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Time-out for ‘Services’ from Offsets

June 19, 2013

The office memorandum issued by the Ministry of Defence (MoD) on May 23, 2013, holding in abeyance till further orders portions of the offset guidelines that related to ‘services’ being an eligible mode of discharging the offset obligation, has put a cat among the pigeons. Every pigeon has a different reason for feeling disturbed. The office memorandum is accessible on the MoD website.

First, a little more about what the MoD has done. In August 2012, it had promulgated a new set of guidelines on defence offsets, which were hailed, albeit with some scepticism, as the harbinger of good times for the Indian defence industry. There were reasons to be upbeat. The new guidelines had bits of practically all the global best practices, with the exception of the provision for offset trading.

The fundamental drawbacks, such as the absence of a provision which would have enabled the MoD to channelize offsets into the area(s) in which those were required the most, were overshadowed by the glitter of several progressive provisions. The new guidelines provided for multipliers and discharge of the offset obligation during an extended period. The guidelines also permitted discharge of the offset obligation through several means, including transfer of technology (ToT). There were other interesting features which, put together, created a feel-good factor.

The revelation in the VVIP Helicopter case that kickbacks were allegedly routed through phony contracts with India-based software companies was the first major blow to the new guidelines that had been promulgated just a few months before this news broke out. The government was quick to announce that it would reconsider ‘services’, which include ‘software development’, as a valid means of discharging the offset obligation. This was ostensibly aimed at preventing misuse of these provisions in the 2012 policy.

After dithering for more than three months since then, the MoD issued orders on May 23, 2013 advising the vendors to keep in mind that, till further orders, it would not be valid to propose discharge of offset obligation through contracts with the Indian Offset Partners (IOPs) for procurement of ‘services’. The orders are applicable not just to the Requests for Proposal (RFPs) to be issued after the date on which the orders were issued but also to the RFPs which have already been issued but in respect of which the last date for submission of the techno-commercial offer has not yet passed.

It may be recalled that the term ‘services’ includes maintenance, repair and overhaul; upgradation/life extension; engineering, design and testing; software development; quality assurance; training; and, research and development. It also includes software, designed and developed for the platforms used by all the services.

Considering the range of activities covered by ‘services’, the MoD’s orders would affect not just the foreign vendors and the Indian companies but the MoD itself. How?

The foreign vendors have long been complaining about the limited capacity of the Indian industry to absorb the offsets in manufacturing. There are problems related to procurement of defence products also as there is not much that the Indian defence market can offer to the foreign vendors, especially within the prescribed timeframes. The tendency, therefore, has been to opt for services and software development because the Indian industry is strong in these sectors. Perhaps half of all the offset contracts signed so far relate to these sectors. More importantly, these sectors are not subject to the cap on the foreign direct investment (FDI) which is often cited as one of the inhibiting factors when it comes to manufacturing.

Suspension of services, including software development from the list of permissible avenues for discharge of offset obligation would, therefore, compel the foreign vendors to look at other modes for discharge of the offset obligation through bringing in FDI for setting up joint ventures, through transfer of technology/ equipment for manufacturing of defence products or through transfer of critical technologies to the Defence Research & Development Organization (DRDO). This will not only entail a long lead time for setting up the facilities but also increase the cost of implementing the offsets, which will ultimately be borne by the exchequer.

In so far as the Indian industry is concerned, the view is likely to be divided. India has been a world leader in software and has not done too badly in the services sector. Both these sectors stand to lose. On the other hand, with these two avenues now not being available, the prospects for the companies in the manufacturing sector could improve substantially, though the problems related to licensing, taxation, FDI, etc., will continue to hold back this sector from realizing its full potential.

The uncertainty created by the temporary abeyance of ‘services’ as a valid means of discharging the offset obligation could prove to be exasperating for the foreign vendors and the prospective IOPs. Those who might have painstakingly drawn up an offset proposal linked to ‘services’, either with the intention of banking the credit or in response to a specific RFP, would need to start from the beginning to formulate alternative proposals. Those who might have been working towards an arrangement related to ‘services’ in anticipation of an RFP will also need to restart the process. It is not an easy task to find suitable companies for a tie-up and work out the details of the arrangement. In any case, it is time-consuming and involves substantial amount of money.

It may be recalled that ‘services’ have been held in abeyance only till further orders. This implies that eventually the MoD may decide not to delete ‘services’ from the list of eligible offsets permanently. Ironically, it would be much more frustrating, who may now be working on formulating alternative proposals, if this temporary ban is lifted and the status quo ante is restored.

All these seemingly negative implications for the foreign vendors and the Indian industry notwithstanding, the decision of the MoD to remove ‘services’ from the list of eligible offsets cannot be faulted, provided this decision is based on the conclusion that ‘services’ are prone to misuse by unscrupulous elements and there is no way such misuse can be checked by a more stringent monitoring system.

It would not be unreasonable to assume that ‘services’ were included in the list of eligible offsets after careful consideration. The MoD cannot allow one unfortunate incident to shake its confidence in the propriety of the decision it had taken less than a year back when it included services in the new offset guidelines. It has to have the courage of its conviction either by boldly revoking the suspension or making it permanent. Going into hibernation on this issue would be in nobody’s interest.

Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.