New Legislation Modifies U.S. Tax Withholding Regime

On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act (the “HIRE Act” or “Act”). The Act incorporated the provisions of the Foreign Account Tax Compliance Act of 2009 (“FATCA”). The FATCA provisions of the Act impose significant reporting and information gathering obligations on individuals and third parties, and will expand the current U.S. withholding regime. The Act will have a substantial impact on foreign investment in the U.S..

Foreign persons are generally subject to a flat tax rate of 30% on their U.S. source fixed, determinable annual or periodic (FDAP) income. In brief, income is fixed when it is paid in amounts known ahead of time and determinable whenever there is a basis for calculating the amount to be paid. Common examples of FDAP income include compensation for personal services, dividends, interest, pensions, alimony, real property income (such as rents other than gains from the sale of real property), royalties and commissions.

The current 30% withholding regulations, set forth in Chapter 3 of the U.S. Internal Revenue Code, have been in place for many years and impose a withholding requirement on payments to foreign persons of U.S. source FDAP income, unless the FDAP income is effectively connected with a U.S. trade or business, or the withholding is reduced or eliminated by operation of a tax treaty. As a result, taxes on FDAP income to foreign persons must generally be withheld by the U.S. payer (otherwise known as withholding agent) and remitted to the IRS.

The Act creates a new withholding tax, added as Chapter 4 of the U.S. Internal Revenue Code, that expands the current U.S. withholding regime by imposing a 30% withholding tax on any withholdable payments made to foreign financial institutions (regardless of whether such institutions have U.S. account holders), unless the foreign financial institution enters into a reporting agreement with the IRS. A withholdable payment is defined as any U.S. source FDAP income, and gross proceeds from the sale or disposition of any property which produces U.S. source interest or dividends. The Act’s withholding provisions will greatly expand existing law because gross proceeds from the sale of stock or debt instruments are currently not taxable to foreign persons and are not subject to withholding. Furthermore, the Act defines foreign financial institutions (“FFI”) so broadly that it includes virtually every type of foreign bank and foreign investment vehicle, including foreign private equity funds and foreign mutual funds. The reporting agreement requires FFIs to disclose the full details of non-exempt accountholders to the IRS in order to avoid the 30% withholding tax. For these reasons, foreign investors should not be surprised if their local investment bank or brokerage firm soon refuses to invest, directly or indirectly, in U.S. securities in order to avoid a withholding tax on FDAP income or, alternatively, enter into the reporting agreement with the IRS.

Additionally, an FFI that has entered into a reporting agreement with the IRS will be required to deduct and withhold a 30% tax on any pass-through payment made by the institution to an FFI that fails to enter into an agreement with the IRS. For this reason, foreign persons that receive FDAP income may potentially face a “double” withholding. As mentioned above, the current tax regime already requires that U.S. payers withhold 30% of U.S. source FDAP income to foreign recipients. Because of the provisions set forth in the Act, a foreign recipient may be subject to a prohibitive additional withholding on the same payment stream if one or more of its banks has not entered into the proscribed information agreement with the IRS. Although the Act authorizes the Secretary of the Treasury to provide rules to prevent double withholding on the same payment stream, there is no explicit provision within the bill that would limit withholding to one level. This is important because prior versions of the bill contained explicit provisions that would seemingly have prevented a double withholding scenario.

To illustrate, suppose the following set of circumstances: USCO, a U.S. firm, makes a royalty payment for the use of certain intellectual property to IndiaCo, an Indian software firm. Assume that the payment qualifies as U.S. source FDAP which is not effectively connected with IndiaCo’s U.S. trade or business, and therefore subject to a 30% withholding. USCO withholds 30% of the royalty payment and remits the remainder to IndiaCo’s foreign account. However the payment does not travel directly from USCO’s local bank account to IndiaCo’s local Indian bank. Instead, the funds are routed through a network of correspondent and intermediary banks, one of which has failed to enter into a reporting agreement with the IRS as required by the Act. Without additional clarification from the Secretary of the Treasury, it would appear that the royalty payment would be subject to an additional Chapter 4 withholding of 30%. While beneficial owners of withholdable payments will be eligible to claim a refund or credit for any withholding in excess of their tax liabilities, this will require the beneficial owner to file a U.S. tax return.

