India remains a market with rapid-growth potential despite the inflationary pressures and fallout from the euro-zone crisis that have slowed economic growth substantially since the end of 2011. The country, the world’s second-most populous, has an expanding middle class of consumers, an improving infrastructure, and a young, innovative workforce.
Ernst & Young’s most recent Global Capital Confidence Barometer rated India No. 3 among top investment destinations, behind China and the United States and ahead of Brazil and Germany. But in India, regulations can be cumbersome, enforcing contracts is difficult, and corruption remains a problem, according to an E&Y risk assessment for rapid-growth markets. To help navigate the obstacles, JofA Senior Editor Sabine Vollmer asked Vikas A. Sekhri, lead tax director of transactional advisory services at accounting and consulting firm McGladrey, to provide a perspective on India’s business and accounting environment.
LEGAL / REGULATORY
Vollmer: What are the available forms of organization for doing business in India (simplest to most complex)?
Sekhri: The principal forms of business organizations are sole proprietorships, partnership firms (legal entities that do not have to be registered if they consist of fewer than 20 partners), limited liability companies (public and private), limited liability partnerships, trusts, and liaison offices, project offices, or branch offices of foreign corporations. Out of these, the most commonly used by foreign businesses are limited liability companies, branch offices, liaison offices, and project offices.
The choice of entity depends on various factors, including ease in setting up, type of activities intended to be performed in India, and need to obtain government approvals. Branch offices, liaison offices, and project offices can be characterized as unincorporated forms of businesses that foreign entities are allowed to have in India. These unincorporated forms are typically chosen by the foreign entities if they expect to have limited operations in India, at least in the short term. The activities that can be undertaken within these unincorporated forms are generally limited. Foreign companies engaged in manufacture and trading activities abroad have been allowed to set up branch offices in India. While the branch offices in India cannot be engaged in manufacturing or processing activities in India and cannot be engaged in retail trading, those offices can import/export goods, render professional or consulting services, carry out research work, and act as buying or selling agents for the foreign parent or other foreign group companies. Approvals from the Reserve Bank of India, India’s central bank, are required to set up branches or liaison offices.
If a foreign entity wants to undertake any activities in India that are beyond the scope of a branch, liaison office, or a project office, then it should consider setting up a corporate subsidiary in India—either wholly owned or with a joint venture partner. Government approvals might be required to set up an Indian subsidiary primarily depending upon the nature of the business of the entity.
Vollmer: What do companies need to understand about protecting intellectual property in India?
Sekhri: As a founding member of the World Trade Organization, India has ratified the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS). TRIPS requires member countries to abide by the mutually negotiated norms and standards with respect to intellectual property rights. To this effect, India has a comprehensive set of initiatives to streamline its intellectual property rights regime. These initiatives include introducing new laws and amending existing laws to protect the intellectual property of the holders. Further, an office has been set up under the Department of Industrial Policy & Promotion to administer all matters relating to patents, designs, and trademarks. A copyright office has also been set up in the Department of Higher Education of the Ministry of Human Resource Development to provide all services including registration of copyrights.
Under the current law, copyright and trademark infringements are characterized as “cognizable offenses,” which means that police have expanded search and seizure authority and can make arrests without having a warrant from the court. The law provides for minimum criminal penalties, including mandatory minimum jail terms.
Despite these efforts, the enforcement of copyrights and other intellectual property rights remains a problem in India. Intellectual property rights enforcement has been largely delegated to state, local, and municipal authorities, which many times have proven ineffective in stopping infringement. Further, due to backlogs in the court system and lengthy procedural requirements, the adjudication of cases is often very slow.
Vollmer: What are the key aspects of India’s labor environment to consider?
Sekhri: India’s working population primarily consists of an organized workforce, an unorganized workforce, and the self-employed. The organized sector accounts for only about 10% of India’s labor force but earns about 25% of the nation’s total wages.
About 2% of India’s workforce has undergone skills training, according to the Federation of Indian Chambers of Commerce and Industry.
The laws governing labor in India are complex in nature and generally favor the employees. The laws provide for some mandatory employee benefits, but many apply only to low-wage earners. For example, medical care is provided for low-wage earners, but employees with higher wages tend to pay out of pocket for their medical care. Some of the mandatory benefits that employers are required to pay to employees include gratuities, bonuses, employee state insurance, and deposit-linked insurance. Further, states typically provide for minimum wages to be paid to employees in their jurisdictions.
Vollmer: Can you share some basics on Indian currency laws?
