On September 17, 2020, the Indian government issued a press note to inter alia liberalize the cap for foreign direct investment (“FDI”) in the defence sector from 49% to 74% under the automatic route and to revise certain conditions for FDI in this sector. Additionally, on September 30, 2020, the Indian government rolled out the revised Defense Acquisition Procedure 2020 (the “DAP 2020”) to replace the erstwhile Defence Procurement Procedure 2016 (“DPP 2016”). The DAP 2020 is the latest iteration of India’s defence procurement policy that seeks to promote domestic manufacturing through offset obligations in defence contracts. In this note, we have discussed the key changes under the FDI regime for the defence sector as well as the DAP 2020.
Changes under the FDI regime
Liberalized FDI cap from 49% to 74% under the automatic route
Previously, up to 49% FDI was permitted under the automatic route in the defence sector, subject to the Indian investee company obtaining an industrial license under the Industries (Development and Regulation) Act, 1951 (the “IRDA”). FDI exceeding 49% required prior approval of the Indian government and was subject to the condition that the investment must result in access to modern technology. With the recent liberalization, the cap for FDI under the automatic route has been increased to 74% and foreign investments beyond 74% which will provide access to modern technology will require prior approval of the Indian government.
Conditions for companies not seeking an industrial license
As per the IRDA, entities engaged in manufacture of specified defence equipment are required to obtain an industrial license. It must be noted that previously, companies which were not required to obtain an industrial license needed to take permission for infusion of fresh FDI within the limit of 49% if such FDI resulted in change of the ownership pattern or transfer of stake to a new foreign investor. Now, an Indian company which does not require to obtain an industrial license or an Indian company that has already obtained government approval for FDI is now only required to file a post facto declaration within thirty (30) days with the Ministry of Defence in the event of a change in its equity or shareholding pattern or transfer of stake by the existing investor to a new foreign investor up to 49%. Foreign investments beyond 49% in companies not seeking to obtain an industrial license will require prior approval of the Indian government.
Changes under the DAP 2020
Offset obligations
Offset obligations are obligations required to be performed by a contracting party as a condition to supply of products to the Indian government, including inter alia, purchasing products worth a certain percentage of the contract from Indian manufacturers or transferring technology to Indian entities. Offset obligations are applicable to the Buy (Global) category of defence procurement, when the contract value exceeds INR20 billion (approx. US$272 million). Under the DAP 2020, offset obligations are not applicable for ab-initio single vendor cases or inter-government agreements and are only applicable to competitive auction deals. Given that a major portion of defence procurement in India is conducted through inter-governmental deals, this is a significant change in policy that aims at simplifying the offset requirements.
Discharge of offset obligations and their multipliers
Under the DAP 2020, the offset obligation is 30% of the cost of the acquisition in the contract, which can be discharged through the following means, in accordance with their respective multipliers:
- purchasing or executing export orders for products listed in DAP 2020 (“Eligible Products”) or services provided by Indian government entities and private sector entities (collectively “Indian Offset Partners”), with a multiplier of 1.0 for the direct purchase or executing export orders of Eligible Products and a multiplier of 0.5 for the purchase of components of Eligible Products. However, when the Indian Offset Partner is a micro, small and medium enterprise (“MSME”), the multiplier for purchase or executing export orders of Eligible Products shall be 1.5;
- investment in defence manufacturing by way of FDI, direct investment, joint ventures or non-equity routes for the development of defence products, with a multiplier of 1.5;
- investment in transfer of technology to Indian entities for manufacturing Eligible Products, with a multiplier of 2.0;
- acquisition of transfer of certain technology listed in the DAP 2020 (“Eligible Technology”) by Indian government entities such as the Defense Research and Development Organization (“DRDO”), Defence Public Sector Undertakings (“DPSUs”) or the Ordnance Factory Board (“OFB”), with a multiplier of 3.0; and
- acquisition of critical defence technology listed in the DAP 2020 (“Critical Technology”), with a multiplier of 4.0.
Formerly, the DPP 2016 only provided two (2) kinds of multipliers, i.e., a multiplier of 3.0 for high technology acquisitions by the DRDO and a multiplier of 1.5 for an MSME engaging in purchase, FDI, and investment in transfer of technology for manufacturing, maintaining and providing certain defence equipment.
This revised list of multipliers incentivizes certain forms of offset discharge by increasing the multipliers for the acquisition and transfer of technology. In our view, the revision of multipliers incentivizes foreign original equipment manufacturers (OEMs) to invest greater responsibility with their Indian Offset Partners by actively purchasing completed Eligible Products or transferring Eligible Technology into India.
No more banking of offset credits
The erstwhile DPP 2016 permitted entities to bank offset credits in anticipation of obtaining a defence contract and using the banked offset credits for the potential contract. The DAP 2020 does away with this provision entirely, and offset credits cannot be banked for future contracts.
Our comments
As of March 2019, India is the second largest defence importer in the world, with a majority of India’s defence equipment being sourced from Russia, France and Israel. Further, the Indian government has also announced plans to spend US$130 billion to modernize the armed forces in the coming years, including acquisition of weapons, fighter planes, artillery, submarines and warships. Given this, the regulatory changes introduced by the Indian government under the FDI regime and the DAP 2020 are well timed. To liberalize the FDI cap to 74% under the automatic route is a welcome move as foreign investors can now look to invest in Indian companies without the requirement of prior approval of the Indian government or having to provide modern technology to the Indian company. Further, the change resolves the catch-22 situation prevailing in this sector as most foreign investors were not willing to share intellectual property and technology with the Indian company unless they retained majority control over the investment. The FDI liberalization and the DAP 2020 emphasize on a greater scope of control that can be exercised by foreign investors by virtue of foreign investment being allowed up to 74% under the automatic route.
That said, the Indian government is yet to clarify the scope of “access to modern technology”. The absence of such clarity will continue to lead to uncertainty on government approvals, as a foreign investor may end up disclosing valuable data to government officials with little guarantee of the approval being received as such proposals are subject to strict security clearances.