Significantly, the payment of foreign source FDAP income is not a withholdable payment under Chapter 3 or Chapter 4 of the Internal Revenue Code. The payment of foreign source income to a foreign person is not subject to U.S. withholding or reporting requirements. Except for certain limitations, wages and any other compensation for services performed by a non-resident outside the U.S. are considered to be foreign source income. The place where the services are performed determines the source of the income, regardless of where the contract was formed, the place of payment, or the residence of the payer. Other examples of foreign sourced FDAP payments include: interest payments by a foreign debtor is foreign, royalty payments for property used abroad, and rental payments for property located outside the U.S. Consequently, US firms may continue to make payments to foreign companies for services performed abroad without withholding taxes.

The withholding rules are not just relevant to the foreign recipient but the U.S. payer as well. The IRS has designated the obligation of a U.S. withholding agent to report and withhold on U.S. source FDAP income as a Tier 1 compliance issue. Tier 1 compliance issues are generally considered the highest compliance priorities within the IRS. A withholding agent is defined as any person, U.S. or foreign, that has control, receipt, or custody of, or the ability to dispose or pay, any item of income of a foreign person that is subject to withholding. The withholding agent is required to remit the withheld amount to the IRS, generally, on Form 1042 called, Annual Withholding Tax Return for US Source Income of Foreign Persons, and Form 1042-S, called Foreign Person’s US Source Income Subject to Withholding. The withholding agent is personally liable for any tax required to be withheld. If the withholding agent fails to withhold and the foreign taxpayers fails to pay its tax liability, both the withholding agent and taxpayer will be liable for the tax, interest, and penalty on the outstanding balances due.

Since its recent passage, the Act has generated a great deal of commentary within the legal and financial communities. The withholding provisions set forth in the Act are scheduled to apply to payments made after December 31, 2012. However, many observers believe that this date will be pushed back to account for the significant issues involved with the Act’s implementation, and for the Treasury to provide sufficient guidance to financial institutions to properly implement the new reporting procedures.

In conclusion, U.S. payers of FDAP income to foreign recipients should keep in mind the IRS’s increased scrutiny of FDAP reporting and withholding requirements. While payments to foreign persons for services performed abroad (and other payments of foreign source FDAP income) should not be affected by the new law, we recommend that U.S. payers nonetheless keep a watchful eye on the changing landscape of the U.S. withholding regime and maintain careful records of their transactions. Likewise, foreign recipients should note that their payments will soon be subject to an expanded withholding tax, which may make potential future investments in U.S. securities markets less attractive.Timothy D. Richards is the managing partner and founder of The Richards Group, in Miami, Florida. He specializes in domestic and international tax, estate planning and corporate law. He may be contacted by email at trichards@richards-law.com

Alonso Sanchez is an associate in The Richards Group’s tax department. He may be contacted by email at asanchez@richards-law.com

 

 

by Timothy D. Richards and Alonso E. Sanchez

 

Regulation Of The Import, Cultivation, And Sale Of Genetically Modified Food Crops In India

Modern biotechnology, involving the use of recombinant DNA (“rDNA”) technologies, has emerged as a powerful tool with applications in healthcare and agriculture. New plant varieties developed using rDNA techniques, commonly referred to as genetically engineered (“GE”), genetically modified (“GM”) or transgenic plants, have and are being developed to enhance productivity, reduce dependence on agricultural chemicals, modify the inherent properties of crops, and enhance the nutritional value of foods and livestock feeds.

