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New Avenues for Discharging Offset Obligations August, 2018

The Defence Offset Policy introduced in 2005 has been revised in bits and pieces over the years. The only time it was completely revamped was in August 2012 when new Defence Offset Guidelines were promulgated by the Ministry of Defence (MoD). What started as a simple policy intended to leverage the huge expenditure India was incurring on buying equipment from abroad by making the foreign companies channelize a certain percentage of the contract value into India’s defence sector has grown into a highly complex policy whose implementation is continuously throwing up new challenges.

In March this year, the Ministry of Defence (MoD) informed the Standing Committee on Defence (SCoD) that a total of 42 Defence offset contracts have been signed out of which 27 cases pertain to Indian Air Force, 04 cases of Indian Navy and 11 to the Indian Army. The committee was also informed that the total offset obligations are estimated to be around US $ 11.20 billion over a period from 2008, when the first offset contract was signed, till 2024, when apparently the last of these 42 contracts would get fully executed.

At one level this indicates the slow pace at which big acquisition contracts are being concluded. The threshold above which offsets kick in used to be Rs 300 crore till it was raised to Rs 2,000 crore in 2016. Assuming that the requirement of offsets was not waived in any acquisition programme where offsets were applicable, it is evident that only 42 such big-ticket contracts have been signed over a period of 10 years between 2008 and 2018. This translates into an annual average of just about 4 contracts.

This is worrisome but so is the fact that implementation of whatever offset contracts have been signed has also not been smooth. According to the information furnished by MoD to SCoD earlier this year, in eleven of the 42 offset contracts interim/final penalty has been imposed on account of shortfalls in offset discharge targets by the vendors and the total amount of such penalties works out to approximately US $ 38.19 million. This indicates in no uncertain terms that the vendors have been facing serious difficulty in discharging the offset obligation, otherwise there is no reason why renowned international companies would have ended up paying penalties.

The problems faced by the vendors in discharging the offset obligations are not new. They have been raising their concerns for a long time but MoD has been slow in addressing those concerns. In 2015 some relief was given by making it easier for the vendors to change their Indian Offset Partners (IOPs) or revise the offset implementation schedule. Option was also given to the vendors to submit details of the IOPs and the offset implementation plan, one year prior to claiming the credit or even at the time of claiming the credit instead of submitting all these details at the time of signing the offset contract.

These changes have helped but only to a limited extent as the problems in discharging the offset obligations are more fundamental and deep rooted. The foreign vendors who are responsible for discharging the offset obligation have been urging the MoD for a long time to widen the scope of offsets and make other policy changes so as to make it easier for them to discharge their obligation. In response to this, MoD now proposes to modify the offset guidelines to include additional avenues for discharging the offset obligations. Apparently, the ministry will finalise the changes in the offset policy based on the feedback from the stakeholders, which was to be furnished by 15 May 2018.

Additional avenues proposed to be included in the policy

It may be recalled that presently, in accordance with the Defence Procurement Procedure 2016 (DPP 2016), vendors can discharge offset obligation through one or more of the following six avenues, subject to certain conditions:

  1. Direct purchase of eligible defence products and services
  2. Foreign Direct Investment (FDI) for manufacture and/or maintenance of eligible products or provision of eligible services
  3. Investment in kind through transfer of technology (ToT) to the private sector IOP(s) for manufacture and/or maintenance of eligible products or provision of eligible services
  4. Investment in kind through transfer of equipment to the private sector IOP(s) for manufacture and/or maintenance of eligible products or provision of eligible services
  5. Transfer of technology or provision of equipment to government entities engaged in manufacture and/or maintenance of eligible products or provision of eligible services
  6. Transfer of critical technologies to the Defence Research and Development Organisations in certain high technology areas

The eligible products and services are classified into four categories: defence products, products for inland/coastal security, civil aerospace products, and services related to the eligible products. These products and services, as well as the critical technologies, are listed in the DPP 2016.

The proposed changes in the offset policy, if finally approved, will result in addition of three more avenues for discharging the offset obligation, in addition to the existing six. These are:

  1. Investment in specified projects.
  2. Investment in defence manufacturing: equity investment on a business enterprise
  3. Investment in specified Funds for Defence, Aerospace and Internal Security that are regulated by the Securities and Exchange Board of India (SEBI)

These investments are expected to foster development of internationally competitive defence, aerospace and internal security related enterprises in India.

