overcoming operational challenges of investing in india · 1 overcoming operational challenges of...

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Overcoming Operational Challenges Of Investing In India

Mark J. RiedyPartner, Andrews Kurth LLP1350 I Street, NWSuite 1100Washington, DC 20005 P: 202.662.2756F: 202.662.2739C: [email protected]

Doing Business in India:Critical Legal Issues for U.S. Companies

Sponsored by the Practicing Law Institute

New York, NY, February 14, 2007PLI New York Center

San Francisco CA, March 7, 2007PLI California Center

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I. INDIA VERSUS CHINA

India

A. FY 1991 – Liberalization begins.

B. FY 1992 - FDI inflow US$2 Billion.

C. FY 2003 – FDI inflow US$5.6 Billion.

D. FY 2005 - FDI inflow US$8 Billion.

E. FY 2006 – FDI inflow US$10 Billion.

F. FY 2007 – FDI inflow Projection – US$13 Billion

China

A. FY 1978 – Liberalization begins.

B. FY 1992 – FDI inflow US$11 Billion.

C. FY 2003 – FDI inflow US$53.5 Billion.

D. FY 2005 – FDI inflow US$60 Billion.

E. FY 2006 – FDI inflow US$69.4 Billion.

F. FY 2007 – FDI inflow Projection – US$75 Billion Plus

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1. India accounts for 1.3% of world export of goods and services and 0.8% of world FDI; while China accounts for 6.6% and 8.2%, respectively. Thus, India must grow faster – its poor infrastructure holds it back.

2. Indian economy grew 9.3% in the quarter ended on March 31, 2006, 8.9% in the quarter ending June 30, 2006, and 9.2% in the quarter ending September 30, 2006. This growth displays momentum on par with China’s growth of 9.9% in 2005. China’s economy has grown by 10.2%, 9.8%, 10.4% and 10.7% in the first, second, third and fourth quarters of 2006.

3. India’s’ early, and strong 2006 Monsoon, always a good indicator of growth, has made for a continued significant annual growth of well over the projected 8% to 9% plus. In FY 2004-2005, India’s economic growth was 7.5%; while in FY 2005-2006, it grew by 8.4%.

I. INDIA VERSUS CHINA (cont.)

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4. India’s manufacturing sector in FY 2006-2007 is expected to grow from 9.1% to 11.3% (November 2006 was 15.7%); while service sector growth is anticipated to increase from 9.8% to 11.2%.

5. The GOI’s inflation number of 6.1% (as of January 6, 2007) for the first 9 months of FY 2006-2007 is very close to, but to date has exceeded, its 5.5% annual prediction, which means that India’s economy is dangerously overheated from an economic perspective.

6. Notwithstanding, a recent PriceWaterhouse Report (April 2006), states that India’s economy with an average annual growth rate of 7.6% will have the fastest rate of all major economies of the world in the next 50 years.

I. INDIA VERSUS CHINA (cont.)

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II. TIMELINE OF ECONOMIC REFORM

1947: India achieves independence from Britain; embarks on socialist economic policies.

1991: Foreign currency crisis, prompted by rising oil prices, forces India to open up to foreign trade & investment.

1998: India tests nuclear weapons; U.S. and other nations introduce economic sanctions.

2001: U.S. lifts economic sanctions.2004: Congress Party wins a surprise victory in national election. 2005: U.S. and India sign framework agreement for civilian

nuclear cooperation.2006: U.S. House and Senate pass civilian nuclear legislation by

overwhelming margins and President Bush signed it into law in late 2006.

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III. INDIA’S ECONOMY IN A NUTSHELL

A. India’s foreign exchange reserves grow from US$160.677 Billion since early 2006 to over US $180 Billion today (versus China at more then US$1 Trillion).

B. Sectors with least regulation have grown the fastest.1. Film production (largest film industry in the world).2. Cable TV distribution (over 70 Million homes with cable).3. IT/ IT services (US$17 Billion in exports in ’05).4. Pharmaceuticals (9th largest in the world).5. Informal retail - Mom & Pop Shops (informal retail accounts for

97% of retail sales).C. India is trying to balance the desire to regulate the

unregulated (e.g. Film, Cable TV, IT/IT Services, Pharmaceuticals, Information Retail) sectors, while de-regulating other sectors. India often defaults to creative taxation when it cannot regulate directly.

