Recommendations of the Task force
on
Knowledge-Based Industries

Introduction

If one were to draw a lesson from the history of evolution of today's major economic powers, it is evident that the average time needed for reaching economic maturity has been declining steadily. While Great Britain took nearly 150 years for the evolution of its industry, US did it in about 100 years, and Japan was able to compress this time to about 40 years. Can India do it in 30?

The single most important factor that has hastened the process of economic evolution is the advancement of technology. Increasingly, the traditional forces of production – land, labour and capital – have become less important when compared with technology; economists have termed this as the 'expansion of the production frontier'. The source of technology is science that is rooted in knowledge. The recent World Development Report highlights the importance of knowledge in the progress of a nation's economy. Developed economies have a abundant resources of knowledge workers; this poses a significant barrier to entry for developing economies. We are in the era of knowledge-based competition – and the progress of our economy will depend on how best we can leverage our intellectual capital. We have amongst the richest potential resources as far as intellectual capital is concerned. We need to find ways of harnessing this resource to bring about sweeping changes in industry and in society at large.

Knowledge-Based Companies (KBCs) are typically engaged in the areas such as software development, consultancy, pharmaceuticals, financial services, engineering services, biotechnology, etc. They operate in a highly competitive environment characterised by rapid change arising from technological advances and have to satisfy increasingly demanding requirements of their customers. Innovation and speed of response to changing market conditions are the critical success factors for them and they are heavily dependent on the accumulated expertise of a workforce consisting primarily of knowledge workers. Clearly, the criticality of operational efficiency for KBCs cannot be overemphasised.

Another key characteristic of KBCs is the intrinsically global nature of their operations. KBCs are usually export-intensive and have customers across the globe. Furthermore, recent trends point to the necessity of globalising production bases as well in order to capture advantages inherent in transnational operations. Therefore, KBCs need a high degree of flexibility to effectively manage global operations. Their operational freedom needs to be comparable to that available to their peers in the rest of the world.

India has the potential to develop a strong competitive advantage in knowledge-based industries. The software industry is a case in point. However, the fruition of efforts to make India a force to contend with in this arena is contingent on the provision of functional flexibility to the players in industries that will drive this transition.

Specific areas where empowerment and ease of operations are needed are enumerated below.

Foreign Exchange Regulations

India has liberalised foreign exchange transactions on the current account to a great extent and slightly eased capital account transactions. However, the necessity of obtaining prior approval from the Reserve Bank of India for certain transactions on the current account (beyond specified limits) impedes operations of KBCs. This is compounded by the fact that foreign exchange laws make it obligatory to prove that, for certain transactions, prior approval of the RBI is not required. This considerably restricts the globalisation efforts of KBCs. For example:

Opening of bank accounts abroad requires prior approval of RBI

Maintaining of balances in foreign currency accounts abroad requires RBI approval

All transactions in overseas bank accounts need to be reported to RBI

Investment in overseas companies beyond a small limit requires prior approval of RBI

Companies do not have free hand in deciding the equity structure of their subsidiaries abroad

Payment of advances for imports above USD 25,000 requires prior approval of RBI

 

Foreign exchange earners have the facility of keeping a substantial part of foreign exchange earnings in Exchange Earners Foreign Currency (EEFC) accounts in India. KBCs should be allowed the free use of such foreign exchange for all current account transactions and capital account transactions without any approval from RBI and without the need for reporting them to RBI. They should be allowed to open, maintain, operate and close these accounts so long as they have foreign exchange earnings.

The increasingly transnational nature of operations of KBCs place high demands on their agility in the global marketplace. The following two steps would help KBCs respond quickly to new business opportunities and to changing environmental contexts.

KBCs should be given a free hand in determining the ownership pattern of their subsidiaries abroad. Specifically, if business imperatives necessitate the dilution of equity stake in these subsidiaries, the parent must be free to do so with minimum procedural bottlenecks.

The existing norms for acquisition of companies outside India (up to $25mn) require prior approval from RBI. Often, this hinders the ability of the parent company to quickly capitalise on an opportunity where the available window of time might be small. This can be addressed by stipulating that companies report such transactions to RBI within, say, 7 days of remittance instead of making them seek prior RBI approval.

