Cover Story: India’s Defence Offset Guidelines 2012

In a major review of the Defence Procurement Procedures (DPP), the Ministry of Defence (MoD) has recently announced its revised Defence Offset Guidelines (DOG), which have come into effect from August 01, 2012. The guidelines have included several new provisions besides modifying and clarifying some of the existing ones.

13th Sep 2012


 India

 India’s Defence Offset Guidelines 2012

 Laxman Kumar Behera / New Delhi

In a major review of the Defence Procurement Procedures (DPP), the Ministry of Defence (MoD) has recently announced its revised Defence Offset Guidelines (DOG), which have come into effect from August 01, 2012. The guidelines have included several new provisions besides modifying and clarifying some of the existing ones. The revised DOG has also for the first time articulated the objectives of the offset policy which are three-fold: (1) ‘fostering development of internationally competitive enterprises; (2) augmenting capacity for research, design and development related to defence products and services; and (3) encouraging development of synergistic sectors like civil aerospace, and internal security.’

SALIENT FEATURES OF D O G

Clarification of Scope and Quantum of Offsets
Like the previous version, the new guidelines also stipulates a minimum 30 per cent offsets in ‘Buy (Global)’ and ‘Buy and Make with Transfer of Technology (ToT)’ contracts valued Rs 300 crore (approximately US $55 million) or more (in the latter case the quantum of offsets of minimum 30 per cent is mandated on foreign exchange component of the contract). However unlike the previous version, the DOG has clarified that an Indian company or its joint venture participating in ‘Buy (Global)’ contracts are exempted from offset obligations, provided the product in question has indigenous content of minimum 50 per cent by value. In case the indigenous content is below 50 per cent, offsets are mandatory on part which involves foreign component.

Expanded Avenues for Discharge of Offsets
The avenue for discharge of offset obligations by the foreign OEMs has been expanded by (1) permitting investment in ‘kind’ in Indian industry, (2) allowing Defence Research and Development Organisation (DRDO) to acquire a select list of high technologies, and (3) increasing the number of Indian Offset Partners (IOPs). As per the revised DOG, the investment in ‘kind’ is allowed in the form of ToT or transfer of equipment (ToE) for manufacture and/or maintenance of permitted items. A difference has been made by way of mandating that while the ToT can be either through the equity or non-equity route, the ToE has to be only through the non-equity route.

In case the foreign original equipment manufactures (OEMs) choose technology transfer as an option for discharge of offsets, the guidelines mandate that such ToT should be provided without license fee and be comprehensive so as to cover all documentation, training and consultancy required for full ToT. The cost of infrastructure and equipment of civil nature are however to be excluded from calculation of offset obligations. The guidelines also mandate that ‘there should be no restriction of domestic production, sale or export’ resulting from such ToT. To ensure that ToT does not lead to ‘dumping’ of foreign technology, and guard against undue pricing of technologies, the guidelines have emphasised on stringent buy-back and value addition conditions. As per these conditions, foreign companies will receive offset credits not for the value of the technologies transferred but for the value addition (in India resulting from such ToT) and their eventual buy-back by foreign companies (see Table).

In case of ToE, the conditions are however somewhat less stringent. The vendors are permitted to claim credits for the entire value of equipments they transfer to their Indian offset partner. This is however subject to, what seems to be, OEM’s minimum buy-back of 40 per cent of permitted items.

The technology acquisition (TA) by the DRDO is permitted in a select list of high-technologies, which will be reviewed and updated periodically. The list, which presently consists of 15 categories includes fiber laser technology; propulsion, aerodynamics and structures for hypersonic flights; nano technology based sensor and displays; and pulse power network technologies among others. Valuation of technologies offered by the foreign vendors is to be evaluated by the Technology Acquisition Committee (TAC) which is a multi-disciplinary body comprising of DIITM (Directorate of Industry Interface and Technology Management) of DRDO, the additional financial advisor to DRDO, and members from armed forces headquarters among others. To ensure a two-way dialogue process between the DRDO and foreign vendor for better understanding of each other’s position, a window of opportunity is provided to enable detailed discussion.

The list of Indian Offset Partners (IOP) has been expanded by including hitherto excluded government institutions and establishments (including DRDO) engaged in manufacture and maintenance of eligible items. The new entrants are allowed to receive both ToT and ToE as offsets for augmenting their ‘capacity for research, design and development, training and education.’ The purchase from and equity investment in these institutions by the foreign OEMs are however not allowed.

