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Chapter 2

THEORETICAL FRAMEWORK OF FDI AND

POLICY INITIATIVES OF INDIA

Foreign Direct Investment (FDI) acquired an important role in the international

economy after the Second World War. Theoretical studies on FDI have led to a better

understanding of the economic mechanism and the behaviour of economic agents,

both at micro and macro level allowing the opening of new areas of study in

economic theory.

To understand foreign direct investment must first understand the basic motivations

that cause a firm to invest abroad rather than export or outsource production to

national firms. The purpose of this unit is to identify the main trends in FDI theory

and highlight how these theories were developed, the motivations that led to the need

for new approaches to enrich economic theory of FDI.

Foreign direct investment (FDI) in its classic form is defined as a company from one

country making a physical investment into building a factory in another country. It is

the establishment of an enterprise by a foreigner. Its definition can be extended to

include investments made to acquire lasting interest in enterprises operating outside of

the economy of the investor. The FDI relationship consists of a parent enterprise and a

foreign affiliate which together form a multinational corporation (MNC). In order to

qualify as FDI the investment must afford the parent enterprise control over its

foreign affiliate. The International Monetary Fund (IMF) defines control in this case

as owning 10% or more of the ordinary shares or voting power of an incorporated

firm or its equivalent for an unincorporated firm; lower ownership shares are known

as portfolio investment.

2.0 Forms of FDI

The Forms of FDI include:

Purchase of existing assets in a foreign country.

New investment in property, plant, equipment.

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Participation in a joint venture with a local partner.

Transfer of many types of assets like human resources, systems, technological

know-how in exchange and equity in foreign companies. An example, Westin

Hotels transferred reservation systems, managers and cost control systems.

Export of goods and equity. They method many not be used in the initial stage of

the establishment of a company.

Through Trading in Equity: Companies also invest in the equity of and foreign

companies by purchasing the equity shares of a foreign company. An example,

KLM of Netherlands acquired the equity of Northwest Airlines of USA by

giving the KLM equity shares to the Northwest Airlines’ Owners.

2.1 International Investment Theories

Neoclassical theory (of international trade and investment) points out that location,

timing and mode of investment are inspired by scale and scope advantages through

FDI. Beside economies of scale, product differentiation, imperfect competition and

trade costs determine the location decision (Krugman, 1991), Krugman, Venables

(1994). Barrell and Pain (1999) summarize these determinants as centripetal and

centrifugal forces leading to centralization or decentralization of foreign investment.

Neoclassical trade theory failed to explain the existence of Multi National

Corporations. Explanations in terms of differences in rates of return between countries

could explain portfolio investments, but foreign direct investments (FDI). It was not

until Hymer presented his work, in 1960, of foreign direct investments and

multinational enterprises that a satisfying explanation was at hand. Transaction cost

theory explains both the ownership decision and the way of growth decision as a way

to minimize transaction costs, due to specific assets (Hennart, 1994). The theory of

incomplete contracts and property rights view of the firm shows that a higher share of

ownership must be given to the party of the transaction that has the greatest ex-post

bargaining power over the division of the surplus. Resource-based theory sees FDI as

an attempt to apply under-utilized productive resources to new business opportunities

abroad. In organizational learning theory, the establishment mode is determined by

the potential firms have to understand knowledge (Barkema, Vermeulen (1998),

Hymer (1976)). Finally, the entry mode decision is not taken in isolation. Global

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strategy and global competition plays in determining the appropriate entry mode (Hill,

Hwang, Kim, 1990)

After all these different attempts to explain why FDI took place and the pioneering

work by Hymer (1976), the conceptual framework used until very recently was the

one proposed by Dunning (1977), the OLI paradigm.

International investment theories include:

Ownership Advantage Theory

Internationalisation Theory

Dunning’s Electic Theory

Factor Mobility Theory

Product Life Cycle Theory

2.1.1 Ownership Advantage Theory

Caterpillar in order to utilize its technologies and brand name more extensively

established its manufacturing facilities in Europe, North America, South America and

Asia. And for the same reason, Komastu – the rival of Caterpillar – also established

manufacturing facilities in the USA, Europe and Asia. Similarly Dr. Reddy’s Lab

started its operations in Europe and South Africa. These companies have the

competitive advantage domestically in technology and brand name and established

their operations in foreign countries in order to utilize these competitive advantages.

Thus, the ownership advantage theory states that the firms having competitive

advantage domestically derived from its valuable assets like technology; brand names

and large scale economics extend their operations to foreign markets through FDI.

2.1.2 Internationalisation Theory

The ownership advantage theory states that companies with domestic competitive

advantage enter foreign markets to utilize their assets. It fails to explain the means of

entering foreign markets to exploit the ownership advantages. Internationalisation

theory solves this problem. Companies enter foreign markets through various means

like licensing, franchising, exporting etc., by entering a contract with foreign firms.

The domestic companies have to negotiate, monitor and enforce a contract which

involves a transaction cost.

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This theory tries to explain the growth of transnational companies and their

motivations for achieving foreign direct investment. The theory was developed by

Buckley and Casson, in 1976 and then by Hennart, in 1982 and Casson, in 1983.

Initially, the theory was launched by Coase in 1937 in a national context and Hymer

in 1976 in an international context. In his Doctoral Dissertation, Hymer identified two

major determinants of FDI. One was the removal of competition. The other was the

advantages which some firms possess in a particular activity (Hymer, 1976).

Buckley and Casson, who founded the theory, demonstrates that transnational

companies are organizing their internal activities so as to develop specific advantages

which then to be exploited. Internalisation theory is considered very important also by

Dunning who uses it in the eclectic theory but also argues that this explains only part

of FDI flows. Hennart (1982) develops the idea of Internationalisation by developing

models between the two types of integration: vertical and horizontal.

Hymer is the author of the concept of firm-specific advantages and demonstrates that

FDI takes place only if the benefits of exploiting firm-specific advantages outweigh

the relative costs of the operations abroad. According to Hymer (1976) the MNE

appears due to the market imperfections that led to a divergence from perfect

competition in the final product market. Hymer has discussed the problem of

information costs for foreign firms respected to local firms, different treatment of

governments, currency risk (Eden and Miller, 2004). The result meant the same

conclusion: transnational companies face some adjustment costs when the

investments are made abroad. Hymer recognized that FDI is a firm-level strategy

decision rather than a capital-market financial decision.

Internalization theory states that the domestic company enters a foreign market

through FDI when the cost of transaction with a foreign firm by high. The domestic

company under these conditions internalizes its production, marketing and other

operations in foreign markets through FDI. Toyota could not shift its competitive

advantages viz., high quality and sophisticated manufacturing techniques through

franchising or licensing to a foreign firm – as it involves high cost of transaction.

Therefore, Toyota internalized its US operations through FDI. In contrast Mc Donald

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and Federal Express entered foreign markets though franchising as they could shift

their competitive advantages including brand names to their franchises in foreign

countries.

2.1.3 Dunning’s Eclectic Theory

Internalization theory fails to explain the reason and locate manufacturing facilities in

a foreign country. In fact, companies locate their manufacturing facilities in a foreign

country when there is location advantage. John Dunning incorporates location

advantage in addition to ownership advantage and internalization advantage in his

Eclectic Theory of FDI. This theory states that FDI reflects both international

business activity and business activity internal to the firm. According to Dunning

location – specific advantages are derived by combining the advantages of country

location like assets, mineral, human and other resources with the specific advantages

of the firm like technology, technical know – how, management, marketing

capabilities etc. According to him companies go to get the competitive advantages by

consuming resource endowments of the host country and unique strengths of the

company. An example, Electrolux established its plant in China to take the advantage

of low cost labour.

Illustration 2.1 Dunning’s Eclectic Theory

FDI will occur when the three conditions are satisfied. They are: ownership

advantage, location advantage and internalization advantage. (Refer Illustration 2.1)

Ownership Advantage: The ownership advantages include brand name,

technology and large scale economies. The firm should have the competitive

advantage in ownership to compete in the foreign markets. Caterpillar has the

Location Advantage: Location specific factors. These are external

to the firm including factor endowment, transportation cost, government regulation,

and infrastructure factors.

OLI

Ownership Advantage: Firm specific factors including:

technology, patent, process, name recognition,

and other core competencies.

