FDI in Multi-Brand Retail Trading: Life after DIPP Clarifications

The Government of India has recently come out with a slew of clarifications on Foreign Direct Investment (FDI) Policy that has a direct impact on the FDI Policy on Multi-Brand Retail Trading (MBRT).

Group Company

Department of Industrial Policy and Promotion (DIPP) released the Press Note No. 2 (2013 Series) on 3rd June, 2013 with the decision to incorporate the definition of “Group Company”. As per the newly introduced definition, if two or more companies, directly or indirectly, hold 26% or more of voting rights in the other or have the authority to appoint more than 50% of the members of the board of directors in the other company, they shall be considered to be group companies for the purposes of FDI Policy.

The newly introduced definition of “Group Company”:
“Group Company” means two or more enterprises which, directly or indirectly, are in a position to:
    (i) Exercise twenty-six percent (26%) or more of voting rights in other enterprises; or
    (ii) Appoint more than fifty percent (50%) of members of board of directors in the other enterprises.

Impact on Retail Sector

The notification promulgating the decision to include the definition of a group company has the potential to affect the sourcing arrangements of some of the companies engaged in Cash & Carry Wholesale Trading (C&C) and MBRT sector businesses.

As per the applicable law i.e. Consolidated FDI Policy, 2013 (FDI Policy), upto 100% FDI under automatic route is allowed for those companies which are engaged in C&C business. However, in the year 2010, when 100% FDI was allowed in C&C, FDI in MBRT was not allowed. DIPP through Press Note no. 5 (2012 Series), issued on 20th September, 2012, liberalised the MBRT sector and allowed foreign investment of upto 51% in MBRT under the government approval route. The approval for investment has been subject to certain conditions such as minimum investment amount ($100 million), local sourcing requirement (30%), minimum investment in back-end infrastructure and geographical limitations. It was an important milestone in the liberalisation history of the Indian economy and a major step towards organizing India’s largely unorganized retail sector.

In order to circumvent the cap of 51% in MBRT and/or other regulations provided for by the FDI Policy, a number of legal structures and arrangements were created that let the foreign investors enjoy benefits without having to comply with FDI Policy regulations. The MBRT companies in India entered into exclusive sourcing arrangements with the C&C companies having foreign investments from big international retail companies. This structure ensured de-facto control of the revenues of the investee MBRT companies having such arrangements with C&C companies.

Sensing such circumvention of legal limitations on FDI in MBRT and in order to bring certainty to the definition of the concept of “Group Company”, DIPP notified the definition of a “Group Company”. This definition has direct impact on such exclusive sourcing arrangements between MBRT and C&C companies as the FDI Policy explicitly restricts wholesale trading of goods among companies of the same group to a maximum of 25% of the total turnover of the wholesale venture.

Therefore, it means that if a C&C company has 26% or more voting rights, or has the authority to appoint more than 50% of members of board of directors in an MBRT company, the C&C company would be required to restrict its trading with the group company (i.e. MBRT company) to 25% of the total turnover of the C&C company Consequently, it would appear that the above mentioned cap of 25% on wholesale businesses’ turnover to group companies is intended to restrict the back-door entry of FDI in retail sector.

The effect of the provisions stated above it can be understood better in the context of one of the most talked about investments in the sector, i.e. Bharti Walmart.

The companies like Bharti Walmart Private Limited, which is a 50:50 joint venture between India’s Bharti group and Walmart of USA, engaged in wholesale C&C business. Therefore, if Bharti Walmart Pvt. Ltd. will either have to restrict their sale to the MBRT arm of Bharti i.e. Bharti Retail Limited at 25% of turnover of the C&C venture, or Bharti will have to consider reduction in its stake in Bharti Walmart Pvt. Ltd. to below 26% should it like to source more than 25% of the total turnover of the C&C company. Interestingly, in the year 2011, sourcing by Bharti Retail from its group company Bharti Walmart accounted for almost 60% of the turnover of Bharti Walmart.

