India: Indian Offset Policy – Outsourcing Of Services By An Indian Offset Partner To A Foreign Vendor

The Indian defence procurement policy under Defence Procurement Procedure 2016 ("DPP 2016") requires a minimum of 30% (thirty per cent) of the estimated cost of the acquisition in 'Buy (Global) category' acquisitions and 30% of the foreign exchange component in 'Buy and Make' categories of procurement as the required value of offset obligations, where the estimated cost of the acquisition proposal is ₹2000 Crore or more. Offset obligations can be discharged with reference to eligible products and services as specified in DPP 2016, by any one or a combination of certain prescribed methods which includes direct purchase of, or executing export orders for, eligible products manufactured by, or services provided by Indian enterprises.

In terms of DPP 2016, Indian enterprises, institutions and establishments engaged in manufacture of eligible products and/or provision of eligible services are referred to as the Indian Offset Partners ("IOP"). The IOP is required to comply with the guidelines/licensing requirements stipulated by the Department of Industrial Policy and Promotion ("DIPP") as applicable. For instance, if a manufacturer intends to manufacture products which fall within the list of defence items notified by DIPP, then it would need to obtain an industrial licence under the Industries (Development and Regulation) Act, 1951. The main vendor is free to select an IOP, however a list of proposed IOPs is to be submitted by the main vendor upfront as part of the technical and commercial offset offer. Any change in the IOP thereafter requires an approval of Secretary (Defence Production).

The DPP 2016 prescribes a list of eligible products and services, with reference to permitted offsets. The provisions related to eligible services were put in abeyance with effect from May 23, 2013¹ in wake of the Agusta-Westland deal, but the Ministry of Defence ("MoD") reinstated the following services as an eligible avenue for offset discharge vide its order dated December 7, 2015², ("Services Reinstatement Order"):

Therefore, if the services proposed to be provided by an IOP do fall within the services specified at serial no. 4(c) or (d) above, then such services can be used as an avenue for discharge of a maximum of 20% of the total offset obligation, and would be subject to a provision of a 'Random Audit' to verify the value of offset contracts and additional requirement of CMMi certification of minimum 4 and above where the discharge envisaged is above 5% of offset obligation.

Further, there is a concept of value addition under the DPP 2016. Para 5.9 of Appendix D to Chapter II of DPP 2016, explains the concept of 'value addition' for products which contain imported components, in the context of offsets, as follows:

Therefore, in case of purchase of products by the main vendor from an IOP, the value addition undertaken by the IOP in India will be determined by deducting (a) the value of imported components and (b) any fees/royalty paid. The general principle being that only the value addition undertaken by the IOP in India is counted towards offset obligations of the main foreign vendor, while the value of imported components and fees/royalties incurred by the IOP does not count towards the value addition and consequently the offset obligations of the foreign vendor. However, the above paragraph in DPP 2016 only deals with 'direct purchase of eligible products', and does not refer to 'eligible services'.

Further, as per the FAQs pertaining to offset contracts as available on the Government's website ("FAQs"), the list of supporting documents for direct purchase of products/services (excluding engineering, design & testing and software development) to be submitted with the offset claims of the foreign vendors, includes submission of a 'certificate of manufacturing and value addition duly signed by CFOs of OEM and IOP' for products only. No such requirement is there in the list of supporting documents prescribed for purchase of engineering, design & testing and software development services specified in the FAQs.

In view of the foregoing, it appears that in case of a services contract there is no specific guideline stating the percentage on the extent of work that can be outsourced/assigned by an IOP to another sub-contractor (whether in the same group or not) under the offset policy contained in the DPP 2016. As a consequence, it appears that an IOP can further assign major or majority of the work to another sub-contractor within or outside India and the foreign vendor can claim offset credits against the services contract executed with the IOP.

However, in this light, it is important to take into account the key objective of the offset policy, which is specified under DPP 2016 as: "to leverage capital acquisitions to develop Indian defence industry by (i) fostering development of internationally competitive enterprises, (ii) augmenting capacity for Research, Design and Development related to defence products and services and (iii) encouraging development of synergistic sectors like civil aerospace, and internal security."

Offset obligations are therefore imposed on main foreign vendors from the perspective of developing the Indian defence industry in respect of the eligible products and services. Accordingly, it can be said that the extent of 'value addition in India' for the purpose of discharge of offset obligations, is a fundamental principle governing offset assessments of the government. However, by limiting the concept of value addition to direct purchase of products and not to eligible services, the DPP 2016 allows a lacuna to exist, where the entire amount paid to the IOP by the foreign vendor under a service contract can be claimed towards discharge of offset obligations even though the IOP has sub-contracted most of the services to a foreign supplier.

That said, the offset contracts and determination of quantum of offset credits are typically subjected to a lot of scrutiny from the MoD and the value of the offset components for which offset credits are sought has to be supported by documentary evidence, as may be required by the relevant government authorities. Therefore, even though there is no reference to 'eligible services' in para 5.9 of DPP 2016 and 'certificate of value addition' in the FAQs is confined to purchase of products, given the checkered past of services contracts in the context of offsets, we are aware that the MoD in the past has required a certificate of value addition even in cases of direct purchase of services (even though the same is not required under the applicable DPP 2016) to assess as to what extent the offset contract resulted in value addition in India. This was probably done to keep the intent behind the offset contracts in perspective.

Footnotes

1. Office Memorandum of MoD (OM No. 9(42)/2013/OFFSETS dated 23.05.2013 and 26.7.2013.

2. MoD Order ID No. DOMW/OP/GEN/03/2015/01 dated 7.12.2015 reinstated services as an eligible avenue for offset discharge.

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