Foreign investment in retail e-commerce: The way to go?

The new favourite for private equity and venture capital investors today seems to be e-commerce. Not only has China’s giant online trading company, Alibaba, had one of the most successful IPOs in recent history, the e-commerce sector in India is not far behind. With Flipkart’s recent acquisition of Myntra, and huge investments by Amazon and other portals, online trading or e-commerce in India is on the rise. The country’s e-commerce sector is estimated to have grown from US$3.8 billion in 2009 to US$12.6 billion in 2013, for at a compound annual growth rate of 35%.

Restrictions in India

In light of the recent investments by major global players, the foreign investment laws of India governing e-commerce have been in particular focus. While 100% foreign direct investment (FDI) in e-commerce has been permitted under the automatic route since 2000, it is restricted to business to business (B2B) activities only.

Looking at the evolution of this provision, it initially came with the condition that 26% of the equity should be divested in favour of the Indian public in five years, if the company was listed globally. At that time FDI in wholesale trading was permitted under the approval route and there was a complete prohibition on FDI in retail. Therefore, while B2B e-commerce was allowed without any approval (thereby allowing companies to make wholesale deals electronically), for FDI in brick-and-mortar wholesale stores, prior permission of the government was required.

The 26% divestment requirement for FDI in e-commerce was removed in 2006 at the same time when FDI in wholesale trading was permitted under the automatic route and 51% FDI in single-brand retail was permitted with prior approval. Consequently, while restrictions on FDI in brick-and-mortar stores engaged in wholesale and retail trading were eased, trading through electronic means continued to be restricted.

More recently, the FDI regime for trading has been liberalized even further, with FDI permitted in multi-brand retail as well, while trading through electronic platforms remains restricted.

Marketplace model

To get around the FDI restrictions on e-commerce, companies have devised the marketplace model, where the sale is completed between the end consumer and the manufacturer/owner of product directly and only hosting/information technology service is provided by websites such as Snapdeal, Amazon, Flipkart, etc. The marketplace model has been questioned by the tax authorities and the government for alleged violations of the foreign exchange regulations and has the risk of unravelling on account of multiple inter-linked transactions.

This gives rise to a strange situation where international companies are permitted to open physical retail stores, but they cannot set up an online platform for the same purpose. If an international company can sell its product from a physical store in India, it is hard to fathom why it should not be able to sell its products through its own website. While the commercial effect of trading through an online portal and completing the transaction at a physical store are the same, the government seems to have always drawn an artificial distinction between the two mediums.

Way of the future

It is often argued that the disadvantage of allowing business to consumer (B2C) e-commerce is that small shopkeepers and traders, such as the “neighbourhood kirana stores” would suffer because they would not be able to compete with the large international e-tailers. However, given the low internet penetration in India and the product mix being sold by the international e-tailers, the risk to small shopkeepers is minimal.

While it is natural that with time internet penetration in India will improve and the percentage of people buying goods online will increase correspondingly, it can similarly be argued that with time the successful domestic retailers will have gained the ability to compete with global retailers on a physical as well as an electronic platform.

Essentially, with the liberalization of the retail policy, FDI in both single and multi-brand retail has been allowed subject to certain restrictions. In light of this, and the increasing cost of having brick-and-mortar stores, the electronic mode is gaining popularity as an avenue of completing sales and it should not make a difference to the government whether the customer is physically entering the store or logging on to a website in order to make the purchase, as both means are equally capable of regulation.

The disparity in the regulatory regime governing FDI in e-commerce and in the physical realm should be removed. Especially when consumers can purchase the same global products in a physical store, the restriction on B2C e-commerce serves no purpose.

Anubhuti Agarwal is a partner and Tanvee Nandan is an associate at Amarchand & Mangaldas & Suresh A Shroff & Co, New Delhi. The views expressed in this article are those of the authors and do not reflect the position of the firm.