Further suggested changes include the following.

Customs notification facilitating import of software through datacom channels and the Internet

Full freedom for KBCs to open non-trading marketing offices abroad and to open bank accounts for the operation of these offices

Freedom for authorised dealers to issue performance guarantees to KBCs without delays

Change in FEDAI rules to give authorised dealers the flexibility to determine forex transaction rates through negotiations

Cash-less exercise of stock options

More liberal export and import norms

A detailed list of modifications required is given in Annexure I.

Employee Stock Option Plans (ESOP)

Knowledge based companies are technology-intensive and people driven. There is tremendous demand for knowledge workers both within and outside India. Recruiting and retaining the brightest talent is a major challenge facing such companies. Retaining such employees requires global level compensation and institution of schemes that enable them to create and share wealth. An ESOP has been widely accepted as an answer to this issue. An IPO provides an ideal opportunity to encash wealth created by first generation entrepreneurs.

In India, such schemes have not taken off because of the pricing restrictions under the SEBI guidelines. The tax laws in India too inhibit the operation of such schemes and act as a barrier.

KBCs should be allowed to freely price stock options issued to employees. The Board of Directors, subject to the approval of the shareholders, should be the final authority for determining the pricing.

The incidence of tax on stock options should arise only upon the sale of stock and not on exercise of stock options due to various reasons such as the lock-in period which prevents an immediate sale, lack of physical custody of shares with the employee, etc.

Income from sale of stock should be taxed as capital gains and not as part of salaries.

Quantum of shares in a year under an ESOP is currently limited to 5% of paid-up capital. This provision should be replaced by a stipulation that the Board of Directors determines the limit (subject to shareholder approval).

More freedom needs to be given to KBCs and to their employees to create wealth legally and ethically. Detailed recommendations are given in Annexure II.

Venture Capital Financing

The risk and asset profile of most KBCs pose a natural barrier to traditional financing options. KBCs rely heavily on knowledge workers and their asset base is much lower than conventional manufacturing concerns; banks and financial institutions are therefore averse to funding start-ups and small companies in knowledge-intensive industries. Also, equity issues are not feasible for start-ups due to the requirements of a 3-year track record and a threshold level of Rs. 5 cr and Rs. 10 cr for regional and national stock exchanges respectively.

The software industry is a case in point. Start-ups engaged in the development of shrink-wrapped packages have huge funding requirements in the initial phases. The business risks associated with such ventures are much higher as compared to software services firms. Even for software services start-ups, financing from banks and FIs is not forthcoming due to the lack of a huge asset base.

The above points to the criticality of venture capital financing for KBCs.

The venture capital (VC) industry in India consists of offshore and domestic funds. Offshore VC funds usually invest a minimum of USD 1 mn and cater to established players with large requirements. Domestic VC funds constitute a minority at present and usually cater to small scale start-ups. However, the negative impact of the Asian crisis on overseas funds and the current unfavourable sentiment of foreign investors towards the Indian stock market will result in local funds gaining in importance in the future. Moreover, local institutions and banks have been encouraged to set up or participate in VC funds.

The following difficulties have hampered the operations of VC funds and have prevented the industry from making a significant impact on the Indian economy.

Lack of an appropriate regulatory framework

Most of the domestic VC funds have been set up under the Indian Trust Act, which was enacted in 1882 and since then has never been changed. Though these funds raise capital from sophisticated institutional investors, they have to register with SEBI – which is usually concerned with protecting the interests of public investors. It is clear that SEBI does not have a role to play in the VC industry and has been a reluctant regulator from the beginning, playing its part only because the Government stipulated a role for it.

Offshore VC funds, on the other hand, are routed through Mauritius and invest in Indian companies under the regulations applicable to FDI, which involve approval either from RBI under the automatic approval process or from FIPB. These funds have to follow RBI guidelines.

The world over, VC funds are settled under the Limited Partnership Act.

Anomaly in Taxation

There is a great anomaly in tax treatment of domestic and offshore VC funds. Because of the Indo-Mauritius double taxation avoidance treaty, offshore funds do not pay tax on capital gains realised by them. However, domestic funds (which usually support small and medium enterprises) have to pay maximum marginal tax. Among domestic players, funds settled by UTI are totally tax-exempt.

