Defence industry seeks tax rationalisation, policy clarity

By Ajai Shukla

Business Standard, 30th Jan 17

In countries that face serious security challenges --- as India does with a two-front conventional and nuclear threat, a 7,500-kilometre coastline, and serious internal security issues --- the levels of security the military and defence industry can deliver mostly hinges on how much money the government allocates to defence.

However, with the defence budget due to be unveiled on Wednesday, enhanced allocations feature on only a few wish lists of the defence industrialists that Business Standard spoke to. Instead, most hope that the defence ministry clears the policy, taxation and procedural logjams that stall capital procurement.

This is unsurprising, given that the defence ministry returns unspent money to the exchequer most years. This invariably comes out of the capital budget, impacting equipment modernisation programmes. The military has no problem spending its revenue budget each year, but the bulk of that goes on salaries and pensions, and running the military, from which the defence industry hardly benefits. Last year, the revenue budget constituted three quarters of the total defence allocation of Rs 340,922 crore. In contrast, the capital budget amounted only to Rs 85,453 crore.

An analysis by Business Standard revealed that capital expenditure has remained static over the last four years. In 2013-14, the last year of the United Progressive Alliance government, the capital expenditure of the army, navy, air force and Defence R&D Organisation (DRDO) was Rs 79,128 crore. This rose only marginally in the three National Democratic Alliance budgets to Rs 80,884 crore in 2014-15, Rs 80,780 crore in 2015-16, and Rs 85,453 crore in the current year.

Graphic: Defence allocations, extrapolated backwards with new calculation methodology

	2013-14 (Actual)	2014-15 (Actual)	2015-16 (RE)	2016-17 (BE)
Ministry of Defence (MoD)*	11706	15222	18989	29267#
Ordnance Factories (OFB)	833	1577	1753
DRDO (revenue)	5627	5775	6011
Army (revenue)	85786	87677	90797	143869^
Navy (revenue)	13034	13679	14635
IAF (revenue)	19094	19741	20377
Pensions	45500	60450	60238	82333
Capital Expenditure^^	79128	80884	80780	85453
Total allocation	260708	285005	293580	340922
Total government spending	1590434	1663673	1785391	1978060
Share of government spend	16.4%	17.1%	16.5%	17.2%
Total GDP	11320463	12488205	13567192	15065010
Share of GDP	2.29%	2.28%	2.16%	2.26%

*    Includes budget for Border Roads Organisation

#    MoD, OFB and DRDO allocations combined into one head w.e.f. 2016-17

^    Army, navy and IAF revenue allocations combined w.e.f. 2016-17

^^  Includes capital allocation for DRDO 

It will become clear this week how much of the current allocation has actually been spent. Military financial planners complain bitterly that the finance ministry deliberately stalls procurements in the fourth quarter of the year, so that surrendered money is available to dress up its expenditure account.

Much of the modest rise in defence allocations over the last three years has been in the revenue budget, and has gone towards meeting the expense of “One Rank, One Pension”. Similarly, much of the rise in the coming budget would go towards meeting higher salary costs necessitated by the 7^th Central Pay Commission.

For industry, the issues remain two-fold. Firstly, how much rise there will be in the capital allocation; and, second, how much of it will go to foreign vendors, the defence public sector undertakings (DPSUs) and the Ordnance Factory Board (OFB). That will determine what is left for private defence firms.

For example, the procurement of 36 Rafale fighters, means that a hefty chunk of the capital budget would be required for instalments on that purchase. In an average year, 85-90 per cent of the capital budget is pre-committed to purchases of earlier years.

Defence Minister Manohar Parrikar, whose promises tend to be well ahead of actual implementation, has publicly declared that, in the last two-and-a-half years, his ministry has placed procurement orders worth Rs 230,000 crore, more than 90 per cent of them in categories that would benefit vendors in India.

Parrikar has also set an ambitious target of exporting $2 billion worth of defence systems from India by 2019. This has aroused scepticism within industry, since it would require a four-fold increase in three years over current export levels.

A staple complaint of private industry is a taxation regime that favours foreign vendors over Indian firms. In the last budget, a time-bound schedule was announced for phasing out incentives on R&D expenditure, something that most governments encourage. Separately, an Indian offset partner is required to pay taxes on the work the company does in India, forcing it to route supplies through his foreign partner.

There is also widespread resentment at the government’s slothfulness in placing orders, even though private companies have invested heavily in creating R&D and manufacturing capabilities in the country. “A procurement that comes through in five years is regarded as lightning quick. What are we expected to do with our capacities while the file is processed at tortoise speed?” asks a CEO.

Small industry is worst affected, since cash-flow is a problem for many. MSMEs are hoping for credits, or loans at low rates of interest, which would enable them to remain competitive with foreign defence industry that gets loans at 1-2 per cent interest.

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The word from industry

Jayant Patil

Larsen & Toubro

In the FY 2016-17 budget, a roadmap was announced for phasing out benefits on R&D expenses under section 35(2AB). Such benefits should not only be continued, but enhanced in order to stimulate R&D for the high-tech defence, nuclear and aerospace sectors.

Jamshyd Godrej

Godrej & Boyce

“It is very complex and cumbersome to execute projects with government organisations.  A significant reduction in complexity is essential for the private sector to execute projects efficiently.”

Ashok Atluri

Zen Technologies

“Government should scrap taxes on equipment being sold to defence. Taxing defence amounts to paying tax with one hand and taking it back with other hand. This has a high transaction cost for the government, and causes untold misery to companies, which struggle to raise the working capital to pay the taxes. 

Ashok Kanodia

Precision Electronics Ltd

"Many Indian defence companies have invested serious money into building capabilities, but procurement files remain pending for years, causing serious cash-flow problems particularly for small and medium companies. So let 2017-18 be the year when the procurement budget is fully spent, and the bulk of it on Indian industry."

Colonel HS Shankar (Retd)

Alpha Design Technologies

“MSMEs are the backbone of defence production. The government should create financial packages for them, of long duration, low interest credits; and also ensure quick disbursement”.