India: An OEM Perspective On Legal Issues Under Offset Manufacturing Arrangements

Introduction

Defence offsets are a significant opportunity for India to provide a growth impetus to its manufacturing sector. The partial liberalization of FDI caps and simplification of the industrial licensing process are some of the steps which have been taken to inspire investor confidence. These steps are also intended to encourage OEMs to engage in more meaningful partnerships with the Indian industry and not merely use it for low end manufacturing tasks.

These recent initiatives are representative first steps and should be viewed positively. However, from a OEMs perspective, entering into a manufacturing arrangement which may require a transfer of technology poses significant legal and commercial risks. Through this article, we have analysed a few options available to OEMs to discharge their offset obligations and the legal risks which they may incur under each of them.

Options to discharge offsets

A few of the options available to an OEM to implement offsets are as follows:

  • Co-development/Co-production
  • Sub-contracting
  • Contract manufacturing
  • Joint ventures
  • Licensed production

From an OEM's perspective, the selection of the Indian partner should be based on its ability to absorb technology, financial capability, experience in managing joint development arrangements and strong ethical & governance standards. Each of these criteria are critical to ensure that the project can be concluded within the term of the offset implementation plan submitted to the MOD.

In light of a few recent examples, another factor which should be considered at the planning stage itself is whether the Indian partner is undergoing a debt restructuring scheme. This is relevant as being a under debt restructuring scheme would require lender consents or waivers which may negatively impact the overall timeline for implementation.

Subsequent to selection of the Indian partner, the more nuanced legal risks under each of these options should be carefully examined while deciding the exact mode of discharge of offset obligations.

Co-production/Co-development

From the Indian industry's perspective, co-development/co-production is the preferred route as it would provide them an opportunity to absorb existing technologies and use them as a baseline for future development, thus reducing development costs and increasing efficiency. However, from an OEM's perspective, co-development and co-production are the most challenging routes, requiring detailed planning and a protracted implementation roadmap while evaluating the technical, commercial and legal issues in such an arrangement.

Protection of intellectual property: The most prominent legal issue associated with co-development is centred on the protection of the IP which the OEM is required to supply to its Indian partner. Protecting this IP is imperative since any unauthorized use of the technology (by the partner) would entail a long winded legal dispute and the damages sought by the OEM would require judicial validation. As valuation of technologies is complex and often has significant subjective elements woven into it, the quantum of damages claimed by an OEM would definitely be challenged by the Indian partner, leading to further complications.

With respect to jointly developed intellectual property, OEMs should also ensure that contractual documents provide for joint ownership in this regard. Further, the ability of the Indian partner to sub-license any new joint intellectual property into new markets should be carefully regulated. Ideally, the OEM's revenue share should be higher than that of the Indian partner, since under a co-development arrangement, the OEM would not charge any royalties on the use of its existing technologies.

Taxation: Another area of concern for an OEM are the multitude of taxation issues which may arise in a joint development agreement. For example, the OEM's personnel may be required to spend a substantial amount of time in India, which if not calibrated adequately may result in creation of a permanent establishment of the OEM in India and potentially result in disputes with Indian tax authorities.

Sub-contracting/Contract Manufacturing

Sub-contracting and contract manufacturing arrangements are relatively easier to develop, implement and monitor. These arrangements also provide the Indian partner an opportunity to absorb manufacturing technologies and skills in a shorter period. However, one of the criticisms of these arrangements has been that the technology absorption could be limited to low level activities such as fabrication and assembly skills.

Product liability: From a commercial and legal perspective, the key risk associated with sub-contracting arrangements pertains to product liability concerns. In case the sub-contracted products are required to be integrated with the main products, the OEM should ensure that the sub-contractor's liabilities adequately mirror the OEM's liability under the main contract. Therefore, it is strongly recommended that "flow through" clauses should be woven into the transactional documents.

Protection of intellectual property: As in the case of co-production/co-development model, OEMs should also ensure that their intellectual property is adequately protected under sub-contracting or contract manufacturing arrangements. The defence manufacturing sector is presently limited to a few key Indian manufacturers and each prospective Indian partner is likely to be engaged with multiple OEMs. In such a situation, care should be taken to ensure that the transactional documents include specific instructions with respect to procedures and/or exclusivity, to prevent leakage of confidential information.

