Clarity needed on contract or job worker manufacturing

By Sourav Kanti De Biswas, Shardul Amarchand Mangaldas & Co
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Manufacturers in India are permitted to sell their products through wholesale and/or retail (including through e-commerce) without seeking prior approval of the government. A long-time provision in the foreign direct investment (FDI) policy permits 100% foreign investment under the automatic route in the manufacturing sector.

Sourav Kanti De BiswasPartnerShardul Amarchand  Mangaldas & Co
Sourav Kanti De Biswas
Partner
Shardul Amarchand
Mangaldas & Co

Due to confusion over what constitutes “manufacturing”, the government, in 2015, defined manufacturing to mean “a change in a non-living physical object or article or thing, (a) resulting in transformation of the object or article or thing into a new and distinct object or article or thing having a different name, character and use; or (b) bringing into existence of a new and distinct object or article or thing with a different chemical composition or integral structure”. Introduction of this definition was intended to ensure that Indian manufacturing companies which have received foreign investment undertake activities that change an object/thing to a new and distinct object/thing. It was aimed at curtailing activities where a company sourced products from third parties and only undertook limited activities such as packing, attaching stickers/logos, or minimal work which does not change the nature/character of the product and then claiming it was engaged in manufacturing.

It is a common commercial practice to outsource some or all manufacturing activities through contract manufacturing. If an Indian company only provides specifications and accepts final or near-final products which meet certain quality standards, this can be considered to fall outside the definition of manufacturing. It will constitute trading and accordingly the conditions attached to trading – wholesale, single-brand retail or multi-brand retail – should be applicable.

However, sometimes companies provide all raw materials to a job worker/contract manufacturer (or direct the manufacturer to procure raw materials from a specific vendor), exercise complete control and supervision during the manufacturing process, determine the manner in which products that do not meet specifications are disposed of/taken back, reimburse all taxes and expenses, etc. Essentially, the contract manufacturer does the work on behalf of the Indian company, which then sells the final product through wholesale/retail. It is akin to the Indian company having taken over an operational lease of a factory and reimbursing the owner of the factory for all costs. The FDI policy lacks clarity on whether such activity will be construed as manufacturing or trading.

If job work/contract manufacturing of this nature is not treated as manufacturing, it will lead to an absurd situation where the Indian company, when directly retailing such products to end customers, will be treated as undertaking single-brand or multi-brand retail trading and will have to comply with all FDI conditions applicable to such sectors.

It is pertinent to note that the FDI policy does not explicitly state that manufacturing activity has to be done within factory premises that are owned or leased by the Indian company. Neither is there a valid reason why manufacturing of products in the above manner should not be considered as manufacturing in terms of the FDI policy. Therefore it is arguable that so long as the Indian company is the principal manufacturer (i.e. undertaking manufacturing in the manner explained above), it will fall within the definition of manufacturing as contemplated under the FDI policy. However, due to a lack of clarity on this, various Indian companies which have received foreign investment are taking risks and continuing their business in a manner which suits them.

Similarly, where a non-resident investor intends to acquire an Indian manufacturing company which undertakes business in the above manner, the Indian promoters are likely to give clear representations and warranties that the company is compliant with foreign exchange laws. Due to a lack of clarity on this matter, the promoters may unknowingly breach such representations if the government considers manufacturing in a different manner.

The government should clarify whether manufacturing through job worker/contract manufacturing in the above manner will be construed as manufacturing under the FDI policy or will be considered as trading. If the government is of the view that such activity amounts to trading, it would help if the government can relax the norms and specify a maximum percentage of the products that can be manufactured through outsourcing, since outsourcing is a common practice and a necessity in the industry.

Sourav Kanti De Biswas is a partner at Shardul Amarchand Mangaldas & Co. The views and opinions expressed are solely those of the author and do not necessarily reflect the official view or position of the firm.

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