10/17/2016

AnOEMPerspectiveOnLegalIssuesUnderOffsetManufacturingArrangementsGovernment,PublicSectorIndia

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India: An OEM Perspective On Legal Issues Under Offset

Manufacturing Arrangements
LastUpdated:5June2015
ArticlebyRajivKhaitanandKabirBogra
Khaitan&Co

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Introduction
DefenceoffsetsareasignificantopportunityforIndiatoprovideagrowthimpetustoitsmanufacturingsector.Thepartial
liberalizationofFDIcapsandsimplificationoftheindustriallicensingprocessaresomeofthestepswhichhavebeentakento
inspireinvestorconfidence.ThesestepsarealsointendedtoencourageOEMstoengageinmoremeaningfulpartnerships
withtheIndianindustryandnotmerelyuseitforlowendmanufacturingtasks.
Theserecentinitiativesarerepresentativefirststepsandshouldbeviewedpositively.However,fromaOEMsperspective,
enteringintoamanufacturingarrangementwhichmayrequireatransferoftechnologyposessignificantlegalandcommercial
risks.Throughthisarticle,wehaveanalysedafewoptionsavailabletoOEMstodischargetheiroffsetobligationsandthelegal
riskswhichtheymayincurundereachofthem.

Optionstodischargeoffsets
AfewoftheoptionsavailabletoanOEMtoimplementoffsetsareasfollows:
Codevelopment/Coproduction
Subcontracting
Contractmanufacturing
Jointventures
Licensedproduction
FromanOEM'sperspective,theselectionoftheIndianpartnershouldbebasedonitsabilitytoabsorbtechnology,financial
capability,experienceinmanagingjointdevelopmentarrangementsandstrongethical&governancestandards.Eachofthese
criteriaarecriticaltoensurethattheprojectcanbeconcludedwithinthetermoftheoffsetimplementationplansubmittedtothe
MOD.
Inlightofafewrecentexamples,anotherfactorwhichshouldbeconsideredattheplanningstageitselfiswhethertheIndian
partnerisundergoingadebtrestructuringscheme.Thisisrelevantasbeingaunderdebtrestructuringschemewouldrequire
lenderconsentsorwaiverswhichmaynegativelyimpacttheoveralltimelineforimplementation.
SubsequenttoselectionoftheIndianpartner,themorenuancedlegalrisksundereachoftheseoptionsshouldbecarefully
examinedwhiledecidingtheexactmodeofdischargeofoffsetobligations.

Coproduction/Codevelopment
FromtheIndianindustry'sperspective,codevelopment/coproductionisthepreferredrouteasitwouldprovidetheman
opportunitytoabsorbexistingtechnologiesandusethemasabaselineforfuturedevelopment,thusreducingdevelopment
costsandincreasingefficiency.However,fromanOEM'sperspective,codevelopmentandcoproductionarethemost
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challengingroutes,requiringdetailedplanningandaprotractedimplementationroadmapwhileevaluatingthetechnical,
commercialandlegalissuesinsuchanarrangement.
Protectionofintellectualproperty:Themostprominentlegalissueassociatedwithcodevelopmentiscentredonthe
protectionoftheIPwhichtheOEMisrequiredtosupplytoitsIndianpartner.ProtectingthisIPisimperativesinceany
unauthorizeduseofthetechnology(bythepartner)wouldentailalongwindedlegaldisputeandthedamagessoughtbythe
OEMwouldrequirejudicialvalidation.Asvaluationoftechnologiesiscomplexandoftenhassignificantsubjectiveelements
wovenintoit,thequantumofdamagesclaimedbyanOEMwoulddefinitelybechallengedbytheIndianpartner,leadingto
furthercomplications.
Withrespecttojointlydevelopedintellectualproperty,OEMsshouldalsoensurethatcontractualdocumentsprovideforjoint
ownershipinthisregard.Further,theabilityoftheIndianpartnertosublicenseanynewjointintellectualpropertyintonew
marketsshouldbecarefullyregulated.Ideally,theOEM'srevenueshareshouldbehigherthanthatoftheIndianpartner,since
underacodevelopmentarrangement,theOEMwouldnotchargeanyroyaltiesontheuseofitsexistingtechnologies.
Taxation:AnotherareaofconcernforanOEMarethemultitudeoftaxationissueswhichmayariseinajointdevelopment
agreement.Forexample,theOEM'spersonnelmayberequiredtospendasubstantialamountoftimeinIndia,whichifnot
calibratedadequatelymayresultincreationofapermanentestablishmentoftheOEMinIndiaandpotentiallyresultindisputes
withIndiantaxauthorities.

