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Incentivising the A&D Sector: Remaining Issues

 

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Over the past year, Government of India has adopted a slew of measures to provide relief and incentivize the national aerospace and Defence Industrial Base (DIB). This journal can derive some pride as many of its policy recommendations raised in the past have been acted upon by the Government of India. The author discusses some more issues...  

Over the past year, Government of India has adopted a slew of measures to provide relief and incentivize the national aerospace and defence industrial base. Though much has been done by word and letter through issue of office memorandum, gazette notifications, and press notes, the spirit that is evident from the openness with which ministry officials now interact with industry and the industry associations is the most refreshing.  This journal can derive some pride as many of its policy recommendations have been acted upon by the Government of India. To begin with, the following policy recommendations made through this publication journal have been accepted:-

Regulatory Matters

Industrial licencing (IL): Licencing requirements has been made easier and the validity has been increased to 15 years. Details are discussed in the cover story.

FDI in Defence: FDI policy has been further liberalised from a restrictive 26% through government route to 49% through automatic route.

Offsets: Requirement for the flexibility in change in offset partners post signing of contract, restoration of few 'services', reduction in indigenous content requirement and submission of the offset implementation plan extended to one year before date of discharge of the offset are the few measures adopted.

Defence Exports

Defence exports have been liberalised with the promulgation of the Notification No 115 (RE  2013)/2009-2014 New Delhi, Dated 13 March, 2015 on the subject: Export of Military Stores. S.O.(E) which amends Table A of Schedule 2 of ITC(HS) Classification of Export and Import Items therefore,  a “No Objection Certificate (NOC) can now be  obtained from the Department of Defence Production, Ministry of Defence, New Delhi as per the provisions of Standard Operating Procedure (SOP) of Department of Defence Production”, in sixteen categories. Critical omissions in the notified list are aircraft and helicopters. However, dual use SCOMET notified items would continue to require NOC of the DGFT. As per a recent Press Release, “The value of the defence equipment exported to various countries in last three years and the current year (up to 30.09.2015) by Defence Public Sector Undertakings (DPSUs), Ordnance Factory Board (OFB) and Private Sector Companies (based on the NOCs issued) is as under which shows an increasing trend:-

YearValue of Export (Rs. in Crores)
2012-13  446.77
2013-14  686.27
2014-15  994.04
2015-16(upto 30.09.2015)  695.70

The Government has taken several initiatives to ease the process of applying for NOC for export of military stores. These initiatives include:

  • Adopting an online system for receiving applications for NOC for export of military stores
  • Simplification of the Standard Operating Procedure (SOP) for issue of No Objection Certificates (NOCs) for export of military stores
  • Notification of the list of Military Stores
  • Requirement of End User Certificate (EUC) to be signed / stamped by the Government authorities of the importing country has been dispensed with for the export of parts, component, sub-assemblies, and sub-systems
  • Provision for issuing advance / in principle clearance for exploring business opportunities abroad.

Integrity Pact

 An Integrity Pact was mandatory for contracts over Rs 100 crore under the DPP 2013. Now, vendors contracting for equipment worth Rs 20 crore will also have to sign the pact.

Taxation Matters

Indirect Taxes: To establish a level-playing field between Indian private sector and the public sector, the anomalies in excise duty/ custom duty have been removed. As per the revised policy, all Indian industries (public and private) are subjected to the same kind of excise and custom duty levies. MoF notification on Custom duty dated 30/04/2015 and MoF notification on Excise duty dated 30/04/2015 refers. This measure has undoubtedly brought parity between Domestic Private Players with OFB/DPSUs in the matter of payment of Central Excise and Customs Duty. However, it retained the exemption of Basic Customs Duty (BCD) on import from foreign suppliers only by DPSUs/OFBs. Further, the Government has also retained the entire import duty exemption in case Foreign OEMs directly supply to MoD. The summary of the impact on the A&D sector is tabulated below-

The impact of this notification is summarised below:

  • DPSUs/OFBs will continue to enjoy the benefit of BCD exemption (ranging from 7.5% to 15%) on their imports for supply to MoD, which will give them a price advantage of 7.5% to 15% over private players.
  • Foreign OEMs will continue to enjoy the complete exemption from payment of Import Duty [Basic Customs Duty (BCD) + Countervailing Duty (CVD) + Special Additional Duty (SAD)], which gives them the price advantage of around 28% over domestic suppliers including DPSUs/OFBs.
  • The Demands for Grants are approved on the Gross Expenditure, and not 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.
  • 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.
  • 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 that payments may take 6 months
  • Since DPSUs/OFBs can avail of tax concessions of BCD for imports from foreign OEMs, they may prefer to source from foreign vendors the same supplies that Indian vendors are now making to the DPSUs/OFBs.
  • Since Foreign OEMs will continue to enjoy import duty exemption benefit for direct supply to Government, they may not have incentive to establish manufacturing in India under Make in India programme. This will defeat the very purpose of the programme as well as the purpose of giving such exemption.
  • The Foreign OEMs will also take advantage of import duty exemption and import equipment / machinery, which would be required by them for manufacture of the defence items to be supplied to GoI, whereas the Indian company has to import such equipment with payment of import duty requiring more investment. This will again adversely affect the economic efficiency of this sector.
  • The impact of the above change is that for purchasing same quantity, MoD will now incur additional cash outflow for the products it buys from the DPSUs and OFB, which is approximately 31% 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.