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III. INDIA’S ECONOMY IN A NUTSHELL (cont.)

D. India ranks as a top investment destination:1. Top destination for retailers in AT Kearney’s Global Retail Development

Strategy.2. Second most attractive destination for manufacturing investors as per AT

Kearney’s latest FDI confidence ranking.2. Leading destination for IT and IT enabled services with revenues of US$ 28.2

Billion in 2004-2005.3. Attracted more than 3 times foreign investment at US$7.96 Billion during the

first half of 2005-2006 compared to US$2.38 Billion during corresponding period of 2004-2005.

E. More than 50% of US Fortune 500 companies are outsourcing to India. Outsourcing in India is growing by more than 30% annually. Merrill Lynch claims that India’s outsourcing industry will create nearly 200,000 jobs per year in India, and require more than 15 million square feet of commercial space, alone, each year. Outsourcing in India in 2004 was a US$15 Billion business. In early 2007, this business is providing nearly US$47 Billion in annual revenues. By 2008, this business is expected to expand to US$50-US$60 Billion.

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0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

IV. INDIA’S GDP GROWTH RATE:1998-2006

1998-1999

1999-2000

2000-2001

2001-2002

2002-2003

2003-2004

2004-2005

2005-2006

2006-2007

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Growth of U.S.-India Bilateral Trade 2001-2006

0.00

5.00

10.00

15.00

20.00

25.00

30.00

V. GROWTH OF U.S.-INDIA TRADE:2001-2006

2001 2002 2003 2004 2005 2006

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VI. SKILLED MANAGEMENT BASE

A. Over 150 Million English speakers, with more than 1/3 of the 1.1 Billion population under the age of 25 years old.

B. World-class educational institutions.1. Indian Institutes of Technology.2. Indian Institutes of Management.

C. Salary for Indian employee with MBA approximately ¼ that of a comparable U.S. employee.

D. Salary for Indian IT employee approximately 1/8 that of a comparable U.S. employee.

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VII. NAVIGATING INDIA’S LEGAL SYSTEM

A. General1. Based on English Common Law/Parliamentarian System of

Government.2. Unitary court system – However substantial backlog/delays in

cases: If no new cases were filed, it would take approximately 350 years to clear current court case backlog (not including administrative judicial and quasi-judicial case backlogs).

3. Administrative judicial bodies.4. Quasi-administrative/judicial bodies.

a. Income Appellate Tax Tribunal (tax appeal matters).b. Advance Authority for Rulings (advance clarifications on tax

issues). c. Dispute Resolution Tribunal – Central Appellate Authority

(started – 2005) (mediation is final and binding).d. Debt Recovery Tribunal (used primarily by banks/financial

institutions to recover debt).

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VII. NAVIGATING INDIA’S LEGAL SYSTEM(cont.)

A. General (cont.)5. With 26% equity, a shareholder receives

negative veto rights (i.e., can advance a special resolution); while 76% equity provides a shareholder positive veto rights and complete control as the minority shareholder cannot block a special resolution.

6. India currently has no concept of preferred stock (but rather preference shares) or limited partnerships (only general partnerships are permitted).

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B. Tax & Corporate Structuring Issues for Investors1. Double Taxation Avoidance treaties (U.S., Mauritius,

Singapore, Cypress, UAE).2. Reduction of tax and non-tax liabilities through limited

liability vehicles/firewalls.3. Use of bilateral investment treaties/ agreements4. Treaties based on a combination of OECD and UN model

conventions.5. No anti-treaty shopping provisions in most treaties

makes for better investment structuring.


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B. Tax & Corporate Structuring Issues for Investors (cont.)6. Current Indian Tax Considerations.

a. 14.025% Dividends Distribution Taxb. 33.66% Indian Domestic Company Corporate Taxc. 41.82% India Tax on Foreign Corporationd. Capital Gains Tax

1) Long-term (>1yr)• listed securities – 0%• non-listed stock/other assets – 20%

2) Short-term (< 1 yr)• listed securities – 10%• nonlisted stock/other assets – 33.6%

e. Fringe Benefits Tax – 33.6%/on value of certain benefitsf. Transfer Pricing – new regulations up to 300% penaltiesg. Special Economic Zones (“SEZs”) have 100% tax holiday and

currently there are more than 237 SEZs with GOI approval, after the GOI lifted the 150 SEZ approval restriction.


