The author acknowledges an anonymous referee of this journal for helpful comments on an earlier draft of this article.
The Indian retail sector is going through a tumultuous transition phase. Competing forces like protecting interests of indigenous players and the liberalisation of the market to incite multibillion dollar investments, are constantly working in tandem. Under these circumstances, it is not easy for any policymaker to roll out a foolproof policy which can impress all stakeholders. Presence of loopholes in extant laws and ambiguity inviting conflicting interpretation are not necessarily attributable to inefficient policymaking. It is also a result of changing dynamics and demands of this evolving market.
In a bid to synchronise law with business, the Department of Industrial Policy and Promotion (DIPP) issued fresh foreign direct investment (FDI) guidelines in March 2016 through a press note (PN3/16) (DIPP 2016a) for the e-commerce sector which is at the helm of this transition. These guidelines have been subsumed in the Consolidated FDI Policy, 2016 (DIPP 2016b). They strive to provide clarity in the grey patches of the e-commerce sector, especially the marketplace models which have been alleged for operating quasi-inventory based model. The precedent shows that every time there have been changes in the FDI policy, the businessmen have come with a new cobweb of structure. This commentary briefly analyses the scenario post PN3/16, and the possible impact on the existing business structure of players running the marketplace models.
What Has Changed?
PN3/16 allows 100% FDI through automatic route into an entity acting merely as facilitator in retail trading business, popularly known as the marketplace model. In other words, an existing company with Indian control and ownership providing a virtual space through which merchandise are sold and purchased is now free to receive foreign investment without any caps or permission from the Reserve Bank of India. Alternately, a foreign company can set up its 100% owned subsidiary engaged in marketplace model business.
Now the immediate question that may follow is: isn’t this something which is already in practice? In the pre-PN3/16 scenario, there was no prohibition of FDI in an entity which merely acted as facilitator in retail trading business by providing a technology platform. The earlier restriction that did not allow FDI in business-to-customer (B2C) e-commerce, except under certain circumstances (DIPP 2015) has not been done away with. On the contrary, PN3/16 further clarifies that no FDI shall be permitted in inventory- based model retail e-commerce entity, that is, a company if funded by foreign investor cannot buy products from different companies and then sell them to final customers through their website.
If one looks at the present pattern of shareholding in marketplace models, there are hardly any companies left in India who have not received foreign funding in the past. For instance, Amazon Sellers Services which owns the website www.amazon.in is owned by Amazon Asia-Pacific Resources Singapore and Amazon Eurasia Holdings Luxembourg. Flipkart Marketplace Singapore holds 99.93% shares in Flipkart Internet which owns the website www.flipkart.com. Similarly, www.snapdeal.com is owned by Jasper Infotech which has several foreign investors, including Alibaba. Also, www.jabong.com, earlier owned by a merged foreign entity known as Global Fashion Group has been recently acquired by Flipkart.
So do these guidelines usher in a new policy with respect to marketplace model? The prima facie answer is no. E-commerce activity has been already defined in the existing FDI policy as “an activity of buying and selling by a company through e-commerce platform” (DIPP 2013a: 67). In other words, e-commerce, as understood in the extant FDI policy was silent on the marketplace model. This led to the obvious interpretation that it was out of the ambit of FDI restrictions, otherwise applicable to B2C e-commerce. To that extent, the PN3/16 formalises and incorporates the existing arrangement in practice as part of the FDI policy in black and white.
The Present Cobweb
The intention behind the FDI policy of not putting any FDI restriction on the marketplace model business was different from the present complex and circuitous structure that some of the foreign-funded marketplace entities have adopted.
As Figure 1 illustrates, Company Y has FDI and hence cannot freely indulge in B2C e-commerce/retail trading unless it fulfils several strict conditions. However, it is free to engage in the marketplace model business. To overcome this restriction of retail trading, Company Z which is funded by Overseas Company X comes into the picture. Company Z sells (product at a heavy discount) to its business customer Company X which is one of the largest B2C seller on the marketplace site owned by Company Y. The whole structure reflects ostensible marketplace model, but in reality, it is a complex hybrid structure consisting of both inventory and marketplace model complying with the letter of the FDI regulations, but definitely not the spirit.