Genetically modified food crops are key to increasing agricultural production and enhancing food security in India. Such crops are not new to India. Genetically modified cotton is commercially cultivated in India, and according to currently available information, twelve crops (of which eleven are food crops) are under various stages of development. While genetically modified crops have been successfully used in India — accounting for about 85% of the cotton grown — their use for food crops is controversial. This article describes the governmental approval requirements in India for the introduction of genetically modified food crops; how the process is expected to unfold in practice, based on experiences in other recent cases; and suggests strategic steps that an applicant should consider in applying for regulatory approval.

Regulatory Requirements and Approval Process

Several governmental authorities regulate the manufacture, import, use, research, and release of genetically modified organisms (“GMOs”) in India. These authorities operate at the central (federal), state, and local (district) level. The approvals required from these authorities often are interdependent and one approval may be a pre-requisite for others.

The apex authority is the Genetic Engineering Approval Committee (“GEAC”), a multi-ministerial body located in the Ministry of Environment and Forests (“MOEF”). The GEAC has the authority to permit the use of GMOs and its byproducts for commercial application, including their large-scale production and release into the environment. GEAC approval is based in part on the clearance given by the Review Committee on Genetic Manipulation (“RCGM”) in the Department of Bio-Technology (“DBT”). In addition, a new regulatory body, the Food Safety and Standards Authority of India (“FSSAI”), has been empowered to regulate the safety aspects and approval process for GM foods and is in the process of framing rules for this purpose.

The regulatory requirements for cultivation of GM crops are set forth in the Rules for the Manufacture, Use, Import, Export and Storage of Hazardous Micro-Organisms, Genetically Engineered Organisms or Cells, notified on December 5, 1989 (“1989 Rules”). The 1989 Rules define the competent authorities (and their composition) charged with administering the 1989 Rules.

Besides the 1989 Rules, the regulatory framework is supplemented by guidelines and notifications issued by the other governmental authorities having jurisdiction over activities addressed under the 1989 Rules. These effectively add another layer of regulation. The steps in the regulatory approval process are as follows:

  • Import of GMOs and/or GM seeds
  • Testing and research in contained conditions, depending on the following risk categories:
  • Category-I Risk (routine rDNA laboratory experiments in a contained environment)
  • Category-II Risk (laboratory and green house or net house experiments in a contained environment)
  • Category-III Risk (green house or net house and limited field trials in open field conditions)
  • Confined field trials (controlled introduction) at bio-safety research level-I (BRL-I) and BRL-II, as defined in bio-safety guidelines for field trials issued by the RCGM
  • Food safety assessment
  • Commercial cultivation of GM crops
  • Production and sale of GMOs

Regulatory Process in Practice

Despite the guidelines provided in the 1989 Rules and related regulations, in practice, there is significant risk and uncertainty. Key risk areas are outlined below. These are based largely on the challenges faced since 2000 for the introduction of a genetically modified egg plant called Bt Brinjal.

Proceedings continue in the Supreme Court in the Public Interest Litigation (“PIL”) filed in early 2005 seeking to establish a comprehensive, stringent, scientifically rigorous, and transparent bio-safety protocol in the public domain for GMOs, and for every GMO before it is released into the environment. Aruna Rodrigues v. Union of India, Writ Petition (Civil) No. 260 of 2005 (“Bt Brinjal Case”). So far the Court has issued six orders addressing the role and function of the GEAC. The PIL is yet to be ultimately determined, with the most recent order of January 19, 2010 requiring the government to respond in four weeks to the question of what steps the government has taken to protect traditional crops. Details of the government’s reply are not available as of this writing.

Such litigation is primarily brought by non-governmental organizations. Often they are brought ex parte, as a matter of urgency and without notifying the other concerned parties. The obvious immediate consequence of such litigation is delay and uncertainty. Typically, the court initially issues an interim order to maintain the status quo while the parties can be heard. For example, in the Bt Brinjal Case, the Supreme Court initially ordered that the GEAC “withhold approvals until further instructions to be issued by this court on hearing of all concerned.” Bt Brinjal Case, Order dated 22 September 2006. This order had the effect of suspending the grant by GEAC of approvals on all applications pending before it, not just the Bt Brinjal application. The Order was subsequently modified by the court (on an application filed by the government) to allow the continuation of field trials subject to conditions stipulated by the court. Bt Brinjal Case, Order dated 8 May 2007.