Internationalization: Cost advantage from vertical and horizontal integration, due to transaction cost caused by market failure

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advantage to compete against the local companies in Brazil. Coca-Cola has

the advantage to compete against soft drink companies in India.

Location Advantage: Locating manufacturing facilities in a foreign country

should be advantageous than operating from the domestic country. US

Software companies enjoy lower labour costs by locating in India. Japanese

automobile companies avoid high import tariffs by locating their

manufacturing facilities in the USA.

Internalization Advantage: As explained earlier it is advantageous to a

domestic company to go with FDI when cost of monitoring, enforcing a

contract is costly and practically difficult.

2.1.4 Factor Mobility Theory

Factor endowments including capital vary among countries. Some countries are rich

in capital whereas other countries suffer from the problem of paucity of capital. There

would be pressures and capital flow from those countries where it is available

abundantly to the other countries. The return on capital would normally be less in

capital abundant countries and more in capital scarcity countries. The return on capital

normally flows from those countries where the return on capital by low to those

countries where the return on capital by high.

Capital mobility through direct investment often stimulates trade because of the need

and the components, complementary products and equipment and subsidiaries. In

addition, FDI enhances exports.

2.1.5 Product Life Cycle Theory

Raymond Vernon’s product life cycle theory explains the pattern of FDI over time.

According to Vernon’s, the firms originally developed the product to establish

manufacturing facilities to produce the product in foreign countries. Xerox originally

introduced photocopier in the USA. It later spread the manufacturing facilities in

Japan, Great Britain and India. According to Vernon, firms establish manufacturing

facilities in foreign countries, when the product reaches maturity stage in the home

country. They invest in low cost countries when cost becomes a competitive edge.

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Vernon believes that there are four stages of production cycle: innovation, growth,

maturity and decline. According to Vernon, in the first stage the U.S. transnational

companies create new innovative products for local consumption and export the

surplus in order to serve also the foreign markets. According to the theory of the

production cycle, after the Second World War in Europe has increased demand for

manufactured products like those produced in USA. Thus, American firms began to

export, having the advantage of technology on international competitors.

Production moves from one country to another during the different stages of product

life cycle. Production takes place in industrial countries during the introductory stage.

Production moves to other industrial countries during the growth stage. Thus,

producer invests in various industrial countries during this stage. Production moves to

developing countries during maturity stage. In other words, the producer invests in

manufacturing facilities in developing counties during this stage, thus, capital moves

to other industrialized countries during growth stage and to developing countries

during the maturity stage of the product life cycle.

2.2 Factors Influencing FDI

Factors influencing FDI are of three categories viz.,

2.2.1 Supply Factors

Firms invest capital in foreign countries due to lower costs of business in foreign

countries. These include production costs, logistics, resource availability and access to

technology. Now, we discuss each of these aspects.

Production Costs: Companies invest in foreign countries in order to avail

the benefits of lower production costs like low labour costs, land prices,

commercial real estate rents, tax rates etc. Gum Sung plastics- a South

Korean firm- established its manufacturing facilities in Mericali, Mexico and

saved two thirds of the labour cost.

Logistics: If the costs of transportation from the domestic country to a

foreign market is high and or the time of transportation of the products to a

foreign market is long then the firms undertake FDI. Coca-Cola selected the

FDI strategy as the cost of transportation by heavy because most part of its

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product by water. Heineken also selected the strategy of FDI as it finds it

cheaper to brew its beverages in foreign locations where customers reside.

Availability of Natural Resources: Companies locate their production

facilities close to the source of critical inputs. The US based oil refining

companies established their oil refining facilities in Saudi Arabia and other

Gulf countries. However, some firms recently prefer FDI to develop

technology jointly with foreign firms.

Availability of Quality Human Resource at Low Cost: High quality

human resource contributes to high value addition to the product/service.

Further, if such human resource is available at low cost, the level of

productivity in monetary terms is higher and the cost of value addition is still

lower. As such high quality human resources at low cost attract FDI. India,

South Korea, Malaysia, China and Thailand attract FDI, as the cost of

operation of business in these countries is relatively less.

Access to Key Technology: Firms go with FDI in order to have access to

existing key technology rather than developing new technologies.

2.2.2 Demand Factors

Companies also select the FSI strategy in order to increase the total demand and their

products. These factors include: Customer access, marketing advantages, exploitation

of competitive advantages and customer mobility.

Customer Access: Certain business firms particularly fast food, service

oriented and retail outlets should locate their operations close to customers.

KFC, Toys ‘R’ us, Aetna locate their operations close to customers in order

to increase the demand and their products or services.

Marketing Advantages: Companies can enjoy a number of marketing

advantages by locating their operations in a host country. These advantages

include lower marketing costs, accessibility to hands – on experience

regarding customer and market handling, improving customer service etc.

Delta products of Taiwan-produces battery packs and laptop computers –

shifted its operation to US-Mexican border in order to meet the US customer

needs quickly and flexibly.

Exploitation of Competitive Advantages: Companies which enjoy

competitive advantages through trade mark, brand name, technology etc., go

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with FDI in order to exploit its competitive advantages in various foreign

markets. As explained earlier, the decision is based on the cost of contract

negotiation, implementation and control.

Customer Mobility: The companies which have one or a few customers

select the FDI strategy along with their customers.

In other words, the ancillary industrial units locate their production facilities in those

foreign countries where their parent companies locate their production facilities. The

business firms supplying parts to Japanese automobile companies located their

production facilities in the USA along with the Japanese automobile companies. Six

Korean parts suppliers to Samsung located their operations in England when Samsung

constructed its electronics factory in northeast England.

2.2.3 Political Factors

Companies enter foreign markets through FDI in order to overcome the trade barriers

imposed by the host country and/or to avail the incentives offered by the host

Governments.

Avoidance of Trade Barriers: Companies establish production facilities in

foreign markets in order to avoid trade barriers like high export tariffs,

quotas etc. Japanese automobile companies established factories in the USA

when the US Government increased import tariff rates in order to protect

domestic automobile companies.

Economic Development Incentives: Governments at different levels i.e.,

local, State and National levels offer incentives to attract domestic as well as

foreign investment. Indian Government as well as Government of Andhra

Pradesh offered a number of incentives to FDI. These incentives include low

tax rate, development of infrastructural facilities, employee training

programmes etc.

2.3 Reasons for FDI

As explained earlier, FDI is the ownership and control over assets held in foreign

countries. There are a number of reasons for FDI. These reasons include: increase in

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sales and profits, enter rapidly growing markets, reduce costs, consolidate trade blocs,

protect domestic markets, protect foreign markets, and acquire technological and

managerial know-how. Now, we shall discuss these reasons.

To Increase Sales and Profits: Companies invest capital directly in various

foreign countries in order to increase sales and profits. This is because

foreign markets offer more attractive opportunities for business than

domestic markets. For example, Mitsubishi, Toyota and Mercedes increased

their sales in the USA, whereas General Motors, Ford and Chrysler increased

their sales in Europe. Coca-Cola has been earning more profits in foreign

countries than in the USA.

To Enter Fast Growing Markets: Some international markets grow at a

fast rate than other markets. The fast growing markets provide better

opportunity to MNC for their business growth. IBM entered Japan laptop

market through FDI during the earlier 1990s as the Japanese laptop market

had grown by 40 per cent during that period.

To Reduce Costs: MNCs invest in foreign countries with view to reduce

cost of production and various other operations. This is due to the availability

of various inputs like raw material, human resources etc., at lower price in

foreign countries. Some of the software companies invested in India due to

lower human resource costs in India. Similarly, domestic companies invest in

foreign markets due to lower transportation costs and energy costs, Japanese

steel firms moved to the USA due to lower transportation. The US firms

moved to Mexico, South Korea, Taiwan, Hong Kong, India, China etc., in

order to utilize te opportunity of lower costs.

To Consolidate Trade Blocs: MNCs prefer to do business with other

member countries of the trade bloc. This is because the MNCs get

preferential treatment in doing business.

To Protect Domestic Markets: Some MNCs invest and operate in foreign

markets with a view to avoid the competition wit the weak domestic firms. In

other words, they leave the domestic market to the less competitive domestic

firms.

