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Doing Business with Indian SMEs


Small industry has been one of the major planks of India’s economic development strategy since independence. India accorded high priority to SMEs right from independence and pursued support policies to make these enterprises viable and vibrant and over time, these have become a major contributor to the GDP of the nation. Despite numerous protections and policy measures, SMEs remained mostly small, technologically backward and lacked competiveness.

The decade of 1990 was characterized by policy changes, nationally as well as internationally. These policy changes took place at the three levels – global, national and sectoral, which had the major implication on the functioning of small industry of India as well as their performance. The policy marked: 1) the beginning of end of protective measures for small industry and 2) promotion of competitiveness by addressing the basic concerns of the sector; namely technology, finance and marketing. These resulted in the decline of number of items reserved exclusively for small industry, to be brought down from 842 in 1991 to 239 in 2007. These policy changes led to the radical change in the environment for the functioning of small industry.

In the recent past the SMEs have performed better than their larger counterpart. Between 2001 and 2006, net companies with the net-turnover of Rs 1 Crore – 50 Crore had a higher growth rate of 701% as compared to 169% for large companies with turnover of over Rs. 1000 Crore. After a steep fall in the production between 1991 and 2000, there are has been a continuous growth in number of units, production, employment as well as the exports of the sector.

Today the scenario of Indian SMEs has changed completely. Some of the SMEs are acquiring companies abroad as part of the globalization process. The SME sector has transformed themselves to the need of large local manufacturers and suppliers to global manufacturers. SMEs have also started investing in R&D activities in order to compete in the global market.

SMEs now occupy a position of strategic importance in the Indian economic structure due to its significant contribution in terms of output, exports and employment. The small scale industry accounts for over 40% of gross industrial value addition and over 50% of total manufacturing exports. Further, there are approximately 30 million SME units, that are spread all over the country and account for production of over 8000 different types of the products, right from very basic to highly sophisticated. They have also become the biggest employment generating engine in the country, providing employment to over 60 million and adding over 1.3 million jobs each year.

With the positive outlook of Indian economy, Indian SMEs plan to increase their capital expenditure and hire more staff in the coming months. To add to this there is an increasing number of SMEs that are eyeing offshore expansion for their businesses.

Research findings indicate that number of Indian SMEs conducing international business activities is expected to rise from 31% to 56% by 2013. The increase is driven by the domestic SMEs, 24% of which plan to go international by 2013. With the initiatives that are being taken by the government and other SME organizations, the future definitely looks bright for Indian SMEs.

Rules and Procedure for Doing Business in India

Indian Legal System & major Commercial Laws of India

India is a common law country with a written constitution and which guarantees individual and property rights. There is a single hierarchy of courts, with courts providing adequate safeguards for enforcement of property and contractual rights. Major bodies of law affecting foreign investment in India 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 (NIP) of 1991. Foreign collaboration and equity participation is governed by FEMA of 1999. The Industries Act governs industrial regulations. The Companies Act of 1956 regulates corporations and their management in India. The Monopolies and Restrictive Trade Practices Act of 1969 governs restrictive and fair trade practices. The New Industrial Policy was launched in order to liberalize the foreign investment in the country. The major changes that are introduced by NIP are:

  • NIP brings about a steam-lining of procedures, re-regulation, de-licensing, a vastly expanded role for private sector and an open policy towards foreign investment and technology
  • Foreign investors are allowed to hold more than 50% ownership in most of the sectors and 100% equity ownership in some sectors.
  • FIIs from reputable institutions like pension funds, mutual funds may participate in the Indian Capital Market
  • Joint venture with trading companies and imports of secondhand plants and machinery are allowed.
  • Monopoly and restrictive trade practices restraints have been eased
  • The rupee in completely convertible; 100% of foreign exchange earnings can be converted at free market rates.
  • Export policies have been liberalized
  • The Foreign Exchange Regulations Act has been amended to encourage foreign investments in India
  • A Tax holiday is available for a period of 5 continuous years in the first 8 years of establishing exporting units.
  • A Tax holiday for up to 5 to 8 years is available and 100% equity partnership is allowed for power projects in India.
  • Concessions in tax regime are available for foreign investors in high-tech areas.
Corporate Income Tax

For the foreign company where the total income is more than Rs 10 million the tax rate applicable is 42.23%, where as in the case where the total income is less than Rs. 10 million the tax rate charged is 41.20%. The Minimum Alternate Tax (MAT) where the total income is more than Rs. 10 million, the companies have to pay 10.5575% of book profits. While the total income is less than Rs. 10 million the MAT applicable is 10.3%. Fringe Benefit tax is 31.6725%.

Companies that are incorporated in India with 100% foreign ownership are treated as domestic companies under the Indian laws. For a domestic company with the total income over Rs. 10 million the corporate tax rate applicable is 33.99%, while for the company with total income of less than Rs. 10 million the tax rate applicable is 30.90%. The MAT for them 11.33% and 10.30% respectively, of book profits. The dividend distribution tax is 16.995% while the Fringe Benefit Tax is 33.99%.

