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Mixed Reaction to India’s Offset Rules

Sep. 1, 2012 - 11:44AM   |  
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NEW DELHI — Industry executives and analysts are lauding India’s move to allow overseas defense companies to fulfill their offset obligations by partnering with local companies, a step aimed at benefiting the indigenous firms and the original equipment manufacturers (OEMs).

But the mechanics of how foreign firms will get credit hasn’t been determined, prompting some analysts to argue that increasing the foreign direct investment (FDI) limit would have done a better job of collaboratively boosting India’s defense industrial capabilities.

Leaving aside the desire to increase FDI, the offset rule changes have been received well, a U.S. industry source said. “No companies were complaining,” he said.

Offsets are industrial compensation in exchange for a defense purchase. Under Indian law, whenever a foreign company signs a deal with India that’s worth more than $60 million, at least 30 percent of the total amount of the deal must be in the form of offsets. The objective of the offsets is to boost India’s nascent domestic defense industry.

The Indian government, in its most recent defense offset policy ruling that went into effect Aug. 1, allowed offsets to be fulfilled through what’s called the non-equity participation route. This covers any participation in a joint venture and investment into Indian companies that does not involve actual transfer of cash. Such participation can be in the form of support, such as tooling or existing software.

Before the rule change, offset obligations could be fulfilled through partnerships between the overseas manufacturer and the Indian firm. The new wrinkle is the elimination of the requirement to transfer cash between the entities.

“The Indian entity benefits more than the OEM since the entity receives more than what it gives back. The capability that did not exist earlier is created in this Indian entity by such technology transfer. The OEM also benefits since they get some sort of multiplier for their efforts, but on a conditional buy back,” said K.V. Kuber, retired Indian Army colonel and CEO of Sugosha Consultancy Services.

However, since the clearances must be routed through the Indian Defence Ministry, fulfilling offset obligations through non-equity participation might actually become bogged down in bureaucratic delays, said Nitin Mehta, a New Delhi-based defense analyst.

Other changes announced recently included creating a multiplier on the value of high-end technology as weighed against offset obligations, placing caps on penalties for companies and extending the discharge timeframe for offsets to two years beyond the end of an acquisition contract.

Preference among analysts and industry here is for an increase in foreign direct investments from the current cap of 26 percent to 49 percent. Under foreign direct investment, if a foreign company strikes a deal with an Indian company, that foreign company could own up to a 26 percent stake in what the new entity generated. A rule change that would increase the cap to 49 percent is pending.

U.S. companies are wary of placing high-end technology in the hands of India-based companies in which they possess only a minority stake, a U.S. industry source said. At the same time the Indian Defence Ministry wants ownership to remain domestic.

“They want their own indigenous companies to develop the technology, but U.S. counterparts are not willing to hand over the crown jewels when they don’t have control over them,” he said.

Still, the rule changes that India has made have been met optimistically, even if other techniques might be preferable.

“Non-equity participation is fine but a better way would have been to keep it as equity participation but make [foreign direct investment] automatic. With [the non-equity participation] route opened up, there is a whole new requirement of development of capability at the government level to validate the non-equity participation. Until the time this capability gets developed and institutionalized, this route — while available to OEMs — may not find much success as little movement on approvals can be expected,” said Mahindra Singh, retired Indian Army major general.

Other Incentives

Under the new offset rules, OEMs that transfer technologies to small- and medium-scale enterprises — and also to the Defence Research and Development Organisation (DRDO) — will be eligible for offset credits three times greater than the money spent. So if technology worth $20 million is transferred to India, the overseas company gets an offset credit worth $60 million.

However, the technology transfer cannot carry any license fee, nor should there be any restriction on the production, sale or export of any goods or services that arise out of that technology; all drawings and documents pertaining to the technology must be transferred as well.

Indian analysts and industry officials weren’t the only ones who had hoped that India would go further in its offset rule changes.

Brinley Salzmann, the overseas and exports director at the U.K. defense and aerospace trade lobby group ADS, acknowledged that the Indian government is listening to criticism about its offset schemes, but they still have work to do to get it right.

“They are moving in the right direction but they have a way to go before it is perfect. It does show, though, that the Indian government is in listening mode over the scheme’s shortcomings,” he said.

“The changes do not tackle the issue of shortcomings in the

capacity and capability [of Indian industry] to absorb all this work. This is a structural change that won’t be solved overnight,” Salzmann said.

He added that the jury is still out on whether disbanding the Defence Offset Facilities Agency and replacing it with the Defence Offset Management Agency (DOMA) would be effective.

“We have yet to see how effective the new Ministry of Defence entity will be in overcoming the legendary bureaucracy which has proved a major cause of companies’ inability to get a decision from DOFA,” Salzmann said.

“Any evolution that helps joint development of work by Italy’s and India’s aerospace and defense industries is positive,” said an Italian industrial source. “Allowing an increase in foreign direct investments in firms above the limit of 26 percent would also be welcome.”

Despite the fact that India updates its defense procurement policy annually, the country continues to import nearly 70 percent of weapons and equipment. The domestic defense market is divided between the state-owned companies that contribute the bulk of equipment and the small- and medium-sized enterprises whose share of the $6 billion annual market is around $1 billion only.

Andrew Chuter in London, Tom Kington in Rome and Zachary Fryer-Biggs in Washington contributed to this report.

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