India: FDI In Single Brand Retail: What DIPP Needs To Do To Sell India's Retail Story

Last Updated: 15 August 2017
Article by Abhishek Sanyal, Sarthak Sarin and Bharat Gupta

Most Read Contributor in India, August 2018

Introduction

The liberalisation of the regulatory framework for foreign direct investment ("FDI") in the retail sector in India has been slow but steady. Most recently, the government removed a layer of bureaucracy by disbanding the Foreign Investment Promotion Board ("FIPB") (a government body that received applications and co-ordinated with various sectoral regulators for grant of approval for infusion of FDI in certain sectors that require government approval). Now, applications seeking approval for FDI in retail trading are directly vetted and approved by the Department of Industrial Policy and Promotion ("DIPP"), the sectoral regulator for retail trading.

FDI regulations have segregated the retail sector into five broad categories, each with varying levels of restrictions:

  1. wholesale trading (entities that sell goods to other retailers, industrial, commercial or business users, but not to end consumers);
  2. single brand retail trading (entities that sell goods of only one brand) ("SBRT");
  3. multi brand retail trading (entities that sell goods of various brands) ("MBRT");
  4. e-commerce retail (entities that act as a marketplace for other retailers to sell products to end consumers); and
  5. food retail (entities that sell (including by way of e-commerce) food products that are produced in India).

In the past, every wave of liberalisation in the FDI regulations pertaining to the retail sector has almost always come with strings attached, more often than not, for political considerations, since unorganised and traditional retail (often mom-and-pop stores) provides livelihood to a large segment of Indian society. The fear seems to stem from the apprehension that large multinational retail chains would drive traditional retail formats out of business and therefore if FDI is permitted, it must help Indian businesses thrive or aid Indian infrastructure. This explains why FDI regulations pertaining to SBRT require the Indian investee entity (where it is more than 51% foreign owned) to procure at least 30% of its products from India and FDI regulations pertaining to MBRT require investments of at least USD 50 million in 'back-end infrastructure' – aimed at improving India's logistics infrastructure and facilities.

This article attempts to outline some of the key policy issues and grey areas relating to FDI in the SBRT sector that need to be clarified to enable India to sell its retail story.

Retail trading of 'sub-brands'

FDI is permitted in entities that retail products of a 'single brand', subject to certain conditions. However, the FDI regulations do not provide any guidance on the meaning or scope of 'single brand'. One of the issues that arises from this ambiguity is the treatment of sub-brands under the FDI regulations. A sub-brand is ordinarily understood as a product or a service that is affiliated with a parent brand, but has its own brand name.

In 2013, Marks & Spencer, a leading retail chain, came under scrutiny from DIPP as it was selling multiple sub-brands, such as 'Autograph', 'Blue Harbour' and 'Collezione' at its retail stores, though it had obtained approval for selling only a single brand, i.e. 'Marks & Spencer'.

Although no formal communication to this effect has been made, according to news reports, in September 2013, the DIPP is understood to have clarified that it was permissible for a brand to market sub-brands in their Indian stores subject to condition that the retailer's own corporate or 'house' brand logo should appear alongside that of the sub-brand on the relevant products.

However, since no official clarification has been issued, this remains a grey area. Moreover, there is still no clarity on the yardstick for determining if a brand is a sub-brand or a distinct brand. For example, given the acquisition of TAG Heuer and Bulgari by the LVMH group, would the brands TAG Heuer and Bulgari qualify as sub-brands of Louis Vuitton or will they be treated as distinct brands? The standard operating procedures issued after the disbanding of the FIPB that lay out the process for approval of FDI applications by the relevant sectoral regulators do not provide any guidance on this issue and there is no visibility on how the DIPP will treat such applications.

Conversion of franchisee into joint venture entity not possible

Since procuring approval for FDI in the SBRT sector is time-consuming; in the past, brands have often asked their proposed joint venture partners to incorporate a company that would, until receipt of SBRT approval, act as a franchisor for the brand. The plan is generally to terminate the franchise arrangement and convert the franchisee into an SBRT entity (usually as a joint venture with the Indian partner) upon receipt of approval and investment by the investor. However, the DIPP has, in the past, taken the view that the franchisee (the proposed joint venture company / SBRT entity) should stop its commercial operations and wait until approval for FDI in SBRT is granted to the brand. There appears to be no logical rationale to such a requirement and it is hoped that the DIPP will reassess its position on this issue going forward.

