding for example, L Capital’s acquisition of 8% stake in Fab India, TPG and Bain Capital’s proposals to invest in Indian kidswear brand Lilliput, TPG’s investment of around INR 2 billion into Vishal Retail etc.)).
However, to reach the promising sales estimate quoted above, the retail sector requires substantial capital investment in the form of foreign direct investment. But there has been severe opposition to foreign investment in retail trade on the basis that the Indian retail sector is still at a nascent stage and opening up of the sector to foreign competition will have an economically adverse impact on the unorganised retail sector as the kirana stores will not be able to compete with the giant organised retail traders and their pricing practices. Contrary to this perception, studies have shown that the high rate of consumption spurred by the growth in organised retail sector will promote the growth of both the organised and unorganised retail sectors in India and that both formats will continue to co-exist. This conclusion is supported by the study conducted by the Indian Council for Research on International Economic Relations ((Mathew Joseph, Nirupama Soundararajan, Manisha Gupta, Sanghamitra Sahu, “Impact of Organized Retailing on the Unorganized Sector”, The Indian Council for Research on International Economic Relations, May 2008, http://dipp.nic.in/english/publications/reports/icrier_report_27052008.pdf; last accessed on October 3, 2012.)), which measured the impact of organised retail on the disorganized retail sector and concluded that the entry of large organised retailers would (i) promote competitive response from unorganised or small retailers through improved business practices and technology upgradation; (ii) generate better price realization for farmers who sell directly to organized retail averaging about 25% higher than sale to regulated government mandis etc.; (iii) transform the logistics industry and promote actions by manufacturers to reinforce their brand strength, increase their own retail presence, adopt small retailers and set up dedicated teams to deal with modern retailers etc.
Organised retail trading has other benefits also, including provision of better consumer choice, lower prices, promotion of employment, better supply chain efficiencies, increased investment in support industries etc. and does not suffer from the disadvantages of traditional retail stores i.e. high costs, shrinkage, inefficiencies, lack of scale economies, low product quality, limited variety, frequent stock-outs, high prices, unpleasant shopping environment and lack the organisational abilities (like financial, managerial & entrepreneurial) needed to change and develop a successful business.
India has seen the progressive entry of foreign operators in retail since the past ten years in different formats, such as through: (i) franchising and commission agents’ services (Pizza Hut, Marks & Spencer); (ii) cash and carry wholesale trading (Metro) (iii) strategic licensing & distribution agreements (Mango-Piramyd) (iv) manufacturing and wholly owned subsidiaries (Nike India Private Limited) (v) liaison office (Gap through Gap International Sourcing India Pvt. Ltd) etc., concluding with the recent changes permitting foreign direct investment (FDI) of 100% into single brand retail and upto 51% in multi brand retail sector subject to the conditions specified, under what we may term the ‘new FDI Policy’. These changes are a step in the right direction.
This note attempts to detail the changes in the policy framework in relation to the retail sector in India introduced in September 2012 and approved by the Indian Parliament in December 2012, the likely issues which may arise and the way forward.
Critique of the new regulatory framework:
Trading maybe carried out in wholesale or retail formats. Wholesale trading is the sale of goods or merchandise to retail, industrial, commercial, institutional or other professional business users or to other wholesalers and related subordinated service providers. 100% foreign direct investment is allowed for cash & carry wholesale trading as per paragraph 22.214.171.124.2 of the FDI Policy, subject to the following conditions:
- The trading entity should obtain the requisite license or registration or permit for carrying out the trading activity;
- Wholesale trading should be made only to ‘valid business customers’ with whom wholesale transactions can be entered into;
- Full records indicating all the details of such sales should be maintained by the wholesale trading entity on a daily basis;
- For companies of the same group, the wholesale trade of all such companies taken together cannot exceed 25% of the total turnover of the entity;
- A wholesale trader cannot open retail shops to sell to the consumer directly.
