Contract Manufacturing - Press Note 4

The question of whether contract manufacturing constitutes “manufacture” from a foreign investment perspective is an oft debated topic in the manufacturing fraternity and many businesses have struggled with this issue for years.

“Contract manufacturing” refers to manufacturing undertaken through a third party and has a range of benefits for the principal manufacturer, including economic efficiency, scale, operational efficiencies and flexibility. For instance, if a specialised set of equipment or skills is required to manufacture a certain product, the principal manufacturer can use the facilities already available with a third party to manufacture these products, instead of investing its capital in creating these facilities for itself. Contract manufacturing also enables a principal manufacturer to utilise a contract manufacturer’s existing supply chains, linkages and labour force. If a principal manufacture has a cyclical manufacturing business, using the facilities of a third party may be more beneficial than making capital investments that may lie idle for large parts of the year. In light of these benefits, contract manufacturing as a business model is one that is preferred by many entities in the manufacturing business.

However, adopting contracting manufacturing as a business model has not been an easy road for entities with foreign investment. The Foreign Exchange Management (Transfer or Issue of Securities by a Person Resident Outside India) Regulations, 2017 (FEMA 20R) and now the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (Non-Debt Instruments Rules) permit foreign investment up to 100% in the manufacturing sector.

FEMA 20R and the Non-Debt Instruments Rules define “manufacture”, with its grammatical variations, as “a change in a non-living physical object or article or thing, (i) resulting in transformation of the object or article or thing into a new and distinct object or article or thing having a different name, character and use; or (ii) bringing into existence of a new and distinct object or article or thing with a different chemical composition or integral structure”. A manufacturer is permitted to sell its products manufactured in India through wholesale and/or retail, including through e-commerce without any Government approval. However, the foreign exchange regulations are silent on whether manufacturing would include contract manufacturing as well.

In light of this uncertainty, many businesses with foreign investment have either adopted self-manufacturing models or have had to classify themselves as single brand retail traders and comply with single brand retail trading norms. However, a carefully considered view has also been taken in many instances that contract manufacturing would fall within the ambit of manufacture for the purpose of the foreign investment regulations, subject to compliance with certain conditions distilled from judicial precedents in the context of indirect tax laws[1] and past experience with regulators.

These conditions include the principal manufacturer:

  1. Prescribing detailed instructions in relation to the product (including design, process to be followed, and other qualitative and quantitative specifications).
  2. Owning all intellectual property and rights in relation to the products.
  3. Having control over where and how the raw material is sourced (or alternatively, sourcing the raw material by itself).
  4. Deputing personnel to supervise or conduct audits of the manufacturing process.
  5. Committing to accepting all products from the contract manufacturer without a right to reject products for any reason.
  6. Taking all liability in relation to the products.

In essence, the underlying principle is that the risk and reward should be borne by the principal manufacturer, and that the relationship between the principal manufacturer and the contract manufacturer should be one of principal and agent.

On August 28, 2019, the Union Cabinet issued a press release approving the review of foreign direct investment in various sectors (Press Release). In a bid to do away with the uncertainty surrounding the question of whether contract manufacturing would fall within the scope of “manufacturing” and to provide clarity on this aspect, the Cabinet also notified in this Press Release its decision to allow 100% foreign investment in contract manufacturing.

The Press Release stated the following: “Subject to the provisions of the FDI policy, foreign investment in ‘manufacturing’ sector is under automatic route. Manufacturing activities may be conducted either by the investee entity or through contract manufacturing in India under a legally tenable contract, whether on Principal to Principal or Principal to Agent basis.”  Subsequently, on September 18, 2019, the Department for Promotion of Industry and Internal Trade issued Press Note No. 4 (2019 Series), which amended the Consolidated FDI Policy Circular of 2017 to, inter alia, incorporate the above provision in relation to contract manufacturing. A key impetus under the amendment is that it also permits foreign investment in principal manufacturers engaging with contractors on a principal-to-principal basis, which could open up a plethora of opportunities in the manufacturing sector.

However, Press Note 4 expressly states that the amendments in the press note will take effect only from the date of the notification under the Foreign Exchange Management Act, 1999 (FEMA). At the time of Press Note 4 being issued, the relevant FEMA regulation on the subject matter was FEMA 20R issued by the Reserve Bank of India. Since then, the Department of Economic Affairs (Ministry of Finance) has notified the Non-Debt Instrument Regulations, which supersede FEMA 20R. However, the amendments made under Press Note 4 were not incorporated into the Non-Debt Instrument Rules. Therefore, as things stand currently, the amendment in relation to contract manufacturing has not yet come into effect.

While the Government set out to clarify a critical issue, the turn of events has left us with uncertainty by virtue of the Non-Debt Instrument Rules not acknowledging the Press Release and Press Note 4. Industry will have to wait for amendments to the Non-Debt Instrument Rules before the opportunities offered by the Press Release and Press Note 4 become a reality.

[1] Some examples are Commissioner of Central Excise vs. Innocorp Limited (2013 (289) ELT 172) and Union of India vs. Cibatul Limited (AIR 1986 SC 281).