Provision of Multiplier
The revised DOG has for the first time included multipliers as a measure to incentivise investment in select areas. The maximum value of multipliers is kept at 03, meaning a foreign company can claim credits upto three times of its actual offset investment. However, multipliers are restricted to two areas: Micro, Medium and Small Enterprises (MSME) and technology acquisition by DRDO. In the case of MSME (the definition of which it taken from another government department), multiplier of 1.5 is allowed when an offset investment takes place in the form of a purchase from, FDI in, and investment in ‘kind’ in these enterprises. Higher multipliers of 2.0, 2.5 and 3.0, are reserved only for the technology acquisition by DRDO. Higher the multiplier, greater is the technology leverage that the DOG intends to achieve. The maximum multiplier of 3.0 is allowed only when a foreign company provides a listed technology without any restriction on its volume of production and sales including exports.

Extended Banking Period
The banking of offset provision which was first introduced in DPP-2008, had so far been drawn a lukewarm response from foreign companies. The primary reason for such response was because of the limited validity period. To overcome this, the revised DOG has extended the banking period to seven years. The banking provision is however allowed in case of purchase from, investment in, and technology/equipment transfer to Indian industry (technology acquisition by DRDO and the government establishments/institutions have been excluded from the banking purview).

Like the previous guidelines, the revised DOG also does not permit offset trading by restricting transfer of banked offset credits to main supplier and its sub-suppliers within the same acquisition proposal. However unlike the previous version, the revised document has stipulated that the pre-approved banked credits can not be used for more than 50 per cent of total offset liabilities arising from a future procurement contract. This would mean that a foreign company would require at least two procurement contracts to discharge its banked offsets credits. To ensure that the banking proposals of the vendors are considered in a time-bound manner, the DOG has provided an eight-week window to dispose off such cases.

DOFA to DOMW
One of the critical features of new DOG is the provision of Defence Offset Management Wing (DOMW), which will replace the existing Defence Offset Facilitation Organisation (DOFA). The new Wing like in past will be under the Department of Defence Production, of the MoD. However unlike DOFA, DOMW is now visualised as a more powerful organisation in the matter related to post-defence offset contract management. The most critical aspect of its power lies in its being one of the repositories of the signed offset contracts, which the DOFA did not have access to. Among others, the DOMW is tasked to formulate offset guidelines, participate in technical and commercial offset negotiations; monitor/audit offset programmes, administer offset penalties in case of default by vendors; implement offset banking and assists vendor in all offset-related matters.

Provision for Supervision at DAC Level
Apart from DOMW, the monitoring aspect in the revised DOG has further been highlighted by way of supervision by the Defence Acquisition Council (DAC) which is the highest decision-making body in the MoD. The revised policy stipulates that DOMW ‘will submit an annual report to the DAC in June each year regarding the status of implementation of all ongoing offset contracts during the previous financial year.’ This will ensure regularity in supervision and possibly its quality.

Clarity in Industrial Licensing & FDI Issues
From the private sector’s perspective, one of the key hurdles in participation in offsets programmes was due to difference in interpretation of industrial licensing requirements and FDI exposure of IOP. The MoD was believed to have taken a stand that IOP, irrespective of its being in defence or non-defence sector, must have an industrial licence and its FDI exposure must not exceed 26 per cent (the MoC guidelines states that an Indian company is subject to IL and FDI restriction if its activities fall only in defence manufacturing).To overcome the above difference, the revised guidelines has made it clear that the provisions in the DOG will be in ‘harmony and not in derogation of any rules and regulations stipulated’ by other agencies. This means, the companies in the non-defence manufacturing sector will not be subject to IL and FDI restrictions and can be easily be co-opted by the foreign companies as their IOPs without any regulatory constraints.

Miscellaneous Provisions
Apart from the above provisions, the revised guidelines have also expanded the list of eligible products/services against which offsets can be discharged; extended the offset discharge period; and put a cap on penalty in case of default. The list of eligible products/services has been mainly expanded in the renamed category of ‘Products for Inland/Costal Security’ (the earlier name was ‘Products for Internal Security’). Four more groups have been added to the category. The ‘Civil Aerospace Products’ and ‘Service’s categories have been expanded by one group each. In the ‘Defence Products’ category, the number of groups has remained the same, but the group under warship building has been expanded by including four distinct sub-groups with greater clarity. In all, there are now 39 group of products/services in which the foreign vendors are allowed to discharge their offset obligations. These groups are apart from the list of high technologies (meant for DRDO) which are allowed as a means for discharge of offset obligations.