Local sourcing norms

Companies engaged in SBRT with more than 51% FDI are required to source at least 30% of the value of the goods purchased by them (for resale to the ultimate consumer) from India. Further, this local sourcing requirement has to be met, in the first instance, as an average of 5 years' total value of the goods purchased by the company, beginning 1st April of the year during which the first tranche of FDI is received ("Average-out Rule"), and thereafter on an annual basis.

In the Indian context, local sourcing norms obviously favour certain industries (such as apparel), where local sourcing can be easily complied with. That explains why brands like H&M, which were already sourcing products from India do not anticipate issues in complying with the local sourcing norms, especially in light of the Average-out Rule. However, complying with the local sourcing norms becomes trickier for some industries - for instance, Swiss watch manufacturers or smartphone manufacturers that have their entire manufacturing ecosystem outside India.

Accordingly, the government relaxed the sourcing norms for the first 3 years for products with 'state of the art' and 'cutting edge' technology and where local sourcing is not possible. Even after this period of 3 years, retailers can resort to the Average-out Rule, effectively giving them a period of 8 years to fully comply with the local sourcing norms on an annual basis.

However, there is ambiguity regarding which products will qualify as having 'state of the art' and 'cutting edge' technology. Further, since the 3 year exemption only applies where local sourcing is not possible, there is no guiding principle for determining if local sourcing can be said to be possible in relation to SBRT of a product that has 'state of the art' and 'cutting edge' technology. Therefore, there is no clarity on which products can benefit from this relaxation – and perhaps this is intentional, giving brands an opportunity to demonstrate how their products have 'state of the art' and 'cutting edge technology'.

The government hopes that the local sourcing norms will encourage foreign brands to tie up with Indian manufacturers and encourage manufacturing in India.

It is pertinent to point out that the Government can altogether relax sourcing norms for entities undertaking SBRT of products having 'state-of-art' and 'cutting-edge' technology and where local sourcing is not possible. However, any such relaxation will not be easy to obtain as this would open floodgates for other applications seeking such relaxation.

'Manufacturers' v 'Indian manufacturers'

In June 2016, the FDI Regulations were amended to include a relaxation for an "Indian manufacturer", whereby the Indian manufacturer was permitted to sell its own branded products in any manner, i.e. wholesale, retail, including through e-commerce platforms.

However, for any entity to qualify as an "Indian manufacturer", it is required to manufacture in India, in terms of value, at least 70% of its products in-house, and source at most 30% from other Indian manufacturers.

This special condition for local sourcing by Indian manufacturers has created confusion for foreign investors. Firstly, the insertion of this condition is in direct conflict with the general exemption granted to manufacturers in India whereby they are allowed to sell their goods without being subject to the conditions imposed on SBRT. Secondly, the scope of the obligation set out in this condition is not clear as the term 'in-house' has not been defined. If the term 'in-house' excludes contract manufacturing or job work, then this may impose substantial costs on the Indian manufacturer as it will not be able to source more than 30% of the value of its products from other Indian manufacturers, and will be required to invest in augmenting its own manufacturing capabilities.

Conclusion

Over the past few years, the government has taken many steps to liberalise the regime governing FDI in SBRT in order to attract large global players. However, some ambiguities still remain.

According to press reports, the government is considering allowing 100% FDI in the SBRT sector without requiring government approval. However, the local sourcing norms continue to be a major deterrent for FDI in SBRT and even the recent relaxations in the local sourcing norms have failed to induce global players to enter the Indian SBRT market.

Though the removal of the cap on FDI in the SBRT sector under the automatic route will make investing in India much more attractive, it remains to be seen if the government will also relax certain conditions and clarify its position on key issues in relation to FDI in the SBRT sector.

An abridged version of this article was published by ETRetail.com on 10 August 2017.

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com

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