The other consequence of such litigation could be the imposition by the court of additional conditions on confined trials in response to concerns expressed by the petitioner and other concerned parties. These additional conditions could adversely affect the overall economics of the GM crop and the timing for its introduction.

Although the GEAC is the designated permitting authority, its decision can be suspended or held in abeyance by the government. Given the past controversy surrounding GM crops, the GEAC is expected as a matter of practice to refer its recommendation to the government (Ministry of Environment and Forests) for a final decision. The outcome of this may be to confirm, suspend or modify the GEAC approval. See MOEF, Report of Minister Shri Jairam Ramesh, 9 February 2010 (“Report of Environment Minister”) (declaring an indefinite moratorium on the release of Bt Brinjal). In view of the public nature of the controversy, the government’s stand in this matter is likely to be dictated by politics as much as scientific considerations.

The regulatory framework for GM crops is evolving. Recent developments are expected to alter existing regulatory requirements. These will most certainly apply to pending applications, but may also affect existing approvals.

  • First, the GEAC has been directed by the MOEF to draft a new protocol for the specific tests that will be conducted on GMOs in order to generate public confidence in GM food crops. The Environment Minister has directed that “under no circumstances should there be any hurry or rush” to complete the aforesaid. Report of Environment Minister, paragraph 30. Therefore until such new protocols are issued, there is substantial uncertainty as to the regulatory requirements.
  • Second, the Food Safety and Standards Authority of India, a regulatory body constituted under the Food Safety and Standards Act, 2006 will hence forth regulate the safety assessment and approval process for GM foods. The FSSAI will regulate “food stuff, ingredients in food stuffs and additives including processing aids derived from living modified organisms where the end product is not a living modified organism.” MOEF, Notification No. S.O. 1519(E) dated 23 August 2007. The FSSAI has released for public comment draft rules on “Operationalizing the Regulation of Genetically Modified Foods in India.” The comment period ended on July 14, 2010. The draft clarifies that the research and development, environmental release, and commercialization of GMOs will continue to be governed by the 1989 Rules, and thus will continue to be regulated by the GEAC at MOEF and RCGM in the DBT.

Suggested Strategic Approach

Given the risks described above, an applicant should consider including the following elements in its strategic approach to complying with the regulatory requirements in India. First, due to the uncertainty in the regulatory process and questions as to finality of the GEAC approval, it would be prudent to enter into an “implementation agreement” with the MOEF. Because the financial investment and effort required to commercialize GM crops is substantial, an up-front understanding with the government will help reduce the degree of arbitrariness involved in the application of the regulatory requirements. Implementation agreements are the norm in sectors where a long gestation period is involved and where successful implementation depends on governmental actions and support, such as hydropower projects.

Second, the applicant should consider applying for “in-principle” approval from the GEAC as early in the process as possible. Such approval, although not final or binding, would typically set forth the conditions to be met by the applicant for grant of final approval. MOEF approvals for infrastructure projects are structured in the foregoing manner.

Third, because most public interest litigation is filed by non-governmental organizations (“NGO”), it is prudent for the applicant to be pro-active and manage its relationships with the concerned NGOs.

Navigating the regulatory process for commercialization of GM food crops in India is not for the faint hearted. The road to commercialization has had, and will likely continue to have, many twists and turns. While the government has decided to embrace food produced through bio-technology to feed its citizens, the regulatory decision making process is often influenced more by political pressure from these opposed to bio-technology than by critical and balanced scientific and technological judgment. To help mitigate the resulting delay and uncertainty, it is helpful for businesses entering this sector to approach the government early on and develop a high-level road map for tackling the approval process.

