THE INDIAN OFFSET STORY: A BLOCKBUSTER AWAITING A SCRIPT

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1 THE INDIAN OFFSET STORY: A BLOCKBUSTER AWAITING A SCRIPT NEW DELHI MUMBAI BANGALORE February 14, 2014 Alina Arora Partner Luthra & Luthra Law Offices

2 MEETING OFFSET REQUIREMENTS - KEY CHALLENGES 1. Who qualifies as an Indian Offset Partner? 2. Who can discharge offset obligations? 3. What are the main ambiguities in relation to investment in kind through provision of equipment as an eligible offset? 4. What are the key challenges & ambiguities with respect to the Transfer of Technology as an eligible offset? 5. What are the key ambiguities in relation to offset contracts executed under the FMS mode of procurement? 6. Should the provision pertaining to change of the offset partner be retrospective in nature? 7. What are the issues pertaining to the abeyance of services as a means of discharge of offset obligations? Luthra & Luthra Law Offices 2

3 Who Qualifies as an Indian Offset Partner ( IOP )? An IOP has been defined under Paragraph 4.1 of the Offset Guidelines under the DPP-2013 as: Indian enterprises and institutions and establishments engaged in manufacture of eligible products and/or provision of eligible services, including DRDO. The terms Indian enterprise, Indian institution and Indian establishment have not been specifically defined in the DPP. Does this mean that any company incorporated in India will be an eligible IOP, irrespective of the level of FDI in the company? Luthra & Luthra Law Offices 3

4 Who Qualifies as an Indian Offset Partner ( IOP )? Whether a company incorporated in India will be an eligible IOP, irrespective of the level of FDI in the company CAG s stance as reported in CAG Report dt November 29, the IOP is required to comply with the guidelines /licensing requirements for the defence industry issued by the Department of Industrial Policy and Promotion (DIPP). Further, the government has allowed 100 per cent participation of private sector in the defence sector with FDI (Foreign Direct Investment) permissible upto 26 per cent. (Paragraph of Chapter II of the CAG Report No. 17 of (Air Force and Navy)). From the above, it appears that as per the CAG, in order to be an eligible IOP, a company would have to adhere to the licensing requirements prescribed for entities operating in the defence sector in India, including the sectoral cap of 26 per cent on FDI. In addition, it appears that the other conditions applicable to FDI in the defence sector would also be required to be complied with such as that the company should be owned and controlled by resident Indian citizens. However, this ownership criterion has been diluted by the recent amendment to the FDI Policy, which provides that FDI beyond 26%, may be approved in certain cases by the Cabinet Committee on Security (CCS) provided that it ensures access to modern and state of the art technology to the country. Luthra & Luthra Law Offices 4

5 Who Qualifies as an Indian Offset Partner ( IOP )? CAG has in the report identified 2 cases, wherein the firms appointed as IOPs were ineligible as IOPs on the ground that in both instances, the IOPs were subsidiaries of foreign companies. The 2 cases are follows: 1. M/s Thales International India- Appointed as IOP for offset contract (July 2009) for procurement of Low Level Transportable Radar (LLTR). According to the CAG, the company being a 100 per cent subsidiary of M/s Thales, Singapore and M/s Thales, Hong Kong was not eligible to be selected as IOP. 2. M/s Wartsila India Ltd. and M/s Johnson Pumps Ltd.- Appointed as IOPs for offset contract (April 2008) for procurement of fleet tankers for the Indian Navy. Both of these are subsidiaries of foreign companies. 5

6 Who Qualifies as an Indian Offset Partner ( IOP )? MoD s response to CAG s report: Interestingly, according to the MoD, M/s Johnson Pumps is an eligible IOP since it is a company registered under the (Indian) Companies Act, 1956 even though it is a subsidiary of a Swedish company. According to the CAG, the MoD s contention is not acceptable since the company is a subsidiary of a foreign company. And therefore the ambiguity continues 6

7 Who can discharge offset obligations? Paragraph 5 of the offset guidelines provides that the vendor of the equipment under the main procurement contract will be responsible for the fulfillment of the offset obligations. The vendor may allow his tier-i sub-vendors to discharge offset obligations, to the extent of their work share (by value), on behalf of the prime vendor. However, overall responsibility and liability for the full discharge of offset obligations shall continue to remain with the prime vendor. The key challenge here is whether the offset obligations may be fulfilled by the group companies of the Vendor/ Foreign OEM. The MoD has in the past taken the view that group companies of the vendor can not be allowed to discharge the offset obligations on behalf of the vendor. The responsibility for discharge of offset obligations is placed solely upon the vendor. This view appears to be unduly restrictive and is required to be re-examined. Arranging for their group companies to discharge their offset obligations may make commercial sense for the OEMs, while being in consonance with the intent of the offset policy (i.e. development of the domestic defence industry). 7

