India: ‘Defence Sector In India – Regulatory Landscape, Recent Developments And Their Impact'

Last Updated: 26 November 2018
Article by Anuj Prasad

Introduction

Regulation of the Defence sector in India has seen immense movement in the last few years. The main objective of the Government has been to spur foreign investment in the sector and promote partnerships between Indian private sector entities and international original equipment manufacturers, with a view to augment domestic production of state of the art technologies, thereby realising the 'Make in India' initiative and reducing India's dependence on imports.

However, given the sensitivities and national security concerns surrounding the sector, investment in Defence remains highly regulated. The following paragraphs briefly analyse the current regulatory framework governing the sector, certain ambiguities that emerge from the recent changes brought about by the Government and their impact on foreign investment in the sector.

Evolution of the Regulatory Landscape

Since the advent of the Industries (Development and Regulation) Act, 1951 ("IDRA"), the Defence sector was treated as the domain of the Government, and private industry was not permitted to participate in its development. In the early 2000s, the sector was first opened up to 100% Indian private participation, with foreign direct investment permitted up to 26%, subject to licensing as per the IDRA. While this unprecedented move by the Indian Government was heralded as a game changer for the domestic defence ecosystem, the real impact remained far from desirable. Most foreign original equipment manufacturers ("OEMs") were uninterested in forming ventures without at least a basic degree of control over the investee entity, and foreign investment numbers remained dismal. This may, to a certain extent, have also been due to the lack of choice of Indian defence industry partners. However, increase in the sectoral cap on investment in defence remained the much voiced industry demand.

The most significant reforms for FDI in the Defence sector came in the year 2014. By way of Press Note 3 of 20141, a list of defence items requiring industrial license under the IDRA was notified, bringing about the much needed clarity on what exactly constituted the "Defence" sector for FDI purposes. For the first time, it was also clarified that items not included in the list at the Annexure to Press Note 3 would not require an industrial license for defence purposes, and that dual use items having both military and civilian applications, other than those specifically mentioned in the list would also not require an industrial license. The DIPP also clarified that items/parts/components/castings/forgings/test equipment, which are not part of list attached to Press Note 3 would not require an industrial license2. Thereafter, by way of Press Note 7 of 20143, the sectoral cap for FDI in Defence was permitted up to 49% under the approval route, and beyond 49% on a case-to-case basis, wherever it was likely to result in access to modern and 'state-of-art' technology. What was meant by modern and 'state-of-art' technology, however, remained undefined.

The next wave of significant reforms came in 2015, where in an unprecedented move by way of Press Note 12 of 20154, the Government allowed FDI up to 49% in the Defence sector under the Automatic route of investment. For FDI beyond 49%, prior Government approval continued to be required (on case to case basis wherever it was likely to result in access to modern and 'state-of-art' technology). As opposed to the previously prescribed onerous conditions on FDI in Defence, Press Note 12 subjected such investment to only the following four conditions:

  1. Requirement for Approval: Infusion of fresh foreign investment within the permitted automatic route level, in a company not seeking industrial license, resulting in change in the ownership pattern or transfer of stake by existing investor to new foreign investor, will require Government approval.
  2. Licensing: Licence applications will be considered and licences given by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, in consultation with Ministry of Defence and Ministry of External Affairs.
  3. Security Clearance: Foreign investment in the sector is subject to security clearance and guidelines of the M/o Defence.
  4. Self-sufficiency: Investee company should be structured to be self-sufficient in areas of product design and development. The investee/joint venture company along with manufacturing facility, should also have maintenance and life cycle support facility of the product being manufactured in India.

The above position stands true today, with some minor tinkering. For investment beyond 49%, the condition relating to access to modern and 'state-of-art' technology has been amended to only require access to "modern technology" and it has been specified that such approval can also be granted "for other reasons to be recorded".

In 2016, the applicability of the FDI regulations governing the Defence sector was expanded. By way of Press Note 5 of 20165, the sectoral caps and conditions on FDI in Defence (i.e., entities engaged in production of items listed in Press Note 3 of 2014) were extended to "Manufacturing of small arms and ammunition under the Arms Act, 1959". Accordingly, today the FDI regulations governing the "Defence" sector are applicable to entities engaged in the manufacturing of items requiring an Industrial License as well entities engaged in the production of small arms and ammunition, which require an Arms License under the Arms Act, 1959.

