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Defence Offset – Way Forward

The Defence Offset policy has not been able to achieve the desired objectives, despite being in operations over a decade. The draft Offset guidelines circulated in May 2018 are yet to be formally approved and formalised.  Department of Defence Production has been seeking industry suggestions through interaction……

Secretary (Defense Production) Dr. Ajay Kumar and team from DOMW interacted with Industry on Defense offset related issues to understand industry perspective on 10 May 2019. The interaction was organized by IDSA. The key objective of Offset policy is to leverage the capital acquisitions to develop the Indian defence industry by:-

  • Fostering development of internationally competitive enterprises.
  • Augmenting the capacity for research, design and development related to defence products and services specified in the DPP.
  • Encouraging development of synergetic sectors like civil aerospace and internal security. (We request addition of Space in this list).

Secy (DP) informed that the defense Offset portal is now functional for on line submission of input from OEM. As it progresses MoD will made it a Dashboard for progress on offset related issues. The decision on acceptance or otherwise on submitted Offset claims will be within three months hereafter. He wanted industry suggestions as to how Offset can be used to get higher technologies for Indian industry. There were number of suggestions and Secy (DP) and his team will examine the same for inclusions on fresh offset guidelines. Some of the under mentioned issues highlighted by industry were also discussed.

 Spread of Offset in Industry

Most of the Offset contracts pre 2015 were placed on DPSU. An approximate generic pattern spread of offset contact is shown below. Now the spread is getting even with OEM having much better understanding of Private sector capability to deliver.

Avenues for Discharge of Offset Obligation

The present avenues available to the foreign vendors for discharging their offset obligations and performance pattern and challenges are:-

An effective offset policy, especially the stipulations it contains as regards the avenues for discharge of the offset obligations, must address the nitty-gritty of its implementation for it to achieve its objective.

 FDI Route

According to the official statistics of the Department of Industrial Policy and Promotion (DIPP), the FDI in defence, counted from the time it was permitted in 2001, stood at Rs 24.36 crore (USD 4.94 million) in June 2014. In the next four years till the end of June 2018, it increased by a paltry sum of Rs 2.17 crore to Rs 26.53 crore (USD 5.27 million). Evidently, the foreign vendors and other investors are not enthused by the juggling of the FDI cap.  It is possible though that, to some extent, the embarrassingly low inflow of FDI is on account of a faulty method of accounting applied by DIPP to classify foreign investment.

Defence industries have attracted a meager FDI in 2014-15, 2015-16 and 2017-18, $0.08 million, $0.10 million and $0.01 million foreign inflows, respectively. During April-September 2018 foreign direct investment (FDI) was $0.21 million, So far, 41 FDI proposals or JV have been approved in defence sector for manufacture of various defence equipment, both in the public and private sector.  FDI of Rs 1.16 crore has been received under 3 National Industrial Classification (NIC) codes of the defence sector as informed by DIPP.  In addition, six companies, for which FDI approval had been accorded, received Rs 237.44 crores in defence and aerospace sector since April 2014 in other than 3 NIC codes.

The May 2018 draft amendment to Offest guidelines were circulated by Department of Defense Production (DDP) that created a provision of "Offset Fund" governed by SEBI norms.  This is an excellent idea as it creates an Domestic Fund for financing the Defence Industrial Base in India. As per the FDI policy& SEBI norms this capital will not be the part of 49% FDI+FII limit in Defence as the "Offset Fund" will transact "in Rupees" ie it will be a Domestic Fund governed by SEBI.   For a 7-15 yearfund that is taking the Foreign Currency risk, the proposed multiplier of 3-5 is required, given the historic trend of Rupee depreciation.  This initiative of Department of Defence Production creates a funding avenue for creating & sustaining a domestic supply chain, create testing infrastructure and support Start ups especially in Cyber & AI yet retain control in Indian hands. As these funds are outside of the Union budget and will largely not dependent on domestic capital formation, this initiative is a great innovation for the "Market Maker Role" of DPP to push "Make in India".   Sector specific funds exist in real estate so no major Policy approvals are need to implement this.  Industry recommended immediate implementation of "Offset Funds" scheme.