Subcontracting/ContractManufacturing
Subcontractingandcontractmanufacturingarrangementsarerelativelyeasiertodevelop,implementandmonitor.These
arrangementsalsoprovidetheIndianpartneranopportunitytoabsorbmanufacturingtechnologiesandskillsinashorter
period.However,oneofthecriticismsofthesearrangementshasbeenthatthetechnologyabsorptioncouldbelimitedtolow
levelactivitiessuchasfabricationandassemblyskills.
Productliability:Fromacommercialandlegalperspective,thekeyriskassociatedwithsubcontractingarrangements
pertainstoproductliabilityconcerns.Incasethesubcontractedproductsarerequiredtobeintegratedwiththemainproducts,
theOEMshouldensurethatthesubcontractor'sliabilitiesadequatelymirrortheOEM'sliabilityunderthemaincontract.
Therefore,itisstronglyrecommendedthat"flowthrough"clausesshouldbewovenintothetransactionaldocuments.
Protectionofintellectualproperty:Asinthecaseofcoproduction/codevelopmentmodel,OEMsshouldalsoensurethat
theirintellectualpropertyisadequatelyprotectedundersubcontractingorcontractmanufacturingarrangements.Thedefence
manufacturingsectorispresentlylimitedtoafewkeyIndianmanufacturersandeachprospectiveIndianpartnerislikelytobe
engagedwithmultipleOEMs.Insuchasituation,careshouldbetakentoensurethatthetransactionaldocumentsinclude
specificinstructionswithrespecttoproceduresand/orexclusivity,topreventleakageofconfidentialinformation.
ExciseDuty:Lastly,thoughdefenceproductsareusuallyexemptedfromthelevyofExciseduty,theIndianpartnermaybe
requiredtodischargeExcisedutyliabilitywithrespecttomanufactureof"dualuse"products.Insuchcases,anyfreeofcost
suppliesmadebytheOEMtotheIndianpartner(forexample,rawmaterialsorcomponentssentunderabilltoshipto
transaction)wouldrequiretobeincludedinthevalueofgoodsclearedbytheIndianpartner.
ThismaycreateapotentialpricingproblemfortheOEMandIndianpartner,ifunderthesubcontractingarrangementthe
productsarerequiredtobepurchasedatapredeterminedprice.Hence,pricingaspectsneedtobecarefullyexaminedto
understandtheimpactoftheIndianindirecttaxesonthearrangement.