Regarding offset obligation discharge period, the new guidelines have extended the period by two years from the date of the main procurement contract (the date of main procurement contract is inclusive of the date of warranty). However the extension is subject to vendors’ submission of an additional performance-cum-warranty bond equivalent to the value of offset obligations falling beyond the period of main procurement contract. The submission of bond is required six months prior to the expiry of the main performance-cum-warranty bond.

While the revised DOG has kept the annual penalty in case of default on the part of vendor at five per cent, it has now mandated that the overall penalties can not exceed 20 per cent of the total offset obligations during the main procurement contract. There will be however no cap on penalty in case of default during the extended period. All matter regarding penalties will be administered by the DOMW.

Revised Guideline: Potential Impact on Indian Defence Industry
The above features notwithstanding, some of the provisions in the DOG do not seem to be well thought out, provide greater leeway to the foreign companies, and have a potentially negative impact on eligible manufacturing sector, particularly the defence manufacturing. Mandating offsets on Indian companies if the products have less than 50 per cent indigenous content, and limiting the timeframe to achieve the required indigenisation level before the production starts, is simply unrealistic. This will dissuade many Indian defence hardware manufactures from competing against their global peers, even if they are hopeful of achieving progressive indigenisation over a period of time.

The manufacturing sector is further marginalised by the DOG’s two more provisions: (1) explicit exclusion of services from the purpose of value addition in India and (2) clarification of MoD’s position on industrial licensing and FDI. The first provision means virtually no incentive to the foreign companies to choose an IOP of manufacturing background as choosing an IOP from services sector will be the far more cost-effective (because the foreign company can theoretically sell its own services through an Indian partner as value addition is not a criteria to determine offset credit). The second provision allows foreign vendor’s cost-effectiveness to be much more if it chooses a non-defence, non-manufacturing IOP which does not requires an IL and is not subject to 26 per cent FDI limit, which is mandated for Indian defence manufacturing enterprises. This means the foreign vendor can set up its 100 per cent-owned subsidiary (in one of the permitted services sector) in India and choose it as its offset partner. Evidently, this does not at all benefit India’s manufacturing sector, let alone defence manufacturing. The revised guidelines need to seriously ponder over these issues if the defence manufacturing is the priority.

Aspects of India’s Defence Offset Policy 2012
Discharge of Offset Obligations: Avenue Type Multiplier Banking (07 years) Condition
A. Direct Purchase of permitted goods/services 1.5 if IOP is an MSME Allowed Offset credit for value addition to be determined by subtracting value of imported items and any fee/royalty paid to foreign companies.
B. FDI in qualified Indian Industry 1.5 if IOP is an MSME Allowed
C. ToT (both through equity (i.e., JV) or non-equity route) 1.5 if IOP is an MSME Allowed Offset credit is to be estimated @10% of value of buy-back of items for which ToT is used. Further, the actual value addition in India will be taken for estimating the value of buy-back.
D. Transfer of equipment (only through non-equity route) 1.5 if IOP is an MSME Allowed Offset Credit is subject to 40% buy-back (by value) of eligible items within the period of offset contract.
E. ToT or transfer of equipment to DRDO labs, ABW, BRD and Naval Dockyards Not allowed Not allowed
F. Technology acquisition by DRDO Up to 3.0:
2.0 if the ToT is meant for unrestricted domestic production for armed forces

2.5 if the ToT is meant for unrestricted domestic production for both civil & military use

3.0 if ToT is meant for unrestricted production for domestic (civil & military) and export purpose Not allowed Offset credit for the critical technologies listed in new guidelines. The technology list is to be reviewed periodically.
Notes: 1. A minimum 70 per cent of offset obligations are mandated to be discharged by any one or a combination of avenue types from A to D in this table. 2. Discharge of pre-approved banked offset credits, where allowed, can not exceed 50 per cent of total offset obligations under each procurement contract. Banked offset credits are not transferable except between the main supplier and his Tier-I sub-suppliers.

 

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