Anand S. Dayal is a partner with Koura & Company, Advocates and Barrister, based in New Delhi, India. Anand received his J.D. cum laude (1992) from Cornell Law School, and is admitted to the bar both in India and the US (NY and DC). He was previously Of Counsel with White & Case and an associate with Chadbourne & Parke and Pillsbury Madison & Sutro. Anand is chairman of the Anti-Corruption Committee of the American Chamber of Commerce in India. He can be contacted at dayala@vsnl.com or adayal@kouraco.com.

 

 

by Anand S. Dayal

 

 

Towards A Global Financial Recoup—The Taxing Path

“The repose of nations cannot be secure without arms. Armies cannot be maintained without pay, nor can the pay be produced without taxes.” – Publius Cornelius Tacitus, a Roman historian

The word “tax” draws its earliest reference in a decree by Caesar Augustus, the first ruler of the Roman Empire, nearly 2000 years ago mandating taxation in all spheres of the world. The origin of the word “tax” stems from the Latin expression, “taxo” meaning, imposition of a financial charge or other levy upon a taxpayer.  India has had a system of taxation since ancient times, as is evident from references in early treatises such as Manusmriti (between 200 BCE and 200 CE) and Arthasastra (4th Century BCE). The conventional criteria of economic neutrality, equity, simplicity, and transparency have been regarded as the foundations of most tax systems. However, with the power of taxation in modern times shifting from the domain of a monarch to that of every sovereign, the regime of taxation has come to be associated with the four “R”s — revenue, redistribution, repricing, and representation. Moreover, for every benefit that mankind receives today, a tax is imposed thereby, redistributing the underlying burden.

The adoption of a flat tax has been debated by various countries in Eastern Europe over the last decade. A flat tax regime is a tax system with a constant tax rate and is usually referred to as a tax in rem, meaning “against the thing.” In 1994, Estonia became the pioneer in instituting the flat tax regime, levying a tax rate of 26% on all personal and corporate income with no deductions or exemptions. The success of the Estonian example led to the adoption of a flat tax regime by various European countries, such as Latvia, Lithuania, Bulgaria, and many others. Nevertheless, the debate continues in Western Europe and the United States.

The dawn of the global financial crisis in 2008 diverted attention to new tax regimes around the world. Rising government debt levels, reduction in bank lending, and instability in the financial markets have cast a shadow over the nascent economic recovery. Though the experiences of different countries vary, as do their priorities as they emerge from the economic crisis, none can claim to be immune from the risk of a future, and inevitably, global financial crisis.

In this respect, a universal policy cannot be imposed across various jurisdictions and each nation’s response to the crisis must be fine tuned in accordance with the assessment of their respective challenges. For example, Sweden has introduced a levy on banks that goes into a ring-fenced fund, created to protect against future bailouts. Germany and Britain are also contemplating a similar measure, and the Obama administration has proposed a levy to recoup $90 billion of public money used so far to shore up banks. However, while there is support in Europe and the United States for some form of levy, other western economies are against the concept of imposing an additional burden on their banks because they did not require rescuing.

There seems to be global recognition of the need for new taxes. The International Monetary Fund has proposed two new taxes on banks—a Financial Stability Contribution (FSC), and a Financial Activities Tax (FAT). The FSC is essentially linked to a resolution mechanism to pay for the fiscal cost of any future government support to the banking sector. Any further contribution, if desired, will be facilitated via the FAT, which would be levied on the profits and remuneration of financial institutions.

However, during the June 2010 G-20 meeting of Finance Ministers in Seoul, the proposal for a global bank tax to protect the public and ensure economic stability was rejected. A bank tax was viewed as increasing costs to consumers and requiring strict consumer and competition regulations for effective enforcement.  Rather, emphasis was put on pressuring countries to adopt more passive economic measures to recoup public funds used to protect against bank failures. Individual countries still may impose the levy in their own jurisdictions, despite the G-20’s collective recommendation. The Indian stand on additional taxation of financial institutions is similar to the G-20’s recommendation. Instead of a fiscal stimulus or additional taxation, India places greater emphasis on financial sector regulation.

