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COLUMNS |
Retail Therapy: Legal Strategies for
Investment in India's
Retail Sector
A review of the fast growing retail and fast moving consumer
goods markets in India and their potential for growth
Introduction
The current global economic downturn, aided by the tightening of interest rates by the Reserve Bank of India, has led to a slump in property development as well as a reduction in property prices, thereby also having an impact on a number of related industries in India. With the real estate sector in the doldrums, foreign investors are closely watching another industry that promises to be at the forefront of India's continuing growth story: the retail industry.
This article provides a quick industry insight and a brief summary of the current policy and regulatory environment for the emerging retail sector in India.
The Indian Retail Market
India's retail market has shown enormous promise over the past decade - between 2000 and 2006, sector revenues increased by about 93.5 percent translating to an average annual growth of 13.3 per cent. The potential market has been estimated at US$ 1.1 trillion (in PPP terms) - a reflection of both India's impressive economic growth and overall rise in income levels of consumers. The retail industry takes pride of place as one of India's largest industries, contributing to about 10 percent of the GDP and employing eight per cent of India's workforce.
The forecast for growth in 'modern retail' (which
accounts for a mere two to three percent of the market currently) is a compounded
annual growth rate of 40 per cent, from USD8 billion in 2006 to USD40 billion
by 2010. Overall, India's retail sector is expected to grow from its current
USD350 billion to USD427 billion by 2010 and USD635 billion by 20151 - impressive
figures by any yardstick.
Organisation and verticals
Not surprisingly, the retail sector in India is predominantly unorganised - estimates suggest that a mere two per cent of the Indian retail sector is organised. Compared to developed markets such as the United States and United Kingdom (where the figures are 80 per cent and 70 per cent, respectively) there is clearly considerable room for growth. Traditional retailing continues to be the backbone of the Indian retail industry - the ubiquitous neighbourhood 'mom-and-pop' retail outlets (also called 'kiranas') are to be found in every corner of the country. There are more than 12 million small and medium retail outlets in India - the highest in any country.2
Organised retail penetration is rapidly on the rise and offers an attractive proposition for both new entrants as well as scope for expansion for existing players. With a smorgasbord of domestic and international brands and product offerings (ranging from food and grocery to furniture and fixtures) now available in retail stores, the Indian urban consumer never had it so good!
The retail sector in India may be classified by the type of products retailed, as compared to types of retail formats in operation. Based on such a classification, the major verticals would include the following: food and beverages, clothing and textiles, consumer durables, jewellery and watches, home décor, beauty care, footwear, books, music and gifts.3
Of these, the 'food and beverages' vertical accounts
for the largest market share of revenues, given the uniform consumer demand
across all income levels and various retail formats. The fastest growing verticals
are 'apparel' and 'consumer durables', also seeing a fairly uniform demand
across income levels. Verticals such as 'jewellery and watches' and 'beauty
care' are more popular with the youth in the urban areas and metro cities,
as they generally tend to require more sophisticated customers, with higher
disposable incomes.
Key markets and players
Given that traditional retailing in India did not involve any kind or organised corporate presence, most domestic retail players in the Indian market are relatively new players themselves. However, India is beginning to see the emergence of truly large-scale, modern retail businesses, and most major Indian conglomerates have entered the race. These include well-known business houses such as Reliance Industries, Bharti Enterprises and the AV Birla group. International retail giants such as Metro, Wal-Mart, Marks & Spencer and Carrefour are also in various stages of implementing their ambitions for retail India. Tesco, the world's number three retailer, recently unveiled its plans for India and intends to undertake a wholesale cash-and-carry business in association with the retail arm of the Tata Group.4
One of the oldest domestic retail players is
possibly Pantaloon Retail (India) Limited which operates multiple retail formats
in both the value and lifestyle segment of the Indian consumer market. The
company operates over 11 million square feet of retail space, has over 1,000
stores across 63 cities in India and employs over 30,000 people.5 Another
experienced retailer, Shopper's Stop (owned by the K. Raheja Group) is possibly
the most well-known Indian department store, retailing a range of branded
apparel, footwear, perfumes, cosmetics, jewellery, leather products, accessories,
home products, electronics, books, music and toys, complemented by cafe, food,
entertainment, personal care and various beauty-related services.6
Domestic conglomerates are also exploring new and innovative retail formats
in an effort to marry the benefits and convenience of modern retail with the