Also, there is inconsistency in the tax treatment of domestic VC funds vis-à-vis mutual funds. Mutual funds participate in the secondary capital market, whereas venture capitalists invest in companies that are in their formative stage and therefore take on greater risks. It is anomalous that they are required to pay maximum marginal tax, while incomes of mutual funds are totally tax-exempt under section 10(23)D of the IT Act.

At present, there is two-level taxation on VC funds, once in the fund itself and later in the hands of the investors after distribution. This seems absurd particularly in view of the fact that the Government has done away with two-level tax even on dividends.

The taxation of local VC funds is not clear. This is due to the fact that the Government had brought in Section 10(23)F for tax exemption but later indicated that it may be withdrawn. Also, the tax exemption is subject to the VC funds following CBDT guidelines for investment. These guidelines are too restrictive in terms of exposure per company, permissible sectors of investment (e.g. investments in non-IT services sector companies are not allowed), permissible instruments of finance (equity but not equity-linked instruments like convertibles), etc.

Difficulty in Fund Raising

In absence of any incentive, it is extremely difficult for domestic venture funds to raise money. Initially, the funds were raised either from multilateral agencies like the World Bank or all-India Financial Institutions. In the US and other developed countries, pension funds and insurance companies invest in the VC funds. In India too, the Government could consider asking the pension funds, insurance companies and mutual funds to invest a very small percentage of their corpus to funds with proven track record, which would go a long way in providing a boost to the domestic VC industry.

Exit

All the early investments made by VC funds were in small companies. These have remained largely illiquid due to the fact that OTC exchanges haven’t taken off. At present, CBDT guidelines permit investment only in equity; this makes exit a difficult task. This can be alleviated by permitting the use of other instruments such as preference shares, convertibles, conditional loans, etc. Buy-back of shares is, of course, yet another means of facilitating exit.

CBDT guidelines need to be modified so as to make them less restrictive. Details of modifications suggested are given in Annexure III.

A proper regulatory framework should be created for structuring of the funds. There is a need for a tax-efficient vehicle for setting up VC funds. A limited partnership concept as exists in the USA is the most ideal form of organisation. This vehicle will be pass-through for tax purposes and the investor will be taxed in his hands on distribution. Alternatively, the IT Act may exempt income of trusts created under the Indian Trust Act.

Throughout the world, pension funds and insurance companies invest in the VC funds. In India too, a policy framework should be created to help existing and new VC funds to raise funds. It could be done in the form of tax incentives, permitting pension funds and insurance companies to contribute at least 5 to 10% of the corpus to VCFs with proven track record.

Encourage creation of local pool of capital for VC activity by offering investors in the VC industry tax breaks based on their investment (similar to those being given under Section 80CC for investment in new companies).

Permit overseas funds freedom in exit valuation and repatriation without the intervention of RBI. Replace the requirement of prior approval from RBI with post-repatriation reporting.

Sweat equity enables entrepreneurs to get value for their intellectual capital. This is reflected in the lower price paid by an entrepreneur for stock vis-à-vis a financier. This has become implementable after the abolition of CCI in 1991. However, the following changes need to be brought about.

In the US market, there is no concept of "par value" of shares. Thus, the differential pricing does not amount to a preferential offer of shares to shareholders. In India, however, the concept of "par value" results in such an issue being treated as a preferential offer and requires clearance from the government. Even though the proposed Companies Bill allows issue of shares at substantial discount, the process of doing it is tedious and requires multiple approvals from government agencies. The Government of India should amend the law to remove the concept of "par value" of share in India so that entrepreneurs fully avail themselves of the advantages of sweat equity.

The Government should eliminate the taxability of sweat equity and stock options at the point of subscription and should tax the capital gains on realisation.

Section 70 of the Companies Act should be amended to the effect that

• A company may issue shares at any value of its choice.

• A company may fix a fair value of its choice only for the purpose of payment of stamp duty.

Regulatory Problems under Customs and Excise

Some KBCs like software companies operating under the Software Technology Park (STP) scheme are required to have their premises customs bonded and need prior approval from government agencies for duty-free import of goods. The need to obtain multiple approvals from various government agencies results in considerable administrative work and delays. These units need to be provided with greater operational flexibility. The monitoring of these units should be on a self-regulatory basis and there should be minimal intervention by government agencies. Alternatively, a single government agency may be designated as a single window for providing all necessary approvals and clearances. Detailed recommendations are given in Annexure IV.