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C. Changing Regulatory Environment1. Independent Regulators Set Up For:

a. Insurance ( Insurance Regulatory Development Authority - IRDA).

b. Telecom & Media (Telecom Regulatory Authority of India - TRAI).

c. Financial Markets (Securities & Exchange Board of India – SEBI and Reserve Bank of India - RBI).

d. Power Generation & Distribution (Central Electricity Regulatory Commission – CERC and State Electricity Regulatory Commissions - SERC, as power has concurrent jurisdiction and oversight).

e. Pension Fund Managers (PFRDA).


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C. Changing Regulatory Environment (cont.)2. FDI Allowed

a. Power – 100%b. Telecom – 74% (up from 26%)c. DTH Satellite – 20%d. Cable TV – 49%e. Internet – 100%f. IT/IT Services – 100%g. Insurance – 26%h. Banking – 74%i. Single Brand Retail – 51%

Multi Brand Retail – 0%j. Print Media – 26%k. Real Estate – 100% in certain sectorsl. Airport Infrastructure – 74%


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D. Expected Regulatory ChangesChanges expected to be seen in the following 12 months include:

1. Opening FDI investments into multi-brand retail trade (as the sector is currently limited to single-brand retail at 51% FDI). While nearly 97% of all Indian retail is conducted through informal, fragmented markets (approximately US $230 Billion), the formal retail industry is projected to grow by 400% in the next 4 years, or from US $7 Billion to US $30 Billion by 2010.

2. Increasing the FDI cap for insurance to 49% (from 26%) which is the only sector requiring legislation in lieu of a simple GOI Cabinet approval.

3. Amending the IT Act to strengthen cyber security laws. 4. Introducing a new content regulator for television.


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D. Expected Regulatory Changes (cont.)Changes expected to be seen in the following 12 months include:

5. Developing new pension fund management regulations.6. Further liberalization of foreign investment in real estate (which

presently allows 100% FDI in undeveloped non-agricultural real estate exceeding 25 acres or 50,000 square meters (or approximately 538,000 square feet), with a US$10 Million capital investment requirement locked-in for 3 years). India’s US $12 Billion real estate market is growing by 30% annually. A recent Merrill Lynch study predicts it will grow to US $90 Billion by 2016. Presently, the GOI suggests that there is a shortage of more than 100 million square feet of commercial office space in India. The real estate sector is the second largest generator of jobs in India, after the agricultural sector says the Federation of Chambers of Commerce & Industry (“FICCI”).

7. Banking FDI moving up to 74%; awaiting final implementing regulations.


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VIII.PROTECTING INTELLECTUAL PROPERTY

A. Patents 1. General

a. Until 2005, India did not grant product patents for Pharmaceutical products, Agrochemical Products, and Food Products.• Patented products could be “reverse engineered”

without incurring legal liability.• Only processes were protected by patent.

b. January 2005 – WTO’s Trade Related Aspects of Intellectual Property Rights Agreement (TRIPS) obligated India to provide IP protection for product patents in all fields of technology. This product and patent law was a struggle to achieve, taking nearly 15 years to accomplish it.

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A. Patents (cont.)1. Areas of Major Concern:

a. Pre- and Post-grant opposition at the patent examiner level.

No standing requirements.No necessary relationship to the matter at issue.No need for the challenger to demonstrate harm.

Anyone may challenge a patent application.Anyone may challenge a granted patent.Actual Impact – prejudices innovators – introduces additional and continuous delay and uncertainty.

VIII.PROTECTING INTELLECTUAL PROPERTY(cont.)

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A. Patents (cont.)1. Areas of Major Concern (cont.):

Established by the Government of India in 1995.Presently exploring whether India may limit protection to new molecular entities.