Clarificatory Notes on FDI in MBRT

DIPP has also issued a clarificatory note on 7th June, 2013 clarifying the various issues related to conditions stipulated for FDI in MBRT. Clarified issues are written herein below:
    1. Mandatory Sourcing from SMEs: One of the conditions of bringing FDI into MBRT is that the investee company shall ensure at least 30% of the value of procurement of manufactured/ processed products purchased are sourced from Indian 'small industries' (SMEs) which have a total investment in plant & machinery not exceeding US $ 1.00 million. There were a lot of speculations with regard to the nature of this mandatory sourcing requirement. It was being speculated that the mandatorily sourced products could be distributed either through retail operations and/or C&C operations and/or export. However, DIPP has clarified that 30% sourcing from SMEs will be reckoned only with reference to the front end store and that MBRT companies cannot engage in any other form of distribution like cash & carry or export for the foreign investor’s international retail & trading operations. 
    It is very surprising that DIPP would decide to exclude distribution of mandatory sourced goods through export as such a restriction not only discourages the potential investors but also is a counter-productive mechanism that will directly discourage the potential export of goods from India. One could argue that if the government policy (of having provision for mandatory sourcing requirement and the recent clarification) was truly intended to save and promote the SMEs, restriction on exports is only going to prove counter-productive. Foreign investors must rather be encouraged to engage actively in promoting exports both from SMEs and other entities. 
    DIPP has also clarified that procurement from SMEs shall be only manufactured and processed products and not fresh produce, which is, however, in line with the original provision governing the mandatory sourcing. 
    2. Investment in back-end Infrastructure: As per the FDI Policy, 50% of the contribution received in FDI shall be used to build the back-end infrastructure of the investee MBRT company. It has been clarified that:
        a. 50% investment in back-end infrastructure has to be an additionality i.e. the investment can be done in greenfield assets only and any acquisition of supply/chain/back-end assets of existing entity is not allowed; 
        b. the investment towards back-end infrastructure can be made across the states, irrespective of whether or not FDI in multi-brand retail is permitted in that state;
        c. investments made in the companies operating in wholesale trading/ cash and carry trading cannot be considered as providing back-end infrastructure to the MBRT company. Therefore, foreign investment in MBRT will require fresh investment in back-end infrastructure only;
        d. investment made by single foreign investor into multiple infrastructure companies will also not fulfill the condition of investment of 50% FDI in back-end infrastructure of MBRT. Therefore, if the same foreign investor is an investor in various companies for logistics, services etc., such investment will made by the investor will not be aggregated.
        e. an investor may individually invest upto 100% FDI in back-end infrastructure as long as it fulfills the condition of 50% investment in back-end infrastructure.
      3. Certification of SMEs as ‘small industries’: It has been clarified that suppliers should have some form of authentication to confirm their status as ‘small industry’. Certificate issued by District Industries Centre would be adequate authentication to confirm status of supplier as ‘small industry’.
      4. Any amendment in the policy falls under the domain of the Central Government; however state laws and regulations will also prevail and therefore the state government have prerogative of imposing additional conditions, in case foreign investor approaches a state government for setting up a retail store. 
      5. Back-end infrastructure developed by MBRT can be used across the states but not under franchisee model. Front end stores set up by MBRT entity will have to be ‘Company owned and company operated’ only.
      6. 50% of the investment brought in, must be invested in back-end infrastructure and any amount spent in acquiring front end retail store would not be counted towards back-end infrastructure. The front-end retail stores must also be set up as additionality and not through acquisition of existing stores.

    Future of FDI in MBRT

    The newly added definition of “Group Company” is believed to have an indirect impact the investor sentiments since the FDI in MBRT already heavily regulated. Many argue that the newly added definition of group companies is very stringent given the fact that Competition Act has, for the definition of group companies, kept the threshold limit at 50%. Moreover, the clarificatory note on FDI in MBRT has only complicated the things more. The mandatory sourcing from SMEs and investment in back-end infrastructure are some of the key provisions seen as hurdles by the foreign investors.

    However, there is a silver lining for the investors as the DIPP on 02nd July, 2013 held discussions with various ministries and departments of the government including ministry of micro, small and medium enterprises (MSME) and the department of consumer affairs in a bid to build consensus on raising FDI cap in MBRT from the present 51% to 74%. The government is also considering relaxations in the mandatory 50% investment requirement in the back-end infrastructure by limiting such requirement to the initial investment of $100 million only. Moreover, there is also a proposal to relax the 30% mandatory sourcing from SMEs requirement as the DIPP is awaiting comments from the ministry of MSME. Further, the limit on sale of 25% total turnover to group companies is also likely to be relaxed for the C&C sector. If the speculations in the media reports are to be believed, the government may be preparing to announce the relaxations in the FDI rules for MBRT and C&C sectors as early as the second or third week of this month of July, 2013 i.e. before the monsoon session of the parliament, which starts in the third week of this month.
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