Changes needed to attract defence sector investment

By Alina Arora and Parth Singh, Luthra & Luthra Law Offices

The current consolidated foreign direct investment (FDI) policy, as amended by the Department of Industrial Policy and Promotion via Press Note 5 of 24 June 2016, allows for FDI in the defence sector up to 49% under the automatic route and up to 100% with government approval. Startlingly, despite the government’s efforts to boost FDI through the Make in India initiative, the defence sector attracted only about US$1 million in FDI equity inflow between April 2013 and December 2016, as reported by the Press Information Bureau.

Alina Arora Partner Luthra & Luthra Law Offices
Alina Arora
Luthra & Luthra Law Offices

The government increased the FDI threshold for the automatic approval route from 26% to 49% in 2014 and subsequently continued to revise conditions under which a 100% FDI proposal would be approved in the defence sector. The government also rolled out the Defence Procurement Procedure – 2016 (DPP-2016), to boost the Make in India initiative in the defence sector and expedite the procurement process. Industry observers have welcomed DPP-2016, which borrows extensively from the report of a committee chaired by Dhirendra Singh, commissioned by the government to recommend changes to the previous defence procurement procedure.

While these attempts are laudable and reflect a clear intent on the part of the government to promote FDI in the defence sector, the definitions of “Indian vendor” and “modern technology” have led to uncertainty and require urgent redress.

DPP-2016 defines the term “Indian vendor” expansively and includes entities owned and/or controlled by foreign entities which are registered under applicable Indian laws (foreign Indian vendors). Surprisingly, as per DPP-2016, entities participating in the “make” category have to be owned and controlled by resident Indian citizens, with foreign investment capped at 49%, thus disallowing foreign Indian vendors from participating in “make” category procurements.

The “make” category envisages design, development and manufacture of defence equipment by Indian vendors. Depending on various factors, the “make” category may be pursued in isolation, in sequence or in tandem with other categories of procurement within the “buy” or “buy and make” classifications of DPP-2016.

Parth Singh Associate Luthra & Luthra Law Offices
Parth Singh
Luthra & Luthra Law Offices

DPP-2016 does not define “owned and controlled” but under laws pertaining to FDI, a company is considered as “owned” by resident Indian citizens if more than 50% of its capital is beneficially owned by resident Indian citizens and/or Indian companies. “Control” includes the right to appoint a majority of the directors or to control the management or policy decisions including by virtue of shareholding, management rights or shareholders’ or voting agreements.

The definition of control is onerous for foreign original equipment manufacturers (OEMs), which may wish to retain management and policy control, in light of their capital commitments and technological expertise in defence manufacturing. The “owned and controlled” requirement for the “make” category may thus impede the development of a robust and technologically advanced domestic manufacturing base, particularly as the Indian industry is technologically nascent and suffers from heavily stressed balanced sheets. Further, foreign Indian vendors are best placed to enhance Indian exports by leveraging existing resources and market penetration of their holding companies.

Excluding foreign Indian vendors from the “make” category is especially perplexing as DPP-2016 gives the government comprehensive rights over intellectual property generated from “make” category projects.

Proposals for up to 100% FDI were allowed earlier under the government approval route, if such proposals gave India and Indian companies access to state-of-the-art technology. The current FDI policy purportedly lowered the threshold to “wherever it is likely to result in access to modern technology or for other reasons to be recorded”. Surprisingly, the FDI policy does not attempt to define “modern technology” nor does it provide any indication as to what “other reasons” will be considered appropriate for the government to permit FDI beyond 49%.

The lack of guidance to interpret the threshold exposes the bureaucracy to tangible legal and regulatory risks, while also deterring foreign OEMs from committing to FDI in India. Given the long gestation periods and the monopsony inherent in the defence sector, it is imperative that the government clarifies the criteria for meeting the threshold and makes other changes needed to foster transparency and provide attractive business opportunities to foreign investors.

Alina Arora is a partner and Parth Singh is an associate at Luthra & Luthra Law Offices. The views expressed here are personal. They are intended for general information purposes and are not a substitute for legal advice.

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