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Commonly Used Models

Structuring Of Investments In eCommerce Businesses In India

Introduction Regulatory framework Possible Models Issues Conclusion About Us

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Disclaimer
This paper is a copyright of Arkay & Arkay, Chartered Accountants. No reader should act on the basis of any statement contained herein without seeking professional advice. The authors and the firm expressly disclaim all and any liability to any person who has read this paper or otherwise, in respect of anything, and of consequences of anything done, or omitted to be done by any such person in reliance upon the contents of this paper.

Arkay & Arkay, Chartered Accountants

Introduction
Over the past few years, business on the Internet in India has grown on the back of a growth in online commerce in the country: eCommerce ventures have delivered growth by bringing more buyers to the web, and more importantly creating happy customers. Venture capital funding has allowed them to spend on acquiring customers by advertising on websites, and via advertising networks and Google. Numerous logistics and delivery businesses have cropped up to support this growth, and the next wave, it appears, will be in businesses that help in customer retention and lower cost of customer acquisitions through loyalty programs. More professionals from retail have joined eCommerce business, given the promise of quick growth, as well as potential exits. With the success of eCommerce ventures like Flipkart, Infibeam, Homeshop18, Myntra and a few others, many more have mushroomed. It remains to be seen whether the customer demand can sustain all of the upstarts: many are struggling to sell inventory, and there is bound to be consolidation in the near term. That said, the fact that there is demand for eCommerce,or that customers find greater variety and value online cannot be doubted. There is room for growth as more and more customers come online, whether the Internet, or to the mobile Internet as wireless data penetration increases in the country. In all of this, recent developments have raised questions about the legality of eCommerce businesses in India, given that there are restrictions in foreign direct investment in multi-brand retail. This document is aimed at educating entrepreneurs and investors about the many different structures that are being used Indian eCommerce businesses to raise venture capital.

Arkay & Arkay, Chartered Accountants

Regulatory Framework
Foreign Direct Investment (FDI) in India is regulated by means of the Foreign Exchange Management Act (FEMA). Amendments to the investment policy are made by the Ministry of commerce in consultation with the Department of industrial Policy and Promotion (DIPP) and then notified by the Reserve Bank of India (RBI) by means of Press notes/Press releases and Circulars. Current FDI regulations have been detailed in circular 1 of 2012, Consolidated FDI policy which came into effect from 10th of April, 2012. The policy was further modified by Press notes 4 and 5 of 2012 which allowed 100% FDI in single brand retail trading and up to 51% in multi brand retail trading, requiring mandatory sourcing of 30%, with other conditions being: a) Companies with such FDI can open retail outlets only in cities with a population of more than 1 million, b) At least 50% of the FDI brought in has to be invested in backend infrastructure c) Such stores can only be opened in states which explicitly allow such FDI While 100% FDI is allowed under the automatic route in companies engaged in Business to Business (B2B) trading . The policy re-iterated the previous position, which stated that companies with FDI would not be allowed to engage in retail eCommerce activities. It is our understanding that this has been done to ensure parity with physical stores with FDI which are only allowed in specific states. As we shall soon see, since the fulfillment is done on a local level through franchises this does not affect current ecommerce players on a significant level. It is true that FDI is flowing in to Business to Consumer (B2C) companies, for there exist a number of models used to structure FDI in such companies, in compliance of the law of the land. We shall examine some of the most prevalent FDI inclusive methods in this paper.

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Possible FDI Models


Equity Goods / Services

Overseas

India Sellers Retail Platform

Platform Approach

Foreign Investors

100%

Buyers

Under the current policy, FDI in multi brand retail is capped at 51% with a minimum investment threshold of $100 million. Of such investment at least 50% has to be invested in the back end infrastructure of the retail company. Such back end infrastructure includes supply chain and warehousing facilities but does not include rental costs or land.

One of the ways to tip toe around these limitations and to avoid the huge entry cost is to enter the market as a trading platform rather than a trader. Since there are no restrictions on investment in a technology platform 100% FDI can be brought into companies which own such platforms via the automatic route. As part of the trading platform model, the Indian company functions purely as an online market place whereby sellers can canvass their products to potential customers and secure sales through the Indian company. The actual customers of the company are the retailers who use the platform to make such sales, the platform owner earns a cut from the sales in the form of either a commission or carriage fee.
This model is within the letter of the law since there is no active retail activity carried out by the company receiving FDI. This model allows companies to function with the greater confidence than other comparable models. Further, in case of any relaxation in policy with respect to 100% FDI in ecommerce, such companies can readily change their business model utilizing the customer database and foraying into retail commerce. Companies operating through this model include Amazon ( Through Junglee.com and soon Amazon Seller Services) and Ebay 3

Overseas

India

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Distinct Co. Model

Foreign Investors

100%

B2B Trading Co.

B2C Trading Co.

