Making India a Defence Manufacturing Hub: Government Modifies Foreign Investment And Defence Procurement Rules

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.  Last year, the Indian government announced plans to spend US$130 billion to modernize the armed forces in the coming years, with large scale acquisition of weapons, fighter planes, artillery, submarines and warships in the pipeline.  Under the “Atmanirbhar Bharat” vision, the Indian government is set to focus on making India a defence manufacturing hub and be capable of self-servicing defence needs locally. 

With the above in mind, the Indian government has recently implemented changes to encourage foreign investment in the defence industry.  The existing foreign investment cap of 49% has been increased to 74% and therefore, foreign investors will now be able to invest in a controlling stake in Indian defence companies under the automatic route, i.e., without requiring prior permission of the Indian government or having to necessarily bring in modern technology.  This benefit, however, can only be sought if the investee company has an industrial license.   If an Indian company does not require an industrial license or has already obtained government approval for foreign investment, a post facto declaration will have to be filed 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 who do not have an industrial license will continue to require prior approval of the Indian government.   

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.   

In tandem with the changes in the foreign investment regime, the Indian government has also rehauled the defence procurement policy and introduced the new Defense Acquisition Procedure 2020 (DAP 2020).  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.  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.  

Formerly, there were only two kinds of multipliers, i.e., a multiplier of 3.0 for high technology acquisitions by the Defense Research and Development Organization and a multiplier of 1.5 for micro, small and medium enterprise engaging in the purchase, foreign investment, and investment in the transfer of technology for manufacturing, maintaining and providing certain defence equipment.  Under the DAP 2020, the offset obligation is 30% of the cost of the acquisition in the contract, which can be discharged through various subcategories depending on the type of acquisition.  The 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 to India. 

Earlier, the defence procurement policy 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. 

The regulatory changes introduced by the Indian government under the foreign investment regime and the DAP 2020 are well-timed.  These changes emphasize 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.  In the end, it remains to be seen if India can emerge as a manufacturing hub for defence equipment, which has always been controlled by countries like Russia, the US and France. 

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