The aforesaid structure is somewhat similar to the Flipkart’s model, where WS Retail is the largest seller on the marketplace which interestingly buys product from Flipkart India (a B2B entity) where shares are held by Flipkart Singapore. While WS Retail is an independent entity, Flipkart exercises operational control (Choudhury 2015). Another complex structure is adopted by Amazon Sellers India which owns the website www.amazon.com. Cloudtail India is the B2C entity and one of the largest sellers on the website. Cloudtail is indirectly owned by Amazon through Prione Business Services through downstream investment taking benefit of the loopholes of the FDI policy (DIPP 2009a, 2009b).
To ensure that the marketplace model business does not start behaving like retail trading, PN3/16 explicitly clarifies that FDI is prohibited in inventory model e-commerce. But most importantly, it lays down several riders on the marketplace entity in a bid to curb this multilevel maze structure. The two most important riders are: first, no marketplace entity will allow more than 25% of its sales affected on its site from one vendor or its group companies. Second, marketplace entities will not directly or indirectly influence the sale price of goods or services.
Effect of Riders
Although the riders imposed through the guidelines are not expected to have retrospective application, it is crucial for the marketplace players to analyse the repercussion for future implications.
Threshold of 25% Sales
In the offline retail market, there is already a restriction on cash and carry wholesale trading entities (that is, entities which can sell only to businesses and not individual customers) having FDI not to sell beyond 25% of its turnover to group companies (DIPP 2016b: 34, Section 220.127.116.11.2). This restriction was imposed so that these cash and carry entities do not limit their transactions only to sister companies (these inter-group transactions are subject to influence and not necessarily at arms’ length price) and consequently it widens the seller base. The same restriction has now been imposed on the marketplace entities. PN3/16 states that no e-commerce entity will permit more than 25% of the sales affected through its marketplace from one vendor or their group companies. The restriction could be better understood in the following manner:
Case 1: Company ABC has FDI and is operating a marketplace. Total sales affected through Company ABC’s marketplace is ₹100. X, a single vendor, unrelated to company ABC contributes to 40% of the total sales affected on the marketplace, that is, ₹40. Post PN3/16 this arrangement is proscribed and company ABC can permit X to affect sales of worth only ₹25 or less through its platform.
Case 2: Company ABC has FDI and is operating a marketplace. Total sales affected through Company ABC’s marketplace is ₹100. Company PQR and XYZ are its group companies (B2C entities) and contributes to 80% of total sales affected on the marketplace, that is, ₹40 each. As per this restriction, PQR and XYZ combined can be permitted to affect sale of a value of ₹25 or less through its platform.
Presently, several marketplace entities have been earning a majority of their revenue from a related single B2C entity. This is done to bypass the restrictions on direct retail trading and thereby generate maximum sales/revenue through a sister company instead. Therefore, the possible reason behind capping of sales could be to bring the complex marketplace models in compliance with law.
The restriction was also expected in view of the recent outlash from the brick and mortal establishments. The impact of this restriction would compel these entities to go back to their respective drawing boards to create a new structure; first, to continue with their complex hybrid model, and second, make it ostensibly compliant with the new guidelines.
For example, Flipkart which earns maximum revenue from WS Retail (last year WS Retail sold goods valuing ₹10,163 crore) (Malaviya 2015) would land up in trouble, unless restructured. However, the recent acquisition of Jabong (marketplace) by Flipkart is a well-timed and strategic move to expand its market share and revenue. Similar problem would be faced by the Amazon which receives maximum revenue from Cloudtail India (Dalal 2015).
To tide over this threshold restriction, first, the companies may do away with their existing single large vendor arrangement and create multiple sellers with each seller contributing to the sales of the marketplace model within the limit of 25%. For example, assume company ABC has FDI and owns a marketplace model. Company XYZ is the largest seller on the marketplace model contributing towards 60% of its sales. Now Company XYZ could be spun off into several entities, for instance, X, Y and Z each contributing 20% of the sales, so that the earlier sales volume could be spread over three entities, yet comply with the limitation of 25%. In other words, a spin-off kind of structuring can be contemplated to achieve the same result in a different manner.
Second, the restriction of a maximum 25% sales is applicable to the group companies as well. If a foreign investor holds 26% or more equity in two companies, then such companies become group companies under the FDI policy.1 For example, assume a foreign investor PQR holds 28% shares in company ABC (market place) and company XYZ (B2C entity) and the rest, 72% shares is held by a resident investor. In such a case company ABC and XYZ would be treated as group companies. This restriction may call for reviewing existing shareholding patterns by company PQR investor. One of the possible outcome could be that PQR offloads equity shares in company ABC or XYZ or both, to bring down its shareholding to less than 26% and increase the shareholding of resident shareholder beyond 74%. This way, the cap of 25% of total sales affected through its marketplace from group companies will no longer be applicable because they will be treated as unrelated companies.