The existing FDI policy permits the infusion of up to 100% FDI in a wholesale trading company through the automatic approval route. While there are caveats related with such investment it offers a potential entry into the ecommerce market in India via an ingenious model. This involves the setting up on two distinct entities, not connected with each other in any way. One of the entities is designated as the B2C entity while the other is classified as a B2B trading company. The B2B company owns the trading platform ( the ecommerce website) and maintains inventory etc of goods to be sold to business customers. The B2C company engages the services of the B2B company in a franchise based model and uses the trading platform, management services and acquires inventory from the B2B company. It is the B2B company that the foreign investment flows in compliance with the letter of the guidelines. The B2B company needs to comply with the FDI policy by: a) Obtaining requisite registrations and licenses for wholesale trading b) Ensuring that all sales are made only to valid business customers c) Keeping record of all sales maintained on day to day basis d) Ensuring that sales to group companies do not exceed 25% of the total turnover of the wholesale venture. While the term group companies has not been defined by the policy or other strictures of law they are generally understood to be companies controlled, directly or indirectly, by a common management or where one company wields significant influence on the day to day operations of the other. Therefore it is important to maintain a clear distinction in ownership and control of the B2B and B2C entities to avoid falling on the wrong side of the law.
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Overseas

India

Indian Promoters 51%

Indirect Holding

Foreign Investors

49%

Holding Co. 100%

B2C Retail Co.

An Indian company is defined by the FDI policy as A company, incorporated in India which is owned and controlled by Indian residents. As per the policy a company is considered as 'Owned by resident Indian citizens if more than 50% of the capital in it is beneficially owned by resident Indian citizens and / or Indian companies, which are ultimately owned and controlled by resident Indian citizens, similarly, a company is considered as controlled by resident Indian citizens if the resident Indian citizens and Indian companies, which are owned and controlled by resident Indian citizens, have the power to appoint a majority of its directors in that company. Therefore if more than 50% of the share capital of a company incorporated in India were to be held by Indian residents or other Indian companies any downstream investment by such companies would not be considered while computing the cap with respect to FDI investments. Taking advantage of this provision, FDI injections up to 49% may be made in an Indian company where the majority ownership would be held by Indian resident Indian Citizens. This option is most preferred in JV arrangements where the foreign players chooses to align with a local partner for its Indian business. While exploring this structure, like all other structures, one must be mindful of the circumstances surrounding the retail sector in India wherein models proposed by the incumbent businesses may find themselves subject to increased levels of scrutiny in the hands of the regulators and the Enforcement Directorate. 5

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Overseas Foreign Investors

India Technology service provider

Technology Provider

100%

B2C Retail Co.

An fourth option that may be considered by established retail players to venture into ecommerce is the technology service provider route. In this scenario the foreign investment flows into a technology services company which can accept 100% FDI via the automatic route, this company in turn provides technical and platform related assistance to enable the retail entity to go online. This is much like option 1, the platform approach, but with the key differentiator being that this technology service provider provides dedicated services to a single group of companies. Since the technology company does not engage in eCommerce itself it does not violate any provision of the policy it does, however, allow Indian retail companies to accept FDI and yet engage in ecommerce through this structure. As with the other structures, an arms length distance has to be maintained between the entities.

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Issues
Would advance booking with Brick & Mortar store for physical pickup later be considered ecommerce?
There remain gaping voids in regulation surrounding ecommerce in India. Intriguingly, the term ecommerce itself has not been defined by the regulations, although there was a statement from the government that foreign direct investment in ecommerce in India has not yet been allowed. Similarly, it is not known if m-commerce is bound by the same regulations as ecommerce. While it may be considered a subset of ecommerce, retail activity via mobile telephony may need to be looked at an independent category. Further, while all of previously mentioned structures are in line with the letter of the law, they may or may not be in accordance with the spirit of the law. It is very possibly that the regulators may take a different view with respect to some of these structures. The notice to Flipkart from the Enforcement Directorate (ED) is a recent example.

Conclusion
The Indian Retail story is an opportunity to deliver value to customers whether in terms of convenience, greater variety of goods, and allow delivery of goods to towns where it may perhaps not be viable to set up physical retail outlets. eCommerce is an enabler for greater customer value and contributes by increasing transactions, and transaction efficiency . The ecommerce industry has created new jobs, and is instrumental in building an affiliated business in manufacturing, warehousing and logistics around it. It is our view that Instead of attempting to stifle the growth of a transformative industry in its infancy, government policy needs to enable ecommerce in India to ensure that Indian enterprises and Indians at large can prosper.

About
Arkay & Arkay, Chartered Accountants is a full service advisory firm, based out of New Delhi. We offer specialized services in the domains of Direct and Indirect taxation, Audit and Assurance, India Entry Advisory, Risk Advisory and other allied services to domestic and global business of all sizes. Our core practice areas include Mergers & Acquisitions ,Tax Litigation, International Tax Advisory, Fund Advisory, Domestic Tax Advisory and Compliance, Service Tax advisory, Statutory Audits, Corporate law advisory and Compliance, Internal Audits etc. Our team comprises of Chartered Accountants, Lawyers and MBAs working together to provide our clients the best value through practical and innovative solutions.

Email : info@arkayandarkay.com

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About
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