On May 16, 2020, as part of the economic packages being announced to revive the Indian economy in the wake of the COVID-19 pandemic, the Finance Minister announced that the automatic route limit for foreign investment in the defence sector will be raised from 49% to 74%. This had been a long-standing demand of the foreign original equipment manufacturers (OEM) lobby, stating unease in transferring high-end, proprietary technology to Indian entities that they cannot control. Therefore, the Government’s move is definitely a positive step, which should accelerate foreign investment in the sector, but the impact of certain other aspects of the present regulatory regime may dampen this positive sentiment. This post discusses the various factors that would impact OEM decision making around investing in the India’s defence sector, and further steps that should be taken to make high-end technology transfer to India a reality.
Negligible impact of past reforms
In 2015, the Government had first permitted foreign investment in the defence sector up to 49% under the automatic route. While the FDI Policy at the time stated that the sectoral cap was 49%, it also stipulated that the entry route for investment beyond 49% was the Government approval route, and decisions would be taken on a case to case basis, “wherever it is likely to result in access to modern and ‘state-of-art’ technology in the country”. The expressions “modern” and “‘state-of-art’ technology” remained undefined, causing lack of clarity. Thereafter, in 2016, the policy was further amended to stipulate that the sectoral cap for defence was now 100%, with investment beyond 49% being subject to Government approval, “wherever it is likely to result in access to modern technology or for other reasons to be recorded”, giving the Government further leeway to allow investments beyond control limits. This change gave the investor community the impression that approvals for foreign investment beyond 49% in the defence sector may be more forthcoming, even in cases where high-end technology was not proposed to be transferred. But the reality on the ground remained very different.
Limited benefit of the Automatic Route
While the automatic route for investments up to 49% has been available for a long time now, investments in the sector remain subject to security clearances by the Ministry of Home Affairs (MoH). In a move to streamline approval processes, in 2015, the Government reformed the FDI policy to stipulate that for automatic route investments, the security clearance can be undertaken as part of the licencing process. Prior to this, foreign companies were required to acquire security clearance before equity infusion. To this end, a condition was inserted in the FDI policy, stating that “infusion of fresh foreign investment within the permitted automatic route level, in a company not seeking industrial licence, resulting in change in the ownership pattern…will require Government approval.”
The practical outcome of this condition is that green-field joint ventures in the defence sector can be set up under the automatic route, without any Government interface, and that the security clearance for the foreign investor will be deferred and get clubbed with the process of obtaining the industrial licence. While this definitely crunches initial investment timelines, the downside to this approach is the risk of the security clearance being denied at a later stage, presumably resulting in the FDI transaction having to be unwound. For brown-field joint ventures, i.e., companies already operating in the defence sector and being in possession of an industrial licence, there is no availability of the automatic route, even for investments up to the automatic route limit. Additionally, any transfer of shares in a defence company to a non-resident requires Government approval.
Elaborating on the74% automatic route policy change, the Finance Minister has specified that the increased limit will continue to be subject to existing security conditionalities. If these conditions remain unchanged, even going forward, the automatic route will only be available to green-field joint ventures and not for increasing existing foreign shareholding percentages. However, we expect that such approvals should be granted in the ordinary course.
Make in India and other incentives
In addition to the increase in FDI cap for the defence sector, the Finance Minister has also announced that going forward, a list of weapons and platforms shall be notified in consultation with the Department of Military Affairs, Ministry of Defence, which shall only be purchased from India. There shall be a ban on imports of such weapons and platforms. Further, the Budget will contain a separate provision for indigenous defence capital acquisitions, and it is presently unclear whether this will be an additional allocation or will be culled out from the existing capital acquisition budget. Emphasis has also been placed on promotion of indigenisation of spares.
To this end, the extant Defence Procurement Procedure also lays immense emphasis on priority being given to indigenous procurement. Several procurement avenues impose conditions of Indian ownership and control to qualify as an eligible vendor.
The reality of the Indian defence ecosystem is that most foreign investments are made for offset fulfilment purposes, and are, at least initially, limited to manufacture of low-technology products, spare parts and components. With the allowance of control in foreign hands, with the increased 74% limit, the initial road-block to such technology transfer has been removed. However, this technology transfer will only be incentivised if the Indian joint ventures with 74% foreign participation are allowed to participate in domestic procurements as “Indian vendors”. Interestingly, the draft Defence Procurement Procedure (DPP)-2020, which was released in March for public comments, introduces a new category of procurement under the head Buy (Global – Manufacture in India), which recognises foreign OEM setting up an Indian “subsidiary” to participate in the procurement. That said, for all other purposes, the draft DPP-2020 specifies that the control of the Indian vendor should be in Indian hands.
Additionally, the draft DPP-2020 also disincentivises offset fulfilment through foreign investment in parts and components manufacture, by specifying a negative multiplier for such investments. This move is aimed to spur high-end technology transfer and manufacture of complete platforms in India.
The exact contours of the proposed FDI policy change are yet to be released. It would be extremely helpful if the press-note/ rule amendments are introduced along with changes to the procurement procedure as well. While some of the provisions of the draft DPP-2020 make provisions for foreign owned and controlled companies to be able to participate in procurement opportunities, wider changes will have to be introduced for foreign players to invest further in India.
It would be interesting to see how the Government proceeds in this regard in the coming few months.
 Press Note 12 of 2015 dated November 24, 2015
 Press Note 5 of 2016 dated June 24, 2016