India: "In Other Words......" - Foreign Investment In E-Commerce Business In India

Last Updated: 9 October 2015
Article by Nidhi Arora and Akshat Pande

With the rapid growth of e-commerce business in India, the sector has caught the eyes of the regulators off late. Where, on the one side e-commerce business appears to be one of the most promising sectors in India for foreign investors, as also supported by the Google's annual online shopping growth trends report envisaging the online shopper base in India to reach 100 million by 2016, on the other hand the regulators are harping on whether the existing players are compliant of FDI policies.

The regulator's attention has been attracted mainly due to two reasons, one being the more than required importance given to the question whether retail sector of our country should be thrown open for foreign investment or not and second, whether those who are waiting for it to open would use e-commerce as a via media to bank on the opportunity that exists in our country as far as retail sector is concerned. This has lead to creative structures which the e-commerce companies follow in order to take advantage of the business opportunities which exists in the market and yet remain compliant with the prevailing laws.

As per the FDI Policy of the country, "e-commerce activities refer to the activity of buying and selling by a company through the e-commerce platform". Such companies are permitted to engage only in Business to Business (B2B) e-commerce and not in retail trading. The FDI Policy further clarifies that the existing restrictions on FDI in domestic trading are applicable to e-commerce as well.

Foreign investment in retail trading in India is categorised under two heads viz. "single brand product retail trading" and "multi-brand product retail trading". Foreign investment in single brand product retail trading though permitted up to 49% under the automatic route, it entails compliance of certain conditions. For instance, products to be sold should be of a 'single brand' only (i.e. products which are branded during manufacturing), products to be traded in India should also be sold under the same brand internationally, etc. As regards foreign investment in multi-brand retail trading, the same is permitted only up to 51% under the government approval route. In addition to seeking the government approval, certain conditions are also required to be met with, such as minimum foreign investment must be USD 100 million, at least 50% of total FDI brought in the first tranche must be invested in back-end infrastructure within three years, restriction on areas in which sales outlets can be opened etc. Certainly, one can imagine the difficulty of an ecommerce venture being complaint with such conditions.

With such regulations governing retail trading in India which are also applicable on domestic retail trading through e-commerce, it is intriguing how the existing foreign funded e-commerce companies (appearing to be engaged in multi-brand product retail trading) have structured their existence. Broadly, there are two models that have been adopted by these companies in India - Marketplace Model and Inventory Model.

Marketplace Model

In order to avoid huge entry cost of procuring government approval and complying with the minimum capitalisation requirements and other conditions applicable on multi-brand product retail trading, these companies enter the market as a "trading platform" rather than a trader. In this model, the company operates as a purely "online marketplace" which facilitates online sale of goods between buyers and sellers. Sellers enter into an arrangement with the company to canvass their products on the trading platform for securing the sale of their products through the company's trading platform. In this model, the company also provides supporting services in the nature of advertising services, logistic services, management services etc. and earns 'service fee' from the sellers in the form of a commission on per sale basis or any other form of agreed service fee. In this model, though the entire sale process is channelized by the marketplace company, the title of the goods to be sold passes on directly from the seller to the ultimate consumers. Since there is no restriction in foreign investment in service sector (including technical services), these companies are operating well within the letter of the law.

Inventory Model

This model is slightly more intricate and operates under a thin line of differentiating itself from multi-brand retail product trading. In this model, two distinct companies are set up where the promoters and directors of the two companies are completely unrelated. One of the companies is wholly owned and controlled by Indian individuals/entities and operates as the B2C entity. The other company, being FDI funded, operates as the "marketplace" company (as detailed above) and as a B2B wholesale company. The B2B entity procures inventory from various vendors and sells the same on B2B wholesale basis to the B2C entity. The B2C Company then utilises the "trading platform" services and other logistical services provided by the B2B Company for sale of products to the ultimate consumers.

The above model provides maximum value to the foreign investors of the B2B Company, as the revenues generated from wholesale trading as well as the trading platform services rest in the books of the B2B Company.

The two company model is also adopted by companies operating under the "marketplace model" where an "unrelated" retail entity is formed which utilises the trading platform services of the foreign funded company for sale of its products. In this case, the scope of services to be provided by the marketplace entity enlarges to a great extent as a facilitator of procurement of goods in the name of retail entity and sale of such goods to the ultimate consumers through the retail entity. The service fee charged by the marketplace entity in this model covers up nearly 80-90% of the revenue earned by the retail entity on sale of products.

Though the above models have been up and running for quite some time now and appear to be well within the "letter of the law", the regulators are now probing into the legitimacy of these structures and are lifting the corporate veil to ascertain the bona fides of "unrelated" entities, arms' length transactions etc.

One other aspect which is still obscure is "international retail trading" by FDI funded e-commerce companies in India. The FDI policy specifically states that "existing restrictions on FDI in domestic trading would be applicable to e-commerce as well". A probable interpretation of the same could be that only the restrictions on FDI in domestic trading would be applicable to e-commerce activities and consequently there will be no restriction if the e-commerce activity is being carried out with respect to "international" trading. Accordingly, though the number of companies which have entered into this market is less, such companies operate their international market place business through a separate entity incorporated in India and having a separate website under the same/similar "domain name" with certain suffixes to reflect the international character.

In this model, two separate companies are incorporated in India, each funded by similar foreign investors. One company operates the Indian marketplace website (under the models mentioned above) and the other company operates an international marketplace website. On placing a request for an international order, the Indian website directs the customers to the international website which clearly states that "deliveries of products will be everywhere in the world except India". Further, various terms and conditions on such international website clearly stipulate that orders on the website can be made only by a person resident outside India, for delivery outside India as well as all payments should be made in US Dollars only.

Plausibly, this business activity is not yet prominent as the same is an outcome of a very lenient and convenient interpretation of the provisions of the FDI Policy and basing a business structure on such interpretation may not be feasible in the long run. In light of the past instances of the DIPP and RBI rectifying such errors in the FDI Policy by merely 'deleting' certain words or providing express clarifications on certain erroneously mentioned words with retrospective effect, it may not be prudent to base a prospective business structure on such interpretation when the intent of the law is quite apparent otherwise.

At a very nascent stage and besides being under the scanner of regulators, the growing number of consumers resorting to "online shopping" demonstrates mounting projections for e-commerce industry in India. The e-commerce industry of India is yet another example where the industry demands will shape up the regulations and require the regulator to take a pragmatic view and finally the policy and industry will speak the same language using same words.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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