Retail trading could be (i) single brand or (ii) multi-brand product retail. Under single brand trading, a retail company sells its own products to consumers for their personal consumption, through its wholly-owned units. Where a retail company can sell multiple brands under one roof to consumers for personal consumption, it constitutes multi-brand retail. As per paragraph 126.96.36.199 of the FDI policy, 100% foreign direct investment can be made in single brand retail and 51% in multi-brand retail trade in India, subject to adherence to the terms and conditions specified therein. The following conditions are imposed in relation to single brand retail trading as per Press Note 4 of 2012 ((See Press Notes, http://dipp.nic.in/English/acts_rules/Press_Notes/pn4_2012.pdf and http://dipp.nic.in/English/acts_rules/Press_Notes/pn5_2012.pdf.)):
- Products sold by the retailer should be of a ‘single brand’ only. Retailing of goods of multiple brands, even if such products were produced by the same manufacturer is not allowed;
- Products should be sold under the same brand internationally;
- ‘Single brand’ product-retail trading should cover only products which are branded during manufacturing;
- A non-resident entity, whether owner of the brand or otherwise, can undertake single brand product retail trading for the specific brand, with the consent of the brand owner, in the form of a license or franchise or sub-licence agreement specifically indicating compliance with the above conditions;
- For proposals involving foreign direct investment beyond 51%, sourcing of at least 30% of the value of products purchased should be from India, preferably from medium & small industries, village and cottage industries, artisans and craftsmen in all sectors ((‘Small industries’ are industries with the total investment in plant and machinery not exceeding USD 1 million. The valuation refers to the value at the time of installation without providing for depreciation. ‘Village Industry’ has the meaning defined under the Khadi and Village Industries Commission Act, 1956. Small & Medium Enterprises are defined under the Micro, Small and Medium Enterprises Development Act 2006 as companies with an investment upto INR 100 million.)). The procurement requirement should be met, in the first instance, as an average of five years’ total value of the manufactured or processed products purchased, beginning from the 1st April of the year during which the first tranche of FDI is received. Thereafter, it should be met on an annual basis;
- Quantum of local sourcing should be self-certified by the company, which could be cross-checked as and when required. The Indian company receiving the FDI should maintain accounts duly certified by statutory auditors;
- E-commerce would not be permissible for companies with FDI engaged in the activity of single-brand retail trading.
The application for retail trade should specifically indicate the product/product categories which are proposed to be sold under the ‘single brand’. Any addition to product categories to be sold under ‘single-brand’ would require fresh approval from the Government.
The following conditions have been imposed for multi-brand retail trading as per Press Note 5 of 2012:
- Fresh agricultural produce, including fruits, vegetables, flowers, grains, pulses, fresh poultry, fishery and meat products may be unbranded;
- Minimum amount to be brought in as FDI by the foreign investor would be USD 100 million;
- At least 50% of total FDI brought in shall be invested in backend infrastructure within first three years, where ‘back-end infrastructure’ includes investment made towards processing, manufacturing, distribution, design improvement, quality control, packaging, logistics, storage, ware-house, agriculture market produce infrastructure etc. Expenditure on land cost and rentals are not counted therefor;
- At least 30% of the value of manufactured or processed products purchased shall be sourced from Indian small industries which have a total investment in plant & machinery not exceeding USD 1 million. This procurement requirement would have to be met, in the first instance, as an average of five years’ total value of the manufactured or processed products purchased, beginning from the 1st of April of the year during which the first tranche of FDI is received. Thereafter, it would have to be met on an annual basis;
- Self-certification by the company to ensure compliance of the conditions above which would be regularly cross-checked by the Government, as and when required. Accordingly, the investors shall maintain accounts duly certified by statutory auditors;
- Retail sales outlets may be set up only in cities with a population of more than 10 lakh as per 2011 Census and may also cover an area of 10 kms around the municipal/urban agglomeration limits of such cities;
- Retail trading in any form by means of e-commerce would not be permissible.
Domestic and international retailers could battle with some of the issues discussed below, before being in a position to formulate new business structures to be compliant with the new FDI policy.
