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Private Sector Participation in Defence Production: Industrial Licensing and FDI Issues

January 27, 2012

It has been more than decade since the Government of India, in a major policy initiative, liberalised the defence industry in 2001. This was done by allowing 100 per cent participation by the private sector, with foreign direct investment (FDI) permissible up to 26 per cent, both subject to licensing and security clearance. The initiative was undertaken to harness the expertise of the private sector and facilitate its participation through infusion of foreign capital and technology for the purpose of enhancing self-reliance in India’s defence production. By October 2011, the Department of Industrial Policy & Promotion (DIPP) gave 200 Letters of Intent/Industrial Licenses (LoI/IL) to various private entities, with proposed investment totalling Rs 11,773 crore, and potential employment opportunities for 38,579 people. By November 2011, a cumulative FDI of Rs 17.68 crore (US $3.72 million) was received by the Indian defence industry.

Notwithstanding these developments, there are certain grey areas in both industrial licensing and FDI policy, which need further improvement to facilitate the private sector’s participation in defence industry in a more meaningful manner. With regard to industrial licences, the first major issue that intrigues the domestic private industry is the definition of defence items. Unlike some other countries and international arms control organisations, which define defence items through a comprehensive list (for example, the Munitions List of the Wassenaar Arrangement), in India there is no such list that specifies what constitutes a defence product. The lack of clarity becomes an issue when defence firms are required to provide the ‘item code’ and ‘item description’ while filling up the application form for industrial licences. As per the current practice, these firms are required to provide the ‘item code’ from the National Industrial Classification (NIC) Code list of 1987, which has only one code—359.4: ‘manufacture of arms and armaments’—for the entire defence manufacturing sector. The NIC code does not specify what constitutes arms and armaments, and whether it covers dual-use items as well. It also does not specify whether parts and components that go into arms and ammunition, but which may or may not have dual-use application, fall under this head.

The issue with the term ‘item description’ is more nuanced. There is not a single dedicated list, which defence firms can rely on, to describe the defence nature of their production. Rather, they have to refer to at least three different lists, depending on which list best describes their products. Apart from the NIC list (the most generic among the three), the two other lists are:

  1. the Indian Trade Classification (Harmonised System) ITC (HS) Code, as maintained by the Ministry of Commerce’s Director General of Foreign Trade (DGFT) for the purpose of India’s external trade; and,
  2. the ‘Product List’ as articulated in the Ministry of Defence’s (MoD) Defence Procurement Procedure (DPP), for the discharge of offset obligations by foreign vendors.

The DGFT list gives some broad sub-details of the items that are covered by the defence industry. For instance, under the broad HS Code 93 (arms and ammunition; parts and accessories thereof), there are 16 sub-categories. Similarly, the MoD list provides some details of items in 27 categories under three broad headings: Defence Products, Products for Internal Security, and Civil Aerospace Products.

Although more elaborate in comparison to the NIC list, the lists of the DGFT and the MoD are still not defence-specific. They cater to items of defence, dual-use, and even products that can be considered to be commercially off-the-shelf in nature. For instance, under the HS Code 88 (aircraft, spacecraft, and parts thereof) there are sub-categories such as ‘gliders’, ‘balloons’, and ‘under carriages and parts thereof’, which are commercially available products or, at best, dual-use items. A company producing any of the above items is free to apply for a defence license; and once it gets the licence, it becomes a part of the defence industry, even though the item in question may not be defence oriented in nature.

Given the above lack of clarity, the Indian defence industry in the private sector comprises of companies that have a defence industrial license. Even this loosely-defined industry is not free from other issues. It is noteworthy that as per the guidelines of the DIPP, defence falls under the ‘Manufacturing’ sector. So, the companies in the manufacturing business can apply for a license and get it (subject to approval), and be formally part of the defence industry. However, this is not the case for companies in the services sector (such as, engineering, design and software, etc.), which do not come under the purview of ‘Manufacturing’, and hence do not require a licence for their services. Consequently, they are not formally part of the defence industry, even though their services have direct application in defence products.

In a manner of speaking, the only way companies in the services sector become part of the defence industry is by becoming an Indian Offset Partner (IOP)—an Indian company partnering with a foreign company for discharge of the latter’s offset obligation. However, the path towards becoming an IOP is not very clear in the existing policy framework. This is because the term ‘Indian’ in IOP, in the context of a company in the services sector, is interpreted differently from one in the manufacturing sector. The difference is because of the foreign equity that is allowed in these two sectors. For defence manufacturing, FDI is allowed up to 26 per cent, whereas it is up to 100 per cent in the case of the services sector. In other words, in the defence manufacturing sector, a company will be called an Indian company only when it owns a minimum 74 per cent of total equity share of that company. For the services sector, the equivalent minimum equity share (by the Indian shareholder) is 51 per cent in order to be called an Indian company. However, it is believed that the Defence Offset Facilitation Agency (DOFA) —the single window agency under the MoD’s Department of Defence Production responsible for facilitating offsets in defence contracts—does not buy this argument and insists that companies in the services sector must have a minimum 74 per cent domestic equity share in order to participate as an IOP.

Apart from the above ambiguity caused by the FDI policy, the way foreign investment in a company in India is calculated also creates confusion. As per the current guidelines issued by the DIPP, foreign investment in an Indian company is calculated by taking into account both the direct and indirect investments—direct investment is the one that comes directly from a foreign source whereas indirect investment is one that comes through another company in India having a foreign equity. The tricky part is that technically, and as per DIPP rules, if an indirect investment comes from a company in India, in which the foreign partner has a minority share, the said investment is not considered as foreign investment. For example, if company X in India with a foreign equity holding of 49 per cent invests 70 per cent in the equity of another company Y (which is ‘owned and controlled’ by resident Indians), the resultant foreign equity share in Y (70% of 49=34.3) is not technically considered foreign investment. The said rules notwithstanding, the MoD has a different view, which is based on actual equity owned by the foreign partner. In the above example, the MoD views the 34.3 per cent equity share in Y company as foreign investment. In at least one case, the MoD has prevailed over the DIPP’s stipulated technical rules, thus sending the message that when it comes to defence industry it is the actual foreign holding that matters rather than the technical calculation, as suggested by the DIPP. However, given the different approaches adopted by the two ministries of the Government, it would be best to clarify once and for all which approach is correct.