In a situation where there are more than one group company (B2C entity) affecting sales on the marketplace, together they can continue to contribute more than 25% of sales of the marketplace entity, subject to an individual restriction of 25%. As far as control and influence on such B2C entities is concerned, the same can be continued through measures like management control rights, appointment of directors or key managerial persons in such company, etc.
This threshold requirement would also impact the continuing arrangements between marketplace entities with sellers (big brands) supplying high-end electronic goods with exclusive discounts only on the platform. This influences buyers to shop electronic goods mostly from online market. These electronic items are usually expensive and requires specific technological specifications and, therefore are procured mostly from a single source. The existing contracts would have to be modified to comply with the threshold restriction.
The policymakers have tried to portray this rider as an anti-abuse provision to promote genuine competition on the marketplace model, and to ensure that the online marketplace is not hijacked by a handful of sellers (B2C entities) backed by foreign funding (Figure 1). This condition has come under heavy criticism from many players and is branded as a clog on business and restrictive in nature.
Interestingly, PN3/16 is silent on a crucial issue. Is this threshold of 25% sales is to be calculated on an annual basis or for a shorter duration? Secondly, the base for calculation of sales is not clear, that is, whether sales are to be calculated on the basis of discounted price of products or maximum retail price. Unfortunately, the Consolidated FDI Policy 2016 fails to clarify both the issues.
No Influence on Sales Price
PN3/16 proscribes a marketplace entity from influencing the sales price of goods or services directly or indirectly and enjoins to maintain a level playing field. Theoretically speaking, this requirement may appear illogical since the marketplace entity is not engaged in retail sales. After all, determination of price of goods or services is the prerogative of the seller and not the platform through which they are merely sold.
However, looking at the operation of the present complex hybrid models, a co-relationship can be inferred between discounts given by the B2C companies and the business generation for the marketplace models. The B2C entities who sell goods on these platforms procures merchandise from the B2B companies at heavy discounts. In turn, foreign investors holding shares in these B2B companies duly compensate/absorb these discounts.
Finally, the B2C entities sell the heavily discounted products through the marketplace model attracting maximum customers, thereby jacking up its gross merchandise value (GMV). If there are 10 mobiles of ₹10,000 each that are being sold over the marketplace, then GMV comes to ₹1,00,000. This GMV is used by investors for determining the valuation of these marketplace models (Economic Times 2014). In other words, there is a direct financial incentive for the marketplace to ensure maximum sales affected through its platform. It must be noted that in these arrangements, the ultimate foreign investor is linked to the downstream marketplace entity. For example, Flipkart Singapore is the foreign investor and Flipkart marketplace is the downstream entity in India. This structure can be better understood from Figure 2.
From Figure 2, we see that, as the value of sales increases on the marketplace, its revenue (from commission per sale) increases, which means profit increases. These profits are passed on to the ultimate foreign investor holding shares in the marketplace entity.
The discounts could also be absorbed at the level of marketplace entities. For example, Amazon marketplace entity offers promotional funding to its sellers where Amazon recommends discounts which are eventually followed by its sellers. Thereafter, the sellers send a debit note to Amazon which is duly paid for by Amazon. This is indirect financing of discounts.
Entities like Paytm (Chinese firm Alibaba has investment in Paytm) runs a payment gateway and offers cashback on selected products after discussion with selected sellers. This is done to attract maximum buyers to make payment through this portal. The practice has been already brought to the notice of DIPP on the ground that Paytm is influencing the sales prices, and therefore, flouting the FDI policy. DIPP tweeted on this issue elaborating the law but did not take any stand on this specific issue.
While in a traditional marketplace, the pricing of product remains the prerogative of seller, in the complex world of e-marketplace, this may not be true. PN3/16 precisely aims to curb this practice and tries to ensure that the decision of giving discounts remains the prerogative of sellers. However, monitoring and implementation of this rider will be nothing less than a nightmare. It will be difficult to establish that the marketplace models are influencing the prices directly or indirectly.
Further, the term “influence” is broad and subject to different interpretations. Does it also include the practice of predatory pricing which may trigger the competition issue? Some marketplace entities show discounts as marketing or advertisement expenditure, a part of their earmarked marketing and promotion budget. Their argument could be that giving such discounts is a part of their advertisement campaign and they are not stepping into the domain of sellers. Hopefully, such creative accounting treatment would fall within the mischief of influencing sales price.