Investment in ‘kind’ - Transfer of Technology (ToT) and Equipment

There are concerns about the equally insignificant investment in ‘kind’ by the foreign vendors in terms of Transfer of Technology (ToT) and equipment and have several questions unanswered for the prospective transferor.

Investment in ‘kind’

Investment in ‘kind’ in terms of ToT to Indian enterprises for the manufacture and/or maintenance of eligible products and provision of eligible services. This could be through joint ventures or through the non-equity route for co-production, co-development and production or licensed production of eligible products and eligible services. The investment in kind in terms of ToT must cover all documentation, training and consultancy required for full ToT. The ToT should be provided without licence fee and there should be no restriction on domestic production, sale or export.

The stipulation that the offset credit for ToT shall be 10 percent of the value of buyback during the period of the offset contract, to the extent of value addition in India’. The way this stipulation is worded gives the impression that the foreign vendors cannot expect to get full credit for the value of the technology, documentation, training and consultancy provided for technology transfer. Instead, the offset credit on this account will be restricted to 10 per cent of the value of the buyback of product and services.

The actual credit may, in fact, be even less than 10 per cent, as it is to be restricted to the extent of the value addition in India (applicable only in the case of direct purchase of eligible products). This is confusing as well as discouraging for the OEM who may be desirous of fulfilling a part of their offset obligation by transferring technology.

In the post GST era (One County One Tax regime) and data being captured in GST network for value addition at IOP or its supply chain (including OEM who is providing ToT) finding "Valuation Addition" on Goods &Services is now possible.  Thus by applying the DPP 2013/2016 norms for indigenous content determination  as the Value Addition norms for Offset value  the confusion can be removed/minimised as this will take care of Royalty payments etc.

Let the value of the technology, documentation, training and related consultancy as claimed  by the foreign vendors, be allowed subject to existing limit of  1/3 of total offset obligation. However this can only be claimed after the Product Export Offsets are fully met.  To avoid the cart before the horse syndrome "provision credits" for ToT etc can be granted which will become full credits once the Product export credits materialise.

Transfer of Equipment

Investment in ‘kind’ in Indian enterprises in terms of provision of equipment through the non-equity route for the manufacture and/or maintenance of eligible products and provision of eligible services (excluding ToT, civil infrastructure and second-hand equipment).

The vendor will be required to buyback a minimum of 40 percent of the eligible products and/or service within the permissible period for discharge of the offset obligations. The way this stipulation is worded does not make it clear whether the offset credit will be restricted to the value of the buyback (which has to be at least 40 per cent) or this credit would be in addition to the value of the equipment.

If the offset credit is to be given also for the value of the equipment, DPP will need to address the question of valuation of the equipment. One way could be to give the credit on account of the transferred equipment to the full extent of its value shown in the offset commercial proposal. In this case, however, MoD will have to make sure that the value shown in the proposal is not at variance with the value with reference to which the custom duty is paid by the foreign vendor while importing the equipment.

Some other questions may also need to be addressed. Just to mention one, the DPP does not visualise a situation in which the foreign vendor may transfer equipment to the IOP free of cost. Where customs duty is payable on such free transfer, there may not be a problem for the MoD in determining the value of the equipment for which the offset credit is to be given, as it can always be limited to the value accepted by the Customs Authorities for the purpose of levying the customs duty.

If, however, the import of the equipment is not subject to levy of the customs duty, it may not be subjected to valuation by the Customs Authorities and, therefore, MoD may face difficulty in accepting the value declared by the foreign vendor. Needless to say, this problem will arise only if the offset credit is to be given for the value of the equipment which may have been transferred temporarily by the foreign vendor only to meet the offset obligation.

It will also need to be clarified by the government in no uncertain terms that temporary transfer of equipment to the Micro, Small and Medium Enterprises (MSMEs) will not push them out of the classification of MSME if by including the value of the temporarily transferred equipment in an enterprise’s investment in plant and machinery, it crosses the monetary threshold provided in the MSME Development Act 2006 for an enterprise to be recognized as an MSME.