Though there seems to be little support for the imposition of new taxes on banks while the economies of countries are still recovering from the global financial crisis, other new taxes are being considered in certain jurisdictions. Australia, for example, has proposed a resource tax, i.e., a tax to be levied on the “additional” profits on account of the use of limited natural resources through 2012. Moreover, the United States has proposed to levy an “excise tax” on U.S. companies that use an offshore call centres.

The levy of new taxes, apart from being viewed as a reactive measure to the global meltdown, forces one to revisit the purpose of a taxation regime. The existing regime is premised on Adam Smith’s core canons of taxation—equity, certainty, economy, and convenience. Today’s economic realities necessitate the addition of two additional principles, restitution and avoidance of double taxation. In this regard, it may be argued that the evolution of novel axes embodies, to a certain extent, the manifestation of the principle of restitution. Ian T. G. Lambert’s treatise, Modern Principles of Taxation, is founded on the principle of restitution. He argues that one cannot take the benefits of government expenditure without taking the burden. That view would justify the imposition of a bank tax or resource tax, effectively widening the scope of the existing four “R”s associated with taxes to include the principle of restitution.

India has been debating the levy of a “Tobin” Tax. The Tobin Tax derives its origin from Nobel Prize-winning economist James Tobin’s proposal to levy a tax on short-term capital currency transactions. Chile, Colombia, Brazil, and Malaysia have experimented with variations of the Tobin Tax. Various jurisdictions view this tax as compensation for the billions of dollars spent by governments to bail out banks.

India, until now, has been silent on the question of additional taxation. As the governments of various countries impose new taxes, the question is whether India will follow the same course. However, before taking this kind of leap, India must exercise caution to ensure that it does not fall prey to the dangers of an evolving short-term tax, susceptible to rapid fluctuations, and ensure that any proposed levy serves long-term stability by avoiding significant wholesale economic restructuring and facilitating the growth of business.

The authors are Mr. Aseem Chawla, Partner, and Ms. Surabhi Singhi, Associate, Amarchand & Mangaldas & Suresh A. Shroff & Co., based out of Delhi. Mr. Chawla leads the tax practice group of the firm and can be contacted at aseem.chawla@amarchand.com. Ms. Singhi is an Associate with the tax practice group of the firm and can be contacted at surabhi.singhi@amarchand.com.

 

 

by Aseem Chawla and Surabhi Singhi

Navigating The India Defense Opportunity

India is embarking on an ambitious defense and homeland security expansion plan, expecting to spend $30 billion over the next five years and upwards of $100 billion over the next decade. Considered one of the world’s fastest-growing defense markets, recently India was ranked as the world’s fastest-growing homeland security market. This growth presents tremendous opportunities for U.S. defense and technology companies in aerospace, government contracting, and homeland security. But to meaningfully participate in the India defense opportunity, one must understand and be prepared to navigate through some nuanced and complex terrains.

Understanding Procurement

Categories

First, a prospective bidder needs to understand the different procurement categories. The defense procurement categories are established in the Defence Procurement Procedure (DPP), which governs procurement by the Indian Ministry of Defence (MOD). The DPP sets out the Government of India’s (GOI) policies for every step in the procurement process, from acquisition planning to preparing requests for proposal (RFPs). Compliance with the DPP is essential to competing effectively for Indian defense contracts.

Before it was revised in 2009, the DPP provided three categories of defense procurement:

  • Buy: Outright purchase of defense equipment from foreign or Indian vendors. Programs where the purchase is made from an Indian integrator of foreign equipment must include at least 30 percent Indian content.
  • Make: Purchase of equipment from Indian vendors using indigenous development and production.
  • Buy & Make: Purchase from a foreign vendor with provisions for Indian co-production or licensed manufacturing.

In November 2009, the MOD amended the DPP and added an important fourth procurement category called “Buy & Make (Indian).” Under Buy & Make (Indian), the RFP will be issued only to Indian vendors, who in turn can decide what foreign suppliers to involve. This is intended to more effectively incentivize technology transfer and co-development in India.