trust and familiarity associated with traditional retail. For example, corporate
heavyweights such as the Indian Tobacco Company ('ITC') and Godrej Industries
have launched rural initiatives, in an effort to increase their customer outreach
in the largely untapped rural India. ITC's 'Choupal Sagar' was launched in
2004, and comprises 100,000-150,000 square feet of retail space with a trading
area, weighing facilities, telemedicine kiosks, and special products for farmers,
etc. The Choupal Sagars double up as retail outlets for the consumers and
also as infrastructure to support ITC's rural procurement. ITC plans to open
over 700 such hypermarkets.7
Similarly, Godrej Industries has started an experimental
retail format called 'Godrej Aadhar' for rural markets. These formats act
as 'complete convenience hubs' and sell FMCG products, fertilisers, animal
feed, etc., as well as provide facilities for banking, insurance, pharmacy,
postal services and petrol pump operations. Godrej plans to set up more than
1,000 stores by 2010.8
Legal and Regulatory Regime
Foreign Direct Investment in retail: policy considerations
India's foreign direct investment ('FDI') policy has undergone gradual phases of liberalisation, since the announcement of the new Statement on Industrial Policy in 1991. In 2000, the FDI policy was further liberalised and foreign direct investment was permitted in most sectors (either up to 100 per cent or up to specified sectoral cap, eg, 26 per cent, 51 per cent or 74 per cent) under two routes:
1 The 'Automatic Route', ie, without any government approval - the only requirement being to file certain documents with the Reserve Bank of India ('RBI') post-investment, or
2 The 'Approval Route', ie, after prior approval from a government body called the Foreign Investment Promotion Board ('FIPB'), constituted under the Ministry of Finance.
Interestingly, 'retail trading' is one of the sectors in which foreign direct investment is not permitted, except for what is referred to as 'Single-Brand Retail Trading' (described below).9
The basis of the prohibition was the perceived (or actual) 'political sensitivities' associated with opening up the retail sector to international investment. Certain political parties in India feared that that permitting foreign investment in this sector would lead to the small domestic retailers being squeezed out by the savvier international retail players, armed with their superior know-how and capital. Since the unorganised retail sector employed large numbers of unskilled workers, it was also feared that the entry of the international players would leave vast hordes of people unemployed. However, as the experience of Thailand, South Korea and China (which opened up their retail sectors to foreign investment) indicates, unskilled labour can be re-tooled and made more productive. It is also generally acknowledged that foreign investment in Indian retail would bring efficiencies in the process of distribution and build crucial infrastructure. Modern retail chains would also ensure improved product quality and service, and result in lower prices for customers.
Nevertheless, the complete removal of all restrictions
to foreign investment in the retail sector is not just a question of time
but also political will.
Single-brand product retailing
In February 2006, the government decided to allow
FDI up to 51 per cent, with prior government approval, in retail of 'Single
Brand' products,10 subject to certain conditions:
1 Products sold should be of a 'Single Brand' only;
2 Products should be sold under the same brand
internationally; and
3 'Single Brand' product retailing would cover only products that are branded
during manufacturing.
Applications for FDI in retail trade of 'Single
Brand' products are required to be made to the Secretariat for Industrial
Assistance ('SIA') in the Department of Industrial Policy & Promotion
('DIPP'), and should indicate the product/product categories that are proposed
to be sold under a 'Single Brand'. Any further additions to the product/ product
categories to be sold under such a 'Single Brand' would require a fresh approval
of the SIA.
Other types of trading permitted
Not all types of trading is closed to foreign
investment, and Press Note 4 (of 2006 Series) elaborates on the sector specific
guidelines for FDI with regard to the conduct of trading activities, and permits
the following:
1 Wholesale / cash & carry trading up to 100 per cent under the Automatic
Route;
2 Trading for exports up to 100 per cent under the Automatic Route;
3 Trading of items sourced from the small-scale sector up to 100 per cent under the Approval Route; and
4 Test marketing of such items for which a company
has approval for manufacture up to 100 per cent under the Approval Route.
Retail trading versus wholesale /cash & carry trading
India's FDI Policy is not generally lauded for its clarity, and the current
policy on retail trading is both complex and ambiguous. The FDI policy manual
and the periodic Press Notes (issued by the DIPP) do not define the terms
'Retail Trading' or 'Cash and Carry / Wholesale Trading', and there is no
guidance on how these terms are intended to be interpreted.
In 2004, the High Court of Delhi11 discussed the meaning of trading, retail trading and cash and carry wholesale trading and observed that it was a matter of policy interpretation as to whether trading by a foreign company of its own products would be construed as 'Retail Trading' or 'Cash and Carry / Wholesale Trading'.
