Currently, ownership by non-Indian investors in Indian defense manufacturing companies may not exceed 49 percent without prior Indian governmental approval. While the relaxed approval threshold to 74 percent is significant, the relaxation comes with caveats with respect to national security. For example, FDI in the India defense industry still requires prior security clearance by the Ministry of Home Affairs. Additionally, Press Note 4 emphasized that permitted FDI in the India defense industry is now universally qualified by the fact that the government may impose limitations on proposed FDI on the “grounds of national security” and that the Indian government reserves the right to review any FDI that may affect national security. Previously, the Indian government did not have such express discretionary power to review FDI in defense companies. A target company’s licensing status also plays a role in determining whether FDI will be approved. If an Indian defense company’s operations do not require an industrial manufacturing license, the threshold below which governmental approval is not required remains capped at 49 percent. Finally, for any new FDI that takes place, such a target company must submit a declaration to the Ministry of Defense within 30 days of the closing of the investment transaction.

In raising the cap on FDI in defense companies without prior approval requirements, policymakers intend to encourage foreign original defense equipment manufacturers to shift their manufacturing operations to India. Studies have shown that many multinational corporations (MNCs) headquartered in the United States and Europe are hesitant to enter in partnerships with Indian defense companies due to the uncertainties surrounding prior governmental approval. MNCs generally are reluctant to share their sensitive defense technology and information without first having a majority stake in the joint venture. The structure surrounding this ownership and control is usually carefully negotiated and crafted, with each element being important to the overall business deal. The threat of government rejection of a proposed investment or certain elements of a structure has a chilling effect on the decision of whether to engage in those structuring decisions at all. The raised investment cap should mitigate those concerns and bring greater global financial and technological support to the Indian defense industry and the larger economy as a whole. Moreover, the more lenient investment rules may encourage global defense conglomerates to establish permanent manufacturing and research and development hubs in India.

The proposed reform also allows smaller, private Indian companies to play a bigger role in Indian domestic defense production. While India procures billions of dollars each year in defense technology, non-Indian contractors win nearly all of the major bids. Indian lawmakers hope that the wider access to foreign investment capital for local defense companies will reduce India’s reliance on other countries for defense equipment and strengthen national “Make in India” efforts.

Indian companies, their investors and their business counterparts should be aware of the government’s ongoing liberalization trend. Press Note 4 demonstrates India’s efforts to bring sophisticated first-world capital and technology to its domestic defense industry. Defense industry groups should monitor the Indian government’s continuing developments and corresponding reactions of the affected businesses. For overseas companies and investors in particular, this rule change represents a significant opportunity to participate in the newest phase of India’s economy.

We summarize the initial announcement of the relaxation of regulations applicable to FDI in the Indian defense sector at reedsmith.com and continue to monitor developments in Indian FDI regulation generally.

Our Reed Smith India business team includes multidisciplinary lawyers from the United States, Asia, Europe and the Middle East who stand ready to advise you on the issues above or others you may face related to cross-border transactions.

Client Alert 2020-528