JointVentures
ThethirdoptionavailabletoOEMsisthejointventureroute.TheearlierFDIregulationscappingtheequityparticipationat26%
failedtoexciteforeignOEMsinanyconstructivemanner.Withtheincreasedequityparticipation,itisexpectedthatOEMs
wouldbeencouragedtoestablishamoremeaningfulrelationshipwiththeIndianindustry.ThoughtheIndianindustryhas
severalsuccessstoriesinformingjointventuresinregulatedindustries(suchasinsurance),jointventuresindefence
productionhavenotmetthesamelevelofsuccess.
TheconcernsofOEMsonrestrictionofcontrolandoperationalaspectsinjointventuresarewelldocumentedandhavebeen
frequentlyvoicedbypolicyanalystsandindustryrepresentatives.However,ifanOEMwishestosetupajointventurewitha
DPSU,certainpeculiarissueswouldmeritconsideration.
IssueswithDPSUs:FormationofjointventureswithDPSUsisgovernedbytheGuidelinesforEstablishingJointVenture
CompaniesbyDefencePublicSectorUndertakings("Guidelines")issuedbytheDepartmentofDefenceProductionunderthe
MOD.TheGuidelinespermitthe"Navratna"and"Miniratna"DPSUstoestablishjointventureswithOEMsupto30%ofthe
DPSU'snetworth.However,theequitycontributioniscappedatnotmorethan15%inoneproject,subjecttoamaximumof
INR1000croreforNavratnaDPSUsandINR500croreforMiniratnaDPSUs1.
Theimpactoftheseguidelinescanbeseenthroughthefollowingexample.GoaShipyard,whichisoneofthelargestship
manufacturingentitiesinIndia,reportedatotalturnoverofINR884croresorUSD147.33million(approx.)duringFY201314.
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Therefore,ifitweretoconsidersettingupajointventurewithashipmanufacturer,itcannotinvestmorethanINR132croresor
USD22million.Further,factoring49%equityparticipationbytheOEM(equivalenttoUSD21million),thenetworthoftheJV
entitywouldbeonlyUSD43million,which,inmostcasesmaybelessthanthevalueofthecomponentorequipmentrequired
tobemanufactured.
CompliancewithSecurityManual:Ajointventureentityoperatingunderanindustriallicensewouldalsoberequiredtobein
compliancewiththeSecurityManualpublishedbytheMOD,whichprovidesthemannerinwhichinternalsystemsarerequired
tobeimplementedandexecuted.
Therefore,intheeventanOEMwishestoformajointventurewithanIndianDPSU,apartfromthetypicalissueswhichmay
requireconsideration,theaboveissueswouldrequireadditionalconsideration.

LicensedProduction
Protectionofintellectualproperty:LicensedproductionisanotheroptionwhichisavailabletoOEMsandisperhapsthe
mosttestingforanOEMthananyoftheotheroptions,sinceitrequirescomprehensivedisseminationofexistingtechnology
andhandholdingtotheIndianpartner,whichis,ineffecttantamounttocreatingacompetitor.Therefore,iflicensedproduction
arrangementsareenteredintowithanIndianpartner,thetransactionaldocumentsshouldclearlyproviderestrictionsonusage
ofthedisseminatedtechnology.
Exportcontrolrestrictions:AnothersignificantlegalriskassociatedwithlicensedproductionsistherequirementoftheOEM
tobeincompliancewiththeexportcontrollawsoftheexportingcountry.Therehavebeenseveralinstancesinthepastwhere
licensedtechnologieshavebeenusedagainstexportingnationsinconflictsduetowhichpolicyregulators(especiallythosein
theUnitedStates)havebeenincreasingtherestrictionsontechnologiesbeingexported.
Productliability:Licensedproductionarrangements,similartosubcontracting/contractmanufacturingarrangements,pose
significantrisksonproductliabilityissues.Eveninextremelyregulatedarrangements,qualityconcernscouldarisewhichmay
causedelaysandadversefinancialimplicationsfortheOEM.Underlicensedproductionarrangements,OEMsshouldensure
comprehensiveindemnitiesarefactoredtoprotectthemincasequalityconcernsresultincancellationofcontractswitha
customer.
Basedontheaboveanalysis,asubcontractingoracontractmanufacturingarrangementwouldseemtobethebestoption
intermsofloweringrisksfromtheOEM'sperspective.
However,licensedproductionsandcodevelopmentarrangementsarebettersuitedforsituationsinwhichtheOEMdesires
tomanufactureatthelowestpossiblecost.Inoptingforthisroute,itwouldbeadvisablefortheOEMtoensurethat
necessaryprotectionswithrespecttoIPandproductliabilityarebuiltintothetransactionaldocuments.

Footnote
1.ApproximatelyUSD167millionandUSD83million,respectively.

Thecontentofthisarticleisintendedtoprovideageneralguidetothesubjectmatter.Specialistadviceshouldbesoughtabout
yourspecificcircumstances.
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