Specifically, under Buy & Make (Indian), Indian firms must submit the project proposal, outline the development and production roadmap, either alone or in a production arrangement with a foreign partner, and provide details of the transfer of technology to the Indian partner. There must be at least 50 percent local content, and the Defence Production Board is responsible for monitoring implementation of the production arrangement, including absorption of technology by the Indian partner.

Buy & Make (Indian) is aimed at helping promote indigenous capabilities by driving technology transfer, joint ventures, licensed production and in-country manufacture. The MOD has not yet publicly indicated which projects will be designated Buy & Make (Indian), but for those which are so designated, Indian bidders will be in control of the process. Thus, non-Indian companies that wish to participate in this category of procurement should think ahead about identifying prospective Indian partners and crafting collaborative arrangements that can satisfy these requirements.

Complying with Agency Restrictions

There are a variety of reasons why agents may be necessary in defense and homeland security bidding. Bidders without an institutional presence in-country may believe it is particularly necessary to have third parties acting on their behalf. But one needs to proceed with caution under the Indian defense procurement rules on agency. The Indian government is particularly sensitive to the role of agents in defense procurement given prior controversies, most notably the Bofors scandal, which is considered “India’s Watergate.” As a result, there are a variety of restrictions governing the use of third party agents. Penalties for non-compliance can include disqualification from the procurement, cancellation of the contract, and debarment from future bidding.

Under the DPP 2005, parties bidding on procurements exceeding approximately $45 million are required to execute a “Pre-Contract Integrity Pact,” the express purpose of which is to ensure that, in competing for a defense contract, bidders take all measures necessary to “prevent corrupt practices, unfair means and illegal activities.” The Pre-Contract Integrity Pact requires bidders to agree to be bound by the “Agency Clause,” which provides:

Bidder confirms and declares that it… has not engaged any individual or firm, whether Indian or foreign whatsoever, to intercede, facilitate, or in any way to recommend to the Government of India or any of its functionaries, whether officially or unofficially, to the award of the Contract…

(emphasis added)

As indicated above, the Pre-Contract Integrity Pact essentially requires bidders to affirm that they have not engaged an agent. Although engaging an agent technically is not prohibited, it requires separate registration under rigorous requirements and the MOD reserves the right to reject any agent. As a result, no one has registered as an agent since the requirement was imposed in 2001. Thus, as a practical matter, for foreign companies interested in bidding for defense contracts in India, the prudent course is to ensure they do not engage any person or entity that performs any functions the nature of which require registration as an agent.

The exact meaning of the terms in the agency clause themselves are not entirely clear, and the Indian courts have not ruled on them. Nonetheless, there are some useful “do’s/dont’s” that may provide general guidance for foreign companies bidding on defense contracts in India. For example, rather than engage an entity to act as a consultant for any particular procurement program, consulting relationships should be for advice and assistance in connection with business opportunities in India generally.

Meeting Offset Requirements

Perhaps the most important issue in accessing Indian defense procurement opportunities is offsets, that is, the requirement to return to India a percentage of the value of the goods and services awarded in a defense procurement. Offsets are seen as a means to use foreign participation to foster and enhance an indigenous defense industrial base in India. It is important to know what offset requirement attaches to each procurement.

Under the DPP, procurements from foreign vendors over approximately $65 million must generally be offset by purchases or investments by the foreign vendor in Indian defense products, services, industries or research and development worth at least 30 percent of the procurement value. Offset requirements involve local purchasing, indigenous content, use of inputs, and co-production. This can be accomplished by (i) buying India defense items; (ii) buying India-defense related services; (iii) investing in an Indian defense joint venture; or (iv) investing in Indian defense research & development. Proposals are evaluated by the Defence Offset Facilitation Agency (DOFA).

Several policy issues are at the heart of the offsets discussion today. One concerns how closely offsets need to be related to the corresponding defense procurement. Currently, India’s system only credits “direct” offsets, i.e., those that are directly related to the product or service being sold. Some contend that India should also credit “indirect” offsets applied in industries outside defense, such as in commercial aerospace or homeland security. This approach would not only make it easier to meet offset requirements (and thus reduce the foreign bidder’s costs in India), but could also enable development in other areas of interest to India, such as infrastructure.

