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Jun, 01 2009

Retail franchise business - Investment climate update

The current financial crisis has affected markets across the world and India is no exception.

The current financial crisis has affected markets across the world and India is no exception. Several industries in India are facing slowdown in their progress which includes retail industry as well. The current market slump has caused consumers to reduce their spendings, which has resulted in slow progress of retail sales. Although the retail industry in India is going through a tough phase, we hope that things will turn around fast and the current phenomenon is over soon. Retailers should be looking at innovative solutions to ride over the slump and create opportunities for growth.
The current slowdown in world markets should not affect India`s position as a favourable investment destination for foreign investors. India is a member of the GATT (General Agreement on Tariffs and Trade) and is a signatory to the WTO (World Trade Organisation) and Intellectual Property laws - TRIPS (Trade Related Aspects of Intellectual Property Rights). As such, India provides for a conducive business environment, well supported by professional audit and accounting firms and qualified corporate law practitioners.

Retail business in India

Trading in India by foreign entities may be in various forms. Some of the common routes available to foreign entities are Wholesale Cash and Carry, Single Brand Retailing, Franchising, Distribution Model and Manufacturing Model, etc. Some of the available routes are discussed herein below.

Wholesale Cash and Carry

In Wholesale Cash and Carry sector, FDI upto 100 per cent is allowed under the Automatic Route. The term `Wholesale Cash & Carry` has not been statutorily defined anywhere in India. However, in Federation of Associations of Maharashtra and Others Vs. Union of India and Others (2005), the Delhi High Court has clarified that it is the `business-to-business` sale that is permissible. Sale is not for end-consumers, but to businesses having valid sales tax registration or valid trade license. It also appears that in `Wholesale Cash & Carry Business`, supply against credit is not allowed.

Although the cash and carry sector has been liberalized for sometime now, foreign investment in such sector has been slow, and is slowly picking up. Germany`s retail major Metro Cash & Carry was the first foreign entity to enter the Indian market through the Wholesale Cash & Carry model.

Single brand retailing

For retail trade of `Single Brand` products, upto 51 per cent FDI is allowed with the prior approval of the Government of India through the Foreign Investment Promotion Board (FIPB), subject to certain conditions.

In effect, a foreign entity contemplating single brand retail trade in India may enter into joint venture with its Indian counterparts to the extent of 51 per cent paid-up equity share capital in the Joint Venture Corporation (JVC). Incorporation of a JVC would mean inflow of foreign investment in the form of participation in the securities of the JVC by the foreign investor and such participation in securities of an Indian company by the foreign investor will come under the ambit of Foreign Direct Investment (FDI).

Under the above routes, foreign companies can retail their products in Indian market without entering into franchising agreements with third parties.

Franchising

In case of franchising, the foreign entity can directly enter into Franchising Agreement with Indian entities and expand its business in India.

However, it is has been often observed that many foreign entities prefer setting up a wholly owned subsidiary in India and thereafter enter into Master Franchising Agreement with its wholly owned subsidiary. In turn, the wholly owned subsidiary, which is now the master franchisee, enters into Franchising Agreements with the Indian entities.
The `Franchising Agreement`, provides for the understanding between the franchisor and the master franchisee, to carry out franchise in India.

Franchising Agreement between a foreign and an Indian entity, does not require approval from the Government of India. Franchising in India through such franchising agreements do not involve inflow of foreign capital investment. The foreign franchisors generally do not contribute capital and is more concerned with developing the master franchisee`s business in India in terms of training the personnel of the master franchisee, sharing intellectual property rights, like trademark, trade secrets, other proprietary business information through licenses, offering consulting services, etc.
There are other ways in which a foreign franchisor can consider supporting its master franchisee and other sub-franchisees in India. By way of example, a foreign franchisor can consider providing logistic support, (like transportation of raw materials, end products to the franchisees or providing warehouse facility, etc.). A foreign franchisor can also set up Whole Sale Cash and Carry Business requiring the master franchisee and the sub- franchisees to obtain raw materials from therein.

Royalty & other consultancy fee

Under foreign exchange regulations, the foreign franchisor is allowed under the Automatic Route to charge royalty upto 5 per cent on local sales for use of foreign technology. As such, a franchising agreement may provide for provisions for the payment to the franchisor within the limit prescribed by the said regulations for which no prior approval is necessary. In case the Franchising Agreement provides for remittances beyond the limit as aforesaid, the franchisee will need to obtain the prior approval of the Government of India through the FIPB. The franchise agreement may provide for payment to the franchisor in lumpsum. The said regulations allow lumpsum payment upto US$ 2 million under the Automatic Route and any lumpsum in excess of US$ 2 million will require the approval of FIPB.

Payment of royalty upto 1 per cent for domestic sales is allowed under automatic route for use of trademarks and brand name of the foreign collaborator without technology transfer. Royalty on brand name/trade mark is required to be paid as a percentage of net sales (gross sales less agents`/dealers` commission, transport cost, including ocean freight, insurance, duties, taxes and other charges, and cost of raw materials, parts and components imported from the foreign licensor or its subsidiary/affiliated company).

A Franchisor may additionally provide other consultancy services, in view of the existing foreign exchange regulations permitting remittances from India upto US$ 1,000,000 (One million) per project under the Automatic Route. Payment for consultancy services in excess of the said amount will require prior approval of the Reserve Bank of India.

Taxation & royalty

Taxation (e.g income tax, withholding tax, service tax) is another aspect which requires due consideration in franchise form business formats. The responsibility of payment of tax for franchise business in India is an important aspect. Under the Indian income tax laws, income of the master franchisee shall be taxed in India as income accruing or arising in India and payable by the master franchisee. Payment of royalty and fees for technical services by the master franchisee to the franchisor shall be taxed in India as income accruing or arising in India and payable by franchisor at such rates as prescribed under the Indian Income Tax Act. However, payment of tax by the franchisor in India shall be subject to provisions of the `Avoidance of Double Taxation Agreements` between India and the country of origin of the franchisor.

Service Tax for providing franchise services would be payable by the franchisee @ 12 per cent of the value of franchise service.

Under the Research & Development Cess Act, 1986, cess is levied on all payments made towards import of technology, at a maximum rate of 5 per cent. Such cess becomes payable on or before making any payment towards such import of technology. The term “Technology” has been defined under the said Act to mean `any special or technical knowledge or any special service required for any purpose what so ever by an industrial concern under any foreign collaboration, and includes designs, drawings, publications and technical personal.`

Conclusion

Although Franchising is still at an early stage in India, it has been making steady progress. Franchise as an option to invest in India may co-exist with other forms of investment models. Even if 100 per cent FDI is permitted under the retail sector, it would not hamper the franchise model because overseas investors who are not willing to invest capital and take risks may look into franchise model to enter the Indian market. As such, Franchise provides for an alternative to overseas investors that do not want to invest capital (in the form of FDI) not only in sectors which have not opened up but also in those sectors where FDI is permitted. Thus Franchise model remains an investment option and creates a platform for many overseas investors intending to tap the Indian market.

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