Interestingly, the Court made reference to the Blacks Law Dictionary (which is widely accepted by Courts in India for interpreting legal terms) to provide some guidance on the definition of the terms. The term 'retail' was defined as 'a sale for final consumption in contrast to a sale for further sale or processing (ie, wholesale). The term 'retailer' was defined as 'a person or entity engaged in the business of selling personal property to public or to consumers, as opposed to selling to those who intend to resell the items'. The term 'wholesaler' was defined as 'one who buys large quantities of goods and resells them in smaller quantities to retailers or other merchants, who in turn sell to ultimate consumers'.
It appears that it is the type of customer which
determines whether the trade is to be regarded as wholesale or retail, and
the DIPP has subsequently also confirmed this view. Strangely, enough, any
customers who are industrial, commercial, institutional or professional business
users are also considered wholesale customers. Therefore B2B sales are not
prohibited and it appears to be irrelevant whether the goods are then sold
to a business customer, who conducts retail business or operations other than
retail (such as restaurant or
a hotel).
Strategies and Other Modes of Entry Into the Indian Market
Notwithstanding the aforesaid restriction on direct investment in retail trading, many international retailers have entered the Indian market in several other forms, which are all currently legally permissible. The most common channels for entry of foreign retailers are:
1 franchising arrangements;
2 distribution arrangements;
3 setting up manufacturing operations; and
4 cash and carry wholesale trading (which can be either through a joint venture with a domestic player or a 100 per cent foreign-owned entity).
Some of these are discussed briefly below.
Franchising arrangements
Franchising is possibly the most popular avenue for many international brands to set up shop in India and is being currently used by Marks & Spencer and Pizza Hut.
A franchisee arrangement can take many forms, depending on the needs of the franchisor and those of the market, including a Unit franchisee (where the franchisee is granted rights to operate a single business unit), b Multiple franchisee (where individual unit franchises are given to multiple parties, which often becomes necessary for a large market with localised players) and c Master franchisee (where rights for an entire territory are granted to a 'master franchisee', who may further grant unit and multiple franchisees in that territory).
While India has no sui generis legislation for franchise arrangements, there are a number of laws that would apply to the franchisor-franchisee relationship, including laws relating to contracts, intellectual property, taxation, labour, competition and exchange control regulations.
Current FDI regulations permit foreign franchisors to charge royalties up to one per cent for domestic sales and two per cent on exports for use by the Indian franchisee of a brand name or trade mark owned by the foreign franchisee, without transfer of technology. If the royalty proposed exceeds these prescribed limits, prior approval of the Reserve Bank of India is required.12
On the other hand, if the proposed franchise
arrangement also involves the transfer of technology by the foreign franchisor,
a lump sum payment of up to US$2 million is permissible. In addition, royalties
up to five per cent on domestic sales and eight per cent on exports can be
paid to the franchisor without approval, subject to a total payment of eight
per cent on sales over a 10 year period, without any restriction on the duration
of royalty payment.13
Distribution arrangements
An international company with several product offerings could set up distribution offices in India for the purpose of supplying products to the local retailers. This option is sometimes combined with the franchisee option. As with the franchise arrangement, a well-drafted agreement and transaction structuring is key to avoid legal minefields and unnecessary tax exposure.
It is reported that German chain store Metro
has set up three distribution centres in Bangalore and Hyderabad. In an effort
to harness efficiencies, Metro has launched a supplier relationship management
portal to modernise supply chains and it has partnered with the Government
of Karnataka to improve the infrastructure in the state, including investing
over USD43 million in infrastructure to build humidity and moisture control
facilities.14
Setting up manufacturing operations
The restriction in relation to retailing directly to Indian consumers does not apply if a foreign company chooses to set up a manufacturing facility in India.15 The most familiar example of this in India is Bata Shoes, the Czech shoe manufacturers and retailers, who have been present in India since 1931. Incorporated as Bata Shoe Company Private Limited, the company set up a small manufacturing operation near Calcutta in 1932 and is one of the more visible brands in India today.16
Operating a manufacturing facility would require
the foreign company to pay close attention to India's labour legislation.
For example, the Factories Act regulates working conditions of workers in
factories and ensures minimum standards of safety, health and welfare conditions
of factory workers, and applies to a factory, which is defined as 'any premises
including the precincts thereof whereon 10 or more workers are/were working
and in which a manufacturing process is being carried on with the aid of power
or; whereon 20 or more workers are/were working and which a manufacturing
process is being carried on without the aid of power'.17 Depending on what
is being manufactured and the location of the proposed factory, an industrial
license may be required, though this is no longer a requirement for most types
of retail products.
