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Defence Offset Guidelines Continue to Confound

Despite revisions of the Offset guidelines the Textual ambiguities and inadequately defined controls on the process are among several factors, which impair smooth discharge of the offset obligation by the vendors. The author highlights some of them.........

The defence offset guidelines, promulgated in 2006, revamped in 2012, and fine tuned a few times since then, continue to confound. Textual ambiguities and inadequately defined controls by the Ministry of Defence (MoD) on the process are among several factors, notably an obstinate offset contract management system, which impair smooth discharge of the offset obligation by the vendors. Focus on the broader policy issues, such as creating more avenues for discharging the offset obligation, or resolving specific problems faced by individual vendors and IOPs comes in the way of purging the guidelines of confounding ambiguities and opaque controls, of which a few examples are given below.

Textual Ambiguities

Software Development both as a Product and a Service

The list of products and services eligible for discharging the offset obligation, given in Annexure VI of the offset guidelines in the Defence Procurement Procedure, 2016 (DPP 2016), is divided into four categories, under each of which specific products and services, eligible for offsets, are listed, as summarised below:

As one can see, software development is listed both as an eligible product and as an eligible service, which raises the question as to what is the difference between software development as a service mentioned at Sr No 4 above (related to eligible products that fall under the first three categories) and the designing, modification or development of software as a product, mentioned under the first three categories of products, mentioned at Sr No 1 to 3 above.

The positioning of these entries in each list adds to the confusion. There are two entries below Sr No (k) under the first category at Sr No 1 of the Table (Defence Products). From the description of the entry at Sr No (k) (last column in the Table above), it appears that software development is considered an eligible product as long as it is related to the items mentioned at Sr No (a) to (j) and not to the items listed at Sr No (l) and (m), which are: (m) are high velocity kinetic energy weapon systems and related equipment, and direct energy weapon systems related to counter measure equipment, super conductive equipment and specially designed for components and accessories.

Going by the description of the entry at Sr No (k), software designed and developed in relation to these two excluded products, listed at Sr No (l) and (m), will not qualify as an eligible product under the first category (Sr No 1 of the table), but such software would apparently become eligible for offsets if the vendor invokes the provisions related to ‘Services’ as an eligible avenue for discharge of the offset obligation(Sr No 4 of Table 1)because software developed in relation to all eligible products (under the first three categories at Sr No 1 to 3 of Table 1) qualifies for offsets.

When does the vendor get the Offset Credit?

Since the vendors are required to discharge their offset obligation as per the already approved implementation schedule and any shortfall in meeting the yearly targets entails imposition of a penalty, any ambiguity about the date on which offset credit becomes due in respect of any transaction carried out by the vendors in accordance with the offset contract has serious implications for them. This is a problem area as various provisions of the offset guidelines, when read together and also in conjunction with the Frequently Asked Questions (FAQs) available on MoD’s website, give rise to many uncertainties. For example, as explained below, there are conflicting provisions in the offset guidelines and the FAQs about when would the vendor be entitled to the credit for Transfer of Equipment (ToE) or Transfer of Technology (ToT), both of which are permissible avenues for discharging the offset obligation.

Para 5.13 of the offset guidelines, which deals with valuation of offsets, provides that in the case of discharge of offset obligation through direct purchase of defence products or services, the date of invoice or the date of final payment (whichever is later) will be reckoned as the date of discharge of the obligation, and in all other cases, which would obviously include discharge of the offset obligation through ToE or ToT, the date of completion of the transaction, based on documentary evidence, shall be reckoned as the date of discharge of the offset obligation. This clearly implies that the credit for ToE or ToT will become due as soon as the transfer is completed, but paras 5.6 and 5.7 of the guidelines and the clarifications given in the FAQs seem to contradict this understanding.

Paras 5.6 stipulates that in the case of discharge of the offset obligation through ToE, the vendor will be required to buyback a minimum of 40 percent of the eligible products and/or service (by value) within the permissible period for discharge of offset obligation. In the case of ToT, para 5.7 stipulates that the credit for technology shall be 10 percent of the value of buyback during the period of the offset contract, to the extent of value addition in India. It is clear from these paras that the offset credit on account of ToE or ToT, which should be available on the day on which the transfer transaction is completed in terms of para 5.13, will be available only after the buyback stipulations mentioned therein are fulfilled. Going by this understanding, offset credit for ToE and ToT will not be available on the date of completion of the transfer transaction but only at the end of the period of discharge of the offset obligation (PoD), tough the vendor can continue to earn the credit for the products and services bought back any time during the PoD.

This view is reinforced by the FAQs where it is clearly mentioned that the claim for discharge of offset obligation through ToE is admissible only if the vendor buys back a minimum of 40 per cent of the eligible product or services generated by using the transferred equipment within the PoD. In the case of ToT also, the situation is not any different because the list of documents required to be submitted by the vendor to earn the credit for the transferred technology as per the FAQs includes the evidence of buyback during the PoD of the offset contract. These clarifications given in the FAQ are not in harmony with para 5.13 which clearly says that the offset credit will be reckoned with reference to the date of completion of the transaction. This exposes the vendors to a grave risk.

Risk in Discharging Offset Obligation Through ToE/ToT

In the case of ToE, whether the vendor has bought back a minimum of 40 per cent of the eligible product or services generated by using the transferred equipment within the PoD, can be determined only on completion of the PoD of the offset contract. Even a fractional shortfall in the stipulated percentage could result in the credit for the transferred equipment being denied to the vendor. There is no provision for the vendor being given any grace period to make up the shortfall. Similarly, in the case of ToT, since the value of the technology for which credit can be claimed by the vendor is to be 10 per cent of the value of the buyback during the PoD, the vendor will have to wait till the end of the PoD to know how much credit he can get for the transferred technology, unless he plans his buyback so meticulously that 10 percent of the value of such buyback works out to the amount of credit he had intended to earn on account of ToT when he submitted the offset proposal. This adds to the difficulty of discharging the offset obligation.

