 "Private sector seeks reform of tax and duty structure")
Notwithstanding the private sector's half-cheer to the new DPP-2013, there is unanimity that policy reform alone will not level the playing field, vis-à-vis global vendors and the public sector. Writing to Mr Antony just days after DPP-2013 was promulgated, Ficci complained that the new policy ignored "critical survival issues" for the private sector, such as anomalies in taxes and duties; and protection against exchange rate variation (ERV). Soon thereafter, in a seminar in Delhi, Assocham urged the ministry of defence (MoD) to move beyond mere "emotional support" and to address "practical business realities" that were blocking the private sector from playing a larger role in defence manufacture.
These industry bodies were referring to a taxes and duties regime that - in contradiction to the MoD's oft-proclaimed intention to promote defence indigenisation - rewards the import of fully-built defence equipment through tax and duty exemptions, while levying charges on equipment built in India.
Assocham has drawn the MoD's attention to an "inverted structure" in which private industry is taxed by both the Centre and the states when it engages in defence manufacture. Importing ready-built defence equipment into the country attracts zero customs duty, since it is exempt. But value addition in India attracts excise duty, service tax, central sales tax (CST), and value added tax (VAT). Paradoxically, the more value one adds in the country, the higher the tax rate.
Incredibly, the greater the component of work transferred to India, the more the cost. If 70 per cent value-addition is done in India, the cost would rise to Rs 120.51. This makes a mockery of the MoD slogan that India must rapidly enhance indigenisation in defence from 30 per cent to 70 per cent.
This tax and duty structure burdens Indian private companies with a serious competitive disadvantage. DPP-2006 granted the private sector a level playing field with respect to foreign vendors and DPSUs on taxes and duties, but only for "Buy (Global)" acquisitions, i.e. in open international tenders. Inexplicably, none of the subsequent DPPs, including DPP-2013, has extended this equity to the other procurement categories - Buy (Indian), Buy & Make (Global), Buy & Make (Indian), Make - and to procurements carried out under the Defence Procurement Manual (from the revenue, not the capital head) and to DRDO procurements. These taxes and duties, which are included in L-1 computations, add about 20 per cent to the supply cost of private companies. Industry bodies have given the MoD detailed calculations while making their case for tax and duty exemptions.
Foreign exchange rate variation (ERV) risk is another major bugbear for the private sector in defence. Even "Made in India" defence systems contain many "commercially available off-the-shelf" (COTS) sub-systems and components that are purchased from abroad. Therefore, Indian private companies bidding for defence contracts invariably incur substantial foreign exchange expenditure.
The need for them to hedge against ERV has been hammered home over the last three years, as the rupee slid from Rs 44 to a dollar in October 2010 to below Rs 60 today. Given the rupee's continuing weakness, and the fact that most defence contracts run five to 10 years from signing to conclusion, an ERV hedge is essential.
But the MoD does nothing to mitigate that burden. DPP-2006 and subsequent revisions provide DPSUs with ERV protection on the forex component of their bids. That is extended to private Indian companies from DPP-2011 onwards, but only for global tenders, i.e. procurements categorised as "Buy (Global)". Industry bodies had expected DPP-2013 to extend that protection to every category of procurement, but that hope has been belied. In every category other than "Buy (Global)", private Indian companies compete at a disadvantage against foreign vendors (that are not affected by ERV), and against DPSUs that enjoy ERV protection in "nominated" manufacturing, which constitutes the bulk of their portfolio. That gives DPSUs a buffer that mitigates their ERV risk on other contracts where they do not enjoy protection.
While hedging rates vary, Ficci says that most banks charge an average of 20 per cent as the cost of a three-year forex hedge. If 70 per cent of this year's capital budget of Rs 86,740 crore were spent in foreign exchange, it would amount to Rs 60,718 crore. The cost of a three-year hedge on that would be approximately Rs 12,000 crore.
Pointing out that banks invariably make a profit on hedging, CII has suggested that the MoD do "self-hedging", bearing the ERV risk in the interest of building an indigenous defence industry. It has also been pointed out that ministry of finance rules explicitly permit the MoD to include ERV protection in a tender. The Manual of Policy and Procedures for Purchases of Goods, issued by the department of expenditure, specifically states: "In case of a contract involving substantial import content(s) and having a long delivery period (exceeding one year from the date of the contract) an appropriate Foreign Exchange Variation clause may be formulated by the Purchase Organisation in consultation with its Finance Wing, as needed, and incorporated in the Tender Enquiry Document."
The MoD says it is now responding to these concerns. Defence Minister A K Antony told Business Standard, "We have taken up a case with the finance ministry for private-sector defence companies to be protected from ERV. Now the ball is in the finance ministry's court."
Indian industry has also drawn the MoD's attention to another structural disadvantage that they face vis-à-vis foreign OEMs while competing for multi-year defence contracts - the significantly higher rate of inflation in this country. Contending that inflation increases the effective cost of a contract by about 50 per cent over a decade, industry bodies have petitioned the MoD to adjust payments for inflation, linking the indigenous component of every bid to the Wholesale Price Index (WPI).
Assocham has also highlighted the discrimination against domestic private vendors caused by a more rigorous payment schedule than the one that the MoD offers foreign and public sector vendors. The latter are paid in tranches that are linked to a series of production milestones, such as placement of orders for materials, receipt of goods, and other production stages. But in contracts with private sector suppliers, the bulk of the payment is made only when the product is delivered, leaving the vendor with the job of arranging his own cash flow right through the production process. Assocham has suggested that private vendors be given letters of credit for progressive milestone payments.
