FDI in Contract Manufacturing – A Game Changer and A Force Multiplier

The Union Cabinet on August 28, 2019, proposed significant changes to the foreign direct investment (FDI) policy, specifically with respect to four sectors, namely contract manufacturing, single brand retail, coal mining and digital media.

The proposed changes are in line with the Budget announcements and should promote ease of doing business in India and boost the ‘Make in India’ initiative.

One of the key changes includes allowing FDI up to 100 percent in contract manufacturing. The extant FDI policy is silent on the sector and accordingly, the meaning of the term needs to be understood in common parlance.

Generally, contract manufacturing means a business model under which the entity concerned (distributor/principal entity) outsources manufacturing activity to another entity (contract manufacturer), which possesses manufacturing facilities (including but not limited to plant, machinery and labour force required to manufacture relevant product as well as sourcing and supplying necessary raw materials) and the requisite licence/registration.

The contract manufacturer undertakes manufacturing activity at the instance of the distributor/principal entity and does not hold any intellectual property right or right to commercially exploit the end products. In such an arrangement, the contract manufacturer receives extensive instructions about the quantity, quality and quantum of production.

The extant FDI policy permits FDI up to 100 percent in the manufacturing sector under the automatic route. Since the liberalisation process, FDI in manufacturing has been continuously encouraged by the government, permitting FDI up to 100 percent in manufacturing through the automatic process.

In absence of any specific guidelines applicable to contract manufacturing, it has been a long-drawn debate on whether the same should be covered under trading or manufacturing sector.

The dilemma is explained through an illustration as under.

In terms of the extant policy, FDI is allowed in those entities that were engaged in manufacturing of the products themselves and there was lack of clarity for the companies which were outsourcing manufacturing activities to others.

Accordingly, if Company A manufactures products on its own, then FDI up to 100 percent is permitted under the automatic route. However, if the company is getting the products manufactured by Company B, then the latter is a manufacturer and FDI up to 100 percent is permitted under the automatic route in Company B.

There were no explicit provisions for Company A in the existing FDI policy. In absence of specific provisions, there was ambiguity as to whether “trading guidelines” or “manufacturing guidelines” should be applicable to Company A.

However, in view of the policy relaxation, contract manufacturing is at par with manufacturing, given the nod for FDI up to 100 percent under the automatic route. Accordingly, manufacturing activities can be undertaken either by the investee entity itself or through contract manufacturing in India under a legally tenable contract, whether on Principal to Principal or Principal to Agent basis.

Pursuant to this relaxation, the settled position is that FDI in Company A should be allowed up to 100 percent under the automatic route and should not trigger “trading guidelines” and local sourcing requirements.

The clarification will incentivise foreign players to spur more foreign investments in the country. It will provide the much-needed impetus to Make in India by boosting the manufacturing sector, through establishment of new facilities and improving utilisation of the existing ones.

Furthermore, it should lead to creation of jobs, increase in exports, inclusion of India in global value chains and ultimately, boosting the economy as a whole.

The move will have multiplier effect on the economy and should be a game changer for the manufacturing sector.

Dev Raj Singh is Associate Partner, Tax and Policy Services, EY India. Views are personal.

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Source: MC

Image Courtesy: Shutterstock

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