Would essentially limit protection to “blockbusters” or entirely new classes of drugs.Would not protect incremental or “follow on”innovation - the lifeblood of the pharmaceutical industry (i.e., new drug delivery systems, salts, esters, etc.).


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3. Data Exclusivity/Protectiona. Applies to Pharmaceutical and Agrochemical

Products. b. Protects valuable data such as clinical trial data.

– Required Under Article 39.3 of WTO TRIPS agreement. Data submitted as a condition for obtaining marketing approval cannot be disclosed to or relied upon by competitors for a set period of time. Obligates member countries to protect such commercially valuable data from: 1) unfair commercial use and 2) disclosure.

c. India’s current practice is to grant marketing approval to competitors based upon approvals granted to innovators in other countries. Competitors need not submit their own clinical trial or test data.

d. This practice is not in compliance with India’s obligations under Article 39.3.


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B. Trademarks and Copyrights1. Laws Largely in Place – Administrative

enforcement is the issue – However, Indian courts have ruled regularly in favor of IP rights holders.

2. Exception:a. India does not regulate the production of optical

discs (e.g., DVDs, CDs, Software).Seized discs are difficult to trace.Licensees can engage in “overproduction”.Production equipment can be moved to various locations.


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C. Non-tariff Barriersa. Depress supply of legitimate goods

Example: Retail did not open to FDI until 2006

Even now, it is not open to multi-brand retailersOnly single-brand retailers with FDI limited to 51% are allowed to operate in India

b. Prevents development of legitimate markets, implementation of best practices in logistics and secure supply chains


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D. Enforcementa. Court System Plagued by intractable delays.b. Lack of judicial and legal capacity.

Few judges and lawyers trained in IP law.New & complex cases set to enter system (i.e., product patents).

c. Serious “pirates” are not deterred by insufficient criminal and civil penalties – In criminal cases:

Enforcement is Conducted at the State, and not the GOI, Level.Sporadic State Government efforts - Lack of will - Lack of enforcement capacity.

d. Attitudes may be changing: Recent case involving Time magazine in which infringer was ordered to pay plaintiff’s costs and damages.Recent precedent-setting case in Delhi High Court, where sole proprietor of law firm was granted a permanent injunction against the use by an erstwhile employee of documents created while in employment, on the theory that the copyright vested in the proprietor of law firm, since the documents were “works” created in the course of a contract-for-service.


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E. Recent Developments: 1. Separate IP Tribunal may be established.

a. Few details known thus far.Unknown as to whether this expected new tribunal would have civil and/or criminal jurisdiction.

b. However, it represents a step in the right direction-Demonstrates a growing understanding of the impact of counterfeiting and piracy on such areas as tax revenue, innovation, and linkage to other criminality/ statutory violations.


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IX. PROTECTING YOUR INVESTMENTA. General

1. Engage Qualified Counsel, Accountants and Consultants at the Outset.2. Need for Upfront & Well-Considered Tax and Corporate Structuring.3. Due Diligence is Key.

a. Ensure that your partner is trustworthy and has the financial ability to implement the investment.

b. Enshrine IP protection in all contracts.4. Contracts Require Certain Protective Clauses.

a. Neutral-country arbitration is a must,e.g., London venue with ICC, UNCITRAL, London Court of International Arbitration Procedural Rulesif pressed into arbitration in India, bifurcate the arbitration clause so smaller disputes are arbitrated in India and larger ones are arbitrated in a neutral country.

B. A “forward waiver” provision requiring Indian joint venture partners to provide No Objection Certificates (“NOCs”) upon request of the U.S. partner to avoid future problems in entering into similar industry ventures with other parties. The foreign party in such circumstances must demonstrate that the new investment would not adversely impact the existing joint venture – Press Note No. 1 (2005 series) versus Press Note No. 18 (1998 Series)

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General: Contracts to Have Certain Protective Clauses cont.

b. Strong indemnification clauses.c. Force majeure – this provision permits suspension of contractual

obligations under certain circumstances.d. Compliance with U.S. Foreign Corrupt Practices Act (FCPA) and

Indian anti-bribery laws – accusations particularly can adversely affect public company stock.