Transfer of Technology Agreements in India and Approvals

Approvals: The Reserve Bank of India (RBI) accords automatic permission for foreign technology agreements in high priority industries up to 5% royalty for domestic sales and 8% for exports, subject to total payment of 8% of sales over 10 year period from date of agreement or 7 years from commencement of production. In addition, lump-sum technology payments up to Rs. 1 Crore/Rs 10 million are permitted under automatic approval system. The prescribed royalty rates are net of taxes and are calculated according to the standard procedures.

Governing Laws: Transfer of Technology agreements must be subjected to Indian Laws. These agreements can be subjected to arbitration under the rules of international institution like the International Chamber of Commerce (ICC). Arbitration can take place in India or abroad. India is a party to the 1958 New York convention on Enforcement of Arbitration Awards. Foreign awards are therefore enforceable in India. Under Indian law, upon the termination of technology transfer document after its 7-10 year period, the technology is deemed to be perpetually licensed to the Indian party for use in India. Special rules apply to the transfer of technology to the Indian government companies.

Repatriation of Investments & Profits from India

One of the biggest concerns for foreign investors in getting their dollars out of India. Though it has never been a problem to repatriate investments and profits from India. The Overseas Private Investment Corporation (OPIC), a US government backed insurer of foreign commercial dealings, has never had to pay a claim due to India’s failure to provide foreign exchange. Dividends, royalties and fess, capital gains can be easily repatriated with the permission of Reserve Bank of India (RBI).

Incase of exit decision, the overseas promoter can repatriate his share after discharging tax and other obligations. He can also disinvest his share either to his Indian partner, to another company or to the public. Even during the Indian crisis period, no foreign company left India without proper and due compensation. Following are the characteristics of Repatriation of Investments:

  • Repatriation of foreign exchange at the existing market rate has become easier
  • Exporters can retain 25% of total receipts in foreign currency accounts to meet their requirements such as travel, advertising etc
  • Foreign exchange will be available at market rates for all imports except specified essential items.
  • Foreign exchange requirement for private travel, debt servicing, dividend or royalty payments and other remittances may also be obtained from banks and or exchange dealers at the current market rate.
Arbitration in India and International Commercial Arbitration

Recently India enacted Arbitration and Conciliation Act, 1996 (New Law). The New Law is based on United Nations Commission on International Trade Law (UNCITRAL) Model Law on International Commercial Arbitration (Model Law). Among others the objective of the New Law are to harmonize the Indian Arbitration Law with the Model Law and establish an internationally recognized legal framework for arbitration, consolidate the laws on domestic and international arbitration and conciliation, and enforcement of foreign awards. Another important purpose of the New Law is to encourage arbitration as an alternate dispute resolution process and avoid prolonged judicial process.

Establishing wholly owned subsidiary in India by Foreign Investors

In number of sectors, India allows setting up of subsidiaries in India which are wholly owned by foreign investors including the foreign companies. There are two ways of forming subsidiary in India: 1) Automatic route and 2) Special Permission route. In certain sectors like information technology, export oriented manufacturing, 100% ownership by foreign investor is allowed. However, necessary applications and permissions need to be obtained from the government authorities.

In certain sectors while specified percentage of FDI is permitted under the automatic route, while there are certain sectors in which 100% FDI is permitted with the prior approval of Foreign Investment Promotion Board (FIPB). The major advantages of having a subsidiary are total control over funding, management and profit share of the business.

Joint Ventures in India by Foreign Investors

Joint venture companies are the most preferred form for investment in India. There are no separate laws for joint venture in India. The companies incorporated in India, even with up to 100% foreign equity, are treated the same as domestic companies. Though the foreign companies are free to open their branch offices in India, they attract a higher rate of tax than a subsidiary or the joint venture company. The liability of the parent company is also greater in case of a branch office.

The government has outlined 37 high priority areas in which the foreign investment up to 74% is permitted under automatic route. Full ownership (100% foreign equity) is allowed in power generation, coal washeries, electronics, Export Oriented Units or a unit in one of the Export Processing Zones (EPZs).

Like any other country, even in India, selection of a good local partner is crucial for the success of the joint venture. Personal interviews with prospective joint venture partner should be supplemented by a proper due diligence. Once a partner is selected generally a memorandum of understanding or a letter of intent is signed by both the parties highlighting the basis of the future joint venture agreement. Before signing the joint venture agreement, the terms should be thoroughly discussed to avoid any misunderstanding at the later stage. Negotiations require an understanding of the cultural and legal background of the parties. These things need to be thoroughly followed while entering in to joint venture in India.

Sectors in which Indian SMEs operate

  • Food Processing
  • Agricultural Inputs
  • Chemicals and Pharmaceuticals
  • Engineering, Electrical and Electronics
  • Textiles and Garments
  • Leather and leather goods
  • Leather and leather goods
  • Bio-engineering
  • Sports Goods
  • Plastic products
  • Computer Software