Labour Legislation

Labour laws in India are a reflection of the industrial scenario of the 1940s and 1950s. They do not reflect the hopes and aspirations of knowledge workers. Knowledge workers by their very nature do not suffer from an inability to bargain or a lack of mobility. The working hours for such knowledge workers should be flexible and the law should reflect the same. Detailed recommendations are given in Annexure V.

Investment in Justice

An important attribute of an open and liberal economy is the ability of the justice system to settle disputes without delay. Uncertainty in the result of transactions, enforcement of laws and in the settlement of commercial disputes impedes progress. Uncertainty and delay in the justice system also creates a situation where commercial transactions can become incapable of fulfilment. A gradual disregard for law arises leading to the use of extra-judicial remedies.

India has a fairly well evolved system of justice and a strong legislative background. Compared to developed nations, India suffers in comparison in the enforcement of regulations. Delay in enforcement is evident in the long time taken for judicial proceedings to come to a conclusion. The reason for the delay is the lack of adequate investment in the justice system. The number of judicial officials, number of judicial courts and the infrastructure for such courts is abysmal. The high workload of the courts in India coupled with inadequate office support, non-use of technology and inadequate remuneration for judicial officers have created a state of inaction. Delays in justice system have led to foreign investors seeking the jurisdiction of overseas courts and overseas organisations for arbitration.

The ratio of the number of judges per million of population in India is 1/15th of that in the USA. Not only do the citizens suffer but so do governmental agencies. About Rs. 50,000 crores is locked up in the courts as regards revenue matters for long periods of time. The velocity of business is diminished due to such delays. Tax tribunals take an inordinate time to deliver justice because of very high volumes and low infrastructure. Debt Recovery Tribunals do not operate in some areas due to lack of premises and judges. One of the primary tasks of a nation, that of delivering speedy justice, remains unfulfilled in India.

A large investment has to be made in the justice system in the next five years at the national, state and local levels.

The number of courts, judges and support staff should be increased by a large factor.

Judicial officers should be highly remunerated and treated as a separate class.

Information Technology should be used extensively in the justice system for creation of databases, electronic filing and retrieval.

The lower courts deserve special attention, as it is the first point of contact for ordinary citizens.

Recommended that a sum of Rs.500-1000 crores be set apart for this purpose.

Investment in justice is an investment in future to create an open creative society.

Research & Development Issues

World-wide, in industries such as pharmaceuticals, companies invest billions of dollars in research. Indian companies lack the critical mass to sustain such a level of research activity. While there is no dearth of intellectual potential in India, companies need support and encouragement to make rapid advances in R&D. It is possible to develop a model where we can make up for our lack of physical capital through our abundant human capital. We need to find innovative methods of maximising the extent to which our intellectual assets can be utilised.

The mettle of Indian scientists is recognised the world over, and many research laboratories in advanced countries have benefited from a national resource that we have failed to effectively tap so far. We need to make a beginning now by consolidating the knowledge that exists in pockets, isolated from each other and leverage it for the benefit of industry and the nation. Moreover, research in India is far more cost effective than it is in the West; therefore, we could well become a source for scientific innovation. It is possible to leverage this factor and find ways of converting it into a source of competitive advantage.

The lack of both infrastructure and capital could be overcome by

Pooling industry and government resources through to exploit economies of scale and scope. These alliances would have to be specific to companies rather than to the industry as a whole.

Focussing on areas where marketable knowledge assets can be generated with limited investments, for instance, in the pharmaceutical industry. This could be yet another avenue for earning foreign exchange for the country.

Annexure VI elaborates on ways to provide a fillip to R&D using the pharmaceutical industry as a case in point.

Annexure VII suggests changes to be made to facilitate exports of intellectual assets.

Telecommunications

It is a truism to say that telecommunications more than any other factor has lead to the creation of a global village. It has enabled instant communication across thousands of miles. It has brought people of the world together and allowed free flow of information. A good telecommunications backbone is characteristic of every developed country.