Sekhri: Prior to 1991, foreign direct investment in India was highly regulated and was not permitted in most of the sectors. The liberalization process, which started in 1991 and was followed by a second wave of reforms in the first decade of the 21st century, has opened the Indian economy for foreign investment in all sectors, barring a few sensitive ones. India has also taken various other measures like delicensing, permitting foreign institutions to invest in shares and securities of Indian companies, current account convertibility, and liberalizing exchange control regulations.
Even though the Indian exchange control laws are significantly more liberal now, they can still be burdensome for companies doing business in India. In some sectors, foreign direct investment may require government approval (for example, tea plantations, mining, broadcasting). Reserve Bank approvals are generally required to open a branch office or liaison office of a foreign company in India. There are stringent rules in connection with loans from lenders who are nonresidents in India (including loans by Indian subsidiaries from their foreign parents or other group companies).
But the rules regarding repatriation of profits by Indian subsidiaries or Indian branches of foreign companies have been liberalized, and no prior approval is generally required, as long as appropriate taxes have been paid by the Indian subsidiary/branch. A certificate from a chartered accountant is generally required for such repatriations.
Vollmer: How does India regulate foreign equity investments?
Sekhri: Foreign direct investment (FDI) in the shares or convertible debentures of an Indian company is allowed under two routes. Under the automatic route, the foreign investor or the Indian company does not need any prior approval from the Reserve Bank or the government. Under the government route, prior approval is required from the Foreign Investment Promotion Board, a government body. Note that, even under the automatic route, 100% FDI is not allowed for all sectors. For example, FDI in domestic airlines is generally allowed only up to 49%. Further, for some sectors, even though FDI is allowed under the automatic route, other regulatory approvals might be required (for example, investment in the insurance sector is subject to licensing by the Insurance Regulatory and Development Authority).
Editor’s note: India is overhauling its archaic income tax laws and laws dealing with indirect taxes, such as sales and service taxes and value-added taxes (VATs). Work on the Direct Taxes Code and the Goods and Services Tax is under way, and new laws are scheduled to take effect in 2013. For that reason, this article does not include tax information.
Vollmer: Are there restrictions on dividends and other fund flows out of India?
Sekhri: Generally, no prior approval is required for repatriation of profits by Indian subsidiaries or branches of foreign companies, as long as appropriate taxes have been paid by the Indian subsidiary/branch. A certificate from a chartered accountant is generally required for such repatriations.
Vollmer: What does a company need to understand about transfer-pricing regulations in India?
Sekhri: Indian transfer-pricing rules were introduced in 2001 and provide detailed guidelines to determine an arm’s-length price for international transactions involving associated enterprises. The methods provided to calculate the arm’s-length price include comparable-uncontrolled-price method, resale-price method, cost-plus method, profit-split method, and transactional-net-margin method.
Further, transfer-pricing regulations provide for recordkeeping regarding international transactions with associated enterprises. The penalties for nondisclosure of international transactions could be 2% of the transaction value apart from penalties for concealment of income, which range from 100% to 300% of the tax deemed to be evaded.
In order to bring certainty to the determination of the arm’s-length price, India recently introduced provisions for advance pricing agreements (APAs). An APA is an agreement between a taxpayer and the Indian revenue authorities on appropriate transfer-pricing methodology for a set of transactions over a fixed period of time in the future, not to exceed five years. APAs will include the determination of the arm’s-length price or specify the manner in which the arm’s-length price will be determined in relation to an international transaction. Similar to a private letter ruling [by the IRS] in the U.S., it is binding to the taxpayer and the revenue authorities for a particular transaction or a set of transactions only.
Vollmer: What are some basic strategies for managing exchange rate risk?
Sekhri: The best strategy to manage the exchange rate risk between any two currencies (including Indian rupees) is to hedge the foreign exchange risk or exposure. Exposure may arise out of investments made by a U.S. entity into India, funding the India business through U.S. dollar-denominated funds and for future earnings in Indian rupees. Investments made by the U.S. entity into India (in the form of equity) normally are hedged via a net investment hedge (NIH). For a hedge designated as NIH, the cost of the hedge (or forward points) does not go to the P&L but is booked in the balance sheet. Funding the business through U.S. dollar-denominated funds is typically hedged via an economic hedge. NIHs and economic hedges are both forward contracts but differ in the way they are accounted for. The cost of an economic hedge goes to the P&L.
