India’s foreign direct investment (FDI) policy in the defence sector has been characterized by cautious and incremental liberalization. This approach aims to strike a balance between attracting capital and technology while safeguarding national security. Despite ongoing reforms and record-setting exports projected at approximately USD 2.6 billion by 2024-25, the actual FDI inflows have been relatively modest, reaching just USD 26.5 million compared to the USD 765 billion in total inflows over the last 25 years. This stark contrast between policy announcements and actual investments merits closer examination.
The Three Gates of FDI Regulation
Contrary to common perception, the FDI cap itself is not the primary barrier; rather, it is one of three critical gates. These gates, comprising licensing requirements, the consolidated FDI policy, and procurement architecture, present more complex hurdles.
Gate One: Licensing Requirements
Unlike most manufacturing sectors, defence manufacturing in India necessitates prior government licensing. Companies must secure either an industrial license under the Industries (Development and Regulation) Act, 1951 (IDRA), or an Arms Act, 1959 license, depending on the item. These licenses, detailed in the annexures of Press Note No. 1 (2019), deem a company FDI-eligible for certain defence-related products.
FDI applications are processed by the Department for Promotion of Industry and Internal Trade (DPIIT), in collaboration with the Ministry of Defence (MoD) and Ministry of External Affairs. Given the long gestation periods of defence projects, industrial licenses are valid for up to 15 years, extendable by 3 years, while Arms Act licenses last for the company’s lifetime, contingent on establishing a facility within 7 years, extendable by 3 years. This licensing gate forms the backbone of the FDI policy and procurement framework.
Gate Two: The FDI Policy
Under Paragraph 5.2.6 of the FDI Policy, as amended by Press Note No. 4 (2020 Series) and the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules), the sectoral cap is set at 100%. Investments up to 74% are permitted under the automatic route, while higher investments require government approval if they likely access ‘modern technology’ or for other specific reasons.
The policy differentiates between greenfield and brownfield investments. The automatic route to 74% is accessible only to those seeking new industrial licenses. For companies not requiring a license or those with existing government-approved defence FDI, new investments are permitted up to 49% under the automatic route, subject to MoD notification within 30 days of shareholding changes. Investments exceeding 49% require prior government approval, with the undefined ‘modern technology’ condition posing additional challenges.
Gate Three: Indian Vendor Status
The third gate involves the practical limits of equity caps. The Indian government, as the primary buyer in the defence market, regulates capital acquisitions via the Defence Acquisition Procedure, 2020 (DAP 2020). This procedure ranks vendors by procurement category, with a preference for indigenously designed and manufactured products. The highest-priority indigenous categories cap foreign shareholding at 49%, rendering the 74% ceiling relevant only to lower-priority categories. Consequently, for foreign investors, the effective cap for substantial procurement opportunities is often 49%.
Strategic Partnership Model and Pyramiding
For complex defence platforms, the DAP 2020 Strategic Partnership model involves an Indian private entity partnering with the MoD as a system integrator. This model caps foreign investment at 49% and prohibits ‘pyramiding,’ a term that remains undefined but implies restrictions on multi-layered indirect investments. The land-border framework further complicates matters, requiring government approval for investments involving entities from countries sharing a land border with India.
Draft Defence Acquisition Procedure 2026
In February 2026, the MoD released a draft Defence Acquisition Procedure, 2026 (DAP 2026), introducing significant changes impacting foreign investment. These include reducing procurement categories, redefining indigenous design, and potentially barring wholly-owned foreign OEM subsidiaries from ‘Indian vendor’ status.
Conclusion
The FDI cap is not the primary obstacle in India’s defence sector. The real challenge lies in navigating the three gates: addressing greenfield-brownfield asymmetry, clarifying ‘modern technology’ and ‘pyramiding,’ and aligning FDI ceilings with vendor-categorization thresholds. For foreign investors, the focus should be on securing a position within the procurement hierarchy and meeting indigenization thresholds to attain the status of a genuine Indian vendor.
Naresh Pareek, Aditya Sood, and Prashant Dound from Lex Consult provide expert insights into these complexities, highlighting the need for coherence in reform efforts.