KBCs more than any other companies depend heavily on telecommunications for their work. Access to good telecommunications infrastructure is especially critical when companies have clients across the globe.

Even though the telecom sector has shown signs of improvement in India it is not yet on par with the rest of the world.

Telecom sector reforms should be actively pursued. Opening up the sector will serve to create a competitive environment and will enhance quality of telecom services in the country.

The following regulatory changes are recommended.

KBCs like software companies are now setting up multi-location development centres within the same state and also across states in India. All these centres need to be linked up. Such linking is available today only through the use of DoT terrestrial links whose tariffs are very high. There is therefore a need for reduction of tariff as regards terrestrial connectivity from dedicated links. The current tariff of 64 kbps data circuits is telescopic. E.g., the annual charges for a link line between Bangalore and New Delhi is approximately Rs.20 lakhs. This needs to be reduced so that distance does not add to the costs of operation. The tariff for 64 kbps data circuits for software exporting companies which are STPs and which are in the DTA area should be reduced to 33.33% of the normal tariff as is being charged in respect of leased lines of the press/newspapers vide circular No.7-4/R dated 25.01.1991 of DoT.

KBCs that are STPs/EOUs and in the DTA area, should be granted a special tariff for international trunk dialling at 50% of the normal tariff.

KBCs that are STPs/EOUs and in the DTA area, should be allowed to network their offices across the country without the payment of additional charges for creating a closed user group network and without the need for any additional approval.

KBCs should be granted international ISDN services on priority.

KBCs that are STPs/EOUs and in the DTA area should be allowed to lease multiple 64kbps data circuits at discounted rates for multiple units. KBCs should be given discounts by VSNL/STP/DoT for multiple links on company-wide volumes rather than on location-wide volumes. The discount should be based on the total usage across multiple locations by a company and should not be for individual lines to enable companies to expand their link facilities at reduced costs.

KBCs are required to communicate with their customers even after regular office hours since there is a time difference of twelve hours between USA and India. Employees of KBCs should therefore be permitted to dial in to the corporate leased lines from their residences. Connectivity between public networks and private leased lines will definitely help to boost both customer satisfaction levels and employee morale. Alternatively, employees can be allowed to lease telephone lines from their residences to the offices at a low cost so as to use dial-in services. They should also be allowed to use duty free equipment at home.

The tariff rate for VSNL satellite links should be reduced and the same should be charged at 50% of the existing rates.

Even though some of the above recommendations have been made by the TRAI, the issue of their implementation needs to be addressed immediately.

Access to the Internet

The Internet has emerged as a leading source of information and also a platform for transacting business and for disseminating information to various stakeholders. It is clear that unconstrained access to the web is critical for KBCs.

Towards this end, the government can consider implementation of the following recommendations.

Permitting private sector ISPs to provide web-related services through their own gateways.

Partially subsidise access to the Internet in the initial years.

Provision of leased lines to KBCs at concessional rates, as in the case of the software industry.

Permitting dial-up-from-home connectivity to the net through corporate leased lines for employees of KBCs.

For companies wanting to have a presence on the web from India, a critical enabler is a high-quality link to the nearest hub; this would permit Internet users to freely access the company’s website. The government needs to ensure that high-capacity and high-quality links are provided to such companies at reasonable rates.

Education

The focus of this set of recommendations is on restoring the glory of the Indian education system through a series of measures aimed at building a learning society – one where the application of thought is the primary means to competitive advantage. The future is going to belong to nations which evolve into learning societies. India must take her rightful place in the new order.

The national education superstructure is envisaged as a pyramid, like that given below:

The metamorphosis of India into an economic superpower is contingent on the use of knowledge as a tool for developing a sustainable competitive advantage. A key enabler for achieving this goal is a movement towards an egalitarian society with merit holding its rightful place as the primary criterion for rewards, recognition and institutional support. Social imperatives, however, need to be given due consideration in this process. Steps to facilitate the achievement of these goals could include the following.

1. Reservation policies need to be changed. Changes could include:

a) Introduction of economic status as an additional criterion.

b) Restriction of reservation benefits to one generation.

2. Increased focus on education of women, esp. in rural areas. Specific steps could include: introduction of part-time education programs, incentives to NGOs, etc.