Excise Duty: Lastly, though defence products are usually exempted from the levy of Excise duty, the Indian partner may be required to discharge Excise duty liability with respect to manufacture of "dual use" products. In such cases, any free-of-cost supplies made by the OEM to the Indian partner (for example, raw materials or components sent under a bill-to-ship-to transaction) would require to be included in the value of goods cleared by the Indian partner.

This may create a potential pricing problem for the OEM and Indian partner, if under the sub-contracting arrangement the products are required to be purchased at a pre-determined price. Hence, pricing aspects need to be carefully examined to understand the impact of the Indian indirect taxes on the arrangement.

Joint Ventures

The third option available to OEMs is the joint venture route. The earlier FDIregulations capping the equity participation at 26% failed to excite foreign OEMs in any constructive manner. With the increased equity participation, it is expected that OEMs would be encouraged to establish a more meaningful relationship with the Indian industry. Though the Indian industry has several success stories in forming joint ventures in regulated industries (such as insurance), joint ventures in defence production have not met the same level of success.

The concerns of OEMs on restriction of control and operational aspects in joint ventures are well documented and have been frequently voiced by policy analysts and industry representatives. However, if an OEM wishes to set-up a joint venture with a DPSU, certain peculiar issues would merit consideration.

Issues with DPSUs: Formation of joint ventures with DPSUs is governed by the Guidelines for Establishing Joint Venture Companies by Defence Public Sector Undertakings ("Guidelines") issued by the Department of Defence Production under the MOD. The Guidelines permit the "Navratna" and "Miniratna" DPSUs to establish joint ventures with OEMs up to 30% of the DPSU's net worth. However, the equity contribution is capped at not more than 15% in one project, subject to a maximum of INR 1000 crore for Navratna DPSUs and INR 500 crore for Miniratna DPSUs1.

The impact of these guidelines can be seen through the following example. Goa Shipyard, which is one of the largest ship manufacturing entities in India, reported a total turnover of INR 884 crores or USD 147.33 million (approx.) during FY 2013-14. Therefore, if it were to consider setting up a joint venture with a ship manufacturer, it cannot invest more than INR 132 crores or USD 22 million. Further, factoring 49% equity participation by the OEM (equivalent to USD 21 million), the net worth of the JV entity would be only USD 43 million, which, in most cases may be less than the value of the component or equipment required to be manufactured.

Compliance with Security Manual: A joint venture entity operating under an industrial license would also be required to be in compliance with the Security Manual published by the MOD, which provides the manner in which internal systems are required to be implemented and executed.

Therefore, in the event an OEM wishes to form a joint venture with an Indian DPSU, apart from the typical issues which may require consideration, the above issues would require additional consideration.

Licensed Production

Protection of intellectual property: Licensed production is another option which is available to OEMs and is perhaps the most testing for an OEM than any of the other options, since it requires comprehensive dissemination of existing technology and hand-holding to the Indian partner, which is, in effect tantamount to creating a competitor. Therefore, if licensed production arrangements are entered into with an Indian partner, the transactional documents should clearly provide restrictions on usage of the disseminated technology.

Export control restrictions: Another significant legal risk associated with licensed productions is the requirement of the OEM to be in compliance with the export control laws of the exporting country. There have been several instances in the past where licensed technologies have been used against exporting nations in conflicts due to which policy regulators (especially those in the United States) have been increasing the restrictions on technologies being exported.

Product liability: Licensed production arrangements, similar to sub-contracting/contract manufacturing arrangements, pose significant risks on product liability issues. Even in extremely regulated arrangements, quality concerns could arise which may cause delays and adverse financial implications for the OEM. Under licensed production arrangements, OEMs should ensure comprehensive indemnities are factored to protect them in case quality concerns result in cancellation of contracts with a customer.

Based on the above analysis, a sub-contracting or a contract manufacturing arrangement would seem to be the best option in terms of lowering risks from the OEM's perspective.

However, licensed productions and co-development arrangements are better suited for situations in which the OEM desires to manufacture at the lowest possible cost. In opting for this route, it would be advisable for the OEM to ensure that necessary protections with respect to IP and product liability are built into the transactional documents.

Footnote

1. Approximately USD 167 million and USD 83 million, respectively.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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