The procurement condition requiring that at least 30% of the value of products purchased by a foreign investor should be locally sourced, has been imposed on the expectation that it would improve manufacturing capacity of domestic industries and provide the benefit of international technology and know-how to generate better incomes for local farmers ((According to the Ministry of Commerce press release dated December 22, 2011 “….the safeguards pertaining to a minimum of 30% procurement from Indian small industries would provide the necessary scales for these entities to expand capacities in manufacturing thereby creating more employment and also strengthening the manufacturing base of the country. Rural economy will benefit as large-scale investment in the retail sector especially in backend infrastructure will provide substantive gainful employment opportunities in the entire range of activities from the backend to the frontend retail business…”; http://commerce.nic.in/pressrelease/pressrelease_detail.asp?id=2877, last accessed on October 5, 2012.)). Those foreign companies which cannot satisfy the 30% mandate should set up their own manufacturing facilities in India. In order to accommodate the interests of various stakeholders, this requirement has been spread out to a period of five (5) years and for the total value of the goods purchased. Despite this relaxation, some retailers like the Swedish home products store IKEA (proposing to invest approximately INR 105 billion to set up single-brand retail stores in India under the ‘IKEA’ brand) find it challenging to meet the local sourcing mandate. IKEA has argued that for a small or medium enterprise to be competitive and able to supply the orders of foreign investors like IKEA, it would have to expand its manufacturing capacity and scale and thus would not remain within the definition of ‘small and medium industries’ eligible for sourcing by global firms under the new FDI policy.
Another problematic issue is the basis for determination of the value of the manufactured product procured by the foreign investor from local sources. Under the consolidated FDI Policy of April 2012, there was lack of clarity on whether the basis of determination of the value was the cost price or the purchase price of the product sourced locally. Under the new FDI Policy, the Government has cleared this confusion by linking the procurement value to the purchase price of the product. This would however operate against the interests of the domestic consumers and generate phenomenal profits for the retailers who on the strength of their internationally recognizable brand value, could mark the selling price of products at a much higher price than the value at which they purchase the local products. Also, usually a large international multi-national corporation would enjoy unequal bargaining power in any price negotiation with a small manufacturer/farmer. The only protection, in so far as the local industries are concerned, is that the foreign investor would pay them an amount at least 30% of the value of the goods sourced from them.
There is also no clarity whether a retail investor can fulfill the procurement condition by sourcing unrelated items, not integral to its business.
Large international luxury brands like Louis Vuitton, Canali etc, which already have a presence in India, are interested in launching their own stores in the country but are restricted by the sourcing requirement as it would require them to change their global manufacturing processes specifically for India. They are likely to face difficulties in finding quality raw materials, skilled labour and sales personnel, since the local salespeople are not adequately groomed to serve the luxury customer, especially in the earlier stages of retail expansion. According to experts “….the scale of the Indian market is small at the moment for it to make sense of the luxury brands to start manufacturing in India, only for India” ((http://www.fashionunited.in/news/fashion/fdi-spillover-luxury-brand-wagon-to-roll-into-india-080220123125, last accessed on October 5, 2012.)). However, this fails to consider that in the long run, it is the ability of an international retailer to localise its products to appeal to the various local markets and harness and develop the quality of the local talent pool, which is crucial to its success in such markets.
Back end infrastructure
The new FDI Policy imposes a requirement of a mandatory fresh investment of USD 100 million to be made by the foreign investor, of which 50% shall be invested in backend infrastructure within the first three years of such investment. ‘Back end infrastructure’ is defined to include processing, manufacturing, distribution, design improvement, quality control, packaging, logistics, storage, ware-house, agriculture market produce infrastructure etc. The purported aims of this requirement are to improve storage infrastructure including cold chains, refrigeration, transportation, packing, sorting and processing, to considerably reduce post harvest losses and to bring remunerative prices to farmers and in other cases, to improve supply chain efficiency and promote investment into technology, all of which would lead to greater productivity in the manufacturing and agricultural sectors.