Another policy issue concerns the level of foreign direct investment, which currently is capped at 26%. Those who advocate foreign investment to at least 49% argue that providing foreign parties a greater ownership stake in Indian entities would stimulate offsets and collaboration. Specifically, in their view it would (i) incentivize foreign bidders to become more fully engaged in their India joint ventures and partnerships; (ii) spur investment as well as joint development and co-production; and (iii) motivate foreign bidders to locate strategic defense related R&D and manufacturing operations in India.

Other offset policy issues concern whether wholly-owned subsidiaries in India may qualify and whether transfer of technology can count. The India defense opportunity is not just a chance for foreign players to serve the Indian market, but is also an opportunity for Indian companies to become a key part of the global defense supply chain. So, as stakeholders focus on how to implement an effective framework for defense procurement and collaboration, both the GOI and domestic and foreign players are deliberating on what system of offsets can best serve the interests of both sides.

Managing Technology

Transfer Controls

Finally, perhaps no issue appears more vexing than U.S. export controls. If not managed effectively, it can be a deal-stopper that prevents transfer of sought after technologies. Upon arriving in Washington for their State visit and tour of duty, respectively, both Prime Minister Singh and Ambassador Shankar expressly mentioned U.S. export controls in their first remarks, underscoring the significance of this issue to U.S.-India defense trade.

India’s push for technology transfer raises significant export control compliance issues both for U.S. companies and foreign companies involved with U.S.-origin goods, software, technology and services. Specifically, the International Traffic in Arms Regulations (ITAR) restricts the transfer from the U.S. to foreign persons of defense-related technology, such as combat aircraft technology. The Export Administration Regulations (EAR) restrict the transfer of dual-use technology, i.e., that considered military useful, such as that for certain airport baggage screening systems. The ITAR and EAR often require export licenses before U.S.-origin technology may be shared with foreign persons. Those licenses can also impose ongoing export reporting and technology transfer compliance requirements. Even having meetings or making sales presentations where technical information is exchanged may constitute technology subject to U.S. export controls and require prior government approval.

In July 2009, the U.S. and India reached a milestone by agreeing on uniform language for End-Use Monitoring (EUM) arrangements that permits the United States Government to inspect on-site certain U.S. defense articles transferred to India, as required by U.S. law. The EUM expands the permissible range of defense-related trade with India, but it does not remove ITAR and EAR licensing requirements. Rather, prospective U.S. and Indian bidders and partners in defense trade need to be thinking about issues such as, what technologies will require licensing; what technologies are likely to receive licenses; what procedural safeguards are likely to be imposed on technology exports; and how should programs be structured to avoid export control problems.

Because compliance with U.S. export controls is critical to the process, early assessment of these issues is recommended, e.g., when companies identify prospective partners for bids. Certainly, U.S. companies cannot proceed without assurances that export control requirements will be met. Also, Indian companies need export counsel to help their U.S. partners deliver on their technology transfer proposals. These issues are complicated but can be managed.

Need for Advance Planning

The U.S. and India are natural allies because they are the oldest and largest democracies, respectively, and share a legal system based on common law. Now, the shared experiences of 9/11 and 26/11 underscore the great potential of the emerging U.S.-India strategic partnership. There are many issues to sort through as India embarks on high-stakes, big-ticket defense procurement, most importantly sensitive national security issues for both countries. By anticipating and addressing these issues in advance, however, private defense bidders can position themselves to participate in this important opportunity.

Mohit Saraf is a senior partner of Luthra & Luthra Law Offices and can be contacted at msaraf@luthra.com. Sanjay Mullick is a counsel in the International Trade practice of Pillsbury Winthrop Shaw Pittman LLP and can be contacted at sanjay.mullick@pillsburylaw.com.

 

 

by Mohit Saraf and Sanjay Mullick