Cash-and-carry wholesale trading
As mentioned earlier, 100 per cent FDI is permitted in 'wholesale trading' where there is no direct contact with the individual retail customers. The foreign company is required to build a large distribution infrastructure to assist local retailers and manufacturers. An example of this is the joint venture that Wal-Mart and Bharti Enterprises have signed. Bharti Retail is a wholly owned subsidiary of Bharti Enterprises. Bharti Retail will set up a chain of multiple format stores in India that will be 100 per cent owned and operated by Bharti. Bharti's joint venture entity with Wal-Mart would be responsible for setting up the supply chain, logistics and cash-and-carry systems to support the burgeoning retail market in India.18
While this mode permits a 100 per cent foreign-owned entity, joint ventures can be very useful for both the foreign company as well as the Indian partner. A joint venture allows the foreign company access to the Indian partner's established distribution and marketing processes, and its local contacts, while allowing the Indian partner to harness the technical expertise and industry know-how of the former. However, since a joint venture company would be incorporated under Indian law, parties need to keep in mind that such an entity would become subject to Indian laws and regulations, including tax laws.
Given the array of entry options available, an international retail player would do well to consult with their legal and tax advisors to ensure that an appropriate structure is adopted, taking into account both legal and tax consideration of each entry option.
Postscript: Whither India?
The spectre of the recent terror attacks in Mumbai has led some to question the continuing viability of India as a growth story. If history is any indication, India is an enormously resilient country. While the short-term effect of such events are likely to impact certain industries such as tourism and related industries which depend heavily on foreign visitors, in the longer term this is unlikely to derail India's attractive growth story. Most multinationals and foreign investors who have invested in India are in it for the longer ride, and therefore it seems unlikely that any real (or perceived) security risk of doing business in India would cause existing investors to exit or deter new foreign investors.
What is also encouraging is that India continues to be the world's largest democracy with an established and familiar legal system based on English common law, and an independent judiciary. India also provides an attractive workforce: huge numbers of English-speaking graduates join the managerial and technical labour force every year, and many of them have proven their mettle in the international arena.
Last and not the least, the economic fundamentals underpinning India's economic ascension still remain the same: a burgeoning middle class with large disposable incomes, a robust service sector and low export dependency. Unlike many of Indian's Asian counterparts, India's economy is driven by domestic consumption, making it possibly more resistant to a global economic downturn. This is especially true for the retail sector, where increasing demand in the retail market is driven by a number of factors including customers' changing lifestyles, income growth, and demographic patterns. Indeed, the retail sector is expected to grow faster than the GDP of India.
The sleeping elephant has finally awoken…
Azmul Haque
Berwin Leighton Paisner
E-mail: azmul.haque@blplaw.com
* This article is intended for general information only. It
not intended to be nor should it be regarded as legal advice.
Notes
1 Professor Allan Fels, 'Regulation of Retailing in India: Entry of foreign retailers into the developing economies', The Retail Digest, The Oxford Institute of Retail Management, Spring 2008.
2 Retail: Markets and Opportunities, A report by the Indian Brand Equity Foundation at www.ibef.in.
3 Ibid.
4 http://www.independent.co.uk/news/business/news/tesco-enters-india-with-cashandcarry-891979.html
5 http://www.pantaloon.com/companyinfo.asp
6 http://en.wikipedia.org/wiki/Shoppers'_Stop
7 http://relianceretail.blogspot com/2008/06/godrej-aadhar-itc-choupal-sagar-dcm.html
8 Ibid.
9 The other prohibited sectors include: atomic energy, lottery business/ gambling & betting, agriculture (excluding floriculture, horticulture, seed development, animal husbandry, pisciculture and cultivation of vegetables, mushrooms etc.), and plantations (excluding tea plantations).
10 Press Note 3 of 2006, issued by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, Government of India.
11 In Federation of Associations of Maharastra and Ors. Vs. Union of India and Ors, 2005(79)DRJ426.
12 Press Note 9 (200 Series), issued by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, Government of India.
13 Royalties are to be calculated on the basis of the net ex-factory sale price of the product, exclusive of excise duties, minus the cost of standard bought-out components and the landed cost of imported components, irrespective of the source of procurement, including ocean freight, insurance, customs duties, etc.
14 Professor Allan Fels, 'Regulation of Retailing in India: Entry of foreign retailers into the developing economies', The Retail Digest, The Oxford Institute of Retail Management, Spring 2008.
15 Bob Jenkins, 'Retail - A Jewel in the Crown' at http://www.licensemag.com/licensemag/
16 Bob Jenkins, 'Retail - A Jewel in the Crown' at http://www.licensemag.com/licensemag/
17 The Factories Act, 1948 at http://www.erlaws.com/showfullact.asp?act=FA
18 http://www.bharti.com/