As equipment is part of the capital investment and this is not capture by Value addition under GST. Valuation of the equipment is best left to market forces. So in the FAQ section a clarification needs to be posted the Maximum offset credit under this “value of the equipment" will be restricted to the actual value addition in buyback. The offset credits will start, pro rata only after 40 per cent of claimed value thru product export is reached.  Once 100% of "value of the equipment" limit is reached thru valuation addition in export, additional offset credits thru Product export will be available to the OEM under normal Offset route.  To incentivised OEMs to create Indian companies in the supply chain a 20% incentive of "value of the equipment” forever 100% of Export offset (based on Value addition) can be considered.  In fact the TOT (discussed earlier) & equipment can be merged under one clause with a suitable limit.

Recent Amendment Impact

MoD recently allowed the vendors the option of furnishing the details of the IOPs a year before claiming the offset credit or even at the time of claiming the credit and permitting rephasing the implementation schedule and change the IOPs. However the emerging pattern of offers to discharge offset obligations are being heavily loaded on to the last two years of the seven-year period.

Some International Practices

South Korea, Turkey, and Japan successfully developed defence industry sectors. Some countries demand specific offsets i.e, use of directed offsets instead of allowing OEM to choose. The specific offsets could be demanded upfront through the tender documents rather than by leaving them to the discretion of the foreign suppliers. South Korea goes to the extent of making offsets the sole criteria for determining the supplier, besides nominating local players who would partner foreign suppliers in the discharge of offset obligations. Some countries stipulate a select list of futuristic technologies on which the foreign vendors are required to invest at least five per cent of their total offsets obligations.

Turkey uses offsets as a tool to promote export by stipulating the export requirement in the tender document itself.

OEM Expectation

  • OEM have been seeking permission to rope in their group companies and Tier 1 to 3 sub-vendors to discharge offset obligation on their behalf without limit. The MoD in the past has ruled that group companies of the vendor cannot be allowed to discharge the offset obligations on behalf of the OEM. OEM considers it to be unduly restrictive as discharge of offset obligations may make commercial sense for the OEMs, while no compromise in development of the domestic defence industry.
  • Value addition is a challenge. Difficulties in tracking value addition for services which can now be mitigated by proper use of GST data and DPP 2013/ 2016 indigenous content definition.
  • Filing the Offset related claims through electronic submission, monitoring and auditing of offset deals, may be through portal. The mechanism for offset monitoring the one like State Trading Corporation offsets monitoring mechanism will be able to process offset credits with efficiency.

Requested Amendments for Consideration

The draft amendment to its offset guidelines shared with industry in May 2018 provides additional ways in which the foreign OEMs can discharge their obligations.

  1. SEBI regulated ‘funds’ for defence, aerospace & internal security.
    1. Long Term Fund - No Budgetary needed to carryout  DDP’s “Market Maker Role”
    2. Creating Test & Measuring Infrastructure, Scaling up MSME  and creating  a stainable Domestic Industrial base
    3. Support Start up (In Cyber & AI  “IP” remaining  Indian)
    4. 7- 15 Year Fund, so to cover FE risk needs 3-5 Multiplier
    5. As “Sector Specific DII Funds” in Real Estate, Solar & other sectors  exist, hence regulatory frame work in place with SEBI/RBI
  1. Investment by foreign OEMs in Defense corridors& Test Facilities will enjoy a higher multiplier as compared to other areas with regard to the discharge of offsets.
  2. Many in Indian Defense Industry have also developed competency in 'Space" working for ISRO. The recognition of Indian frugal engineering capabilities in Space is well recognized.  As many Indian Industries who are in Defense & Aerospace are also active suppliers to ISRO for Sub System, Propulsion& Boosters; if Space is added to Aerospace, Homeland Security and Defense as offset eligible products, given the de-centralization of "Space" in the world market and need for "Frugal Engineering" (for cost competiveness), Indian entities can find ready acceptability in "Risk Sharing" development cum supply projects.  This will be a win for Indian Defense too as the test and measuring infrastructure needed  to create these Products especially in Electronics, communication (Data Link)   and Power (LI Batteries / Fuel Cells) are dual use.

Pragmatic approach to moving all OEM's Offset obligation under different DPP's to one uniform Offset Guideline if OEM agrees to add 5%/10% (one or two years worth additional obligation) based on mutual consent.  This may need a Cabinet approval as was the case in Telecom when in 2002 different mobile licensing regimes were simplified and made uniform across India.

 

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