To Protect Foreign Markets: Some MCs invest in foreign countries in

order to protect foreign markets. British Petroleum invested in the USA and

protected the declining service stations.

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To Acquire Technological and Managerial Know-How: Sometimes the

technological and managerial know – how in various foreign countries might

be superior to those of domestic country. In such cases MNCs invest in

foreign countries in order to acquire the superior foreign technological and

managerial know-how. For example, the US companies acquired the

technological as well as managerial know – how from Japan by investing in

Japan. Kodak established the world class research facilities in Japan.

2.4 Costs and Benefits of FDI

FDI has its costs and benefits to the home country as well as host country. Now, we

shall discuss the costs and benefits of FDI to home country.

2.4.1 Benefits to Home Country

Inflow of foreign currencies in the form of dividend, interests etc. Nissan’s

profits repatriated to Japan are from its FDI in the UK. They helped Japan for

positive balance of payments.

FDI increases export of machinery, equipment, technology etc. from the

home country to the host country. This in turn enhances the industrial

activity of the home country.

The increased industrial activity in the home country enhances employment

opportunities.

The firm and other home country firms can learn skills from its exposure to

the host country and transfer those skills to the industry in the home country.

2.4.2 Costs to Home Country

There are costs to the home country, in addition to benefits form the FDI. They

include:

Home country’s industry and employment position are at stake when the firms

enter foreign markets due to low cost labour. The US textiles moved to Central

America. This resulted in retrenchment in USA.

Current account position of the home country suffers as FDI is a substitute for

direct exports.

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2.4.3 Benefits to Host Country

Resource-Transfer Effects: The resources which are scarce in host country

are transferred from the foreign country. These resources include foreign

capital, technology, machinery and equipment, management and

organization. Transfers of these resources develop the host country

economically and socially. Indian government has been encouraging the FDI

after 1991 to develop the Indian industry, infrastructure and service sectors.

Employment Effects: The FDI contributes for the establishment of new

industries and business directly and for the employment of existing economic

activity. Further, FDI helps for the developing of ancillary industries. These

developments invariably increase the employment opportunities for the

people of the host country.

Balance – of – Payments Effects: Balance of payments position and foreign

exchange resources are very crucial from the view point of external situation

of country. India faced severe foreign exchange resource crunch and thereby

unfavourable balance of payments position before July 1991. In fact this

adverse position forced the Indian government to announce economic

liberalization in July 1991.

FDI provides capital for the production of a number of goods and services

domestically. This in turn reduces the imports and thereby improves the current

account position of the host country’s balance of payment.

Further, the foreign companies export the goods, produced in the host country to a

number of other countries. This activity helps the host country to have foreign

exchange earnings. For example, Nissan established its plants in the UK and exports

80% of its automobiles to other countries and improved Britain’s balance of

payments.

2.4.4 Costs to Host Country

Though the FDI benefits the host country and also cost the host country. Its cost are in

the form of intensifying competition, negative effects on balance of payments and

impact on national sovereignty and autonomy.

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Intensifying Competition: Foreign MNCs have more competitive abilities in

view of their large size, resource base and widespread operations than

thoseof the domestic companies. Hence, they pose severe competition and

threat to the domestics.

Negative Effects on the Balance of Payments: The foreign companies affect

the balance of the host country in three ways:

i. Foreign companies repatriate the dividends to their home countries that

affect the current account. Coca-Cola initially invested US $18 million in

India and it transferred US $54 million to the USA in the form of

dividends. The foreign firms may purchase and sell the machinery and

equipment that affect the capital account transactions.

ii. The MNC in the host country imports the goods from its subsidiaries from

other countries. These imports result in a debit on the current account of

the balance of payments of the host country. Japanese automobiles

operating in the USA, extensively import components parts from Japan.

These imports substantially resulted in adverse balance of payments

position of the USA.

iii. National Sovereignty and Autonomy: Some of the host governments

fear FDI as it affects the sovereignty and autonomy of the country. In fact,

some of the MNCs destabilize the governments in African countries. But

the economists of the advanced countries dismiss these criticisms as

groundless, irrational and silly.

2.4.5 Implications of FDI for Business

The following implications of FDI for business:

Location-specific advantages argument indicates the flow of FDI in order to

take the advantage of mineral and other resources in foreign countries.

If the costs of transportation are minimum, it would be preferable for the

companies to export.

The firm can go for licensing if the know – how is not valuable.

If the company’s skills and capabilities are not available for licensing, better

the company go for FDI.

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2.5 Foreign Direct Investment Policy of India

As part of the economic reforms programme, policy and procedures governing foreign

investment and technology transfer have been significantly simplified and

streamlined.

2.5.1 Automatic Route

Today, foreign investment is freely allowed in all sectors including the services,

sector except in cases where there are sectoral ceilings.

All items/activities except the following are under the automatic route for foreign

direct investment (FDI):

i. All proposals that require an industrial Licence. An industrial Licence is

mandatory if:

a. the item involved requires on industrial licence under the Industries

(Development & Regulation) Act, 1951 or

b. the foreign equity portion is more than 24% of the equity capital of

units manufacturing items reserved for small scale industries; or

c. the item concerned requires on industrial Licence in terms of the

locational policy

ii All proposals in which the foreign collaborator has a previous

venture or tie-up in India. (Excluding IT Sector).

iii All proposals relating to the acquisition of shares in an existing

Indian company in favour of a foreign investor.

a. iv. All proposals outside the notified sectoral policy/caps, or under

sectors in which FDI is not permitted

Investment in public sector units as also in Export Oriented Units

(EOUs), and units in Export Processing Zones (EPZs), Special

Economic Zones (SEZs), Software Technology Parks (STPs) and

Electronics Hardware Technology Parks (EHTPs) also quality for the

Automatic Route.

FDI in the Sector up to 26%, is allowed under the automatic route

subject to licence from the insurance regulatory & development

Authority for undertaking insurance activities.

In addition to Automatic Approval for new companies, such approval

can also be granted for existing companies proposing to induct foreign

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equity, for existing companies with an expansion programme, the

additional requirements are that:-

i. the increase in equity level must result from the expansion f the equity

base of the existing company.

ii. the money to be remitted should be in foreign currency, and

iii. the proposed expansion programme should be predominantly in the

sector(s) under automatic route.

For existing companies without an expansion programme, the additional requirements

for eligibility for automatic approval are :

i. they should be engaged predominantly in industries under the

automatic route.

ii. the increase in equity level must be from expansion of the equity base,

and

iii. the foreign equity must come in foreign currency.

Otherwise, the proposal would need Government approval through the Foreign

Investment Promotion Board (FIPB).

Investors coming through the Automatic Route are required to file relevant documents

with the Reserve Bank of India within 30 days after the issue of shares to foreign

investors. Proposals which do not fulfil the conditions for automatic approval will

require the approval of the Government. The investors have to make an application to

the Foreign Investment Promotion Board, Ministry of Commerce & Industry, Udyog

Bhawan, New Delhi, for obtaining such approval.

2.5.2 Foreign Investment Policies-Procedures

Foreign Direct Investment (FDI) inflows for the year 2009-10

Cumulative amount of Foreign Direct Investment (FDI) flows into India from

April 2000 to March 2010 amounted to US$ 161.54 billion. It covers the

equity inflows, including data on ‘re-invested earnings’ & ‘other capital’,

available from April 2000 onwards.

Cumulative amount of Foreign Direct Investment (FDI) equity inflows (from

August 1991 to March 2010) stood at US$ 132.43 billion.

Foreign Direct Investment (FDI) equity inflows of US$ 34.17 billion were

received during the financial year 2009-10 (from April 2009 to March 2010)

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covering the equity inflows, including (Provisional) data on ‘re-invested

earnings’ & ‘Other capital’ compiled at the end of the financial year.

Under the extant Foreign Direct Investment (FDI) policy, FDI upto 100

percent is allowed under the automatic route in most sectors/activities, except

a few, where sectoral equity/entry route restrictions have been retained. FDI,

under the automatic route, does not require any approval and only involves

intimation to the Reserve Bank of India within 30 days of inward remittances

and/or issue of shares to non-residents.