Despite these changes, FDI figures in the defence sector reflect lacklustre investor appetite. So far, the Government has only received one proposal for investment beyond 49%, which singular proposal has also been rejected by the Government, the specific reasons for which have not been officially disclosed. Foreign investment numbers released by the Department of Industrial Policy and Promotion ("DIPP"), the nodal agency responsible for approving and regulating foreign investment in the country, show that in spite of the liberalisation of the FDI cap, foreign investment in the sector between April 2000 and March 2017 was merely USD 5.12 million. This, when the Government is actively promoting its "Make in India" initiative with a particular emphasis on the Defence sector, and the Prime Minister personally taking up the issue of investment in the sector at each of his numerous diplomatic meets since coming to power.

In the following paragraphs, this paper seeks to analyse some of the factors that may have contributed to the lack of FDI number in the Defence sector in India.

Administerial Tussle: Too many regulators

While the Defence sector has traditionally been under the administrative control of the Ministry of Defence, internal security and control over the police forces is the domain of the Ministry of Home Affairs. The Ministry of Home Affairs has time and again also attempted to wrestle out control over manufacturing of guns and ammunition for itself. The reasons for this power struggle are unclear, however, the Ministry of Home has historically demonstrated itself to be a highly inaccessible regulator, with no defined timelines for undertaking specified tasks, which does not bode well for the sector. For instance, the FDI policy regime used to specify that defence sector related FDI proposals would be disposed off within a period of 10 weeks. However, because deliberation over such proposals also contained an element of security clearance of the promoters and management of the investor and investee entity (which was to be carried out by the Ministry of Home), we have seen FDI proposals kept pending for well beyond 6 months.

Activities under the Arms Act are governed by the Ministry of Home Affairs, and in the last decade, this Ministry has not issued any new licenses for manufacture of items under the Arms Act. Applications have been kept pending for several years and have either been deferred or rejected at licensing committee meetings. Such response from a regulator is the exact opposite of what development and growth of a sector would require. As opposed to stand, the DIPP has been actively issuing licenses for manufacture of items under the IDRA. The reasons for this dichotomy of approaches lies in the manner of functioning of the Ministry of Home.

Policy Uncertainty

The FDI regulations have historically remained silent on what exactly constitutes the "Defence" sector. Since the sector had always been linked with licensing under the IDRA, the industry view was that restrictions on FDI in the Defence sector would only be applicable to entities undertaking "manufacturing" activities, and not pure service oriented entities. However, questions such as whether manufacturing of any item (including minor parts and components) which had a defence application would be treated as part of the "Defence" sector, and applicability of FDI regulations to manufacturing of items that have a dual-use (i.e., items which could have civil as well as military applications), continued to plague the industry. Under the IDRA, manufacture of "Arms and ammunition and allied items of defence equipment, defence aircraft and warships" continued to require a licence and as such, the prevailing view was that a company engaged in the production of any item which falls within the aforesaid description would be hit by the FDI restrictions applicable to "Defence". While the "Manufacturing" sector broadly remained open to 100% FDI under the Automatic route of investment, the prevailing industry view led to the belief that manufacture of even a small nut or bolt which would eventually be used in a military aircraft would require an license under the IDRA and would be subject to FDI restrictions imposed on the "Defence" sector.

Thereafter, for entities manufacturing items included in Press Note 3 of 2014 (i.e., requiring an Industrial License under the IDRA), it has expressly been clarified that items not included in the annexure to the said Press Note would not require an Industrial License from the defence angle, and that items/ parts/ components/ castings/ forgings/ test equipments which are not part of the list in the Annexure to Press Note 3, would not require an Industrial License, and would therefore not be hit by the restrictions imposed on FDI in Defence. However, a similar clarification has not been issued in relation to manufacture of "small arms and ammunition" under the Arms Act. There is significant overlap between the list of items set out in the Annexure to Press Note 3 of 2014 and the items that would be covered within the ambit of "small arms" and "ammunition" as defined for the purposes of the Arms Act, and this led to the industry being perplexed as to scope of restrictions on FDI in the Defence sector.