International retailers, including Walmart find this requirement onerous and have complained of the lack of clarity over issues such as whether existing investments in back-end cash & carry will be counted for meeting the minimum investment requirement. Companies may also face issues due to the existence of multi layered transportation & distribution networks in India adding to the cost of bringing products to the Indian market, concerns over an uncertain taxation regime and the lack of clarity in policy whether information technology outsourcing operations already established by them in India are included within the meaning of ‘back end infrastructure’.
To address such concerns and to ensure uninterrupted supply of their products to meet the ever increasing consumer demand, Apple Inc, for example, has developed vast sourcing networks in South-East Asian countries without the need to source for its products from India. This is due to the availability of better infrastructure, cheaper labour, completeness of supply chains and the ability of such countries to produce at scale and to continually improve productivity ((http://economictimes.indiatimes.com/tech/hardware/apple-plans-to-set-up-its-own-stores-in-india-if-govt-eases-local-sourcing-norms/articleshow/16618793.cms, last accessed on October 1, 2012.)).
The new FDI policy specifies that the fresh investment requirement described above does not include expenditure already incurred by the investor towards land cost and rentals, which would in most cases form a sizeable chunk of the investment brought in by the foreign investor. This requirement being part of a fresh proposal cannot be merged with the investment already made under the previous policy (i.e. the one existing before September 2012). Investment by a foreign retailer in existing Indian retail stores is permitted provided the investor does not exceed the 51% foreign holding requirement. However, it is not clear if a foreign investor would be required to make the additional investment if it were to acquire such existing Indian retail operator.
The cumulative effect of these conditions would be to place an undue burden on international retailers vis-à-vis domestic operators who are not subject to these requirements and to limit the flexibility of such international retailers to harness the investment already made by them in India. Practically, this would result in foreign retailers investing in a phased and calculated manner, thereby limiting the vast benefits that large scale foreign investment can bring to India.
Brand ownership implications
Brands apply to single or multiple products and could be ‘manufacturer’ or ‘own-label’ owned. Registration of a product under one or more relevant class (es) as per the Trademarks Act, 1999 provides the registered user with the exclusive right to use/apply the brand name in relation to the product and to obtain relief in case of infringement ((Section 2 (m) of the Trade Marks Act, 1999 provides that ‘mark’ includes a device, brand, heading, label, ticket, name, signature, word, letter, numeral, shape of goods, packaging or combination of colours or any combination thereof. Case law has expanded the definition of mark to include sub-brands. See, Hem Corporation v ITC Limited, Suit No. 2808 of 2009. The Trade Marks Act, 1999 provides for what marks are not registrable under Section 9 (Absolute grounds for refusal of registration) and Section 11 (Relative grounds for refusal of registration) and the circumstances in which a mark may be registered as a trademark.)).
Under the consolidated FDI Policy of April 2012, a foreign investor was required to own the brand in order to be able to invest ((For instance in June 2012, the Foreign Investment Promotion Board (FIPB) had rejected an application made by the Netherlands-based international fashion chain Zara Holding on the basis that the investment was proposed to be made by the holding company rather than Inditex, the registered owner of the brand. However in September 2012, the FIPB indicated that Zara may re-apply to set up its single-brand retail ‘Masimo Dutti’ stores in India; http://profit.ndtv.com/news/corporates/article-zara-can-set-up-massimo-dutti-brand-stores-dipp-310954, last accessed on September 17, 2012. Also, Pavers England, the UK-based footwear major, set up a USD 60 million Mauritian joint venture company Pavers Foresight Smart Venture Mauritius, in equal partnership with the Indian company Foresight Group. In order to comply with the earlier FDI requirement that the foreign investor should own the brand, the Company transferred its brand ownership to the joint venture company, which would then invest in India. Pavers’ application to set up single brand retail stores in India has now been cleared by the FIPB; http://economictimes.indiatimes.com/news/news-by-industry/services/retail/fdi-in-retail-pavers-england-brooks-brothers-and-damiani-allowed-to-set-up-stores-in-india/articleshow/16886144.cms, last accessed on October 20, 2012.)). This requirement has been relaxed under the new FDI policy such that a non-resident entity, whether as the owner of the brand or otherwise, can undertake retail trading for the specific brand with the consent of the brand owner through a license or franchise or sub-licence agreement. This is a welcome development as it would improve transaction structuring flexibility for international retailers who usually choose the location for making foreign investment based on a cumulative consideration of tax issues, anti-trust regulation, foreign exchange control restrictions, protection of intellectual property rights etc ((Usually companies hold their intellectual property including brands (i) in their holding company (centralized intellectual property ownership set up within a corporation) or (ii) in separate group entities by creating specific Intellectual Property Holding Companies (IPHC) (localised intellectual property ownership). The parent company, the original owner of the intellectual property transfers ownership of its intellectual property company to the IPHC.)). The new FDI Policy provides that a retailer may sell multiple products provided they are of the same brand and with the permission of the brand name holder. Also (consistent with the Trade Marks Act, 1999) the same joint venture partners could operate various brands but under separate legal entities. Government approval is not required for a change in foreign equity or for selling additional goods as long as the brand continues to be owned or used by the same non-resident entity, with the consent of the brand owner.