Commercial Matters

Exchange Rate Variation (ERV): ERV protection has been allowed on foreign exchange component to all Indian companies including private companies in all categories of capital acquisitions, so as to create a level playing field between the Indian and foreign industry.

Outsourcing and Vendor Development Guidelines for DPSUs and OFB: Outsourcing and Vendor Development Guidelines for DPSUs and OFB have been formulated and circulated to SMEs for defence manufacturing to promote the participation of private sector. The guidelines mandate that each DPSU and OFB are to prepare a short-term and a long-term outsourcing and vendor development plan to gradually increase the outsourcing from private sector including SMEs. The guidelines also include vendor development for import substitution.

Preference: Only so far as categorisation is concerned the preference has been prioritised as to 'Buy (Indian)', 'Buy & Make (Indian)' & 'Make' categories of acquisition over 'Buy (Global)' category, thereby giving preference to Indian industry in procurement.

From the foregoing, one can say with certainty that the recent measures signal the Government's intention to encourage growth in the defence sector and put India on the global map vis-à-vis defence industrial capabilities. However, several matters that directly impinge upon the industry are yet to find resolution. These are discussed hereafter.

Concerns Remain

In spite of the proactive stance of the Government, with regard to private sector participation in defence manufacturing, doing business in India continues to be a highly complex and daunting task for companies. Several challenges remain in implementation that must be addressed for this policy shift to become successful.

  • Taxation

The present tax regime is the biggest disincentive for investment and growth of the A&D sector. Essentially, relief is sought for the growth of the Indian A&D industry on two aspects.

First, provide a level playing field between the Public, Private and Foreign OEMs by rationalization of indirect taxes such as Central Excise, Customs Duty and Service Tax and  exemption from duty on purchase / import of inputs/ raw materials / capital goods etc. for all domestic manufacturers so that the tax levies on manufacturing is same for all players. This has been achieved though its final impact on industry and the MoD budget is yet to be seen.

Second, promote creation of additional industrial units to boost manufacturing. Benefits under the IT Act on the same lines as has been made available to other core sectors are yet to be extended to the A&D Sector. Also of note is that in the proposed Goods and Service Tax defence products and services supplied to the MoD need to be classified under Zero Rate.

  • Deemed Exports

The present taxation regime and the Foreign Trade Policy does not aid in promoting “Make in India” since the inverted tax and duty structure makes direct imports cheaper than manufacturing in India. Considering the indigenous content by way of local production and value addition to be about 30% of the product base cost and the balance 70% being import content, the table below summarizes the final cost to the MoD under  different scenarios and highlights the disadvantageous tax regime for indigenous manufacturing:-

However, the best solution to this problem does not lie in imposing taxes and duties on defence imports, whether as systems or components. This would stretch the already meagre allocations to the MoD and be revenue neutral for the Government of India as a whole regardless. Instead, it is proposed that “deemed export” related benefits be extended to defence acquisitions categorized under “Buy Global” or under the “Buy and Make with TOT” or the “Buy and Make (India)” category or under an “Intergovernmental Agreement” which require, amongst other manufacturing requirements,  final assembly, integration, testing and delivery to the MoD from a facility located in India. For sourcing of certain equipment and systems from abroad for “Make” projects, either for technical or commercial reasons, a similar situation may be obtained.

This policy intervention would provide the following benefits:-

  • Lower capital cost of acquisition
  • Reduce revenue expenditure towards spares, and MRO services.
  • Promote “Make in India for the World”
  • Encourage Foreign Manufacturers to set-up manufacturing base in India as JVs or W.O.S
  • Provide level playing field to Indian companies
  • Skill development in high technology manufacturing and Job creation in this sector
  • Increase capacity of Indian industry to deliver larger volumes of A&D products and compress delivery schedules after learning curve stabilizes. Potentially indirect jobs would also accrue.
  • Increase national capability to undertake complex manufacturing, system integration, and product/platform testing.
  • Export promotion

The revenue loss is notional since the mechanism does not exist for the revenues to accrue in the first place. It may also be mentioned here that in order to promote “Make in India” and to provide a level playing field to the indigenous manufacturers, status of  Deemed Export  under The Central Sales Tax Act be accorded to all supplies of defence goods manufactured in India and supplied to MOD/ DRDO/ DPSU/OFB/ Armed Forces. For clarity, defence goods are those equipment/platforms that require an industrial licence for manufacture in India.

