More Avenues for Discharge of Offset Obligation – Nitty-gritty poses a challenge

Vendors have been facing difficulty in discharging the offset obligation for various reasons. Although lack of avenues is not one of the primary reasons, availability of more avenues to choose from cannot cause any harm.

Earlier this year, the Ministry of Defence (MoD) had come up with a draft amendment to the existing offset guidelines which sought to add three more avenues to thesix avenues envisaged in the Defence Procurement Procedure (DPP) 2016 for discharge of offset obligation by the foreign vendors. Basically, all the three avenues proposed by MoD are centred around investment by the foreign vendors in (a) the projects to be specified by the ministry (specified projects), (b) defence manufacturing (equity investment in a business enterprise), and (c) specified SEBI (Securities and Exchange Board of India) regulated funds for defence, aerospace and internal security.

Investment in specified projects

The first of these three avenues, viz., investment in specified projects, is proposed to include. Capital investment in defence related infrastructure development projects like testing laboratories, testing ranges, skill development centres, Technology acquisition projects, Critical technologies.

Three separate lists in respect of each one these sub-categories are to be notified by the ministry.  These lists will be prepared by a collegium of experts from the Service Headquarters (SHQ), Defence Research & Development Organisation (DRDO), Defence Public Sector Undertakings (DPSUs), Ordnance Factory Board (OFB).  It is not known if the work of preparing the list is in progress and, if so, who is preparing it. It will, therefore, be pointless to second-guess the outcome but there are expectations that the list of specified projects (List A) would include projects for development of Technology Innovation Centre, Centre for testing hardware/embedded technologies, facilities for carrying out Electromagnetic Interference (EMI) and Electromagnetic Compatibility (EMC) tests, Quality Assurance/Control laboratories, Test Ranges, Simulation-based test facilities, etc.

Similarly, List B in respect of technology acquisition is expected to focus on technologies required for the equipment/platforms planned for acquisition under the Buy and Make category, such as the Fighter Aircraft; Medium Lift and Utility Helicopters; Warships; Combat Vehicles; Autonomous Weapon Systems; Gun systems; Small Arms; Ammunition and Explosives; subsonic, supersonic and ballistic missiles; sensors; propulsion and power generation systems; surveillance and detection systems, Electronic Warfare systems; Communication systems; Night Fighting Enablers; and many other capabilities required by the Indian armed forces.

The third list (List C) is to cover critical technologies. It remains to be seen whether this list will include technologies different from the following technologies included in the list of critical technologies that already forms a part of the offset guidelines.

It may take some more time before these lists are notified. Meanwhile, it will be worthwhile to address the challenges that will need to be met to facilitate investment in specified projects to achieve the stated objectives.  Take for example, defence related infrastructure development projects. The ministry proposes to allow the capital cost of the projects to be reckoned for discharge of the offset obligation. This avenue could be viewed by the vendors as an opportunity to invest in the real estate which will defeat the very purpose of defence offsets. The challenge will be to ensure that the capital investment made in raising the infrastructure, for which the offset credit is claimed by the vendor, is not disproportionate to the cost of equipment or the spin-off benefit from the development of the infrastructure.

Likewise, investment in technology acquisition projects may run into the real or perceived constraints imposed by the existing policy on Foreign Direct Investment (FDI) in defence which permits foreign investment only up to 49 per cent through the automatic route. No doubt, the existing policy permits foreign investment even beyond 49 per cent but that is with the approval of the government and only in those cases where it is likely to result in access to modern technology or for other reasons to be recorded. No foreign investment seems to have come under this provision so far. Unless the root cause of this disinterest on the part of the foreign investors is addressed, opening of the avenue for discharge of offsets through investment in technology acquisition projects may not be of much help.