It is felt that the ‘brand ownership’ requirement has been imposed in order to ensure the international quality standards for products are maintained. Due to the requirement for the products to be branded at the manufacturing stage, the policy appears to discourage domestic label products and is tilted heavily towards the foreign manufacturer brands ((For instance the wording in clause 2(b) of Press Note 4 of 2012 provides that “the product should be sold under the same brand internationally…in one or more countries other than India”.)). The new FDI Policy is unclear whether retailing of goods with sub-brands bunched under a parent brand falls within the scope of single-brand retailing. There is also no clarity on whether co-branded goods (specifically branded as such at the time of manufacturing) would fall within the scope of single brand retail trading.
The requirement to enter into a binding legal agreement with the brand owner to be able to use the brand in India would entail increased paperwork and legal costs for the Indian party as the onus is on the Indian party to seek the consent of the brand owner, which may, in many cases, lead to a delay in the implementation of the project concerned. However, the new policy ensures that the brand is still held within the same group and licensed as per international practices.
Ban on electronic commerce activities
Broadly defined, electronic commerce encompasses all kinds of commercial transactions that are concluded over an electronic medium or network i.e. business-to-consumer (B2C) and business-to-business (B2B). Under the Information Technology Act, 2001, the term has not been precisely defined and electronic commerce is used in the context of transactions carried out by means of electronic data interchange and other means of electronic communication which involve the use of alternatives to paper-based methods of communication and storage of information.
With the growth of internet shopping and the increased use of online sites like eBay, Amazon etc., there is increasing comfort among Indian consumers towards e-commerce. India’s electronic retail industry is likely to touch INR 70 billion in the next three years, up from the current estimate of INR 20 billion ((http://www.indianmirror.com/indian-industries/2012/retail-2012.html, last accessed on October 22, 2012. See also, Aashish Bhinde, Karan Sharma, Sanchit Suneja, Anshu Agrawal, Kanchan Mishra, “India goes digital”, Avendus Capital, November 2011; http://www.avendus.com/Files/India_goes_Digital.pdf, last accessed on October 19, 2012.)). However, ignoring the vast potential for development of India’s digital infrastructure which would directly result from foreign investment inflows, the new FDI Policy prohibits electronic commerce on the retail side (i.e. B2C). Paragraph 188.8.131.52 of the consolidated FDI Policy provides that 100% FDI is allowed under the automatic route for companies that engage only in Business to Business (B2B) e-commerce, so that existing restrictions on FDI in domestic retail trading would be applicable to e-commerce as well. On the wholesale side, as per Paragraph 184.108.40.206.1, B2B commerce including cash & carry outlets is allowed.
The stated intention of the ban on e-commerce in retail is to protect the nascent state of online trading companies in India from international competition and monopolization of the domestic market by big foreign retailers. The general view is that it may take upto ten (10) years for this ban to be removed.
