[Bhavin Gada is a Partner and Soumya Shanker a Senior Associate at M/s Economic Laws Practice, Advocates and Solicitors. The views of the authors are personal]
Timeline of Liberalisation of FDI Regime
From 2000 to 2016, foreign investment in the Indian defence sector has been approximately USD 5.12 million. Looking at the total foreign investment inflows to India, one could say that this investment is an insignificant amount (almost less than 0.1%).
Until the year 2000, foreign direct investment (FDI) was not permitted in the Indian defence sector. The year 2001 marked the advent of privatization in the defence industry and the Government permitted FDI in the defence sector up to an equity stake of 26% through the Government approval route. However, following such liberalisation, there was an underwhelming response, with FDI of only USD 4.94 million in the sector during the period from 2001 to 2014.
In 2014, the legal framework governing FDI in the defence sector was amended to permit up to 49% FDI under the automatic route and beyond 49% under the Government approval route, subject to certain conditionalities. This 2014 amendment set out that only foreign investments which were ‘likely to result in access to modern and ‘state-of-art’ technology in India’ would be considered under the Government approval route. However, this did not result in new foreign investment or attract modern technology to India, given that from 2014 to 2016 the FDI influx in this sector was merely USD 0.18 million.
Currently, pursuant to the most recent amendment in 2016, FDI in the defence sector was further liberalised to allow up to 49% under the automatic route, and beyond 49% to 100% under the Government approval route “on a case to case basis, wherever it is likely to result in access to modern technology or for other reasons to be recorded.”
Evidently, the various reforms of the Government at liberalising FDI in the Indian defence sector have not yielded the desired result. That is, there was neither a boost to the domestic defence manufacturing or services sector, nor did India receive significant FDI or technology transfers. It would be pertinent to note that India has spent approximately USD 63 billion on goods and services in the defence sector in 2017, and is amongst the top 10 defence importers in the world. However, the value of Indian defence exports in the past three years has been in the range of USD 150 million to USD 320 million per year.
In this post, we have deliberated on two proposed changes in the regulatory framework for the Indian defence sector which may attract FDI to the sector, more specifically in domestic manufacturing.
Under the Draft Defence Production Policy, 2018, the proposal of the Government was to further liberalise the extant FDI regime in the defence sector by permitting FDI up to 74% under the automatic route, ‘in niche technology areas’. Please note that no other details pertaining to such liberalisation have been specified in the Draft Defence Production Policy, 2018.
If the said proposal is brought into force, it may provide the much-needed impetus to the domestic defence industry. In addition, the foreign players would for the first time be able to control an Indian entity (that is hold more than 51% stake) under the automatic route. Upon implementation of this proposed reform, the potential foreign investors would be incentivised to invest in an Indian entity engaged in the defence industry, as they would be able to exercise control over the target.
Separately, under the extant Defence Offset Guidelines issued by the Ministry of Defence, which forms part of the Defence Procurement Procedure, 2016, foreign vendors in the defence sector are required to conform with an “Offset Obligation”, which is computed on the basis of the value of the procurement contract executed by the foreign vendor. Currently, any defence procurement contract of a value of Rs. 2000 crore or above would trigger an offset obligation amounting to 30% of the contract value or the foreign exchange component thereof, depending on the nature of the contract.
As per the extant Defence Offset Guidelines, offset obligations can be fulfilled by the vendors through specified avenues. One such avenue for discharging the offset obligations is FDI (equity investments) by the foreign vendors in joint ventures with Indian enterprises, for the manufacture and/or maintenance of eligible products and provision of eligible services. The FDI would also be subject to the guidelines/licensing requirements set out by the Department of Industrial Policy and Promotion.
Further avenues for discharge of offset obligations have been proposed in the “Draft Modifications to Defence Offset Guidelines” released by the Ministry of Defence for public comments. One of the suggested avenues is ‘Investment in Defence Manufacturing:equity investment in a business enterprise for fostering development of internationally competitive defence, aerospace and internal security related enterprises in the country’. Under this avenue, the equity investment would be in an Indian company for setting up a manufacturing unit in defence, aerospace and internal security. In this respect, the usage of the term “setting up” appears to suggest that only foreign investments in greenfield projects would be considered for satisfaction of offset obligations. A clarification may have to be sought with respect to investment in brownfield projects, if the language of the amended Defence Offset Guidelines does not clarify the aforementioned. Certain other important parameters are as follows:
- The investor will be eligible to returns on its investment as per law. Under the extant foreign exchange laws of India, assured returns are not permitted for foreign investments. Exits by foreign investors must comply with pricing guidelines issued by the Reserve Bank of India, which impose a cap on the exit price.
- The investments in defence manufacturing would be eligible for the following multipliers: (a) 4 in the defence corridor; and (b) 3 in other areas.
If given effect to, the revised Defence Offset Guidelines would incentivise foreign vendors to also make equity investments in indigenous manufacturing projects. As stated above, if the relaxation of the sectoral cap in the Indian defence sector under the extant foreign exchange laws to 74% under the automatic route is implemented, these investors would be able to exercise control over the Indian target company in this sector. It is likely that such investors would be more willing to transfer defence technology to its Indian subsidiaries where they would be able to regulate distribution of their intellectual property and know-how.
The outcome of the proposed changes, if implemented, should expectedly provide a thriving environment for foreign investment in the indigenous defence manufacturing industry. In addition, the transfer of technical knowledge or technology by their foreign vendors will also provide a boost to the quality and scope of local manufacturing.
The Government’s commitment can be seen through the proposed measures; liberalisation of the FDI regulations in the Indian defence sector to augment foreign participation, and changes to the Defence Offset Guidelines. However, these initiatives may not be sufficient to accomplish the desired purpose and the Government may also have to revisit the regulatory framework in its entirety for foreign investment in the defence sector.
The proposed change in the permissible sectoral limits should also be followed by changes to the sectoral conditionalities that would complement the effort of the Government to liberalise the FDI regime for the defence sector as the sectoral conditions could possibly be onerous to such initiative of liberalisation. Under the Draft Defence Production Policy, 2018, there is an indication that the Government may further liberalise the extant sectoral conditionalities, however, there is no development in this regard.
Having said this, the liberalisation of FDI in the defence sector and the increase in avenues for discharging offset obligations should hopefully have the effect of accelerating FDI in the defence sector in India.
– Bhavin Gada & Soumya Shanker