Recent Policy Initiatives during 2009-2010

2.5.3 Guidelines for calculation of total foreign investment i.e. direct and indirect

foreign investment in Indian companies: Salient features

All investment directly by a non-resident entity into the Indian company

would be counted towards foreign investment.

The foreign investment through the investing Indian company would not be

considered for calculation of the indirect foreign investment in case of Indian

companies which are 'owned and controlled' by resident Indian citizens and

Indian Companies which are owned and controlled ultimately by resident

Indian citizens .

For cases where this condition is not satisfied or if the investing company is

owned or controlled by 'non resident entities', the entire investment by the

investing company into the subject Indian Company would be considered as

indirect foreign investment.

As an exception, the indirect foreign investment in only the 100 percent

owned subsidiaries of operating cum-investing/ investing companies will be

limited to the foreign investment in the operating-cum investing/ investing

company. This exception has been made since the downstream investment of a

100 percent owned subsidiary of the holding company is akin to investment

made by the holding company and the downstream investment should be· a

mirror image of the holding company.

In the I & B (Information and Broad casting) and Defence sectors where the

sectoral cap is less than 49 percent, the company would need to be 'owned and

controlled' by resident Indian citizens and Indian companies, which are owned

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and controlled by resident Indian citizens. For this purpose, the equity held by

the largest Indian shareholder would have to be at least 51 percent of the total

equity.

Any foreign investment already made in accordance with the guidelines in

existence prior to issue of this Press Note would not require any modification

to conform to these guidelines. All other investments, past and future, would

come under the ambit of these new guidelines.

2.5.4 Guidelines for transfer of ownership or control of Indian companies in

sectors with caps resident Indian citizens to non-resident entities: Salient

features

Government/FIPB approval will be required in sectors with caps where:

An Indian company is being established with foreign investment and is owned

by a non-resident entity; or

An Indian company is being established with foreign investment and is

controlled by a non resident entity; or

The control of an existing Indian company, currently owned or controlled by

resident Indian citizens and Indian companies, which are owned or controlled

by resident Indian citizens, will be/is being transferred/passed on to a non-

resident entity, as a consequence of transfer of shares to non-resident entities

through amalgamation, merger, acquisition etc; or

The ownership of an existing Indian company, currently owned or controlled

by resident Indian citizens and Indian companies, which are owned or

controlled by resident Indian citizens, will be/is being transferred/passed on to

a non-resident entity as a consequence of transfer of shares to non-resident

entities through amalgamation, merger, acquisition etc.

2.5.5 Policy for downstream investment by Investing Indian Companies

The guidelines clarify the need for obtaining government/FIPB approval (or

otherwise) for foreign investment into Indian companies, which can be either:

Operating companies; or

Investing companies; or

Operating-cum-investing companies; or

Neither of the above

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It has been clarified that operating companies, as well as operating-cum-investing

companies, need to comply with relevant sectoral conditions on entry route,

conditionalities and sectoral caps.

Investing companies, as well as companies which are neither investing nor operating

companies, require prior Government/FIPB approval for infusion of foreign

investment, regardless of the amount or extent of foreign investment.

Downstream investments by investing companies, as well as operating-cum-investing

companies, would need to comply with relevant sectoral conditions on entry route,

conditionalities and sectoral caps.

2.5.6 Foreign Direct Investment (FDI) into a Small Scale Industrial Undertaking

(SSI)/ Micro & Small Enterprises (MSE) and in Industrial Undertaking

manufacturing items reserved for SSI/ MSE clarification

It has been clarified that:

The present policy on Foreign Direct Investment (FDI) in micro and small

enterprises (MSE) permits FDI subject only to the sectoral equity caps, entry

routes, and other relevant sectoral regulations.

Any industrial undertaking, with or without Foreign Direct Investment (FDI)

which is not a micro and small enterprises (MSE), manufacturing items

reserved for manufacture in the MSE sector (presently 21 items) as per the

Industrial Policy, would require an Industrial Licence under the Industries

(Development & Regulation) Act 1951, for such manufacture. Such an

industrial undertaking would also require prior approval of the Government

(FIPB) where foreign investment is more than 24 percent in the equity capital.

2.6 Liberalization of Foreign Technology Agreement Policy

The Government of India has reviewed the payment of royalties under Foreign

Technology Collaboration, which provides for automatic approval for foreign

technology transfers involving payment of lumpsum fee of US$ 2 million and

payment of royalty of 5 percent on domestic sales and 8 percent on exports. Now,

47

Government of India has decided to permit payment for royalty, lumpsum fee for

transfer of technology and payments for use of trademark/brand name on the

automatic route i.e. without any approval of the Government of India. All such

payments will be subject to Foreign Exchange Management (Current Account

Transactions) Rules, 2000, as amended from time to time.

2.7 Review of cases under Government Route i.e. which require prior approval

of the Government of India for making foreign investment

Proposals for foreign investment under Government route i.e. requiring prior approval

from the Government of India as laid down in the FDI policy from time to time, are

considered by the Foreign Investment Promotion Board (FIPB) in Department of

Economic Affairs (DEA), Ministry of Finance.

The Government of India has reviewed the extant policy and it has been decided, that

the following approval levels shall operate for proposals involving Foreign Direct

Investment under the Government route i.e. requiring prior Government approval:

(a) The Minister of Finance who is in-charge of Foreign Investment Promotion Board

(FIPB) would consider the recommendations of FIPB on proposals with total foreign

equity inflow of and below US$ 254.9 million (Rs.1200 crore).

(b) The recommendations of FIPB on proposals with total foreign equity inflow of

more than US$ 254.9 million (Rs. 1200 crore) would be placed for consideration of

Cabinet Committee on Economic Affairs (CCEA).The FIPB Secretariat in DEA will

process the recommendations of FIPB to obtain the approval of Minister of Finance

and CCEA.

(c) The CCEA would also consider the proposals which may be referred to it by the

FIPB/ the Minister of Finance (in-charge of FIPB).

It has also been decided that companies may not require fresh prior approval of the

Government i.e. minister in-charge of FIPB/CCEA for bringing in additional foreign

investment into the same entity, in the following cases:

(a) Cases of entities whose activities had earlier required prior approval of Foreign

Investment Promotion Board (FIPB)/Cabinet Committee on Foreign Investment

(CCFI)/Cabinet Committee on Economic Affairs (CCEA) and who had, accordingly,

earlier obtained prior approval of FIPB/CCFI/CCEA for their initial foreign

48

investment but subsequently such activities/sectors have been placed under automatic

route;

(b) Cases of entities whose activities had sectoral caps earlier and who had,

accordingly, earlier obtained prior approval of FIPB/CCFI/CCEA for their initial

foreign investment but subsequently such caps were removed/increased and the

activities placed under the automatic route; provided that such additional investment

along with the initial/original investment does not exceed the sectoral caps; and

(c) The cases of additional foreign investment into the same entity where prior

approval of FIPB/CCFI/CCEA had been obtained earlier for the initial/original

foreign investment due to requirements of Press Note 18/1998 or Press Note 1 of 2005

and prior approval of the Government under the FDI policy is not required for any

other reason/purpose.

2.8 Investment Routes

Entry Strategies for Foreign Investors

A foreign company planning to set up business operations in India has the following

options:

2.8.1 As an Indian Company

A foreign company can commence operations in India by incorporating a company

under the Companies Act, 1956 through

Joint Ventures; or

Wholly Owned Subsidiaries

Foreign equity in such Indian companies can be up to 100% depending on the

requirements of the investor, subject to equity caps in respect of the area of activities

under the Foreign Direct Investment (FDI) policy.

2.8.2 Joint Venture with an Indian Partner

Foreign Companies can set up their operations in India by forging strategic alliances

with Indian partners. Joint Venture may entail the following advantages for a foreign

investor:

Established distribution/ marketing set up of the Indian partner

49

Available financial resource of the Indian partners

Established contacts of the Indian partners which help smoothen the process of

setting up of operations

2.8.3 Wholly Owned Subsidiary Company

Foreign companies can also to set up wholly owned subsidiary in sectors where 100%

foreign direct investment is permitted under the FDI policy.

2.8.4 Incorporation of Company

For registration and incorporation, an application has to be filed with Registrar of

Companies (ROC). Once a company has been duly registered and incorporated as an

Indian company, it is subject to Indian laws and regulations as applicable to other

domestic Indian companies.

