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Finance Bill: Impact on the Aerospace and Defence Budget

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The new DPP may bring in seminal changes in the acquisition process; however, global OEMs and Indian industries are waiting for critical changes, in particular, on matters of taxation and timelines of procurement…

There is little doubt that the slew of measures introduced by the Government of India in the recent past to promote the A&D sector is truly laudatory. Whilst all of industry is awaiting the new Defence Procurement Procedure which may bring in seminal changes in the acquisition process equally importantly global OEMs and Indian industry are waiting for critical changes, in particular, on matters of taxation and time lines of procurement. This article is restricted to issues of taxation.

Indian industry has been seeking relief in the tax architecture in two core areas.  The first relief sought was to provide the same indirect tax exemptions for the private sector as was applicable to DPSUs/OFBs and their sub-contractors for supplies to the Ministry of Defence (MoD).This relief was intended to create a level playing field by rationalizing indirect taxes such as Central Excise, Customs Duty and Service Tax for all stakeholders in the A&D industry. The foreign OEM who exports to India, the DPSU/OFB and the Indian Private sector had differential tax regimes which benefited the OEM and the DPSU/OFB more than the private sector.

It is also worth noting that foreign OEMs possibly avail export related incentives in their respective countries for their international contracts. Indian Private Manufacturers need level playing field to make their cost of production as well as cost of supply at par with that of Foreign OEMs and DPSUs. Therefore, rationalization of tax is required on inputs / raw materials / capital goods whether imported or locally procured.

                Also, the earlier inverted duty structure making foreign OEM fully formed items cheaper than CKD/SKD/IM solutions needs correction for the indigenous industry to grow. This is possible by way of exemption from duty on purchase / import of inputs/ raw materials / capital goods etc. by domestic manufacturers within the country as has been given to foreign OEMs / DPSUs and their sub-contractors which requires gazette notification for each case. In an earlier article I had made a case for according deemed export status and removal of Central sales tax for products integrated in India for supply to MoD.

                After much soul searching and deliberation the win-win simple proposal (Alternative 1) that was made to the Ministry of Defence was that Notifications No. 39/96 dated 23.07.1996 for customs duty and Notification No. 62/95 (OFBs) and 63/95 (Defence PSUs) dated 16.03.1995 for excise duty by which DPSU/OFBs and Foreign OEMs are exempted when supplying goods to the Ministry of Defence should be paripassu made applicable to Indian private industry supplying such goods and services to the MoD/DPSU/OFB as a contractor /sub-contractor.

                The alternate (Alternative 2) solution to provide a level playing field that was discussed was to remove all exemptions for all entities and for MoD to absorb all duties as their procurement cost. The downside of this was that it would inflate the Defence Budget, which would attract international attention, without actual commensurate capacity building and the tax dues (which may add at least 30%) would have to be paid back to the Contingency Fund as receipts.

                Recently, the Government of India has issued two critical notifications that does create a level playing field for industry but critically raises the cost of acquisition by the Ministry of Defence favoring to increase the cost of acquisition to MoD but gathering taxes rather than exempting taxes and duties and reducing the cost of acquisition to the MoD.  In the case of excise duties GoI in partial consideration of alternate solution(II)  provided above has withdrawn excise and customs duty exemptions presently available to goods manufactured and supplied to MoD by OFB/DPSUs. For supplies from Ordnance Factory Boards Sl.No.1 and 6 of notification No.62/95-CE dated 16.03.1995 as omitted by notification No.23/2015-Central Excise, dated 30.04.2015 refers. Further, excise duty exemption presently available to Defence PSUs is also withdrawn. S.No.2 and 16 of notification No.63/95-CE dated 16.03.1995 as omitted by notification No.23/2015-Central Excise, dated 30.04.2015 refers.

In its recent budget proposals, in the case of customs duties Government has scrapped the Customs Duty benefit available to DPSUs and Foreign OEMs w.e.f.01.04.2016 by virtue of notification no.14/2016-CUS dated 01.03.2016 withdrawing the Sl. No.9, 9A, 10 & 10A of the exemption notification no.39/1996-Cus.

                These measure may have brought parity between Domestic Private Players with OFB/DPSUs in the matter of payment of Central Excise and Customs Duty and imposed duties on OEMs which in both cases have to be borne by the MoD. The summary of the impact on the Ministry of Defence for procurements is as tabulated below:-

     Due to the removal of the exemptions for all entities, the MoD has to absorb all duties as their procurement cost. This would inflate cost of procurement by as much as 32% and MoD will have to absorb these tax burdens within their allotted budgets since the Demands for Grants are approved on the Gross Expenditure and not on Net Expenditure. This implies that taxes paid by MoD as part of the purchase cost would be budgeted within the allotted Gross Expenditure and tax refunds (should it be notified) would go to the Consolidated Fund of India. This pre supposes that the MoD has the ability to prepare and follow up with the tax authorities for refunds which itself are unlikely to be credited within the same financial year.

