While the new framework for FDI in the defence sector in India is clearly aimed at providing an impetus to the Government's objective of boosting defence manufacturing locally, some loose ends remain, which signify a lack of cohesiveness in policy making. In order to send a strong signal that India means business, and is serious about creating a strong defence industry domestically, these concerns must be addressed.
BackgroundIn May 2001, India's regulatory regime opened the defence industry to private participation for both domestic and foreign capital. The caps on foreign direct investment ("FDI") have been gradually diluted, with up to 100% FDI permitted subject to prior permission of the Indian Government where the level of FDI exceeds 49% of the paid up share capital of the Indian target entity.
Substantive ChangesRelaxation of FDI linked conditions: Press Note 12 of 2015 eliminated several conditions that applied to FDI in the defence sector. One of the major proclamations of liberalisation was dispensation from the requirement that Indian companies with FDI must ensure that all key management positions are staffed with Indian citizens. Apart from the Chief Security Officer, Press Note 12 of 2015 seemed to suggest that other management positions can be staffed with foreign nationals. This was initially perceived as a huge relief to foreign OEMs who found it difficult to identify Indian citizens with adequate experience and bandwidth.
Unfortunately, once the initial euphoria subsided, the cause for cheer for short-lived. Since the Guidelines pertaining to the grant of defence industrial licenses have not yet been modified by the concerned authorities (to bring them in line with the recent changes introduced by Press Note 12 of 2015), care must be taken to ensure that the defence industrial license terms are not breached while planning the management and organisation structure. We hope that the Government will provide appropriate clarifications to address this anomaly. For parties planning a "greenfield" venture, it is advisable to reach out to DIPP and Ministry of Defence seeking a specific clarification on this issue, before making any assumptions.
Under the new rules, FDI exceeding 49% is permissible where the foreign investor makes "modern and state of the art technology" accessible. Informally, the Government has clarified that this is not a "conjunctive" test i.e., so long as the proposed technology is "modern" relative to the systems currently operating in India, it need not be "state of the art".
Somewhat more problematic is the condition that the Indian target/joint venture company must be structured to be "self-sufficient" in areas of "product design and development". Self-sufficiency is a high standard to be discharged. The range of obligations and commitments subsumed within this condition are not immediately obvious and difficult to estimate or budget. This condition has a perverse impact on attracting advance systems as by definition it implies a proportionately greater burden. There is little by way of market practice to demonstrate to what extent an investor must go in order to discharge this obligation.
Clearly, the Government must be under no illusion that investment will be forthcoming with a lopsided rule book and provisions that are open for abuse, especially by a local partner in a joint venture scenario in an emerging market where resolution of disputes is notoriously time consuming and expensive. Ambiguous, inconsistent and lofty drafting has no place while setting the principles for foreign investment.
Unless there is a specific legislative purpose for the self-sufficiency conditions, the Government will do well to delete this condition and leave it for the RFPs to deal with long term operational viability issues in a competitive market.
Industrial Licensing Requirement: Defence is subject to the requirement of obtaining an industrial license under the aegis of the Industries (Development and Regulation) Act of 1951. The initial validity of such an industrial license has been revised to 15 years (further extendable up to 18 years for existing and future licences). To ease the process further, applications for such licences can now be made electronically on an e-biz portal launched by the Government.
Change in Ownership: The Press Note 12 has introduced a condition under which infusion of fresh foreign investment within the permitted automatic route level, in a company not seeking industrial license, resulting in change in the ownership pattern or transfer of stake by the existing investor to a new foreign investor will require Government approval. This condition has significantly muddied the waters. The confusion is centred on the understanding that the provisions in the FDI Policy relating to investment in the defence sector is in any case subject to the grant of an industrial license to the relevant company. With the introduction of this new condition, it is possible to take a view that an Indian enterprise which is engaged in manufacture of dual use products (which hitherto did not require an industrial license to be obtained or any prior permission to be taken from the Government) would now require the prior approval of the Government before effecting any increase in foreign equity or a transfer of shares to a new foreign investor.
Procedural ChangesThe only major procedural change introduced is the approval of FDI in excess of 49% being placed under the aegis of the Foreign Investment Promotion Board ("FIPB") and consequent dilution of the Cabinet Committee on Security's role in monitoring FDI in this sector.
ConclusionWhile Press Note 12 may seem to simplify the conditions associated with FDI in the defence sector, a deeper analysis reveals that this reshaping of the policy has in fact created new issues and concerns which may undermine the efforts put into the sector thus far. The industry requires the ambiguities highlighted in this memo to be adequately and substantially addressed by the DIPP so that investment can start flowing to meet the pent up demand.
(With contribution from Bharat Anand, Partner, Khaitan & Co)