The biggest uncertainty surrounds investment in critical technology as a new avenue for discharge of the offset obligation. This is one of the six avenues that already exist. The existing guidelines even provide for a multiplier of 3 for transfer of critical technologies to the DRDO. However, no proposal is understood to have been made by any vendor to make use of this avenue for discharge of the offset obligation. Even if the new list of critical technologies, which is yet to be notified by MoD, is different from the list of critical technologies that already exists as a part of the offset guidelines, it is difficult to see how this would make any difference. True, the new list will carry a multiplier of 5 as against a multiplier of 3 under the existing guidelines, but it remains to be seen whether this will turn out to be a game changer.

Overseeing implementation of the investment projects will also present a big challenge. According to the draft amendment, these projects will be implemented through an agency comprising personnel from the DRDO, DPSUs and the OFB or through a Special Purpose Vehicle (SPV) to be set up with or without the participation of the industry. Any agency comprising serving personnel from the above-mentioned organisations is likely to be too unwieldy to provide a dynamic oversight. On the other hand, setting up of an SPV will present its own difficulties, especially if the private industry is to be associated with it as the manner of representation of the private industry in the SPV will always be contentious.

Investment in Defence Manufacturing
It will entail equity investment in a business enterprise with a view to 'fostering development of internationally competitive defence, aerospace and internal security related enterprises in the country' by setting up a manufacturing unit. The investment will attract a multiplier of 4 if it is made in setting up the unit in the Defence Industrial Corridor and 3 if the unit it set up in other areas. The investor will be eligible to the returns on his investment as per the existing law. These features appear to be attractive but ultimately the success of this avenue depends on there being a business case for making the investment which, in turn, depends on the investor's assessment of whether he will be able to sell the products made by the unit he invests in. The defence market in India continues to be unpredictable and the export potential continues to be limited, thereby casting a shadow on investment in defence manufacturing as an attractive proposition.

One clear downside of this avenue is that the 'offset discharge will be subject to physical completion of the project and verification of the audited accounts of the company setting up the manufacturing unit'. If this implies that the offset credit will be available only on physical completion of the project, it will become a high-risk avenue for discharge of the offset obligation. The investors are also likely to find it disappointing that procurement of products and services from the unit set up with their investment will not be eligible for offset discharge.

Investment in SEBI-regulated Funds for Defence, Aerospace and Internal Security
This is arguably the most attractive of the three new avenues proposed by the ministry. Investment made in MoD-registered and professionally managed SEBI-regulated Funds dedicated to development of start-ups and Micro, Small and Medium Enterprises (MSMEs) in the country, subject to a ceiling of 30 per cent of the Fund corpus, would qualify for offset credit. The vendor contributing to the Fund will be entitled to the usual returns on investment as per the law. The detailed instructions are yet to be issued by MoD for registration of the Funds for this purpose, but the idea has found resonance with the industry for several reasons.

One, investment in these Funds will be subject to the least interference by MoD which has not acquitted itself very well in the past when it comes to monitoring the discharge of offset obligations by the vendors. Two, such investments would not require any elaborate plan for setting up infrastructure or SPV or entering into agreements for transfer or technology as required under the other two proposed avenues. Three, the vendor will be able to earn the offset credit as soon as the investment is made without having to wait for an elaborate audit by the MoD or its nominated agency. Four, a professionally managed Fund will have better chances of providing reasonable returns on investment. Five, it should be possible for the vendor to withdraw his investment after the lock-in period. Six, it would serve MoD's objective of promoting the defence industry through offset as the Fund will be focussed on the defence, aerospace and internal security sector.

What next?
Whatever be the pros and cons of the three new avenues proposed by MoD, the proposed amendment should be formally adopted without any further delay. This will afford a wider range of choices to the vendors who have been facing difficulty in discharging the offset obligation for various reasons. Although lack of avenues is not one of the primary reasons, availability of more avenues to choose from cannot cause any harm. On the contrary, at least one of the three proposed avenues, namely investment in sector-specific Fund, could lessen the rigours of the existing offset regime both for the vendors and the MoD, provided due care is taken while working out the nitty-gritty of each of these avenues and these are made applicable retrospectively.

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