E-commerce investment: Treading in the dark?

By Rajesh Begur, ARA LAW
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E-commerce is one of the fastest growing sectors in India in recent years. Technology, favourable demographics, and increasing use of the internet have been major drivers for the rapid growth of the sector. As per an ASSOCHAM-PwC study it is estimated that the Indian e-commerce industry will cross the US$100 billion mark by 2019. E-commerce business models can broadly be categorized as business to business (B2B), business to consumer (B2C), consumer to consumer (C2C), consumer to business (C2B), business to business to consumer (B2B2C) and the marketplace model.

Rajesh Begur
Rajesh Begur

Foreign direct investment (FDI) in India is regulated by Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000, and the consolidated FDI Policy formulated by the Department of Industrial Policy and Promotion (DIPP).

The FDI Policy states that “E-commerce activities include all activities of buying and selling by a company through the e-commerce platform”. While 100% FDI under the automatic route is allowed in companies engaged in B2B e-commerce, FDI is prohibited in companies engaged in B2C e-commerce.

In light of this restriction, B2C e-commerce companies seeking FDI have been compelled to structure their businesses in innovative ways to ensure compliance with the requirements of the FDI Policy. Two of the commonly used structures are outlined below.

B2B2C: Until recently, the B2B2C model was one of the most commonly used structures by e-commerce companies. In this model FDI is received by a “back-end entity”, which makes a B2B sale to an intermediary, “front-end entity”, which in turn makes a B2C sale to the end customer. The two entities enter into various revenue sharing arrangements in terms of commissions and platform fees. In view of the 25% restriction imposed on aggregate B2B sales between group companies, and scrutiny on account of violation of the FDI Policy, questioning the genesis of transactions done by the front-end entity on a just in time basis with little or no inventory, such entities were forced to find friendly investors to own such a front-end entity and demonstrate substance.

Marketplace model: Acknowledg-ment received in the DIPP’s “Discussion Paper on E-commerce in India”, released in January 2014, coupled with the challenges to the B2B2C model described above, has made the marketplace model popular in the e-commerce industry. In this model the entity acts as facilitator by providing an online trading platform for transactions between buyers and sellers (who maintain the inventory) and the end sale is concluded between the buyer and the seller. However, in some instances, the marketplace not only acts as a facilitator but also provides services such as logistics, packaging, inventory management (by maintaining fulfilment centres), marketing, customer support, etc.

E-commerce has faced legal (and political) hurdles as India’s regulatory framework continues to struggle to stay abreast with the changing business landscape.

In certain states the inventory-based marketplace model is faced with taxation jurisdiction and applicability issues in relation to value-added tax and sales tax. Despite justification being provided by such entities, the tax authorities have apparently taken the position that ownership of goods passes to the marketplace when the goods reach its warehouse or fulfilment centre.

Further, in a petition filed by the Retailers Association of India before the Delhi High Court, brick and mortar retailers have expressed their strong opposition to opening up of the e-commerce sector on grounds that the models used are functionally similar to B2C e-commerce currently prohibited under the FDI Policy.

E-commerce companies have to comply with several laws, some of which are still evolving and many of which are archaic. Issues related to cyber law, privacy, data protection, foreign exchange management contraventions and regularizations, regulatory uncertainty especially in the manufacturing sector on whether manufacturers are allowed to sell online, and delayed policy decisions haunt the industry at large.

Many government initiatives and campaigns – namely, Digital India (an initiative to boost e-commerce marketplaces by increasing the reach of the internet to remote areas), Make in India (an initiative to enhance the global competitiveness of Indian manufacturers and traders from even tier 2 and tier 3 cities in reaching customers all across India), development of a strong postal network by modernizing the Indian post office, Skill India (creating opportunities for skilled and unskilled employment) – will have a far reaching impact on the e-commerce sector and the development of the economy.

To facilitate the ease of doing business in India, the government needs to open up the e-commerce sector, and in particular to allow FDI in B2C e-commerce, in order to counter the increasing trend of externalization adopted by e-commerce companies on account legal and administrative hurdles. However, until that happens, e-commerce companies and investors will have to tread carefully to ensure that they are not in violation of India’s tax regulations and FDI Policy.

Rajesh Begur is the managing partner of ARA LAW, a first-generation law firm with offices in Mumbai and Bengaluru.

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