8 Offset Trading? Paragraph 5.8 of the offset guidelines provides that banked offset credits will not be transferable except between the main vendor and his tier-i sub-vendors within the same procurement contract. The prohibition on transferability of banked offset credits may be inhibiting the growth of the domestic defence industry. OEMs wishing to supply defence equipment to India may be reluctant to take recourse to the provision for offset banking since if a procurement project does not materialize within the prescribed period of seven years, they would not be able to avail of the banked offset credits. Allowing for offset trading may create greater incentives for OEMs to invest in the Indian defence sector. 8

9 What does Provision of Equipment mean? One of the avenues for discharge of offset obligations is through investment in kind in Indian enterprises in terms of provision of equipment through the nonequity route for the manufacture and / or maintenance of eligible products and provision of eligible services (excluding TOT, civil infrastructure and second hand equipment). Some aspects that require further clarification: What does provision of equipment really mean? Does it mean the transfer of ownership of the equipment or the transfer of right/ license to use the equipment or both? If it includes the right/ license to use, how should the valuation of the same be done for the purpose of the commercial offset proposal? Does the equipment have to be a foreign product or can it be an indigenous product procured domestically? The offset Policy should clarify the import of provision of equipment i.e. whether it refers to the transfer of title or the right to use or both? If the right to use" is to be included, guidelines should be provided for its valuation. 9

10 Transfer of Technology as an eligible offset One of the available avenues for discharge of offset obligations is through investment in kind in terms of transfer of technology (TOT) to Indian enterprises for the manufacture and/or maintenance of eligible products and provision of eligible services. For significant technology to be successfully transferred from a foreign OEM to an Indian company, the foreign investor would require certain minimum rights which would ensure the effective conduct of the operations of the Indian JV Company. These at the least would be: significant interests in the ownership and control of the Indian JV company the right to appoint the chief executives of the Indian JV company who must possess the requisite degree of technical skill and know-how The key point then is - Do the existing policies provide the enabling environment to facilitate the ToT? 10

11 Transfer of Technology as an eligible offset FDI Policy for Defence Sector FDI up to 26% allowed under the approval route i.e. with the permission of the FIPB FDI beyond 26%, in certain cases may be approved by Cabinet Committee on Security (CCS) provided that it ensures access to modern and state of the art technology to the country. The aforesaid approval of the FIPB or the CCS through the FIPB is subject to Industrial Licensing and the other conditions for FDI in Defence. 11

12 Transfer of Technology as an eligible offset The Other Conditions for FDI in Defence Sector Resident Indian citizens should have the power to appoint a majority of the directors in the company. The chief executives of the company should be resident Indians. The management of the company should be in Indian hands The standards and testing procedures for equipment to be produced under licence from foreign collaborators will have to be provided by the licensee to the Government nominated quality assurance agency. Self-certification may be permitted by the MoD on case to case basis for a fixed period and subject to renewals. The company would need to be owned and controlled by resident Indian citizens and Indian companies, which are owned and controlled by resident Indian citizens. 12

13 Transfer of Technology as an eligible offset Ambiguities under the FDI Policy: Lack of clarity on whether a joint venture company with FDI above 26% would be an eligible IOP under the Offset Policy. Ambiguity on what constitutes state of the art technology for approving FDI beyond 26% The only indicative guidance (available in public domain) is the List of Critical Defence Technology Areas and Test Facilities for Acquisition by DRDO through Offsets, issued by the DRDO. Inherent contradiction on the requirement of being owned and controlled and allowing FDI beyond 26% in case of access to state of the art technology The other conditions and the requirement that the JV Company should be owned and controlled by resident Indian citizens have not been viewed as being conducive to promoting ToT. 13

14 Transfer of Technology as an eligible offset Ambiguities/ Challenges under the Offset Policy for TOT 1. Whether offset credits for the TOT shall be in addition to the offset credits which may be availed for the direct purchase of eligible products. Under the Offset Guidelines, the offset credit for TOT is 10 per cent of the value of buyback during the period of the offset contract, to the extent of value addition in India. As per the above provision, in the event that an OEM sets up a joint venture in India and transfers technology to that joint venture, the OEM would be required to undertake buy-back from the joint venture and the offset credits for the TOT shall be 10 per cent of the value of the buyback to the extent of value addition in India. It is not clear whether in addition to the 10% value credit for ToT, the Foreign OEM will be able to avail of offset credit for direct purchase of eligible products. 14

15 Transfer of Technology as an eligible offset 2. No restriction on domestic production, sale or export The offset guidelines provide that the TOT should be provided without licence fee and there should be no restriction on domestic production, sale or export. This condition pertaining to TOT is required to be re-examined since most OEMs would be highly reluctant to supply technology without any restriction on the extent of domestic production, sales and export, particularly since the Indian company would then be able to compete with and supply to the competitors of the foreign OEMs. 15