2.8.5 As a Foreign Company

Foreign Companies can set up their operations in India through

Liaison Office/Representative Office

Project Office

Branch Office

Such offices can undertake any permitted activities. Companies have to register

themselves with Registrar of Companies (ROC) within 30 days of setting up a place

of business in India.

2.8.5.1 Liaison office/ Representative office

Liaison office acts as a channel of communication between the principal place of

business or head office and entities in India. Liaison office cannot undertake any

commercial activity directly or indirectly and cannot, therefore, earn any income in

India. Its role is limited to collecting information about possible market opportunities

and providing information about the company and its products to prospective Indian

customers. It can promote export/import from/to India and also facilitate

technical/financial collaboration between parent company and companies in India.

The approval for establishing a liaison office in India is granted by the Reserve Bank

of India (RBI).

50

2.8.5.2 Project Office

Foreign Companies planning to execute specific projects in India can set up

temporary project/site offices in India. RBI has now granted general permission to

foreign entities to establish Project Offices subject to specified conditions. Such

offices cannot undertake or carry on any activity other than the activity relating and

incidental to execution of the project.

2.8.5.3 Branch Office

Foreign companies engaged in manufacturing and trading activities abroad are

allowed to set up Branch Offices in India for the following purposes:

Export/Import of goods

Rendering professional or consultancy services

Carrying out research work, in which the parent company is engaged.

Promoting technical or financial collaborations between Indian companies and

parent or overseas group company.

Representing the parent company in India and acting as buying/selling agents

in India.

Rendering services in Information Technology and development of software

in India.

Rendering technical support to the products supplied by the parent/ group

companies.

And Foreign Airline/shipping Company.

A branch office is not allowed to carry out manufacturing activities on its own but is

permitted to subcontract these to an Indian manufacturer. Branch Offices established

with the approval of RBI, may remit outside India profit of the branch, net of

applicable Indian taxes and subject to RBI guidelines Permission for setting up branch

offices is granted by the Reserve Bank of India (RBI).

2.8.5.4 Branch Office on "Stand Alone Basis"

Such Branch Offices would be isolated and restricted to the Special Economic zone

(SEZ) alone and no business activity/transaction will be allowed outside the SEZs in

India, which include branches/subsidiaries of its parent office in India. No approval

shall be necessary from RBI for a company to establish a branch/unit in SEZs to

undertake manufacturing and service activities subject to specified conditions.

51

2.9 Sector wise Regulation in Foreign Investment

2.9.1 Automatic route for specified activities subject to Sectoral Cap and

conditions

Table 2.1 Automatic route for specified activities with sectoral cap

Sectors Cap

Airports

Existing

Greenfield

74%

100%

Air Transport Services

Non Resident Indians

Other

100%

49%

Alcohol distillation and brewing 100%

Banking (Private Sector) 74%

Coal and Lignite mining (specified) 100%

Coffee, Rubber processing and warehousing 100%

Construction and Development (Specified projects) 100%

Floriculture, Horticulture and Animal Husbandry 100%

Specified Hazardous chemicals 100%

Industrial Explosives Manufacturing 100%

Insurance 26%

Mining (Precious metals, Diamonds and stones) 100%

Non banking finance companies ( conditional) 100%

Petroleum and Natural gas

Refining (private companies)

Other areas

100%

100%

Power generation, transmission, distribution 100%

Trading

Wholesale cash and carry

Trading of Exports

100%

100%

SEZ’s and Free Trade Warehousing Zones 100%

Telecommunication

Basic and cellular services

ISP with gateways, radio paging, end-end bandwidth

ISP without gateway (specified)

Manufacture of telecom equipment

49%

49%

49%

100%

52

2.9.2 Prior Approval from FIPB where investment is above Sectoral caps for

activities listed in table 2.2:

Table 2.2 Activities needed Prior Approval from FIPB

where investment is above Sectoral caps

Sectors Cap

New Investment by a foreign investor in a field in which the investor already has an existing

joint venture or collaboration with another Indian partner

New investment sought to be made in manufacture of items reserved for Small Scale Industries

74% to 100%

49%

74%

Broadcasting

o FM Radio

o Cable network

o Direct-To-Home (DTH)

o Setting up hardware facilities

o Uplinking news and current affairs

o Uplinking non-news, current affairs TV channel

20%

49%

49%

49%

26%

100% Cigarette manufacturing 100 %

Courier services other than those under the ambit of Indian Post

Office Act, 1898

100 %

Defence production 26 %

Investment companies in infrastructure / service sector (except

telecom)

49 %

Petroleum and natural gas refining (PSU) 26 %

Tea Sector – including Tea plantation 100 %

Trading items sourced from Small scale sector 100 %

Test marketing for equipment for which company has approval

for manufacture

100 %

Single brand retailing 51 %

Satellite establishment and operations 74 %

Print Media

o Newspapers and periodicals dealing with news and

current affairs

o Publishing of scientific magazines / specialty journals

periodicals

26 %

100 %

Telecommunication

o Basic and unified access services

o ISP with gateways, radio paging, end to end bandwidth

o ISP with gateway (specified)

49 % to 74 %

49 % to 74 %

49 % to 100 %

53

2.9.3 The activities attract equity cap for FDI (refer table 2.3)

Table 2.3 Activities attract equity cap for FDI

S.

No.

Sector FDI cap

(in %)

Activities

1. Telecom 49

74

basic, cellular, value-added services,

global mobile personal communications

by satellite

internet service providers with gateways,

radio paging and end-to-end bandwidth

2. Coal &

Lignite

49

50

74

public sector undertakings

other than public sector undertakings

for exploration & mining of coal or lignite

for captive consumption

3. Mining 74 exploration and mining of diamonds and

precious stones

4. Private Sector

Banking

49 private banking sector

5. Insurance 26 insurance sector (subject to obtaining

license from IRDA)

6. Domestic

Airlines

40 no direct or indirect equity participation

by foreign airlines

7. Petroleum

(Other than

refining)

Refining

60

51

51

74

26

in unincorporated joint venture

in incorporated joint venture

petroleum products and pipelines sector

in infrastructure related marketing and

marketing of petroleum products

for public sector undertakings

8. Investing

companies in

Infrastructure

/Service

sectors

49 investment through such vehicle is treated

as resident equity

54

9.

Atomic

minerals

74 a. mining and mineral separation;

b. value addition;

c. integrated activities.

10. Defence

industry

sector

26 for arms and ammunition and allied items

of defence equipment, defence aircraft and

warships

11. Broadcasting

Setting up

hardware

facilities,

such as

uplinking,

HUB, etc.

Cable

network

Direct-to-

Home

Terrestrial

Broadcasting

FM

49

49

20

20

(portfolio

investmen

t)

Private companies incorporated in India

with permissible FII/NRI/OCB/PIO equity

within the limits (as in the case of telecom

sector FDI limit up to 49% inclusive of

both FDI and portfolio investment) to set

up up linking hub (teleports) for leasing or

hiring out their facilities to broadcasters

Foreign investment allowed up to 49%

(inclusive of both FDI and portfolio

investment) of paid up share capital.

Companies with minimum 51% of paid up

share capital held by Indian citizens are

eligible under the Cable Television

Network Rules (1994) to provide cable

TV services.

Companies with a maximum of foreign

equity including FDI/NRI/OCB/FII of

49% would be eligible to obtain DTH

License. Within the foreign equity, the

FDI component not to exceed 20%.

The licensee shall be a company

registered in India under the Companies

Act. All share holding should be held by

Indians except for the limited portfolio

investment by FII/NRI/PIO/OCB subject

to such ceiling as may be decided from

time to time. Company shall have no

direct investment by foreign entities, NRIs

and OCBs. As of now, the foreign

investment is permissible to the extent of

20% portfolio investment. No private

operator is allowed in terrestrial TV

transmission

12 Small Scale

Industries

(SSI) sector

24 FDI in an SSI unit exceeds 24% of the

paid up capital then the company loses its

SSI status. Further, if the item/s of

manufacture is/are reserved for SSI sector,

55

the company has to obtain an industrial

license and undertake a minimum export

obligation of 50% of annual production on

such products

13. Satellites 74% Establishment and operation of Satellites

14. Tea Sector 100%* FDI permitted in Tea sector, including tea

plantations requiring prior Government

approval

* subject to compulsory divestment of

26% equity of the company in favour of

an Indian partner/Indian public within a

period of five years.