By some very rough estimates the impact of these notifications for FY 16-17 alone could be:-

  • Additional payment towards Basic Customs Duty of 5% (on indirect import i.e. import made by domestic suppliers assuming 50% of supply value), CVD at 12.5% &impact of the same on VAT of2.5% i.e. total impact of 20% on INR 65,000 Crs amounting to INR 13000 Crs.
  • Additional payment towards Customs Duty on direct import from Foreign OEMs/suppliers at 29% (which includes Basic Customs Duty 10%, CVD 12.5% and SAD 4%) on about INR 100,000 Crs (including about 70% of the Capital budget and about 50% of spares under revenue) amounting to INR 29,000 Crs.
  • Thus the operational impact could be a shortfall of about INR 42,000 Crs for meeting the same procurement requirements and quantities as well as delays in delivery due blockage in cash.

                Thus MoD would procure lesser quantity of items as domestic procurement since these taxes and duties have to be absorbed within the allotted gross expenditure. Also, cash flows of the Indian A&D industry, particularly MSMEs who form the bulk of the supply chain, would be impacted significantly as operating cash will be locked in for paying the excise duty on supply of defence items to DPSUs / OFBs. This in turn will raise the cost of production by the cost of capital over the period of refund which may be at least 5-7% considering a 6 monthly payment period.

                The impact of the above change is that for purchasing same quantity, as earlier, Ministry of Defence may have to incur additional cash outflow of INR 42,000 crores for the products it buys from the Foreign OEMs, DPSUs and OFB, which is approximately 25% more than what MoD had to incur prior to the issuance of this Notification. Consequently, sales will decline in the sector leading to unutilized capacities.

                Also for existing programs for which imports are continuing and pending agreements such as the Rafael program, M777 howitzers and weapons package of the P-17A ships totaling about INR 100,000 crs alone would now be raised to INR 129,000 crs at a minimum.

                Considering that the defence budget is nearly at its lowest level of GDP ever, the MoD would now have to bear the additional burden of customs and excise duties in its force modernization endeavours. Since the budget is limited the “loss” in capability building and “operational” capability and readiness by ensuring sound material state of the equipment for which spares are required would be severely impacted.

                It is noteworthy to mention here that while the Government has withdrawn all customs and central excise duty exemption on defence procurements, on the other hand it has slashed customs duty and excise duty on various items by 50% on refrigerated containers, reduction of excise duty from 12.5% to 6% on parts for manufacture of Pump, reduction of customs duty from 10% to Nil on magnetrons for microwave oven etc. to name a few.

                As I had discussed in an earlier article the second relief that was sought for the growth of the industry was under the Income Tax Act.  There is no doubt that substantial capacity has to be built in the defence industry. Almost 2000-3000 MSMEs/new production units are required to meet the Tier2/Tier 3/Tier 4 workshare alone for import substitution and exports and certainly these companies would need investment for capital goods. Since the defence industry has a long gap between proposals and orders there is a certain risk in the investment and returns on investment are much slower to come by. It is in this context that the following proposals for relief under the IT Act are sought to be extended to the entire Aerospace and Defence Sector;-

  1. Section 10(6C) for exemption from income tax in respect of royalty or fees for technical services for providing services under the projects / agreements entered into by Indian aerospace and defence industry with foreign companies i.e. OEMs.
  2. Section 10AB or Section 10AAA (as new sections) for deduction / exemption of income from sale of IT products, MRO and ESO required for the Aerospace and Defence Industry.
  3. Section 32AC provides for a deduction of 15% of actual cost of new assets by a company engaged in business or manufacturing which invest a sum of INR 25 Crs or the business entity. This deduction should be provided to the entities registered under SME Act.
  4. Section 35AD provides for a deduction on any expenditure of capital nature incurred, wholly and exclusively, for the purposes of any specified business. Specified business should be extended to include licensed manufacture and production of defence and aerospace equipment and their parts thereof.
  5. Section 80IA provides for a deduction in respect of profits and gains from industrial undertakings or enterprises engaged in infrastructure development.
  6. Section 80IB provides for a deduction in respect of profits and gains from certain industrial undertakings other than infrastructure development undertakings.

These very exemptions have been permitted in various other sectors such as roads, highways, airports, telecommunications, ports, other businesses such as manufacture of ships, operations of hotels, housing projects, multiplexes, hospitals, cold chain, warehousing, petroleum pipelines, hotels above 2 Star, hospitals more than 100 beds, wafer fabrication manufacturing unit etc.  So these exemptions and benefits should also be logically applicable to the strategic A&D sector.

                However, in the Finance Bill 2016 some of these incentives and deductions have been done away with for the notified sectors. Of course, needless to say the Aerospace and Defence Sector was not a notified sector and hence arguably no benefit has been foregone.

                The Government of India must weigh the impact of these notifications on the defence budget in terms of the burden that it would additionally impose on its plans for force accretions and modernization on the one hand and Indian industries plaint for a level playing field. These measures may sound good for Indian industry but certainly imposes major challenges for national security.

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