Additionally, industry has asked the MoD to impose a 10-15 per cent import duty on all imported systems, in order to offset the advantages that overseas OEMs enjoy through the availability of finance at low rates of interest, low inflation regimes, and exchange rate stability.
These industry bodies were referring to a taxes and duties regime that - in contradiction to the MoD's oft-proclaimed intention to promote defence indigenisation - rewards the import of fully-built defence equipment through tax and duty exemptions, while levying charges on equipment built in India.
Assocham has drawn the MoD's attention to an "inverted structure" in which private industry is taxed by both the Centre and the states when it engages in defence manufacture. Importing ready-built defence equipment into the country attracts zero customs duty, since it is exempt. But value addition in India attracts excise duty, service tax, central sales tax (CST), and value added tax (VAT). Paradoxically, the more value one adds in the country, the higher the tax rate.
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According to Assocham's calculations, which it has presented to the MoD, equipment that costs Rs 100 when procured ready-built from a foreign OEM and imported into the country, would cost Rs 116.31 if a private Indian company chooses to buy only 70 per cent ready-built, and adds 30 per cent value in India.
Incredibly, the greater the component of work transferred to India, the more the cost. If 70 per cent value-addition is done in India, the cost would rise to Rs 120.51. This makes a mockery of the MoD slogan that India must rapidly enhance indigenisation in defence from 30 per cent to 70 per cent.
This tax and duty structure burdens Indian private companies with a serious competitive disadvantage. DPP-2006 granted the private sector a level playing field with respect to foreign vendors and DPSUs on taxes and duties, but only for "Buy (Global)" acquisitions, i.e. in open international tenders. Inexplicably, none of the subsequent DPPs, including DPP-2013, has extended this equity to the other procurement categories - Buy (Indian), Buy & Make (Global), Buy & Make (Indian), Make - and to procurements carried out under the Defence Procurement Manual (from the revenue, not the capital head) and to DRDO procurements. These taxes and duties, which are included in L-1 computations, add about 20 per cent to the supply cost of private companies. Industry bodies have given the MoD detailed calculations while making their case for tax and duty exemptions.
Foreign exchange rate variation (ERV) risk is another major bugbear for the private sector in defence. Even "Made in India" defence systems contain many "commercially available off-the-shelf" (COTS) sub-systems and components that are purchased from abroad. Therefore, Indian private companies bidding for defence contracts invariably incur substantial foreign exchange expenditure.
The need for them to hedge against ERV has been hammered home over the last three years, as the rupee slid from Rs 44 to a dollar in October 2010 to below Rs 60 today. Given the rupee's continuing weakness, and the fact that most defence contracts run five to 10 years from signing to conclusion, an ERV hedge is essential.
But the MoD does nothing to mitigate that burden. DPP-2006 and subsequent revisions provide DPSUs with ERV protection on the forex component of their bids. That is extended to private Indian companies from DPP-2011 onwards, but only for global tenders, i.e. procurements categorised as "Buy (Global)". Industry bodies had expected DPP-2013 to extend that protection to every category of procurement, but that hope has been belied. In every category other than "Buy (Global)", private Indian companies compete at a disadvantage against foreign vendors (that are not affected by ERV), and against DPSUs that enjoy ERV protection in "nominated" manufacturing, which constitutes the bulk of their portfolio. That gives DPSUs a buffer that mitigates their ERV risk on other contracts where they do not enjoy protection.
While hedging rates vary, Ficci says that most banks charge an average of 20 per cent as the cost of a three-year forex hedge. If 70 per cent of this year's capital budget of Rs 86,740 crore were spent in foreign exchange, it would amount to Rs 60,718 crore. The cost of a three-year hedge on that would be approximately Rs 12,000 crore.
Pointing out that banks invariably make a profit on hedging, CII has suggested that the MoD do "self-hedging", bearing the ERV risk in the interest of building an indigenous defence industry. It has also been pointed out that ministry of finance rules explicitly permit the MoD to include ERV protection in a tender. The Manual of Policy and Procedures for Purchases of Goods, issued by the department of expenditure, specifically states: "In case of a contract involving substantial import content(s) and having a long delivery period (exceeding one year from the date of the contract) an appropriate Foreign Exchange Variation clause may be formulated by the Purchase Organisation in consultation with its Finance Wing, as needed, and incorporated in the Tender Enquiry Document."
The MoD says it is now responding to these concerns. Defence Minister A K Antony told Business Standard, "We have taken up a case with the finance ministry for private-sector defence companies to be protected from ERV. Now the ball is in the finance ministry's court."
Indian industry has also drawn the MoD's attention to another structural disadvantage that they face vis-à-vis foreign OEMs while competing for multi-year defence contracts - the significantly higher rate of inflation in this country. Contending that inflation increases the effective cost of a contract by about 50 per cent over a decade, industry bodies have petitioned the MoD to adjust payments for inflation, linking the indigenous component of every bid to the Wholesale Price Index (WPI).
Assocham has also highlighted the discrimination against domestic private vendors caused by a more rigorous payment schedule than the one that the MoD offers foreign and public sector vendors. The latter are paid in tranches that are linked to a series of production milestones, such as placement of orders for materials, receipt of goods, and other production stages. But in contracts with private sector suppliers, the bulk of the payment is made only when the product is delivered, leaving the vendor with the job of arranging his own cash flow right through the production process. Assocham has suggested that private vendors be given letters of credit for progressive milestone payments.
Additionally, industry has asked the MoD to impose a 10-15 per cent import duty on all imported systems, in order to offset the advantages that overseas OEMs enjoy through the availability of finance at low rates of interest, low inflation regimes, and exchange rate stability.