15. Print Media 74%**

26%**

In Indian entities publishing

scientific/technical and speciality

magazines/periodical/journals

In Indian entities publishing newspapers

and periodicals

** subject to guidelines notified by

Ministry of Information & Broadcasting

from time to time

2.9.4 India Opens up Key Sectors for Foreign Investment further

India has liberalized foreign investment regulations in key sectors, opening up

commodity exchanges, credit information services and aircraft maintenance

operations. The foreign investment limit in Public Sector Units (PSU) refineries has

been raised from 26% to 49%. An additional sweetener is that the mandatory

disinvestment clause within five years has been done away with.

FDI in Civil aviation up to 74% will now be allowed through the automatic route for

non-scheduled and cargo airlines, as also for ground handling activities.

100% FDI in aircraft maintenance and repair operations has also been allowed. But

the big one, allowing foreign airlines to pick up a stake in domestic carriers has been

given a miss again.

India has decided to allow 26% FDI and 23% FII investments in commodity

56

exchanges, subject to the proviso that no single entity will hold more than 5% of the

stake.

Sectors like credit information companies, industrial parks and construction and

development projects have also been opened up to more foreign investment.

Also keeping India's civilian nuclear ambitions in mind, India has also allowed 100%

FDI in mining of titanium, a mineral which is abundant in India.

Sources say the government wants to send out a signal that it is not done with reforms

yet. At the same time, critics say contentious issues like FDI and multi-brand retail are

out of the policy radar because of political compulsions.

2.9.5 Prohibited list (No FDI is permissible in the following activities)

Agriculture (excluding floriculture, horticulture, development of seeds,

animal husbandry, pisciculture, aqua culture, cultivation of vegetables and

mushrooms (specified and services) related to agro and allied sectors) and

plantations (other than tea plantations)

Atomic Energy

Business of chit fund Gambling and Betting Housing and Real Estate

busines

Lottery Business

Nidhi Companies

Retail Trading (except 51% in single brand product retailing)

Trading in Transferable Development Rights

2.10 Foreign Direct Investment in India

The policy of the Government of India towards the foreign direct investment has been

positive due to the shortage of domestic capital. This is evident from various

industrial policy resolutions and the declarations issued by the Government from time

to time. However, foreign investors did not show keen interest in investing in India

57

until 1991 due to the type of economic system of our country. The Government of

India with regard to FDI announces significant measures since 1991 include:

Granting of automatic permission for foreign equity participation up to 51

percent in high technology and high-investment priority industries.

Allowing foreign equity participation up to 51 per cent in international

trading companies, hotel industry and tourist industry.

Constitution of a Specialized Empowered Board in order to attract FDI by

negotiating with multinational corporations.

Dispersing with the bureaucratic rules and regulation which caused delays

and created hurdles for the FDI.

Allowing the MNCs to use their trade marks in India with effect from 14th

May, 1992.

Allowing 100 per cent foreign equity for setting up of power plants with free

repatriation of profits.

Allowing 100 per cent equity contribution by the NRIs and the corporate

bodies owned by NRIs in high priority industries, with automatic approval

and capital repatriation benefits.

Foreign investors can disinvest at market rates on stock exchanges from 15

September, 1992. However they should repatriate the proceeds of such

disinvestments.

Foreign companies can use their trade marks in India w.e.f. May 14, 1992.

According to the Finance Minister, FII portfolio investments are not subject

to the sectoral limits for foreign direct investment except in specialized

sectors. However, various factors including exchange rates affect the

investment of FIIs to be hard.

The holding non-banking financial companies can hold foreign equity up to

100%.

Foreign investors are allowed to establish 100% operating subsidiaries and

should bring at least US $ 50 million for this purpose.

Private sector firms can have FDI up to 40% in automatic route subject to

conformity to Reserve Bank of India guidelines.

100% FDI is permitted in business to business (B2B) e-commerce, power

sector and oil refining.

58

Manufacturing activities in all special economic zones can have 100%

automatic route except for arms, ammunition, explosives, allied defence

equipment and warships, narcotics, hazardous chemicals, distillation,

brewing of alcoholic drinks, cigarettes/cigars and manufactured tobacco

substitutes.

74% FDI is allowed subject to licensing and security norms in internet

service providers with gateways, radio paging and end-to-end band width.

However, 100% FDI is allowed in other telecommunication projects.

Offshore venture capital funds/companies can use automatic route subject to

SEBI regulations.

Insurance companies can have FDI up to 26% under the automatic route

subject to the licensing requirements of Insurance Regulatory and

Development Authority.

100% FDI is permitted in airports, courier services, development of

integrated townships hotel and tourism sector, drugs and pharmaceuticals.

2.11 Industrial Policy-Main features

Objectives of the Industrial Policy of the Government are –

to maintain a sustained growth in productivity;

to enhance gainful employment;

to achieve optimal utilisation of human resources;

to attain international competitiveness and

to transform India into a major partner and player in the global arena.

Industrial Policy focus is on the following important aspects.

Deregulating Indian industry;

Allowing the industry freedom and flexibility in responding to market forces

and

Providing a policy regime that facilitates and fosters growth of Indian

industry.

59

2.11.1 Policy measures

Some of the important policy measures announced and procedural simplifications

undertaken to pursue the above objectives are as under:

i) Liberalisation of Industrial Licensing Policy

The list of items requiring compulsory licensing is reviewed on an ongoing basis. At

present, only six industries are under compulsory licensing mainly on account of

environmental, safety and strategic considerations. Similarly, there are only three

industries reserved for the public sector.

ii) Introduction of Industrial Entrepreneurs’ Memorandum (IEM)

Industries not requiring compulsory licensing are to file an Industrial Entrepreneurs’

Memorandum (IEM) to the Secretariat for Industrial Assistance (SIA). No industrial

approval is required for such exempted industries. Amendments are also allowed to

IEM proposals filed after 1.7.1998.

iii) Liberalisation of the Locational Policy

A significantly amended locational policy in tune with the liberlised licensing policy

is in place. No industrial approval is required from the Government for locations not

falling within 25 KMs of the periphery of cities having a population of more than one

million except for those industries where industrial licensing is compulsory. Non-

polluting industries such as electronics, computer software and printing can be located

within 25 KMs of the periphery of cities with more than one million population.

Permission to other industries is granted in such locations only if they are located in

an industrial area so designated prior to 25.7.91. Zoning and land use regulations as

well as environmental legislations have to be followed.

iv) Policy for Small Scale Industries

Reservation of items of manufacture exclusively for the small scale sector forms an

important focus of the industrial policy as a measure of protecting this sector. Since

24th December 1999, industrial undertakings with an investment up to rupees one

crore are within the small scale and ancillary sector. A differential investment limit

has been adopted since 9th October 2001 for 41 reserved items where the investment

60

limit up to rupees five crore is prescribed for qualifying as a small scale unit. The

investment limit for tiny units is Rs. 25 lakhs.

749 items are reserved for manufacture in the small scale sector. All undertakings

other than the small scale industrial undertakings engaged in the manufacture of items

reserved for manufacture in the small scale sector are required to obtain an industrial

licence and undertake an export obligation of 50% of the annual production. This

condition of licensing is, however, not applicable to those undertakings operating

under 100% Export Oriented Undertakings Scheme, the Export Processing Zone

(EPZ) or the Special Economic Zone Schemes (SEZs).

V) Non-Resident Indians Scheme

The general policy and facilities for Foreign Direct Investment as available to foreign

investors/company are fully applicable to NRIs as well. In addition, Government has

extended some concessions especially for NRIs and overseas corporate bodies having

more than 60% stake by the NRIs. This inter-alia includes (i) NRI/OCB investment in

the real estate and housing sectors up to 100% and (ii) NRI/OCB investment in

domestic airlines sector up to 100%.

