Background

Foreign Direct Investment (“FDI”) upto 100 percent is allowed in single brand retail trade (“SBRT”) sector. FDI upto 49 percent is allowed under the automatic route and FDI in excess of 49 percent requires prior government approval. In addition, FDI in SBRT sector requires compliance with several other conditions. For instance, the products are required to be of a single brand only and sold under the same brand name internationally. Furthermore, companies engaged in SBRT sector with more than 51 percent FDI are required to locally source at least 30 percent of the value of the goods purchased by them (the “SBRT FDI Norms”).

An Indian manufacturer is permitted to sell its own brand’s products manufactured by them in India in any manner without restrictions regardless of whether it is through wholesale, retail or through e-commerce platforms without complying with the SBRT FDI Norms. However, for an entity to qualify as an Indian manufacturer under the 2016 FDI Policy, it had to manufacture in terms of value, at least 70% of its products in-house and source at most, the remaining 30% from other Indian manufacturers (the “70-30 Rule”). Unfortunately, this 70-30 Rule was not favourable for many Indian manufacturers since this condition implied exclusion of contract manufacturing. This was particularly troublesome for entities without sophisticated manufacturing capabilities and that took recourse to contract manufacturing.

The 2017 FDI Policy made some changes in relation to SBRT FDI Norms. The objective of this article is to analyse the potential impact of such changes. In particular, special emphasis will be given to analyse the issue whether an entity that engages in retail trade of products manufactured by third party contract manufacturers, will be considered to be falling under the SBRT sector or manufacturing sector for the purpose of determining the applicability of the SBRT FDI Norms to such entity.

Key Changes in 2017 FDI Policy

Committee for Examining Applications for Exemption from 30% Local Sourcing Norms

The 2017 FDI Policy provides for 3 years maximum exemption limit from the 30% local sourcing norms for SBRT of products with ‘state-of-art’ and ‘cutting edge’ technology where local sourcing is not possible. A committee under the chairmanship of Secretary, DIPP, with representatives of NITI Aayog, concerned administrative ministry and independent technical expert(s) on the subject will examine the claim of applicants on the issue of the products being in the nature of ‘state of the art’ and ‘cutting edge’ technology where local sourcing is not possible and give recommendation for relaxation from the local sourcing norms. This is a prudent move as it will effectively streamline the application process for such products and ensure that such applications are evaluated by trained & capable personnel.

The 2017 FDI Policy, however, does not provide for any guidelines or criteria for the committee to determine whether a product is ‘state of the art’ and possesses ‘cutting edge’ technology. It would be welcome if government publicly provides for some broad guidelines or criteria which would be an aid to prospective applicants seeking exemption from the local sourcing norms.

Relaxation for Indian Manufacturers from the 70-30 Rule

The 2017 FDI Policy deleted the wordings of the 70-30 Rule that existed under the 2016 FDI Policy. Many industry experts have welcomed this deletion claiming that this would allow FDI in Indian companies operating in SBRT sector which were incapable of manufacturing their products in-house. However, the full impact of the deletion of the wordings of the 70-30 Rule remains unclear.

One could argue that deleting the wordings of the 70-30 Rule from the 2017 FDI Policy, effectively permits an Indian company that out-sources more than 30% of its production to contract manufacturers, to avail 100 percent FDI via the automatic route and sell its products manufactured in India through wholesale and/or retail, including through e-commerce without any governmental approval or compliance with the SBRT FDI Norms.

However, whether this argument can be sustained or not would depend on the definition of the term manufacturing as provided in the 2017 FDI Policy. The 2017 FDI Policy has defined manufacture, with its grammatical variations, “as a change in a non-living physical object, resulting in transformation of the object into a new and distinct article having a different name, character and use, or bringing into existence of a new and distinct thing with a different chemical composition or integral structure”. This definition has been reproduced verbatim from Section 2(29BA) of the Income Tax Act, 1961.

The Judicial Test of Manufacturing

In the leading case of Union of India v. Cibatul Limited [see endnote 1] (the “Cibatul Case”), the Supreme Court interpreted the term manufacture in a brand owner-contract manufacturing structure, albeit from the perspective of the Central Excise Act, 1944. In this case, certain resins were to be manufactured by a contract manufacturing company in accordance with a programme that was jointly drawn up by the contract manufacturing company and the brand owner. The brand owner also authorised the contract manufacturing company to affix its trademarks on the manufactured products that were to be sold to the brand owner. As per the existing arrangement, subsequent to inspection and approval by the brand owner, the goods so approved would be sold by the contract manufacturing company to the brand owner. Here, the Supreme Court had to examine the question of whether the goods were being manufactured by the contract manufacturing company on its own account or on behalf of the brand owner.