5. Need for insurance requirements to protect transactions, such as political risk insurance against expropriation, etc.

6. Need for transfer pricing protective provisions particularly in related party (parent-subsidiary) transactions (e.g. outsourcing).

a. The Government Of India (GOI) is aggressive on transfer pricing requiring mandatory tax audits, if the annual aggregated contract amounts between related parties exceed a very low US$3.3 Millionthreshold (Rs. 15Crore) which previously was US$1.1 Million (Rs. 5Crore).

b. The GOI imposes the largest transfer pricing penalties in the world ranging between 100%-300% and without any benchmarks on applying this range.

IX. PROTECTING YOUR INVESTMENT(cont.)

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B. Investment Risks1. Taxation issues

a. India dramatically changes core tax rules regularly- usually not to the benefit of foreign investors.

b. GOI “virtual” permanent establishment (PE) cases (100% penalties and interest, plus an additional 8% (originally 18%) annual compounded interest if payments are not made to the GOI before contesting the assessment). The GOI attempts to assert tax jurisdiction over income, where the assessee does not have a demonstrated physical presence in India.

c. GOI’s new set of permanent establishment (“PE”) cases markedly have increased – recently a US$37 Million tax charge was imposed on one company for one assessment year (5 years ago) plus 100% penalties and interest measured from 5 years back. The GOI is going after the company’s world—wide income. It also could be hit in each of the next 4 assessment years since the original charge in a similar fashion. The total sum could be staggering, and will require years of litigation to resolve.

d. GOI is increasingly become more aggressive in transfer pricing cases. The Delhi Branch of the GOI Tax Department recently required more than 450 foreign subsidiaries to come in to prove they are not under invoicing but are transacting with arms length contracts even if they did not qualify for a mandatory tax audit. The GOI has been targeting private insurance companies with foreign partners, telecom operators and service providers.

e. Andrews Kurth recently won the largest tax award case in Indian history at the Income Tax Appellate Tribunal level. Wins at this level virtually never happen. It took 9 years to reach this victory.


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B. Investment Risks (cont.)2. India only has 16 years’ experience in opening markets. The regulatory

environment still evolving rapidly- expect change.3. Corruption is still rampant in India- not so much top-level corruption (e.g.

receipt of project permits as permit requirements are reduced), but “frictional”corruption across the lower levels - inspectors, meter readers, etc.

4. Choose your states wisely. Each has different level of development and different levels of market-friendliness.

5. Relations with key neighbors- China & Pakistan- as good as ever, but a positive course not set in stone.

6. Potential for radicalization of India’s government exists should economic reform program backfire. I think this risk is very low.

7. India has a growing Maoist movement- Naxalites- along eastern part of country. Appears to be growing.

8. State elections rarely are good for the incumbents. Expect political instability every 5 years, particularly at the state government level.

9. India still has antiquated labor laws, making it difficult to hire short-term workers or to lay off employees.

10. Contract sanctity remains a major stumbling block in many industries.


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C. Mitigating Investment Risks1. Use India’s tax treaty country partners as pass-through

(Mauritius & Singapore). 2. Encourage corporate culture of saying “no” to corruption.

Once a company is recognized as clean, attempts to collect payoffs will drop.

3. Join trade associations/ find sources of information to learn about and influence potential regulatory changes.

4. Do not “dip your toe in the water”. If you decide to enter India, it requires your full attention and commitment. In nearly every industry, foreign companies compete effectively and profitably.

5. Obtain political risk insurance from U.S. OPIC – a must for infrastructure projects.


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X. PROBLEM AREAS FOR INVESTORS

A. Restricted sectors or Low FDI caps - multi-brand retail trade (banned), insurance (26%), print news media (26%).

B. Power investments 1. Lack of contract sanctity (Dabhol Power Project/Tamil Nadu tariffs)2. Failure of states to uniformly apply the 2003 Electricity Act with

respect to 3rd party salesC. Purchase Preference Policy- gives state and GOI-owned companies

a 10% bid amount preference in government contracts.D. Television carriage regulations favor distributors (i.e. cable

companies), not content providers (i.e. companies that provide the channels).

1. Content providers are required to provide content to all distributors irrespective of price.

2. TRAI, the telecon regulator, has frozen cable TV, retail and wholesale rates at 2003 levels has.

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E. Foreign investors cannot invest in existing real estate assets, but can invest in undeveloped real estate.