Commercial Matters

Price Variation Clause: The Defence Procurement Procedure 2013 (DPP 2013) issued by the Ministry of Defence does not provide a price variation clause for projects running into several years which is unrealistic and a disincentive for the A&D Sector. Under Rule 204 (viii) (a) of GFR (2005) and various other procurement manuals of the Indian Railways, Department of Atomic Energy, etc, where projects run into several years, a price variation clause is provided. Since the provision for price variation already exists in government guidelines, the same must also be made applicable to defence contracts.

Multi-Currency Bids by Indian Industry: Indian bidders can only bid in INR for defence ministry projects. Since the import content of defence products can be as high as 50%, multi-currency bids by Indian Vendors bidding for Defence projects can offset major currency risks particularly for long duration projects requiring global sourcing. Multicurrency bids by Indian Vendors should be permitted for Defence contracts also. RBI guidelines permit such bids.

Purchase Preference for Indian A&D Industry: Under DPP 2013, Indian bidders require an indigenous content of 30% when competing under 'Buy Global' (without attracting offset provisions) and 'Buy Indian' acquisitions. This direction, originally intended to benefit Indian industry, may be counter-productive, since Indian companies would have to source 30% content from local Indian Tier-1/Tier-2 vendors, who do not have ready capability, are at the bottom of the learning curve and lack the economies of scale to offer a competitive price. On the other hand, Global OEMs are free to select vendors from across the world,  who offer the best price and terms and conditions, thus making their bids more winnable. In 'Buy Global' cases a purchase preference for Indian vendors becomes logical and a 10% price advantage would be eminently reasonable. This is admissible under Indian law and should be included in the DPP 2013.

DCF Method for Multi-Currency Bids: Disadvantageous to Indian Industry. The Discounted Cash Flow (DCF) method is applicable to determine the Net Present Value (NPV) of stage payments made over several years. However, as per the methodology adopted in the DPP 2013 Indian and foreign currency bids (after conversion, basis the spot rate of the date of opening of the price bid, to the INR equivalent) are both discounted at the GoI's lending rate on loans to state governments. This is extremely disadvantageous to Indian bidders since the interest rate differential in risk free interest rates across currencies maybe as much as 7 to10 times the GoI's lending rate. It is proposed that the applicable discount rate for bids in different currencies should first be discounted at its own risk free interest rate or LIBOR + 2% and then converted to INR on the spot rate prevailing on opening of bid as per internationally accepted norms.

Regulatory Matters

Offsets: There are no two opinions that the offset policy has not achieved its intended objective. It is evident to all stakeholders that the key issue is that the offset policy/procedure is unnecessarily complicated and is more an exercise in accounting than a strategic instrument to generate much needed national capacity and capability building in addition to skill development in the A&D Sector. The crux of the problem is the unnecessary and restrictive stipulation of offset fulfilment limited to the OEM or his project specific Tier 1 Vendor only in proportion to the work share in the specific product. Since OEMs are mostly system integrators and have about only 30 percent content by value in a product with the balance 70  percent contributed by  possibly 60-70 or more Tier 1 Vendors there can be no useful offsets that can build national capability in this salami slicing approach. In addition, each product the Tier 1 Vendor list may be different, thus making a Tier 1 vendor under one project ineligible for offsets under another project by the same OEM. Similarly, a group company may have won another contract in India but that company cannot meet offset requirements from Indian vendors who are already “qualified” to the OEMs vendor specifications. Therefore:-

  • Such stipulation should first be removed. Offsets must remain the sole responsibility of the OEM alone. So long as the offset requirements are clearly and unequivocally complied with details such as participating partners and vendors, respective workshare etc. are inconsequential and do not add any value to creating robust business or industry in India. On the contrary, if these artificial restrictions are removed OEMs could be encouraged to create major industrial hubs in India by cumulatively adding to capability and capacity in India through offsets.
  • Offsets should not be vendor driven but buyer demanded to achieve specific national capabilities
  • All unnecessary and complicated formulae that are presently included in the DPP 2013 should be removed.
  • Unless offsets have, a commercial “value” in determining the L1 vendor there should be no requirement for all vendors to submit technical and commercial offsets proposals. Only the L1 vendor should submit the offset proposal before the CNC process is completed.
  • Offsets are a cost to the OEM, are reflected as liabilities on his balance sheet until discharged, and thus subject to shareholder scrutiny. Therefore OEMs also wish to protect their Brand Equity and reputation by discharging their offset commitments in a time bound and productive manner. However, the above lacuna impedes the effectiveness of offsets and poses challenges for their implementation on ground. In summary the following are proposed:-

