Foreign direct investment (“FDI”) into the defense sector has always been something of a contentious issue. Two reasons for this were articulated in a discussion paper published by the Department of Industrial Policy and Promotion (“DIPP”) in 2010 (“Discussion Paper”), though some of these reasons have been in the forefront since India’s independence: firstly, a desire to protect the domestic defense sector from foreign competition, and secondly, concerns regarding foreign ownership/control of a sector that is very sensitive from a national security perspective.

However, of late there has been sustained wave of liberalization on the FDI front, not only in defense, but also in other so-called ‘sensitive’ sectors; and at the political level, there are signs of increased engagement between India and its key defense partners – for example, the recent progress of the Indo-US Defense Technology and Trade Initiative, or the US’ recent relaxation of export control restrictions on transfer of jet engine technology to India.

In this backdrop, the DIPP has recently further liberalized the rules for foreign investment into India’s defense sector by issuing a press note (“PN12”) that amends the DIPP’s Consolidated FDI Policy, 2015 (“FDI Policy”). This blog post will discuss PN12 and its implications for FDI in defense, but we first need to take a broad look at the commercial and strategic aspects of FDI in the defense sector.

Foreign investors see a lucrative opportunity in India’s defense sector: Western defense markets are showing signs of saturation, the Indian defense budget has been trending upwards year-on-year, India’s armed forces are looking to buy advanced defense equipment, and the lack of indigenous development in the Indian defense sector has led to import dependency for advanced weaponry and a consequent demand-supply gap. For its part, the Government wants India to be free from import dependency and become self-reliant in defense manufacturing – and it sees FDI in the defense sector as a key tool through which domestic players will acquire the elusive know-how and technical expertise necessary to make this a reality.

Despite the above, foreign defense industry players have shown reluctance to invest in India and collaborate with Indian partners. One of the reasons for this is technology. Simply put, foreign defense companies are not willing to bring their know-how and advanced technologies into domestic defense sector joint ventures (“JVs”) unless they are able to control the JV, and thereby protect the technology they have poured billions of dollars’ worth of R&D into.

However, the FDI Policy did not, and still does not, allow a foreign JV partner to control an Indian defense sector JV. The FDI Policy previously allowed foreign investment in Indian defense companies only up to 26% of the investee company’s share capital under the approval route. In 2014, this was increased to 49%, but numerous (vaguely worded) strings remained attached, such as: (a) the company applying for the FDI must be owned and controlled by resident Indian citizens, and its management had to be in Indian hands; (b) the majority of its Board of Directors, and its chief executives, must be resident Indians; and c) the Chief Security Officer of a defense JV must be a resident Indian citizen (“Defense Conditions”). The Defense Conditions resulted in considerable ambiguity regarding the board composition and the management of a defense sector JV with FDI, and largely, the industry was dissatisfied with the FDI Policy. The Defense Conditions seemed to be aimed at adding an extra layer of protection against a foreign defense industry player exercising influence and control over its Indian defense JV.

That said, it was not as though the DIPP and the Foreign Investment Promotion Board were blind to the concerns of foreign defense companies: FDI above 49% into the defense sector was allowed through the approval route (applications in such cases would be considered by the Cabinet Committee on Security) whenever the FDI was likely to result in access to modern and ‘state-of-art’ technology – thus giving the foreign collaborator the necessary comfort when transferring advanced proprietary technology into an Indian defense sector JV.

PN12 has now modified the FDI Policy vis-à-vis the defense sector in two significant ways: firstly, FDI in the defense sector up to 49% is now permitted under the automatic route, and secondly, the Defense Conditions have been omitted from the FDI Policy.

While this development is positive because the ambiguity surrounding the Defense Conditions is now gone, and the timelines for setting up a defense sector JV may be reduced, the 49% sectoral cap remains, and in my view, this implies that the regulatory thinking – that foreign control over defense sector companies is undesirable and may only be permitted in exceptional cases when the technology transfer benefits arising from the investment outweigh other concerns – has not really changed. Consequently, the Government may not be comfortable with contractual arrangements that give a foreign JV partner rights that are not commensurate with its 49% shareholding.

This absence of a ‘big bang’ reform for the defense sector has therefore left the core issue unaddressed, and reports in the press suggest that at an international level, India has assuaged concerns about protection of transferred defense technology by agreeing to allow investments above the 49% sectoral cap (presumably under the approval route), whenever there is a concern regarding the same. However, this will most probably be the exception rather than the rule, and such investments may require significant political will to achieve, both in the source country of the FDI and in India.

With PN12, the Government seems to want substantial FDI inflow as well as technology transfer, but is unwilling to cede ground on the ‘control’ issue by allowing foreign investment in excess of the 49% sectoral cap. From a long term point of view, it may not be possible for the Government to ‘have its cake, and eat it too’ in this regard, and it is hoped that the rules for FDI in the defense sector will be further liberalized.