With respect to future earnings, there is an exposure on the future earnings in Indian rupees, which in the corporate plan may be projected at a specific rate but, because of the currency fluctuation, actually gets converted at a different rate. This is an off-balance-sheet exposure and is generally hedged via forward contract or a nondeliverable forward.
Vollmer: How difficult is it to sell an Indian company?
Sekhri: The Companies Act, 1956, generally governs mergers and acquisitions in India, requiring approvals from various parties, including shareholders, directors, and creditors. An approval from the high court of the concerned state is also required in case of certain merger transactions.
The Competition Act, 2002, prohibits anticompetitive agreements and regulates the various forms of business combinations through the Competition Commission of India. It aims to restrict an acquisition, merger, or amalgamation which causes or is likely to cause an appreciable adverse effect on competition in the relevant market. Not all combinations call for scrutiny, unless the resulting combination exceeds the threshold limits in terms of assets or turnover as specified by the Competition Commission of India.
Further, the Securities and Exchange Board of India (SEBI) has issued guidelines to regulate mergers and acquisitions. The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, and its subsequent amendments aim at making the takeover process transparent and protecting the interests of minority shareholders.
If the transaction has foreign buyers or sellers, the parties must also comply with the government’s foreign direct investment policy and the Foreign Exchange Management Act, 1999. Compliance with income tax withholding provisions is also important.
Vollmer: What are some basics that Americans need to understand about Indian business culture? Are there differences from region to region?
Sekhri: India is a federal republic with 28 states and seven federally administered union territories, where more than 20 languages are spoken. English is the commonly used business language.
Of all the cultural influences that most impact Indian business culture, hierarchy plays the biggest role. The decision-making generally rests with senior-level people, and their authority is rarely challenged. Relationship building is the key in India, and Indians tend to deal favorably with those whom they know and trust.
Dealings with government happen at their own pace, and red tape is very prevalent in government work. Some states are considered more business-friendly than the others due to their policies and business focus.
Cricket, Bollywood, and politics (not necessarily in that order) are some of the favorite discussion topics among Indians. Use of creative ideas (or jugaad) to work around a problem—commercial, logistic, or legal—is very common.
Vollmer: What is the commercial lending environment like?
Sekhri: India has a vast network of commercial banks wherein nationalized banks, Indian private banks, and foreign banks compete with each other for almost all types of commercial banking business. While the State Bank of India is India’s largest nationalized bank, ICICI Bank is its largest private-sector bank. Further, most of the major banks from major countries are represented in India through their Indian branches or subsidiaries.
Banks typically lend on the strength of a company’s balance sheet, the length of cash cycle, and depending upon the credit products offered by the bank. A detailed due diligence by the banks is common practice, and banks generally require detailed documentation before granting the loan. Interest rates in India tend to be very high compared to the U.S.
Vollmer: How does trade credit work in India? What are the standard terms and conditions of buying and selling?
Sekhri: Trade credit is a major source of funding for businesses. It is the credit that the firms get from their suppliers. Companies can buy raw materials, components, stores, and spare parts on credit from different suppliers without making an immediate payment.
The period of trade credit depends upon various factors, including the nature of the product, the location of the customer, the degree of competition in the market, the financial resources of the suppliers, and the eagerness of the suppliers to sell their stocks. Availability of this type of finance is also connected to business volume. When the production and sale of goods increase, there is an automatic increase in the volume of purchases, and more trade credit is available. Generally, suppliers grant credit for a period ranging anywhere from one to six months and, thus, provide short-term finance to buyers.
Vollmer: Have your U.S. clients who opened operations in India made the money they expected?
Sekhri: Generally, yes. I think, despite the challenges that you may face, the opportunities offered by India far overweigh the challenges. The key for success is that you should do your homework and go there well prepared.
Sabine Vollmer is a JofA senior editor. To comment on this article or to suggest an idea for another article, contact her at email@example.com or 919-402-2304.
CGMA Magazine articles
- “CFO Optimism in India Declines in the First Half of 2012,” Oct. 16, 2012
- “Report: Euro-Zone Crisis Largely to Blame for Economic Slowdown in BRIC Economies,” Sept. 4, 2012
- “Rapid-Growth Markets Hit a Temporary Lull,” Aug. 13, 2012
- “Globalisation Risks Challenge Executives,” Feb. 29, 2012
- “Letter From… Delhi,” Jan. 30, 2012
- International Taxation: To and From the United States (#731898)
- International Versus U.S. Accounting: What in the World Is the Difference? (#745941)
- IFRS Certificate Program (#159770)
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