This has however not stopped companies from finding innovative means around the policy mandate albeit acting with the prescribed policy. For instance in late 2011, Flipkart Online Retail Services Private Limited (wholesale company) transferred the ‘Flipkart’ brand name to Flipkart India, a B2B entity, which was then licensed to WS Retail Services Private Limited (retail company), a B2C entity. In August 2012, an investment of USD 150 million was made into the wholesale supplier entity, which would then supply to the retail company, which would sell the products to the final consumer, which is permitted under the FDI policy ((http://articles.economictimes.indiatimes.com/2011-08-17/news/29896669_1_e-commerce-private-equity-creative-accounting/2, last accessed on October 5, 2012. Similarly, foreign funding into the online retailer Jabong was made into a company Jade eServices, which is a B2B wholesale operation. Xerion Retail Private Limited, a B2C Indian company would market the product under its name and make the final sale to the customer; http://economictimes.indiatimes.com/news/news-by-industry/services/retailing/fdi-in-multi-brand-retail-foreign-players-worried-over-mandatory-100-mn-investment-in-first-3-years/articleshow/16563785.cms, last accessed on September 27, 2012.)). It has also been observed that online retailers are providing loans or heavy discounts to their B2C arms only to ensure that their B2C operations survive, despite their B2B operations suffering huge losses in India ((Shrutika Verma, “FDI Escapades”, Business World, October 1, 2012; http://businessworld.in/en/storypage/-/bw/fdi-escapades/546637.37489/page/0, last accessed on October 8, 2012.)).
The recent changes to the FDI Policy are highly controversial and fraught with many ambiguities and uncertainties ((For instance, immediately after the announcement of the liberalised foreign investment policies, the opposition parties made a populist declaration to roll back the new policies if voted to power, justifying this on the basis of the ‘grave threat’ to the traditional kirana shops, if foreign direct investment into retail was allowed; http://www.hindustantimes.com/India-news/Haryana/NDA-will-do-away-with-FDI-policy-if-comes-to-power-BJP/Article1-935929.aspx, last accessed on October 5, 2012. However, the Indian Government has been able to win the approval of the Parliament for the proposed policies, providing some comfort to foreign investors eager to enter the Indian retail space; http://www.indianexpress.com/news/upa-govt-wins-retail-fdi-vote-in-rajya-sabha-as-sp-walks-out/1041842/0, last accessed on December 27, 2012.)). It is only an enabling policy and State Governments and Union Territories are free to implement the policy as per their requirements. Those states which oppose the implementation of the retail policy are specifically exempt from its application (Andhra Pradesh, Assam, Delhi, Haryana, Jammu & Kashmir, Maharashtra, Manipur, Rajasthan, Uttarakhand, Daman & Diu and Nagar Haveli have agreed to implement the new FDI Policy). It is therefore not surprising that many international retailers are being cautious to embrace the changes in the FDI policy ((“India’s retail reform- No massive rush”, December 2, 2011, http://www.economist.com/blogs/schumpeter/2011/12/indias-retail-reform, last accessed on December 25, 2012.)). Despite encouraging signs ((Carrefour chief’s letter to the Government whole heartedly congratulating the new FDI policy; http://economictimes.indiatimes.com/news/news-by-industry/services/retailing/government-flaunts-carrefours-gratitude-letter-on-fdi-in-multi-brand-retail/articleshow/16618689.cms, last accessed on October 1, 2012))and subdued optimism among Indian suppliers to international retailers, ((http://economictimes.indiatimes.com/news/news-by-industry/cons-products/fashion-/-cosmetics/jewellery/luxury-brands-set-to-flaunt-made-in-india-tag-indian-suppliers-see opportunities/articleshow/16648036.cms, last accessed on October 3, 2012)) so many details in the policy regime are still to be worked out.
Expanding growth in food and non-food retail sectors in India is inevitable given the expanding middle class with higher disposable incomes, increased consumer confidence, exposure to global brands, rapid urbanization etc. Given the benefits of organised retail, greater clarity on the policy initiatives and a more robust implementation of the new FDI policy would go a long way in ensuring the rapid growth of the retail sector in India.