Some Figures

India is an attractive destination for foreign retailers if only for the sheer size of its market, and in particular its fast-growing middle class, estimated at 300 million people. To this, one can add the relatively small presence of international retailers which of course means less competition.

According to a study by the Indian Council for Research on International Economic Relations (ICRIER), the Indian retail sector is expected to grow to $590 billion by 2011-12, rising by 83-% from approximately $322 billion in 2006-07. Within this period, organized retail is likely to grow 45-50% per annum and quadruple its share in the overall retail sector to 16%by 2011-12.[1]

The Global Retail Development Index (GRDI), released by the global consulting firm AT Kearney, named India, for the third consecutive year, as the most attractive market for retail investment, followed by Russia and China.[2]

Background

The liberalization and opening up of India to the world economy brought with it the gradual opening of various sectors to foreign investments. These investments played a significant role and have been a major catalyst in the Indian economy’s proliferation in recent years.

Many sectors are now open to foreign direct investments (FDI) without any limitation as to the equity held by the foreign investor (i.e. up to 100% of the equity) or any requirement for prior approval ("automatic route"). Such sectors include, inter alia, construction and development projects, petroleum and natural gas, and non-banking finance companies. Foreign investment has been capped in certain sectors (e.g. certain telecom activities – 74%), while a small number of sectors are prohibited to foreign investors, namely atomic energy, gambling and betting, and the lottery business.

The retail sector is a special case. This sector currently comprises millions of small unorganized businesses, many of which are family-run enterprises, with most of them employing only a handful of people. On the one hand, the Indian government wishes to encourage the development of this sector for various reasons including: "…attracting investments in production and marketing, improving the availability of such goods for the consumer, encourage increased sourcing of goods from India, and enhancing competitiveness of Indian enterprises through access to global designs, technologies and management practices."[3]

On the other hand, the Government is also committed to protect the many of millions whose livelihood is dependent on all of those small businesses. Indian politicians from various parties across the political spectrum expressed their concern that the presence of multi-national conglomerates will cause the massive closure of small shops and the impoverishment of entire communities.

FDI Rules for Retail

The current FDI rules referring to the retail sector reflect the attempt to balance between the above mentioned forces.

Thus, FDI in retail is capped at 51% of the equity, and is confined to single brand product retailing; i.e. a foreign investor cannot open, for example, a department store selling several brands. In addition, this investment is subject to additional conditions.

The conditions can be summarized as follows:

i. Products to be sold should be of a ’Single Brand’ only.

ii. Products to be sold under the same brand internationally.

iii. ’Single Brand’ product retailing would cover only products which are branded during manufacturing.

iv. The prior approval of the Foreign Investment Promotion Board (FIPB) is required – i.e. the foreign investor cannot enjoy the advantage of the automatic route. Any addition to the product or to the product categories which are sold under ’Single Brand’ requires a new approval.[4]

It should be noted that the Government in India is considering relaxing the above mentioned conditions. Thus, in the Economic Survey 2008 – 2009, which was announced on July 2009, there is a suggestion that FDI in multi-format retail will be allowed, starting with food retailing, subject to certain conditions, such as setting up a modern logistics system or first running for five years wholesale outlets where small, unorganized retailers can also purchase items.[5] The reforms suggested in the retail sector are aimed at providing proper infrastructure. This would help to modernize India and facilitate rapid economic growth coupled with efficient delivery of goods and value-added services to the consumer making a higher contribution to the GDP. In our opinion, though, this also brings to mind the way in which Walmart entered the Indian market, and seems to clear the way to its future development in India.

Wholesale / Cash & Carry

Walmart, together with Bharti of India, utilized the alternative channel open to foreign investors interested in entering the Indian market, namely "Wholesale/Cash & Carry" trading. Under this channel 100% FDI is permitted in the automatic route, i.e. no prior governmental approval is required. In May 2009 the first outlet of this joint venture was opened in India, and the current plan is to open at least 15 outlets across the country within the next three years. These outlets are expected to supply goods to the local retailers – as echoed in the Economic Survey cited above.

For many foreign players though, this is not a viable channel due to the nature of their business.

Franchising

Another channel available to the foreign investor is franchising or other, more limited, forms of licensing, e.g. trademark licensing. Franchising by foreign firms was introduced into India before retail sector was opened up to FDI, and is still applied in various retail branches such as food, clothing, and others.

In franchising, the foreign entity does not directly invest in India, but rather grants an Indian entity the franchise and in return receives franchise/service fees or royalties. Until recently, foreign franchisors are entitled to charge royalties up to 1% for domestic sales and 2% on exports for use of the foreign franchisor’s brand name or trade mark. Higher royalty rates were subject to the prior approval of the Reserve Bank of India (RBI). In December 2009 the Government of India announced its decision to permit, inter alia, payments for use of trademark and brand name on the automatic route, i.e. without any Governmental approval. Only post-reporting will be required.[6] The higher payments now available is expected to encourage the foreign players to enter the Indian market in collaboration with Indian companies.

Other Considerations

Of course, when selecting the optimal channel for entering India, additional considerations, which are not the subject matter of this article, need to be taken into account, including:

i. tax issues – while FDI in retail is taxed as per the legal structure selected for the venture, franchise is taxed based on the franchise/service fees or royalties paid by the Indian franchisee to the foreign franchisor. The tax is paid under India’s Income Tax Act, as income arising and accruing in India. In both cases, the terms of the tax treaty between India and the relevant country, if applicable, need to be taken into consideration.

ii. the level of control and involvement in the day-to-day affairs of the business, including labor issues, which the foreign entity wishes to exercise.

iii. in most cases, additional approvals are required beyond those mentioned above. e.g. the approval of the Reserve Bank of India.

In sum, the retail sector in India presents significant opportunities to the foreign players. Legally and regulatorily this sector is not entirely open, though it is expected that at least some of the restrictions will be removed or relaxed. In any event, even today there is usually enough leeway for the foreign retailers to design and execute their entry into India.

Daniel Siegel Adv., is a partner and the head of the firm’s India Desk