Budget 2017: Roll out simplified and rationalised offset policy guidelines

BMR AdvisorsWith a history of border disputes in strategic locations and mounting threats to national security, the Defence & Aerospace industry carries an enormous sovereign responsibility. India needs a continuous investment in this space owing to increasing instances of cross-border terrorism, infiltration attempts and domestic threats posed due to insurgency in certain regions. The state of geo-political affairs coupled with concerns surrounding archaic defence gears has nudged the Indian government to take several measures not only to accelerate defence procurements, but also to promote technical capabilities for in-house research and design. In order to meet its modernisation needs, India’s defence layout on capital procurements is anticipated at ~USD 250 billion over the next decade.India has historically been amongst the largest importers of defence systems and equipment worldwide, with 60-70 percent of its requirement being met by imports. Over the past two and half years, the incumbent government has demonstrated unstinted commitment to reverse the trend, by embarking on the path to become self-sufficient through progressive indigenisation of defence manufacturing. Towards this endeavour, significant policy strides have been made. To recount a few, progressive Defence Procurement Procedure, 2016 (‘DPP 2016’) was unveiled; defence manufacturing space has since been opened up for 100 percent foreign direct investment (“FDI”) [49 percent under the automatic route, extendible to 100 percent with prior government approval, dispensing with ‘mandatory’ requirement for transfer of ‘state-of-art technologies’ for cases involving >49 percent FDI]; manufacturing of majority defence products has been delicensed, and the duration of industrial licence has been extended to usher in administrative ease (15 years, with a permissible extension of 3 years). DPP 2016 has unveiled a unique procurement category under the heading ‘Buy – Indian (IDDM)’ (Indigenously Designed, Developed and Manufactured) as the preferred mode of defence procurements by the government. The new procurement priority is targeted to help the government achieve twin objectives of ushering in ‘state of the art’ technologies in defence procurement, and promoting indigenisation of design and manufacturing of defence capital products. This would also provide fillip to the government’s flagship ‘Make in India’ programme, through preference being extended to Micro, Small and Medium Enterprises (‘MSMEs’) for inclusion in supply chain. It is in this backdrop that players in the defence sector, both Indian and foreign, are looking up to Union Budget 2017 with a series of expectations which can reset the Indian defence industry to achieve rapid growth. Key expectationsPolicy reformsWhile key policy and regulatory reforms would require executive decisions, Union Budget 2017 must set the tone for reforms. Key policy related expectations are summarised below:• Roll out simplified and rationalised offset policy guidelines under DPP 2016, considering the following: Allow sharing of offset credits within group companies / subsidiaries of foreign Original Equipment Manufacturers (‘OEMs’); Extend performance period of offset obligation to encourage investment in advanced and long term engineering and manufacturing defence projects; and Strengthen Defence Offset Management Wing (‘DOMW’) to ensure timely decision making.• Enhance permissible FDI under automatic route from 49 percent to 51 percent to encourage transfer of technology to Indian industry. Present limit has not resulted in meaningful FDI inflows since traditionally, strategic investors in defence space prefer to collaborate under a majority-owned joint venture. • Rationalise framework and approval requirements for setting up a Project Office (‘PO’) / Liaison Office (‘LO’) by foreign OEMs. Despite a number of clarifications issued in 2016, certain administrative concerns remain unaddressed; e.g. whether a foreign OEM who is awarded a defence contract under the Government to Government (‘G2G’) framework and wishing to set up a PO / BO in India, would be permitted to do so without a prior RBI / Government approval. • Roll out measures to promote defence research and skill development to enhance scalability in indigenous manufacturing, to propel India into becoming the defence export hub of Asia. The government must continually foster the start-up ecosystem in defence and aerospace industry, which has the potential of growing at CAGR of 18 to 20 percent in next five to seven years. Direct tax • Provide for exemption from income-tax under section 10(6C) of the Income-tax Act, 1961 (‘ITA’) for royalties / fee for technical services (‘FTS’) earned by foreign companies in respect of agreements entered into with Defence Public Sector Undertakings (‘DPSUs’). Also clarify that in cases where the contract with DPSUs has been executed pursuant to the main contract with the Ministry of Defence (‘MoD’), exemption under section 10(6C) of the ITA would be available. • Address procedural delays in issue of notification in the Official Gazette in respect of claim of tax exemption under section 10(6C) of the ITA, by prescribing a timeline for processing of the application.• Clarify availability of tax exemption under section 10(6C) of the ITA, to foreign OEMs entering into defence services contracts, pursuant to G2G contracts. Historically, the Indian tax regime has catered to contracts for defence procurements / services, which are entered directly between the MoD, Government of India, and foreign OEMs / service providers. With increased focus on G2G contract model for strategic defence procurements, often times foreign OEMs / contractor lose out on tax concessions / exemptions owing to absence of privity of contract with the Government of India. • While ‘infrastructure’ status has been granted to maintenance, repair and overhaul (‘MRO’) activities for civil aircrafts in India¹, MRO sector should be incentivised further to extend the infrastructure status for MRO for defence aircrafts. To promote wider private investment participation, MRO activities should be included within the list of activities eligible for investment-linked deduction under section 35AD of the ITA. Indirect tax • The government withdrew customs and excise exemptions available in relation to supply of defence equipment (including components) goods by the government or contractors / sub-contractors to government / defence public sector undertakings during financial year 2016-17. This was done to create a level playing field for private players and give impetus to ‘Make in India’ scheme. However, even after this elimination there are instances of inverted duty structures such (for instance, artillery weapons are taxed at a higher rate than its components). This discourages indigenous manufacturing of defence equipment. Such inverted duty scenarios should be appropriately addressed. • Allow manufacturers and foreign governments to register and pay taxes in India without having a place of business in India and allow seamless flow of input tax credits. This would facilitate implementation of contracts involving sales to MoD by foreign governments or prime contractors located outside India with manufacturing supply chain based in India. • At present, exemption is provided in respect of services provided by an offshore service provider to government for non-commercial purposes (this would include services in relation to defence). However, no such exemption is available to an Indian service provider. This disparity needs to be addressed. • In line with the National Civil Aviation Policy 2016, aircraft manufacturing facility including manufacturing of defence aircrafts should be notified as ‘SEZ’. This should be extended to other key defence equipment manufacturing facilities. Additionally, domestic clearances from such facilities should be counted towards net foreign exchange earnings (as is currently the case for IT products). While a number of policy overhauls are underway, quantum of foreign investments received in past 24 months in Defence & Aerospace industry has been far low from what is desired to be achieved². With a large number of proposals for defence manufacturing and for joint ventures still in the negotiation stage, impact of the PM’s flagship ‘Make in India’ programme is yet to be witnessed insofar as the Defence & Aerospace industry is concerned. It is imperative that the government ups the ante with its progressive reform initiatives to enable rapid modernisation of the sector, with an eye on the larger objective of promoting indigenisation of defence manufacturing and technological advancement in the sector. 1. Vide National Civil Aviation Policy 2016 2. Based on the Quarterly Fact Sheets on FDI (updated upto September 2016) published by Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India, total FDI in Defence industry over the past 16 years has been INR 25.48 crore, including FDI of ~INR 1 crore over the past 24 months.