• Devina Narvekar

Make in India: An overview of defence sector regulations and key aspects of vendor collaboration

Devina Deshpande


Introduction


The Indian government has, in recent years, ramped up efforts towards ‘Make in India’ – an initiative geared towards facilitating global investment into India and strengthening local manufacturing and employment. A key initiative in this respect is the Public Procurement (Preference to Make in India) Order, 2017 which grants purchase preference to ‘local suppliers’ (i.e. suppliers with minimum 50% local or Indian content in their products/services) across all government tenders.


An area of major focus for indigenisation has been India’s defence sector. To this end, sector-specific regulatory measures have been rolled out with the aim of achieving self-reliance in defence. To continue to remain eligible for defence tenders, and to stay competitive in the long-run, both Indian and foreign defence vendors will need to comply with these indigenisation initiatives. Given that, in practical terms, Make in India for defence requires both local manufacturing and cutting edge technology, long-term collaborations between Indian and overseas vendors can often be the most effective (and, at times, quickest) way to achieve compliance - through joint ventures, licensed manufacturing and other forms of strategic partnership.


To assist efforts in gearing your India operations towards compliance, this article provides an overview of – (a) the specific regulatory requirements that you would need to account for, as well as (b) aspects that collaborating Indian and foreign companies should be mindful of to achieve a mutually beneficial balance, so as to make the most of the government’s preference for Make in India in defence procurement.


Part I: Indigenous Production under the Defence Acquisition Procedure, 2020


1. Overview


The Defence Acquisition Procedure, 2020 (“DAP 2020”) which governs capital acquisition for the defence sector, sets out certain categories (methods/routes) under which the Ministry of Defence (“MoD”) undertakes capital procurement. These categories are ranked in order of procurement preference, with the purchase of indigenously designed, developed and manufactured products being the highest priority and outright purchase of fully formed equipment being the lowest priority[1].


Qualification under each of the various categories of procurement will depend on a number of factors. These factors tie in to the indigenisation demands of Make in India and include the amount of Indigenous Content (i.e. local content, “IC”) in the product/service, the contracting entity (i.e. local/foreign and who holds shareholding/control in this entity), control of intellectual property rights (“IPR”) etc.


2. Prioritized categories of procurement


The Buy (Indian-IDDM) category holds the highest procurement preference. It envisages:

(a) The acquisition of products designed, developed and manufactured in India, with a minimum IC (local content) of 50%.

(b) The product may be developed via in-house R&D or under the Make procedure (discussed in the next section).

(c) Only ‘Indian vendors’ (i.e. entities incorporated or registered under Indian laws) are eligible to participate in tenders under this category. Further, ownership and control of the vendor entity must lie with resident Indian citizens.

(d) The Indian entity must own the IPR or design of the main equipment and should have the technology and capability to implement equipment upgrades. Indigenous design will be verified (via documents/on-site inspection) by the MoD.


Under Buy (Indian) (which is the second highest category of procurement):

(a) No indigenous design and development is required. Instead, local manufacture of the product in collaboration with, or via transfer of technology (“ToT”) from, the OEM is sufficient.

(b) Indian vendors (incorporated/registered in India) are eligible, and there are no restrictions on ownership and control.

(c) That said, this category mandates a minimum of 60% IC.


It is evident from the attributes of Buy (Indian-IDDM) category that the intention is to promote indigenous design and development of defence equipment as well as to ensure that control over the manufacturing entity and IPR resides with resident Indian citizens. While the Buy (Indian) category is not as stringent in this respect, it continues to promote indigenisation through a high requirement of minimum IC.


It is relevant to note that when computing IC, outflows from India (such as costs of imports, fees to foreign citizens/entities, royalties, licensing or technical fees etc. paid out of India) as well as taxes and statutory levies in India are to be excluded. Before a company outsources production or services to foreign persons/entities, it is advisable to work with financial advisers to ensure that the minimum IC is met (particularly so in the case of Buy (Indian), given the high IC threshold).


Even with the remaining schemes of procurement, the preference for local manufacture and transfer of technology (“ToT”) is clear, with categories that envisage ToT and some amount of production in India ranking higher than an outright purchase of equipment from either Indian or overseas vendors (and with offset obligations attracted in the case of the latter).


3. 'Make’ under DAP 2020


In addition to the categories for purchase of equipment, the DAP 2020 also envisages the ‘Make’ procedure of procurement which promotes indigenous design and development of prototypes of military equipment. The aim here, in line with the wider Make in India policy, is to develop long term defence capabilities (rather than an off-the-shelf acquisition of equipment).


Once products are designed and developed under Make, they are procured by the Ministry of Defence under either the Buy (Indian-IDDM) or Buy (Indian) category, as applicable. Hence, the required attributes of the relevant procurement category (as set out above) will need to be met by the vendor/product to ensure eligibility for procurement.


The Make procedure is further sub-divided into 3 categories:


Part II: Vendor Collaboration – Achieving a Mutually Beneficial Balance


From Part I above it is evident that qualification for Make in India benefits in the defence sector would typically mean either qualifying under one of the Make procedures or for the product to directly qualify under Buy (Indian-IDDM) or Buy (Indian). This in turn would require the specific attributes of the category of procurement to be met by the vendor (such as Indian ownership and control of shares and IPR for Make I and II), product and design/manufacturing process (ranging from local manufacture only, to local design, development and manufacture).


As such, while evaluating the structure of your India operations, first consider the eligibility of your existing entity and product based on an assessment of recently released defence tenders. For instance, have the recent tenders been geared towards one category of procurement (expressly or impliedly - for instance, by levying a very high requirement of IC), does a proforma calculation of IC based on your existing supply chain reveal that your product falls short of the required IC threshold, is there sufficient local competition for your product which would effectively negate your participation without local design/manufacture etc.?