As stated above, the Ministry of Home Affairs is the nodal agency with the power to issue licenses for manufacture of arms and ammunition under the Arms Act. In the recent past, by way of a notification6, the Ministry of Home has delegated certain licensing powers and functions in respect of the category of arms and ammunition and defence items specified in a schedule to the Ministry of Home Notification to the DIPP. Thereafter, by way of a clarification regarding the Ministry of Home Notification issued through an Office Memorandum7, the Ministry has analyzed the definitions of "manufacturing" and "parts and components" under the Arms Rules to conclude that "manufacturing under the Arms Rules, 2016 is confined to manufacture of a complete firearm or pressure bearing part of a firearm only." Through it Office Memorandum, the Ministry has clarified that all other parts or components, being non-pressure bearing, are out of the ambit of the definition of manufacturing under the Arms Act and would therefore not require an Arms License. Since the FDI restrictions are also applicable to "manufacture" of small arms and ammunition under the Arms Act, it is open for the industry to now conclude that FDI restrictions are not applicable to entities engaged in the manufacture of any parts of arms and ammunition, but only to entities engaged in the manufacture of pressure bearing parts of such of items. However, no clear guidance has been issued in this regard. In our experience, investors have often been unable to conclusively determine whether licensing under the Arms Act is applicable to the scope of their proposed joint ventures, and have had to make clarification applications to the regulators for a conclusive answer in this regard. Since responding to these clarifications requires receiving inputs from the Ministry of Home as well, we have seen applications remain pending for well over several months, leaving the investor in a state of complete confusion and uncertainty on the very basics of its investment.

As such, the dichotomy between the applicability of the licensing regime under the IDRA and the Arms Act has resulted in creating immense confusion for the sector.

Question of Control

Previous iterations of the FDI policy (which at the time was only applicable to manufacture of items governed by the Arms Act) used to regulate the manner in which an Indian defence sector company with FDI would be controlled. In particular, the FDI policy used to prescribe that the applicant should be an Indian company and that the management of the applicant company should be in Indian hands, with majority representation on the Board as well as the Chief Executive of the company being resident Indians. As part of the liberalisation drive, these conditions were removed from the FDI policy, thereby allowing foreign investors to negotiate a certain degree of control over the investee entity, even where their investment was capped at 49%.

The Arms Act however, has brought back the control related conditions stated above, which are applicable to all entities that have a manufacturing Arms License and FDI below 49%. Additionally, the Arms Act prescribes that prior approval of the licensing authority shall be mandatory for any change in the directorship of the company or any change in its key managerial personnel / responsible person of the company. Further, prior approval of the licensing authority is mandatory for any change in control or ownership, either directly or indirectly, of the company or any change in shareholding resulting into dilution of promoters shareholding (both Indian and foreign) or any change in shareholding of the company or any change in the beneficial interest in the shareholding of the company beyond 5%. Absurdly enough, the Arms Act also prescribes that "Any restrictions under a joint venture agreement which may be imposed by the foreign partner shall have no legal consequence on the Indian entity that is granted a licence under the Arms Rules." The language of this restriction can be construed to have wide and far reaching effects on structuring of investments in the sector, and with such restrictive conditions, the already stunted investor appetite for investing in the sector is further disrupted.

Adding to the confusion is the fact that these restrictions are not directly applicable to entities licensed under the IDRA, since the IDRA and the FDI policy both are now silent in this regard. The rationale for this dichotomy seems to be mere oversight on the part of the legislators and it is expected that these control restrictions will be made applicable to entities governed by the IDRA as well.

The Timing of Licensing Applications: Brownfield v. Greenfield Investment

From a bare reading of the FDI policy condition prescribing Governmental approval for Defence sector FDI, it appears that the Automatic route facility is only available for foreign investment up to 49% in a Defence sector company prior to it obtaining an industrial license. Any investments post receipt of an industrial license where the investee company undergoes a change in shareholding structure, or other future investments resulting in a change in the ownership pattern or transfer of stake by existing investor to new foreign investor, are under the Government route. The rationale behind extending the automatic route facility to only those investments which are made prior to obtaining an industrial license could emanate from the Government's desire to retain the right to assess every proposal and carry out a security check in all cases. Where an industrial license is yet to be obtained, the Government has allowed Automatic route investment on the premise that a security check of the shareholders and management of the Defence entity would be undertaken at the time when an application for a license under the IDRA is made, which is a pre-requisite for commencing manufacture. Where an industrial license has already been obtained, the Government has retained the right to assess the security status of shareholders and management at the foreign investment approval stage itself. While the FDI policy does not contain a similar reference to a license under the Arms Act, it can be presumed that the Automatic route availability will be similarly structured in the Arms Act regime as well.