Indigenous Content: A high indigenous content must be the final objective. However, this does not mean that every item of a system is sourced only from indigenous vendors. Smart 'Self-reliance' in today's context means a mixture of global buy and localized “buy or make” to achieve reduced costs, faster deliveries and most importantly, superior quality and system performance.  However, the present direction of the DPP 2013 requires each item of the Bill of Material to exclude import content at all stages (tiers) of manufacturing/ production/ assembly. For example, steel sourced from SAIL would require deletion of all import by way of ore, scrap iron, mineral additives etc. that may be sourced from global vendors and this 'import' content reduced to arrive at the indigenous content! Hence, this definition and restrictions needs major alignment with the core realities of production and manufacturing unique to the A& D sector, and should be aligned with the concept of “Make in India”, as visualised by PM Modi instead of this futile accounting exercise conceived in the DPP 2013.

Incentives for Indian Industry for the A&D Sector

 The following measures could be considered:-

  • A single window system to address all matters of the A&D industry including defence licencing, imports and exports, offsets, domestic sales, etc. be created at the Ministry of Defence
  • Promoting a sustainable and encouraging industrial ecosystem combining resources of the government, industry and academicians for innovation, R&D and manufacturing.
  • Bolstering confidence in Indian designed, Indian developed, and Indian produced defence equipment in the armed forces by encouraging “Make” projects.
  • Promoting directed investment in education and skill development to create a sustainable pool of high calibre talent for this sector.
  • Allowing easier access to funds for investments in A&D R&D, Innovation and Brand India through domestic or External Commercial Borrowings.
  • Encouraging “Made for India” designs, solutions and devices, local value addition and IP creation.
  • As an incentive to promote the Indian aerospace and defence industry and develop a strong domestic manufacturing base, encourage entrepreneurship and promote research & development, the following is proposed:
  • A Defence Manufacturing Promotion Fund (DMPF) for providing grants and loans for procurement of capital goods/input services for establishing defence and aerospace industries, particularly in the MSME sector.
  • A Defence Entrepreneurship Promotion Fund (DEPF) for providing grants and loans to entrepreneurs, investing in import substitution goods and services for the A&D sector.
  • Defence Industrial Research & Development Funds for providing grants and loans to encourage research and development in the private sector/academic institutions for creating test facilities, financing mission mode projects, etc.
  • The defence and aerospace sector also requires a fillip for innovation. A Joint Innovation Council with participation of Indian Industry, IITs/IISc, MoD and Defence Services could be considered.
  • A Task Force could be constituted, drawing members from the Ministries of Defence, Finance, Civil Aviation, Surface Transport, Electronics and Telecommunications, and Commerce and Industries and the Industry bodies to draft the national aerospace and defence production policy. This would consolidate incentives and exemptions for domestic industry, encourage directed FDI, promote Foreign Technology Cooperation Agreements, and recommend processes to build national capacity in this vital sector. A suitable representative from the PMO could chair the Task Force.

Concluding Remarks

There are mega projects in the A&D sector today worth about US $400 billion over the next three plan periods. It is our collective national duty that all these projects must be “Make in India”. We must note that our Hon'ble Prime Minister said “Come, Make in India” not just “Make in India”. This means that the facilitation for “Make in India” must extend to the foreign OEMs, which in turn means a more rational FDI/taxation/industrial policy in this sector. The key question is should we deny 100% FDI to OEMs now and import from third countries later which offered them that option? For example, do we want to import helicopters from an OEM facility in Vietnam because Vietnam offered the OEM 100 % FDI and India did not? As our Hon'ble Prime Minister indicated if existing procedures are impediments to this objective then we must change them but “Make in India” we must.

Resolving the above issues will further encourage participation of Indian industry in meeting the requirements of the Indian armed forces. Of course, all proposals can and should be always refined and bettered through debate and discussion. If the above ideas generate informed debate, the objective of bringing attention to these impediments that fetter the growth of the national military industrial complex would be achieved. This challenge faced by the domestic industry impedes their effort in strengthening the national defence industrial base and overall indigenization efforts. The anomalies captured above leave little room for doubt that the Indian A&D manufacturing sector would remain uncompetitive unless state intervention makes it a global player.

The writer is the Director & Chief Executive Officer, ShinMaywa Industries India Pvt. Ltd.

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