Creation of Brand Equity

The world economy has, over the past few years, made significant advances towards integration on economic and political fronts. This irreversible trend towards globalisation, coupled with the global aspirations of India’s leading corporates, points to the necessity of an increased focus on brand building initiatives. The following steps would enable India to harness its acknowledged economic potential and emerge as a force to contend with in the global arena.

1. Promotion of the "India" brand by the government abroad. Focus on communicating our ability in high technology (KBC) areas instead of promoting India as a "land of saints and half naked fakirs".

3. To evolve a logo that can be used to highlight a product from India. This logo should communicate the above idea (that India is a highly capable, technology advanced, knowledge based society).

4. Establishment of a fund from which Indian companies can draw loans at low interest rates and with long, back-loaded repayment periods for funding brand promotion / brand building / marketing efforts abroad. The fund will be managed by a professional fund manager.

5. Co-ordinated efforts by commercial counsellors in embassies abroad for putting up India stalls in major KBC related conventions / expositions / trade fairs. Participation from all Indian KBCs with interests in those areas. As above, focus to be to demonstrate, in a co-ordinated fashion, our abilities and achievements in these areas.

6. To create a program by which students in related areas from foreign universities can spend time / training projects in Indian KBCs understanding them and their capabilities. These students will then spread the word about India's capabilities in their knowledge related areas.

7. Interaction between Indian KBCs and eminent faculty in their particular area from foreign educational institutions. Try to get case studies written about Indian KBCs.

8. Freedom to Indian KBCs to hire the best marketing talent, pay for the best advertising and creative talents, anywhere in the world, for their brand building exercises.

9. Easy funding / clearances for acquisitions of foreign brands by Indian companies

10. Severe crackdown on exporters who seek to sully the Indian brand name by exporting substandard goods and services / duping foreign buyers, including criminal penalties.

11. To get the most MAJOR world convention in that particular KBC to be held in India once during the next Five years.

12. To co-ordinate visits of delegations of foreign companies in the same KB Industry to India to encourage them to set up shop here, given the nation's strengths in that KBI.

Intellectual Property Rights

As KBCs globalise their operations, a strong legal framework to protect Intellectual Property Rights (IPR) is essential. Under the WTO, India has made certain commitments on patent laws to be in sync with global standards on the issue. It is essential to study the entire gamut of IPR laws in India, benchmark Indian laws against the same and amend or add to the Indian laws so that KBCs can have a strong legal framework to protect their IPRs.

Industry Academia Interaction

Increased interaction between industry and academia – both domestic and international – can facilitate attempts by KBCs to effectively confront challenges faced by them. The interaction can be in the form of sabbaticals by faculty from leading institutions of learning, internships by students at various companies, consulting assignments given to faculty, active participation by KBCs in research conducted by these institutions, etc.

Benefits to KBCs from these interactions include the following.

Increased interaction with international academia can enhance awareness about KBCs at the global level. This would contribute to attempts by KBCs to metamorphose into transnational corporations.

KBCs can benefit from improvements in organisational processes, implementation of best management practices, and transfer of technical knowledge from academia through increased interaction.

Joint initiatives with academia would result in improvement in reputation among educational institutions; this would increase the ability to attract quality manpower from these institutions.

Close interaction would enable educational institutions to tailor their curriculum and research agenda to the requirements of the industry. This would result in improvement in skill sets of graduates from these institutions and also facilitate a focus on research issues of immediate relevance to the industry.

Government – Industry Interaction

The WTO has become the forum for the new global order in trade and services. It is essential that the quality of government-industry interaction be enhanced to put forth India’s views in the WTO based on an internal consensus with industry. It is suggested that a special task force be set up with KBCs and government to act as a thinktank for furthering India’s cause. Industry would have a forum to put forth their views on new developments and measures to enhance their competitiveness.

Economic Diplomacy

Diplomacy in the next millennium is going to have more economic content than currently. The diplomat of the future would be a businessperson trained in the art of diplomacy. Therefore it is essential that diplomats have a close interaction with KBCs so that they would be well briefed on business matters. Indian missions abroad would become the focal point abroad to enhance the penetration of KBCs globally. They could act as front ends to generate business for KBCs in India.