NRI/OCBs are also allowed to invest up to 100% equity on non-repatriation basis in

all activities except for a small negative list. Apart from this, NRI/OCBs are also

allowed to invest on repatriation/non-repatriation under the portfolio investment

scheme.

vi) Electronic Hardware Technology Park (EHTP)/Software Technology Park

(STP) scheme

For building up strong electronics industry and with a view to enhancing export, two

schemes viz. Electronic Hardware Technology Park (EHTP) and Software

Technology Park (STP) are in operation. Under EHTP/STP scheme, the inputs are

allowed to be procured free of duties.

The Directors of STPs have powers to approved fresh STP/EHTP proposals and also

grand post-approval amendment in respect of EHTP/STP projects as have been given

to the Development Commissioners of Export Processing Zones in the case of Export

61

Oriented Units. All other application for setting up projects under these schemes, are

considered by the Inter-Ministerial Standing Committee (IMSC) Chaired by Secretary

(Information Technology). The IMSC is serviced by the SIA.

Table 2.4 Sector-Wise Break-up of Foreign Technology Collaborations

(Covering Both Automatic and Government Route) Since Aug 1991 to Aug 2010.

Name of the Sector No. of

Approvals

by RBI

No. of

Approvals

by SIA +

FIPB

Total Sectoral

Percentage

Electrical Equipments (including

Electronics and Software)

811 452 1263 15.5

Industrial Machinery 623 251 874 10.7

Chemicals (Other than

Fertilizers)

451 461 912 11.2

Transport Industries (Including

Automobiles)

400 361 761 9.4

Miscellaneous Mechanical &

Engineering

267 177 444 5.5

Metallurgical Industries 217 165 382 4.7

Fuels (Including Power & Oil

Refineries)

56 355 411 5.1

Drugs and Pharmaceuticals 197 79 276 3.4

Hotel & Tourism 42 266 308 3.8

Textiles 75 95 170 2.1

Food Processing Industries 93 73 166 2

Telecommunications 52 90 142 1.7

Industrial Instruments 91 30 121 1.5

Miscellaneous and other

Industries

1205 703 1908 23.4

TOTAL 4580* 3558 8138 100

* Since August 1991 to August 2010 Source: SIA news letters

62

vii) Policy for Foreign Direct Investment (FDI)

Promotion of foreign direct investment forms an integral part of India’s economic

policies. The role of foreign direct investment in accelerating economic growth is by

way of infusion of capital, technology and modern management practices. The

Department has put in place a liberal and transparent foreign investment regime where

most activities are opened to foreign investment on automatic route without any limit

on the extent of foreign ownership. Some of the recent initiatives taken to further

liberalise the FDI regime, inter alia, include opening up of sectors such as Insurance

(up to 26%); development of integrated townships (up to 100%); defence industry (up

to 26%); tea plantation (up to 100% subject to divestment of 26% within five years to

FDI); Enhancement of FDI limits in private sector banking, allowing FDI up to 100%

under the automatic route for most manufacturing activities in SEZs; opening up B2B

e-commerce; Internet Service Providers (ISPs) without Gateways; electronic mail and

voice mail to 100% foreign investment subject to 26% divestment condition; etc.

The Department has also strengthened investment facilitation measures through

Foreign Investment Implementation Authority (FIIA).

2.12 Double Taxation Treaties

To increase foreign direct investment (FDI) in their country is a desirable policy goal

for most policy makers. Yet, often the factors influencing the influx of FDI are not

easily amenable to policy, either because they are unalterable, like natural endowment

of physical resources, and cultural and geographic proximity to major source

countries, or because changing them is a very long-term process, as in the case of the

efficiency of political institutions, market size, or the education and productivity of

the local labor force. However, there are still a number of measures which can be

taken to compete in the rivalry for foreign investment: on the one hand, restrictions

imposed on investors regarding, e.g., the profit repatriation can be unilaterally eased,

red tape or corporate taxes can be reduced, and on the other hand, bilateral measures

can be taken, such as concluding bilateral investment treaties (BITs) or double

taxation treaties (DTTs).

The conclusion of a DTT leads to more bilateral FDI between the two respective

countries. If existent, this benefit could compensate for the costs attached to DTTs. In

63

addition to the costs of negotiating and ratifying the contract and giving up some

fiscal sovereignty, there could also be a loss in tax revenues for at least one of the

signing parties. This is particularly important from the point of view of developing

countries as most treaties favor residence-based over source-based taxation.

2.12.1 The Benefits of Double Taxation Treaties

Double taxation is generally defined as the imposition of comparable taxes in at least

two countries on the same taxpayer with respect to the same subject matter and for

identical periods (OECD, 2005). This may occur if one country claims taxing

authority based on the residence or the citizenship of the taxpayer, while another

country postulates taxing authority based on where the income originates. Another

potential source of twofold taxation could be the fact that both countries claim either a

certain taxpayer as a resident or that an income arises within its country (Doernberg,

2004). Also, different methods for the determination of the internal transfer price

applied in two states can lead to a double taxation, e.g., a company has a production

facility in two countries and delivers intermediate goods from the plant in country A

to the factory in country B. If domestic rules in B set a value of 80 USD as

appropriate, but country A ascertains a value of 100 USD, then revenues of 100 USD

in the source country stand vis-a-vis expenses of only 80 USD in the recipient country

(Lang, 2002).

Even though measures to prevent double taxation can be implemented unilaterally,

countries have on a very large scale resorted to the conclusion of DTTs. By burdening

economic activity in a foreign country twice, double taxation is often believed to have

a negative effect on the total amount of FDI as well as on the allocation of FDI across

countries. In the words of Egger et al. (2006: 902): "One of the most visible obstacles

to cross-border investment is the double taxation of foreign-earned income." One

major purpose of DTTs is thus the encouragement of FDI. Tax relief to foreign

investors from double taxation is not the only purpose of DTTs, however. Another

important purpose is the exchange of information. DTTs help to combat tax evasion

and tax avoidance and to prevent double nontaxation by making information from one

contracting state available to the other contract partner. In principle, these other

aspects of DTTs could discourage FDI.

64

In addition, other regulations, calculation methods, and definitions are harmonized in

a tax treaty, mitigating the uncertainty an investor faces when dealing with foreign

fiscal systems and lessening the administrative effort. The tax authorities of either

country profit from this harmonization, as the variety of different legislations they

have to deal with is reduced. Closely related to the anti-tax-avoidance objective of

exchanging information and setting rules for transfer-price calculation is the argument

that DTTs may help to reduce harmful international tax competition from tax havens.

Even though tax treaties are an insufficient measure (due to their bilateral character)

to completely avoid harmful tax competition (Toumi, 2006), they include some

regulations to at least mitigate the problem: the permanent establishment rule and the

provisions against treaty shopping limit the circle of beneficiaries and curb (along

with the transfer pricing restrictions) the opportunities to channel income through tax

havens (OECD, 1998).

Finally, similar to BITs, the benefits of concluding DTTs may go beyond any

concrete treaty provision in that countries may acquire "international economic

recognition" (Dagan, 2000: 32) or, in the words of Rosenbloom (1982, cited in Reese.

1987: 380), a "badge of international economic respectability" with a dense network

of DTTs.

Against these benefits of DTTs, there are also a number of costs to the contracting

parties. Negotiating and ratifying the contract ties up administrative resources. Given

the length and labor intensity of the negotiation process, and the additional effort of

matching versions in different languages, the costs can be substantial, especially, but

not only, for smaller or developing countries. The provisions in the treaty may

conflict with domestic tax law which has to be adapted as a consequence. Here, the

national fiscal sovereignty is curtailed.

The most important cost factor is the potential loss of tax revenue since DTTs

regularly favor residence over source taxation. Due to the reciprocity of FDI flows,

benefits offered to investors from the contracting partner in one country should, in

theory, be compensated by the same benefits given to that country's own investors in

the other contracting state. This is because a country serves as both a host and a

65

residence country for foreign investment at the same time. However, especially FDI

flows and stocks between developing and developed countries are highly asymmetric,

as developing countries are mainly net-capital importers. Entering a DTT therefore

often leads to a loss of tax revenue in developing countries (Easson, 2000).