Investment in specified projects

This category will cover defence related infrastructure projects like testing laboratories, testing ranges, skill centres, etc. (only the capital cost will qualify for offset credit); technology acquisition projects; or critical technology projects. All such projects will be identified by a collegium of representatives from the DRDO, Defence Public Sector Undertakings (DPSUs) and the Ordnance Factory Board (OFB), or by a Special Purpose Vehicle (SPV) to be set up with or without industry participation. The list of projects would be updated periodically.

This introduces an element of uncertainty as activation of this avenue will depend on setting up of the collegiums or the SPV and identification of projects by them. However, what should be music to the ears of the foreign vendors is that the investment will be permitted to be made not just by the vendor who has to discharge the offset obligation but also by any of the sister companies or affiliates of that vendor. It addresses a long-standing demand that the offset obligation be permitted to be discharged by the group companies of the vendor.

Investment on defence manufacturing: equity investment in a business enterprise

Discharge of offsets under this category will entail equity investment by the foreign vendor for setting up a manufacturing unit in defence, aerospace or internal security sector. However, there is some ambiguity about whether the group companies will be permitted to make the investment, as in the case of investment in the specified projects. This ambiguity arises from the way the text of the relevant provision in the draft circulated by the MoD is worded which says that the ‘investment should be made by the vendor having offset obligation as per the contract or by such other vendors specified in the contract’.

Investment in SEBI-regulated Funds for Defence, Aerospace and Internal Security

The funds eligible for investment would be dedicated for development of start-ups and the Micro, Small and Medium Enterprises (MSMEs) in the defence, aerospace and internal security sector. These funds will be registered by the MoD but professionally managed by SEBI. Detailed terms and conditions and other guidelines for registration of these funds will be issued by the MoD in due course. Investment in any such fund would be subject to a ceiling of 30 per cent of the fund’s corpus. Unlike the other two avenues, it is not mentioned in the draft circulated by the MoD whether the group companies will be permitted to make investment in such funds.

Multipliers

To make these avenues more attractive, MoD also proposes to provide for multipliers. This essentially means that the vendor will be able to claim offset credit equalling the value of the offsets discharged multiplied by the applicable multiplier factor. The proposed multipliers are as follows:

 

Avenue

Defence Industry Corridor

Other areas

Investment in specified projects:

Defence related

Specified technology related

Specified critical technology related

 

3

4

5

 

2

3

5

Investment in defence manufacturing: equity investment in a business enterprise

4

3

Investment in specified SEBI-regulated Fund for Defence, Aerospace and Internal Security

3

 

Methodology for offset discharge

In the case of investment in specified projects, offset discharge will be subject to physical completion of the project and verification of the audited accounts of the implementing agency which should clearly indicate that the investment has been made. However, procurement of products/services arising out of the investment made in the project shall not be eligible for offset discharge.

In the case of investment in defence manufacturing (equity investment in a business enterprise), offset discharge shall be subject to physical completion of the project and verification of the audited accounts of the company setting up a manufacturing unit in defence, aerospace or internal security sector. In this case also, procurement of products/services arising out of the investment made in the project shall not be eligible for offset discharge.

In so far as investment in SEBI-regulated funds is concerned, offset discharge shall be based on verification of transfer of funds from the vendor to the specified fund. The vendor will, of course, only be entitled to the usual returns on the investment as per the applicable law.

Applicability

The proposed changes will come into effect from the date of issue of the amendment to the existing guidelines. Other terms and conditions regarding discharge of the offset obligation will continue to be applicable mutatis mutandis. All existing vendors who carry the offset obligation as on the date on which the existing guidelines are amended will be permitted to avail of the new avenues with the approval of the government.

Looking forward

While expanding the list of avenues through which offset obligation can be discharged provides more options to the vendors and, therefore, should be welcomed by them, the actual usefulness of the proposed move will depend on how soon and how efficiently action is taken to identify the projects in which the investments can be made. Setting up of an implementing agency or the SPV will also be a challenge.

The utility of the proposed changes will also depend on how soon funds are set up in which investment could be made by the vendors. Working out the modality of their registration by MoD and regulation by SEBI will decide the future of the funds and, consequently, their ability to attract investment.

The condition that the existing vendors will require the government’s permission to opt for one or more of the proposed avenues creates avoidable opaqueness about the circumstances in which such permission may be granted or denied. This could be a big dampener and can further add to the unnecessary delays.

Looking at the larger picture, incorporating the proposed changes in a seamless manner with the existing guidelines and improving the system of monitoring the discharge of offset obligation by the vendors will hold the ultimate key to successful implementation of the proposed changes.