Finally, the Supreme Court held the contract manufacturing company to be the manufacturer even though the trademark was not owned by it. It observed that the mere supply of raw material to the job workers would not make the brand owner the manufacturer of the goods even if the goods were produced under its brand-name and under its quality control standards so long as the contact manufacturing company’s relation with the brand owner was on a ‘principal to principal’ basis. The underlying rationale was that the contract manufacturing company manufactured the goods on its own account on a principal-to-principal basis and not on behalf of the brand owner. In other words, the risk of manufacturing vests with the contract manufacturing company and not the brand owner.

Hence, going by the ratio of the Cibatul case, it logically follows that a brand owner may not be considered as a manufacturer under the 2017 FDI Policy even if it procures the raw materials and retains the title over the same, exercises quality control over the manufacturing process, causes its trademark to be put on the goods or pays the labour charges to the contract manufacturer, if its relationship with the contract manufacturer is on a principal-to-principal basis. However, if the brand owner were to assume the entire risk in respect of manufacturing the goods and did not reserve the right to reject the goods for not conforming to the brand owner’s given specifications, then it would indeed be considered as a manufacturer as per the Cibatul case. It is necessary that the brand owner must bear all risks, proprietary or otherwise, associated with the manufacturing process so that it is a situation where the contract manufacturer merely carries out the manufacturing process on behalf of the brand owner.

The Standard Commercial Model of Contract Manufacturing

The principle of law laid down in Cibatul case was in the context of a tax legislation but whether it will be applicable to interpret the definition of manufacturing under the 2017 FDI Policy can not be commented with certainty. The terms of each contract of manufacturing must be analysed independently.

A review of the terms of various manufacturing contracts across industry sectors including textiles, electronics, food processing, pharmaceuticals reveals that the terms are largely similar. As a matter of commercial practice, in agreements for contract manufacturing, the manufacturing company usually assumes all the risk associated with the manufacturing process such as the risk of rejection of defective goods manufactured, health and safety risk of workmen, environmental risks, legal and regulatory non-compliance risk, product liability risk, etc. The outsourcing company although usually provides for guidelines and standards of manufacturing, it still generally retains the right to inspect and reject the goods manufactured.

Since the risk associated with the manufacturing process is assumed by the manufacturing company and the right to reject is available with the outsourcing company, going by the judicial test of manufacturing laid down in the Cibatul case, it appears that in most cases of contract manufacturing the outsourcing company shall not be considered as the manufacturer.

Relaxation for Manufacturers to Manufacture Indian Brands

The wordings of the 70-30 Rule in the 2016 FDI Policy stated that in order to qualify as an ‘Indian Manufacturer’, an investee manufacturing company must also be the owner of the Indian brand. Therefore, for illustration, if an Italian company owning an Italian garment brand intended to set up a subsidiary company in India for 100 percent in-house manufacturing and selling of garments under the Italian brand name in retail brick and mortar stores situated in India, it would not be considered as ‘Indian Manufacturer’ since it did not own an Indian brand. Therefore, an unintended consequence of the existence of the 70-30 Rule wordings in the 2016 FDI Policy was that such an Indian subsidiary of an Italian company had to comply with SBRT FDI Norms despite the fact it was manufacturing in India in full compliance with the 70-30 Rule.

However, with the deletion of the 70-30 Rule wordings from the 2017 FDI Policy, foreign companies will now be allowed to manufacture their foreign branded products in India, perhaps through a subsidiary, and subsequently sell them through wholesale, retail or e-commerce without government approval.

Conclusion

FDI in the retail sector has always remained a controversial issue ever since the government started introducing reforms to liberalise this sector in 2006. While the recent changes introduced by the government under the 2017 FDI Policy are welcome, there are still ambiguities in connection with the SBRT FDI Norms as to what are the parameters for determining whether a product is ‘state of the art’ and possesses ‘cutting edge’ technology and also whether the SBRT FDI norms will be applicable to Indian companies who engage in SBRT of products manufactured by them through contract manufacturing.

Undoubtedly, the biggest gainer from the 2017 FDI Policy will be the manufacturing sector if one accepts the view that companies that outsource their production to ‘contract manufacturers’ would also be considered to be operating in manufacturing sector and therefore implying that the SBRT FDI norms will not be applicable to such companies.