2.12.2 Double Taxation Treaties with different countries

India has entered into tax treaties with a number of countries including, Australia,

Belgium, Canada, Denmark, France, Germany, Indonesia, Japan, Korea, Mauritius,

Singapore, the United Kingdom and the United States. These treaties endeavor to

avoid double taxation and attract know- how and technology. In many treaties the

withholding tax on royalties and fees for technical services emanating from India is

lower than the general tax rate. A careful planning and corporate structuring can

reduce the tax obligations considerably. The following treaties have been successfully

used by international investors to reduce their tax obligations in India and in their

home countries:

(a) India - U.S.A. Tax Treaty

The Indo-U.S. tax treaty considerably reduces the withholding tax in India for

royalties, fees for technical services, and for interest paid to the US banks and

financial institutions. The withholding tax on dividends arising out of India is 15% if

the parent company owns at least 10% of the voting stock. The withholding tax on

royalties and technical services fees is at the rate of 15%. The capital gains is taxed at

a rate of 20%. The withholding tax on rental of equipment and interest paid to U.S.

banks and financial institutions is at the rate of 10%. All these rates are lower than the

regular withholding tax rates.

(b) India - Mauritius Tax Treaty

The withholding tax rates for dividends and capital gains can be reduced further by a

careful corporate structuring and tax planning. The Indo-Mauritius tax treaty offers

reduced withholding taxes for companies incorporated in the island country of

Mauritius. Recently some U.S. companies have invested in India through offshore

subsidiaries incorporated in Mauritius. For companies incorporated in Mauritius there

is no withholding tax on capital gains in India and the withholding tax on dividends is

66

only 5%. The companies incorporated in Mauritius, at present, can opt not to pay any

tax in Mauritius.

2.12.3 Withholding Tax Rates for Foreign Companies Doing Business in India

under the Tax Treaties

Section 90 of the Indian Income Tax Act authorizes the government of India to enter

into Double Tax Avoidance Agreements (tax treaties) with other countries. The object

of such agreements is to evolve an equitable basis for the allocation of the right to tax

different types of income between the 'source' and 'residence' states ensuring in that

process tax neutrality in transactions between residents and non-residents.

A non-resident, under the scheme of income taxation, becomes liable to tax in India in

respect of income arising here by virtue of its being the country of source and then

again, in his own country in respect of the same income by virtue of the inclusion of

such income in the 'total world income' which is the tax base in the country of

residence. Tax incidence, therefore, becomes an important factor influencing the non-

residents in deciding about the location of their investment, services, technology etc.

Tax treaties serve the purpose of providing protection to tax payers against double

taxation and thus preventing the discouragement which taxation may provide in the

free flow of international trade, international investment and international transfer of

technology. These treaties also aim at preventing discrimination between the tax

payers in the international field and providing a reasonable element of legal and fiscal

certainty within a legal framework. In addition, such treaties contain provisions for

mutual exchange of information and for reducing litigation by providing for mutual

assistance procedure.

2.12.4 Effective year of Double Taxation Avoidance Treaties

India has entered into Double Taxation Avoidance Treaties with the following

Countries:

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Table 2.5 Double Taxation Avoidance Treaties with effective year

S.No. Name of the

Country

Effective from

Assessment Year

Status

1 Australia 1993-94

2 Austria 1963-64

3 Bangladesh 1993-94

4 Belgium 1989-90; 1999-2000 (Revised)

5 Brazil 1994-95

6 Belarus 1999-2000

7 Bulgaria 1997-98

8 Canada 1987-88; 1999-2000 (Revised)

9 China 1996-97

10 Cyprus 1994-95

11 Czechoslovakia 1986-87; 2001-2002 (Revised)

12 Denmark 1991-92

13 Finland 1985-86; 2000-2001 Amending protocol

14 France 1996-97 (Revised)

15 F.R.G 1958-59 (Original)

F.R.G. 1984-85 (Protocol)

D.G.R. 1985-86

F.R.G. 1998-99 (Revised)

16 Greece 1964-65

17 Hungary 1989-90

18 Indonesia 1989-90

19 Israel 1995-96

20 Italy 1997-98 (Revised)

21 Japan 1991-92 (Revised)

22 Jordan 2001-2002

23 Kazakhstan 1999-2000

24 Kenya 1985-86

25 Libya 1983-84

26 Malta 1997-98

27 Malaysia 1973-74

28 Mauritius 1983-84

29 Mongolia 1995-96

30 Namibia 2000-2001

31 Nepal 1990-91

32 Netherlands 1990-91

33 New Zealand 1988-89 (1999-2000 notification)

(2001-2002 Supp. protocol)

34 Norway 1988-89

35 Oman 1999-2000

68

36 Philippines 1996-97

37 Poland 1991-92

38 Qatar 2001-2002

39 Romania 1989-90

40 Singapore 1995-96

41 South Africa 1999-2000

42 South Korea 1985-86

43 Spain 1997-98

44 Sri Lanka 1981-82

45 Sweden 1990-91; 1999-2000 (Revised)

46 Switzerland 1996-97

47 Syria 1983-84

48 Tanzania 1983-84

49 Thailand 1988-89

50 Trinidad & Tobago 2001-2002

51 Turkmenistan 1999-2000

52 Turkey 1995-96

53 U.A.E. 1995-96

54 U.A.R. 1970-71

55 U.K. 1995-96 (Revised)

56 U.S.A. 1992-93

57 Russian Federation 2000-2001

58 Uzbekistan 1994-95

59 Vietnam 1997-98

60 Zambia 1979-80

Source: www.madaan.com/taxtreaty.html

2.13 Indian Legal System & Major Commercial Laws of India

India is a common law country with a written constitution which guarantees

individual and property rights. There is a single hierarchy of courts. Indian courts

provide adequate safeguards for the enforcement of property and contractual rights.

However, case backlogs often result in procedural delays. Most of the laws are

codified. Regulations and policies fill in the details.

Major bodies of law in India affecting foreign investment are the Foreign Exchange

management Act of 1999 ("FEMA"), the Companies Act of 1956, the Industries Act

of 1951, the Monopolies and Restrictive Trade Practices Act of 1969 and the New

Industrial Policy of 1991. Foreign collaboration and equity participation in India is

regulated by the Foreign Exchange management Act of 1999. The Industries

69

(Development Regulation) Act of 1951 governs industrial regulation. The Companies

Act of 1956 regulates corporations and their management in India. The Monopolies

and Restrictive Trade Practices Act of 1969 ("MRTP") governs restrictive and fair

trade practices. The New Industrial Policy of 1991 ("NIP") which lays down the

policy and procedure for foreign investment has liberalized and simplified the

investment procedures. The major changes introduced by NIP are as follow:

1. NIP brings about a streamlining of procedures, deregulation, de-licensing, a

vastly expanded role for the private sector and an open policy towards foreign

investment and technology.

2. Foreign investors are allowed to hold more than 50% equity ownership in

most of the sectors, and 100% percent equity ownership in some sectors.

3. Foreign Institutional Investors ("FII's) from reputable institutions (like pension

funds, mutual funds) may participate in the Indian capital markets.

4. Joint ventures with trading companies and imports of secondhand plants and

machinery are allowed.

5. Monopoly and restrictive trade practice restraints (i.e., antitrust laws) have

been eased.

6. Customs duties have been slashed considerably; duty-free imports are allowed

in some cases.

7. The rupee is completely convertible; 100% of foreign exchange earnings can

be converted at free market rates.

8. Export policies have been liberalized.

9. The Foreign Exchange Regulation Act has been amended to encourage foreign

investments in India.

10. A tax holiday is available for a period of 5 continuous years in the first 8 years

of establishing exporting units.

11. A tax holiday for up to 5 to 8 years is available and 100% equity participation

is allowed for the power projects in India.

12. Concessions in tax regime are available for foreign investors in high-tech

areas.

70

2.14 Conclusion

International investment theories attribute various reasons behind the investment like

ownership advantage, utilization of assets, location advantage, factor availability

advantage etc. As every coin has two faces, the influence of FDI is beneficial to host

and home countries as well as costs them to some extent. Favourable market

conditions, cost advantage, availability of resources like raw materials, proximity to

market, highly talented manpower, size of economy and many factors provide an

opportunity to invest. India has been liberalizing its policies by simplifying the

investment procedures and opening of limits to sector by sector. India introduced and

modified several acts and also entered agreements with different countries like double

taxation avoidance treaties for creating good investment climate.

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