Investment control and the e-tailing marketplace

By Rajat Mukherjee and Arjun Rajgopal, Khaitan & Co

Over the past few years, India has seen the rise of a robust e-commerce economy with all kinds of merchandise being sold to customers through online platforms. E-commerce revenues were over US$14 billion in 2012, having more than doubled from 2011, and are estimated to reach US$38 billion by 2015. E-commerce in India has attracted the attention of large and respected investors from across the globe, including major private equity, venture capital and sovereign wealth funds. Most of the e-commerce businesses which have succeeded have received some form of foreign direct investment (FDI).

From a legal standpoint, it is clear that e-commerce companies which have foreign investments cannot engage in direct selling to end customers, i.e. they can only engage in business-to-business (B2B) trading. This has affected the structure of many e-commerce businesses.

Rajat Mukherjee
Rajat Mukherjee

Common structures

In one common structure, the foreign investor invests in an operating and holding company which is ultimately majority owned and controlled by Indian citizens. Any downstream investment through this holding company into any entity carrying on direct retail (B2C) trading is not regarded as indirect foreign investment.

A second structure is where the foreign investment is made in a pure B2B company which does everything other than the final sale to the end consumer. This B2B company sells its products to a B2C company which is 100% owned by Indian citizens and does not have common ownership or directors with the B2B company. The B2C company sells the products to end consumers with enough margin to cover its operating costs.

The challenge with the first structure is that the holding company should have some other business income and should not be a pure holding company. The challenge with the second structure is that the FDI policy limits sales from B2B companies to its group companies at 25% of the total turnover and therefore the B2B and the B2C companies should have a demonstrable lack of common control or ownership.

Both these structures have been questioned by the regulators in the recent past.

Exchange control factor

From an exchange control perspective, certain aspects of the FDI policy come into play in devising these structures. The most important are the definitions of “ownership” and “control” and the impact these have on the treatment of a company as being Indian owned and controlled.

A company is considered to be “controlled” by resident Indian citizens if resident Indian citizens, and Indian companies which are owned and controlled by resident Indian citizens, have the power to appoint a majority of the company’s directors. Further, a company is considered to be “owned” by resident Indian citizens if more than 50% of its share capital is beneficially ultimately owned by resident Indian citizens.

Under the FDI policy FDI in an investing Indian company would not be considered in calculating indirect foreign investment in the case of Indian companies which are “owned and controlled” ultimately by resident Indian citizens. In other words, where the majority of a company’s board and shareholding is under the control of Indian residents/companies, the “ownership and control” test under the FDI policy is satisfied and any subsidiary of such a company is to be regarded as having no foreign investment at all. Therefore, such a subsidiary should not be limited in terms of carrying on any legitimate business activity, despite any exchange control regulations.

Interpretation unclear

However, the interpretation above remains unclear for various reasons. Certain e-commerce companies using similar structures have been served notices requiring them to show that they are not engaged in retail trade. Other structures have been questioned as shams where the B2C company has little or no business. Clearly, an underlying subjective stance is being taken, whether for genuine reasons or perhaps as a result of a lack of clarity in the manner in which Indian exchange control regulations have evolved.

Arjun Rajgopal
Arjun Rajgopal

The Reserve Bank of India, in its recent amendment of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, appears to have retained the objective tests mentioned above and given its blessing to the present understanding of “‘ownership and control” under the FDI policy, instead of viewing so-called indirect control mechanisms as indicative of intent to control.

This is a positive step which may lay to rest the regulatory uncertainty surrounding determination of foreign ownership and control of Indian entities and downstream investments by Indian entities. At the end of the day all investors want regulatory certainty and one would hope that there is no further policy flip-flop on this issue.

Rajat Mukherjee is a partner and Arjun Rajgopal is a senior associate at Khaitan & Co. The views of the authors are personal and should not be considered as those of the firm.


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