While this structure prima facie appears to reduce the number of approvals required to invest in the Defence sector with a view to encourage investment, however, in practice this hybrid structure injects a lot of uncertainty for the foreign investor. In a situation where the foreign investor remits its foreign investment under the Automatic route and subsequently the investee company's application for an industrial license is denied, the investee company would not be in a position to commence manufacturing activities, and the foreign investment infused in the company would be stuck. The foreign investor would then have to find ways to unwind the transaction, which given the pricing caps on sale by a non-resident to a resident and the loss in value of the investee company due to rejection of its license application, would nearly in all cases make repatriation of the entire foreign capital impossible. Not many prospective investors would want to risk their capital or subject their corporations to this uncertainty.

While the condition specifies the need for Government approval in case of transfer of shareholding in a Defence entity from an existing investor to a "new" foreign investor, it is unclear whether Government approval will be required for transfer of stake by an existing investor to an existing foreign investor within the permitted automatic route level. Basis discussions with the DIPP, it appears that Government approval will be required in this instance as well. However, the wording of the regulations remain unclear in this regard.

Security Clearance Conundrum

The FDI policy subjects foreign investment in the Defence sector to a security clearance procedure. This security clearance is undertaken by the MHA and in practice, obtaining this clearance often results in delays in obtaining Government approvals for foreign investment. Further, in case of an Automatic route transaction, where a foreign investor enters India without interfacing with any Governmental entity and therefore, the security clearance only occurs post investment (i.e., at the time of obtaining a license under the IDRA or the Arms Act), a negative report on security aspects could lead to the entire transaction having to be unwound. As mentioned above, this would lend a lot of uncertainty to any transaction and may discourage the foreign investor from investing and risking its capital.

Underdeveloped Supporting Ecosystem and Requirement for Self-Sufficiency

The Indian Defence ecosystem has traditionally comprised Government sector undertakings, with very few private players entering the fray. Of the ones that do exist, very few have proven capabilities of indigenous design and development. The FDI policy prescribes that the investee / joint venture company is required to be structured to be self-sufficient in areas of product design and development, with a manufacturing facility and maintenance and life cycle support facility of the product being manufactured in India. Previously, the requirement in this regard was only for the licensing authority to satisfy itself regarding the adequacy of the net worth of the foreign investor taking into account the category of weapons and equipment proposed to be manufactured. As such, this new condition requires adherence to much tougher thresholds, which given the existing state of the Indian Defence industry will be very tough to achieve.

Further, given that intellectual property rights of products would normally be with the foreign OEM and such a foreign entity would have rights over product design and development, it is unclear if a license of patents and other forms of intellectual property from the foreign original equipment manufacturer to the Indian joint venture will be sufficient to be considered "self-sufficient". The Defence sector typically sees foreign investments of up to 49%, and in a situation of lack of control over the investee company, it is unlikely that any foreign investor would be keen to completely assign its intellectual property to the investee company. As such, despite the Government's desire to have Indian Defence companies set up as completely self-sufficient entities, this condition would remain impossible to meet.

A Numbers Game

Like any other manufacturing industry, before the manufacture of large platforms or integration of complex systems, units manufacturing parts and components have to be established. While the Indian Defence ecosystem The Indian market is also starting to see this happen and a significant amount of foreign investment has already come in for manufacture of parts and components of defence equipment, especially of fighter jets, helicopters and allied products. However, basis the clarity brought about by Press Note 3 of 2014 and the Ministry of Home's Office Memorandum, these FDI inflows are counted under the general "Manufacturing" head and not under the "Defence" head. Therefore, publically released FDI in Defence numbers cannot be taken as representative of the real investment appetite for the sector.

Conclusion

Even though the foreign investment policy in the Defence sector has been liberalised to a great extent, lack of clarity and overlap of regulation and Government interface continue to plague the industry. While India is ripe with investment possibilities in the Defence sector and there appears to be a lot of appetite for such investment as well, time delays hamper even large scale proposals. Given the sensitive nature of the industry, it is unlikely that the Government would ever consider letting go of its control over any investment in the sector. However, one may hope that in future, the Government would be more forthcoming in hearing the concerns faced by the industry to create a simple and uncomplicated compliance framework.

Footnotes

1. Dated June 26, 2014

2. Clarification No. 7(3)2009.Ip (Vol. III) to Press Note 3, dated October 9, 2014

3. Dated August 26, 2014

4. Dated November 24, 2015

5. Dated June 24, 2016

6. Dated May 19, 2017

7. Dated September 22, 2017

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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