Besides, as demonstrated in Figure 2, discounts could also flow from the B2B leg to the B2C company. Pulling up marketplace model for influencing the prices will be difficult, under such circumstances, unless it is established that such marketplace has directly or indirectly influenced the sales price. Moreover, discounts are a prime force for these online platform to woo customers and it is unlikely that they are going to be discontinued easily. While the customers addicted to discounts need not start worrying at this point of time, the policymakers through PN3/16 have tried to curb the practice of surrogate discounting adopted by marketplace models.
Other Impacts of FDI Guidelines
Entities like Amazon and Flipkart have been locking horns in the past with the value added tax (VAT) authorities in states like Karnataka and Tamil Nadu. The basic issue is that an entity like Amazon has been treated as “commission agent” of the sellers under the respective VAT legislations, because of various services like storing of goods in their godowns, assurances to retail customers, etc, rendered by Amazon on behalf of its B2C entity.
Obviously, these services are rendered to attract both sellers and customers for the generation of maximum revenue for the marketplace. However, this has invited troubles and eventually slapping of hefty tax demands by the VAT authorities. PN 3/16 allows marketplace models to provide warehousing, logistic services, order fulfilment, payment collection and other services. The PN3/16 has also defined several terminologies like e-commerce, e-commerce entity, inventory based model and marketplace based model, as the lack of definition of these essential terms had only contributed to a policy vacuum resulting in more legal disputes (DIPP 2016a, para 2.1).
Further, to draw a distinct demarcation between the marketplace and inventory place model, there are additional conditions to be fulfilled by the marketplace entities like no ownership over the inventory; else the same is to be treated as inventory-based model. The guidelines also prescribe that activities like post sales, delivery of goods or services to the customers, customers responsibility, obligation of guarantee/warrantee must vest with the sellers (DIPP 2016a).
This would certainly impact the marketplace entities who have been offering these services to attract maximum traffic on its site. This clarity was much needed, and it would be correct to say that for the first time, the detailed constituents or attributes of a pure marketplace model has been spelled out in the Indian FDI policy. Let’s hope these clarifications would bring a fresh perspective to the ongoing legal disputes between the marketplace entities and the VAT authorities and also provide the much needed consistency in policy.
While one may argue that PN 3/16 merely restates the policy of the government in explicit terms, that is, to allow FDI in marketplace model and not to allow FDI in inventory business model. The riders are a clear indication to tighten the screws on alleged back-door entry of marketplace models into retail e-commerce. However, it is unlikely that the marketplace entities are going to toe the line and not create convoluted structures instead.
Although PN 3/16 is likely to have a prospective operation, the guidelines may influence the course of pending litigation in the Delhi High Court between the offline and online retailers, where the brick and mortar retailers have accused the online players of flouting the FDI rules.2 These new guidelines are also an attempt by the government to pacify the offline retailers by spelling out the grey areas so the scope of convenient interpretation by the online retailers is reduced.
But a pertinent question arises here: how long is the government going to don the cap of referee, balancing the equation between the two formats of the game? Should not the market forces be left to decide the survival of the fittest? Moreover, there is enough evidence to suggest that offline retailers have been actively collaborating with these marketplaces which has allowed them access to wider market and better revenue. How long will this dual policy for online and offline retail continue with unique concepts like single-brand retail and multi-brand retail, adding only more complications for the policymakers and a state of uncertainty for the businesses?
PN3/16 has acknowledged the reality of foreign investment in marketplace entities and formalised the same. Going ahead, the law will have to accept the changing dynamics of e-commerce and allow retail sales by marketplace entities, so the players are not forced to come up with layers of complicated structuring to somehow only to give a semblance of compliance.
For the time being, if the architects behind the complex maze of marketplace models find it too onerous to comply with the new requirements of PN3/16, probably they would prefer to devise an alternative structure so they fall out of the scope of applicability of FDI guidelines. If they choose to do so, they would have to snap the ties between the marketplace entity and the foreign holding entity and create a new form of holding entity whose investment in the marketplace model is not tagged as FDI. This way they may avoid making other complex changes in terms of discounting strategy (for passing and absorption of discounts), manner of procurement of goods by B2C leg from B2B leg and so on. The speculation about the new cobweb structure will be put to rest only once the e-commerce giants complete their internal restructuring.