16 FMS Procurement & Offsets India has been increasingly relying upon the FMS route for defence procurement. Under this route, there is a direct contract for supply of defence equipment between the MoD and the United States Government (USG). The USG, in turn, contracts with OEMs for the supply of the equipment. While the OEMs are not party to the primary contract between the MoD and the USG, the OEMs have been required to enter into the offset agreement directly with the MoD for discharge of offset obligations. Such offset contracts are executed in the standard format and the foreign OEM is contractually mandated to adhere to the Offset Policy. The MoD is reluctant to modify the draft standard offset contract, while contracting with OEMs in relation to an FMS procurement since a deviation from the standard contract requires the approval of the Raksha Mantri. Since under an FMS procurement, the OEM is not a party to the main contract, the OEM is not a vendor for the purposes of the offset guidelines under the DPP. This leads to ambiguity in the interpretation of the offset guidelines, as applicable to the OEMs. 16

17 FMS Procurement & Offsets By way of illustration: While the OEM is contractually mandated to adhere to the provisions of the offset guidelines under the DPP, the OEM may not be able to take the benefit of such provisions. For instance, if the offset contract does not provide an express provision for re-phasing of the offset obligations or for changing the offset partner, then even though such provisions are present in the currently applicable offset guidelines, it may become difficult for the OEM to take the benefit of such provisions. Moreover, the OEMs often face various difficulties in implementing the offset contract since they are not party to the primary contract and are unable to furnish a copy of the same to obtain various approvals / licenses. Given the significant number of FMS transactions which are undertaken by the central government, the MoD may consider preparing a separate standard template of the offset contract pertaining to FMS transactions. It may be advisable to include a general provision in such standard template to the effect that the offset guidelines are incorporated by reference into the offset contract. In the case of contracts already executed, it may be advisable to extend the benefits of the applicable offset guidelines to the OEMs which have entered into such contracts. 17

18 Change in IOP- should it be retrospective? Paragraph 8.11, Appendix D of the DPP, 2013 permits change in the Indian Offset Partner (IOP). Change in IOP allowed in: (a) exceptional cases; and (b) where change is necessary to enable the vendor to fulfill offset obligations. Procedure for Change: DOMW to recommend change. Change in IOP of a Tier-1 sub-vendor to be forwarded to DOMW through the main/prime vendor. Change in IOP to be approved by Secretary (Defence Production). However, as only RFPs issued post June 1, 2013 are governed by DPP, 2013, parties of previous contracts/rfps cannot avail benefit of Para 8.11, Appendix D of the DPP, 2013 to change their IOP. 18

19 Change in IOP- should it be retrospective? Often, there is a long time lag between the submission of the offset offer by the OEM and the execution of the primary procurement contract. In this time period, the proposed offset project may become unfeasible on account of various factors which are outside the control of the OEM such as the reluctance of the IOP to go ahead with the offset project. Permitting change in IOP is a step in the right direction, but changing IOP can be timeconsuming and may affect ability of vendor to achieve offset target within the agreed time-frame. Therefore, the procedure for change in IOP should also specify timelines for proposing and accepting change in IOP. Moreover, provision should be made to allow an extension in the period for discharge of offset obligations in the event that a change in the IOP is permitted on grounds, which were outside the OEM s control. Provision of DPP, 2013 enabling change in IOP ought to have been applied retrospectively to all offset contracts, as: It has been a long standing demand of vendors that flexibility in offsets is necessary to delivery efficiently on offset obligations. It is possible that a change in IOP is necessitated by: (i) existing IOP not being keen to move forward with the contract; (ii) emergence of better qualified Indian partners; (iii) technological upgradation; and (iv) MoD subsequently blacklisting an IOP (whether for acts of the IOP in pursuance of the offset contract or otherwise). 19

20 Abeyance of Services the Butterfly Effect of Agusta Westland? Office Memorandum No. 9 (42)/2013/OFFSETS dated May 23, 2013 ( Services Abeyance OM ): Temporary abeyance of provisions in the DPP related to discharge of offsets through services, till such time that further instructions are issued. Services Abeyance OM to come into force with immediate effect, for: (i) all RFPs issued on or after the date of the Services Abeyance OM; and (ii) RFPs already issued for which the last date of submission of technical and commercial bids is not over. Wide range of activities covered within services including (i) Maintenance, repair and overhaul; (ii) Engineering, design and testing; (iii) Software development; (iv) Quality assurance; (v) Training; and (vi) Research and Development services (from recognized R&D facilities). Services Abeyance OM issued in the aftermath of the controversy surrounding Agusta Westland deal. 20

21 Abeyance of Services the Butterfly Effect of Agusta Westland? What next? Further Instructions - Revised Offset Policy? Probable options for the Government (i) Complete ban on discharge of offset obligations through Services ; or (ii) Cap on percentage of discharge through Services ; or (iii) Revised definition of Eligible Services for discharge of offset obligations? Issues to be addressed (i) Difficulties in tracking value addition for services; (ii) Preventing misuse of services as a mode of discharge of offset obligations; (iii) Ability of Indian defence manufacturing industries to absorb offsets?; (iv) Move towards improved monitoring mechanism? Re-assessment of whether discharge of offset obligations through services meets the objectives of the Offset policy. 21