Absence of Real Time Feedback About Acceptability of Offset Credit Claims

A further complication arises from para 8.9 of the guidelines which provides that the offset credits shall be assigned after scrutiny of six-monthly reports required to be submitted by the vendors by 30thJanuary and 30th July every year.  This implies that if, for example, a vendor completes certain transactions eligible for earning offset credit, say on 1st of February of a particular year, he will be able to reflect this transaction only in the next report due by 30th July and then he will have to wait till the report is scrutinised and the claim audited (for which no time limit is prescribed) for the offset credit to be reflected in his account. If any claim is rejected at this stage, the vendor faces the additional risk of retrospectively falling short of the annual target fixed for the relevant year in the offset contract, rendering him liable to pay the penalty for such shortfall.

What is the limit on penalty for failure to meet the offset obligation in full?

Para 8.13 of the offset guidelines provides that penalty equalling five percent of the unfulfilled offset obligation will be levied on the vendor who fails to meet the annual target in a particular year in accordance with the annual phasing envisaged in the offset contract. The unfulfilled offset value will thereafter be re-phased over the remaining period of the offset contract. The penalty may either be paid by the vendor or recovered from the bank guarantee of the main procurement contract or deducted from the amount payable under the main procurement contract or recovered from the Performance Bond of the offset contract. The said para also provides for an overall penalty cap of 20 percent of the total offset obligation during the period of the main procurement contract, but it also clearly says that there will be no cap on penalty for failure to implement offset obligation during the period beyond the main procurement contract. Para 8.14 further provides that any vendor failing to implement the offset obligation will be liable for action as per MoD’s ‘Guidelines for Putting on Hold, Suspension, Debarment and any other penal action on the Entities dealing with Ministry of Defence’.

Several issues arise from these provisions. First, while para 8.13 provides for imposition of penalty equalling five per cent of the unfulfilled offset obligation of a particular year and specifies the mode of recovery of the penalty, an example given in the FAQs indicates that the monetary value of the penalty is to be added to offset obligation to be discharged by the vendor in the following year. Second, the stipulation that there will be no cap on the amount of penalty beyond the period of the main contract implies that, technically, MoD can impose penalty that even exceeds the value of the unfulfilled offset obligation. Third, the guidelines referred to in para 8.14 envisage suspension and banning of dealings with a defaulting entity. Invocation of these guidelines could lead to a situation where, apart from having to pay an unspecified amount of penalty, the vendor may also face suspension or debarment. This makes the offset guidelines somewhat swingeing.

Need to remove textual ambiguities

There must surely be some explanation for the ambiguities in the offset guidelines, including those mentioned above. Some other ambiguities have indeed been removedin the FAQs, but there is no reason why the text of the offset guidelines should not be combed through, bugbears identified, and necessary corrections made in the very text of the main guidelines. Many clarifications given in the FAQs go to the core of the offset guidelines and, therefore, must form a part of the main text.

Opaque Controls

The offset guidelines provide for scrutiny of the technical and commercial offset proposals by the Technical Offset Evaluation Committee (TOEC) and the Contract Negotiation Committee (CNC) respectively to ensure their conformity with the offset guidelines. These committees can also ask the vendor to modify the proposal if they find it to be not in conformity with the guidelines.

Ideally, there should be no need for such a scrutiny if the offset guidelines are absolutely clear about the quantum of offset obligation that a vendor has to discharge, the avenues for discharging the obligation, the eligibility criteria for choosing the Indian Offset Partners (IOPs) (which even as per the existing guidelines is the vendor’s prerogative), the methodology for claiming and earning the offset credits, the PoD of the offset contract, and all other requirements thata vendor must keep in mind while formulating the offset proposal.

The fact, however, is that the offset guidelines provide for pre-scrutiny of the offset proposals which signifies that either the MoD is not sure if the guidelines are comprehensive enough,as a result of which the vendors are prone to submitting proposals that are not in conformity with the offset guidelines as understood and interpreted by the TOEC and CNC. It is also an implied admission of ambiguities in the offset guidelines and a clear indication of undefined controls the MoD wants to exercise on the process.Scrutiny under these circumstances can be subjective, especially in the absence of any publicised checklist followed by the MoD to determine conformity of a proposal with the offset guidelines.

Considering that the vendor is fully responsible for discharging the offset obligation – with the help of his Tier-I sub-vendors, if required – and the offset guidelines give him the freedom to choose the avenues and the IOPs for discharging his obligation, it is inexplicable why the offset guidelines stipulate that after signing the offset contract the vendor cannot change the IOPs, alter the avenues for discharge of the offset obligation or rephase/ restructure the offset implementation schedule without the prior permission of the MoD (for which no time frame is prescribed). If there are any considerations, other than those mentioned in the offset guidelines, that are taken into account by the MoD for accepting or rejecting a vendor’s request for change/rephasing/restructuring, these considerations ought to be in the public domain, but they are not.

This opaque controls undercut the objective of procedural transparency.It may be too drastic to suggest that all such controls should be done away with, but there is little doubt that at the least disclosing the checks exercised by the TOEC and CNC to determine whether the offset proposals conforms to the prescribed guidelines, and while accepting/rejecting the vendor’s request for change/rephasing/restructuring, will ensure submission of guidelines-compliant offset proposals by the vendors, save the processing time for conclusion of the contract, eliminate subjectivity in contract management, and, most importantly, speed up execution of the offset contracts.

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