1. Need for an independent real estate regulatory body (like TRAI – Telecon, IRDA –Insurance, SEBI – Capital Markets) is important.

2. Single window clearance should be introduced for central, state and local government permitting.

3. The Reserve Bank of India (RBI) is holding up the issuance by the GOI Securities & Exchange Board of India (SEBI) of the required Foreign Venture Capital Registrations (FVCIs) necessary for FDI real estate investments from foreign funds. Such FIPB approval is markedly-less beneficial for foreigner investors, as those investors will encounter onerous GOI share pricing compliance and other problems at investment exit. Hopefully this problem will be cleared up shortly.

F. Need for independent regulator for oil & gas distribution.1. Administrative Price Mechanism presently distorts the market and makes private

distribution uneconomical.G. Increase the default limit for Foreign Institutional Investor (“FII”)

investments - 24% equity now – seek to be in-line with sector FDI caps.1. An FII can only invest up to 24% in an Indian company, except for special

approval from the RBI.

X. PROBLEM AREAS FOR INVESTORS(cont.)

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H. Need to stabilize tax environment- tax regulations change frequently, with tax incentives regularly added and dropped. Recently, the GOI Finance Ministry eliminated the 100% tax exemption on income earned by investors (“ROI”) and lenders (interest) for investments and loans into infrastructure projects. The removal of this important incentive will increase the costs of developing infrastructure projects.

I. Heavy regulation of labor- difficult to scale down jobs during economically-depressed times. Like the power sector, the labor sector is subject to “concurrent jurisdiction,”meaning that the central and state governments each may adopt regulations. This approach overly complicates the area.

1. Difficult to attract contract labor for short-term projects.2. If more than 100 employees, then one needs express approval from Ministry of Labor to eliminate

jobs/employees or generally downsize to restructure.3. Concerns exist over proposed “reservations,” i.e., India’s version of affirmative action being applied

to the private sector.J. Requirement for No Objection Certificate (“NOC”) from a previous JV partner where

subsequent investment is in the same field – potential for abuse. While Press Note 1 (2005 Series) is an improvement over Press Note 18 (1998 Series), it still leaves uncertainty for foreign investors.

K. Poor Infrastructure acts as deterrent to foreign investment in manufacturing sector – must privatize government-owned enterprises to attract substantial necessary foreign capital.

L. High Tariffs – must lower tariffs on raw materials & imported goods, move IT & telecom products into zero duty schemes – India continues to have the highest customs duty rates in Asia, if not the world.


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M. Must rationalize complex transfer pricing rules & reduce penalties – increase the low US $3.3 Million level of permitted transfer pricing before a mandatory audit is initiated.

N. Expiration of the Software Technology Park 10-year tax exemption in 2009, unless extended. Moving the existing, or creating new, IT companies (to get around the expiration of the tax exemption) at the end of the tax holiday into a Special Economic Zone (SEZ) to obtain the benefit of the SEZ 10-year holiday is not achievable under the current SEZ statute.

O. Must rationalize GOI procurement processes and licenses – ending the 10% state and GOI-owned company purchase preference agreement and adopt international best practices.

P. Foreign Banks must be allowed greater market participation to augment the development of the banking market and introduction of new products and services.

Q. Unregulated IT/BPO sector.1. additional training for criminal investigators, judges and lawyers.2. improvement in tax environment.3. inflexible labor regulations must be made flexible.

R. Must permit greater FDI in the agro- and food processing areas, as the agricultural value-chain in these areas are substantially restricted.


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XI. CONCLUSION

In nearly every sector of the economy, there are examples of foreign investors

who have had success in India.

Don’t be deterred by initial problems. Plan your investment well. Remain

committed. And be prepared for an exciting time.

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Contact Info:

Mark J. RiedyPartnerAndrews Kurth LLP1350 I Street, NWSuite 1100Washington, DC 20005

P: 202.662.2756F: 202.662.2739C: 703.201.6677

[email protected]

USIBC1615 H Street, NWWashington, DC 20062

P: 202.463.5679F: 202.463.3173

[email protected]

www.usibc.com

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