Based on the above assessment, you may need to work with your legal and financial advisers to determine the best route to achieve qualification under Make in India for defence. This may need you to set up local manufacturing facilities, move from licensed manufacture to a more fulsome ToT model or set up some other form of collaboration with an Indian or foreign vendor (as is relevant to you).


When running this analysis, certain factors to consider are:


1. Certain schemes/categories require ownership and control of the participating vendor to vest in resident Indian citizens.

2. Schemes which require ‘indigenous design and development’ would require an Indian entity to own the IPR or the design of the main equipment (i.e. necessitating complete ToT to the Indian entity).

3. Defence tenders typically require the bidding entity to have 2 years registration (except for joint ventures specifically set up for a project), which means that a new entity may be ineligible to apply.


In addition to Make in India requirements, any structure that you pursue would also need to account for following aspects :


1. Foreign investment restrictions: The maximum amount of foreign direct investment in defence manufacturing is currently set at 74%. Any higher investment would require government approval. In addition, the investee company must be self-sufficient in product design and development and have maintenance and life cycle support facilities in India.


2. Other relevant defence-focused regulations: The MoD has notified an ‘embargo list’ of weapons/platforms which the Armed Forces cannot import in fully finished form. The list presently includes 101 items including artillery guns, assault rifles, anti-submarine rocket and rocket launchers, corvettes, sonar systems, transport aircraft, light combat helicopters and radars, and will come into effect over a 5 year period. If the equipment you propose to supply falls within this list, you may have no choice but to set up your operations to qualify under the Buy (Indian - IDDM) and Buy (Indian) procurement categories.


3. Tax efficiency: Consult tax advisors on the various tax aspects of the proposed structure such as the implications of purchasing shares in a newly incorporated entity versus a secondary purchase, tax treatment of dividend and share sale (including under any applicable tax treaty) and the feasibility of relying on fee payments or cost reimbursements for repatriation of profits (such as management consultancy fee, technical know-how fee, brand royalty, IT support fee etc.).


4. Commercial structuring issues: Mutually acceptable commercial positions for both parties are vital for a successful long-term partnership.

(a) Some issues that potential partners may need to consider are:

(i) Fundamentals of the collaboration:

  • ·What are the key objectives of the joint venture (including role and business plan)?

  • What will the contribution of each entity be to the business (including licensing of technology, transfer of existing customers etc.)?

  • What are the control expectations (who will manage day to day operations)?

(ii) Funding (both domestic/international)

  • How much will each party invest and what is the form of investment?

  • How will future funding requirements be met by each party?

(iii) Management arrangements

  • How many directors will each party have, what are the reserved matters and how will a dead-lock be dealt with?

  • Who will appoint KMP/senior management and have day to day control?

(iv) Revenue structure: Will this be dividend based or value/exit based?

(v) IP ownership

  • How will the ownership of IP be dealt with, including in the case of an exit?

  • Will lumpsum or periodic license fees be payable for any licensed IP? If so, what is the impact on IC?

(vi) Non-compete/exclusivity considerations

  • Will the collaboration be exclusive for the territory of India and will any products of either partner be excluded from the scope of the collaboration?

  • Will any non-compete restrictions apply post-termination?

(vii) Exit considerations

  • Is a lock-in period contemplated for both/either parties?

  • Are any targets contemplated which, if not met, would trigger an exit by a party?

  • What rights would a party have to trigger an exit or to purchase the stake of the other party (drag, ROFO, tag, insolvency, breach etc.)?

  • If the JV is terminated, how will any existing customers be serviced?

(b) In addition, some critical aspects to consider where the collaboration is between an Indian and a foreign entity are:

(i) Valuation: Transfer of shares between an Indian resident and a non-resident person/entity may mean paying a multiple of fair market value (this will be relevant if shares of an existing company are being transferred).

(ii) Shareholding control: Certain operational matters require shareholder consent under Indian company law (such as altering charter documents, winding up, share buy-back etc. ). For some matters, a simple majority (over 50%) is sufficient, but in most cases a special majority (over 75%) is required. However, read with the defence sector and Make in India requirements discussed above, the foreign party may not have substantial control and this could impact decision-making.

(iii) Management control: Structuring requirements (under defence sector conditionalities and Make in India) may also restrict parties’ board control as well.

(iv) Ability to exit: Given sectoral caps and restrictions, it may be difficult to exit the joint venture unless an alternate buyer is willing to take over grandfathered obligations (for instance, the existing Indian partner would need to be replaced by another Indian entity so as to maintain foreign direct investment limits).

(v) IPR: Preferred schemes under Make in India require full ToT. The party holding the IP will need to consider this requirement in light of its larger company policy.

(vi) Business commencement: May be delayed if a new entity is being set up as part of the collaboration, as fresh licenses, permissions, security clearance (given the sensitivity of the sector) etc. may be required before business can be commenced.


Conclusion


In keeping with the objectives of the broader Make in India policy, the Ministry of Defence has made the prioritization of developing indigenous capacity and self-reliance amply clear with the measures discussed in this article. To remain eligible and competitive, vendors will need to ensure compliance with these indigenisation initiatives and collaborations between Indian and foreign vendors offer an effective opportunity to do so. For long term commercial success, it is our recommendation that these collaborations should, in equal measure, be compliant with applicable laws, qualify for Make in India contracts in India, be tax efficient and offer mutually acceptable commercial positions for both parties.

 

[1] For brevity and relevance, we have not discussed all categories of procurement in this article. However, we would be glad to assist you with this information if required. Please reach out to us at practicemanager@btg-legal.com.

 

This article was originally published in the March 2022 issue of Geopolitics (www.geopolitics.in)