Incentive Structure for Domestic Electronic Manufacturing Industry Under the WTO regime

By: Pranav Narang


INTRODUCTION

The developing economies like India are facing the problem of the slow growth of the domestic industry in the area of telecom equipment and other electronics and semiconductor-based product manufacturing under the World Trade Organisation (hereinafter ‘WTO’) regime. The major concerns of India involve regulation of subsidies under Agreement on Subsidies and Countervailing Measures (hereinafter ‘the SCM Agreement’) and tariff concessions for advanced Information Technology (hereinafter ‘IT’) products under Agreement on Information Technology (hereinafter ‘ITA’). Further, India has been facing challenges on the front of slow growth in export, specifically electronic goods. In addition, the Indian market has been flooded with Chinese electronic goods, which has created a huge gap between import and export. 

India, herself, has faced an allegation of providing export performance-based subsidies to the domestic industry. The issue is directed towards various schemes where India has been providing benefits which qualify as ‘remission or drawback of import charges in excess of those levied on imported inputs that are consumed in the production of the exported product’ as mentioned under Annex I (i) of SCM Agreement. The article aims to analyse the issues faced by developing countries in promoting the growth of domestic electronic manufacturing industry under the WTO regime.  

Further, the ITA has been recently amended to include telecom products which were not included in the list of products to be exempted under the said agreement. The article will also investigate concerns of India regarding the dilution of the definition of IT products by addition of advanced IT and telecom products in the list of products under the ITA. The effect of such inclusion could have been a restriction on India in imposing import duty on advance telecom and IT products. Hence, developing nations like India cannot provide relief to domestically produced goods by domestic players lack in capacity against imported goods from competitive markets.

Such limitations under the WTO regime has impacted semiconductor-based manufacturing sectors in India, hence limiting the ability of the domestic industry to build capacity and growth to achieve economies of scale which can be used to compete with industries in China, US, South Korea, Taiwan and other emerging semiconductor-based manufacturing hubs. In addition, the global economy is facing slowdown with looming protectionist agenda around international trade, specifically dealing with the ICT sector. 

The article will explore incentive structure and instruments for improving the export performance of the domestic industry and increase share in the domestic market and other markets of semiconductor-based finished products without raising concerns about violating WTO agreements. Before identifying the incentive structure, the article will gauge both the issues of export-related subsidies, extended tariff concessions under ITA and non-tariff measures being taken under the guise of national security issues arising out of vulnerability of telecom network.

US v INDIA EXPORT SCHEME DISPUTE

Under the SCM agreement, the subsidy contingent upon export performance is prohibited, whereas contingency can be in law or in fact. The standard for export contingency has been held by the Appellate Body in Canada – Aircraft same as for both de jure and de facto contingency. For de facto export contingency, a relationship of conditionality or dependence must be shown between the subsidy and actual exportation or export earnings. However, the standard for “contingency … in fact” is not satisfied by merely ascertaining expectations of exports on the part of the granting authority. On the other hand, de jure contingency can be established based on words expressed in legislation, regulation or other legal instrument constitution the measure, but can also be derived by ‘necessary implication’ in the form of expectation from the wording of a legal instrument. Therefore, there is a higher threshold of evidence required for establishing de facto contingency than de jure contingency.

The United State Trade Representative (hereinafter ‘USTR’) had filed for consultations with India before Dispute Settlement Body (hereinafter ‘DSB’) regarding the validity of export-oriented schemes like Export Oriented Units (hereinafter ‘EOU’) scheme and Electronic Hardware Technology Parks (hereinafter ‘EHTP’) scheme which promote export by exempting custom and excise duty for units which are exporting all of their production. The issue involved in the US-India export subsidy case is about de jure subsidy as exemption has been expressly provided under government schemes. EOU and EHTP scheme documents clearly mention that units undertaking to export their entire production can procure goods from Domestic Trading Units (hereinafter ‘DTU’) or international exhibitions without payment of custom and excise duties. But GST for goods procured from DTU need to be paid, which can later be refunded. Therefore, schemes expressly provide for subsidy dependent upon the export orientation of units, which clearly fall under the scope of de jure contingency. 

In addition, the financial contribution in the form of revenue foregone also qualifies as subsidy under the SCM Agreement. The financial contribution in the form of revenue foregone exists if “the government revenue that is otherwise due is foregone or not collected”, which can be tax credits as fiscal incentives. To ascertain whether the revenue otherwise due is foregone, the benchmark for comparison between revenue actually raised and the revenue that would have been raised ‘otherwise’ has to be established. The legal standard for such comparison has been derived as a three-step test. The first step would be to identify tax treatment being applicable to alleged receipts as financial contribution. Subsequently, in the second step, it needs to identify the benchmark suitable for comparison with respect to tax treatment, whereas comparison should be limited in such way that it does not affect the sovereignty of the member state and comparison can be made with respect to comparable income of comparably situated taxpayers. Finally, the panel needs to determine whether, with respect to the member’s treatment of fiscal situations legitimate to compare, the government has foregone revenue otherwise due.

The panel applying the first test identifies tax treatment constituting financial contribution as:

(i) An EOU/EHTP/STP/BTP unit may import and/or procure, from DTA or bonded warehouses in DTA/international exhibition held in India, all types of goods, including capital goods, required for its activities, provided they are not prohibited items of import in the ITC (HS) subject to conditions given at para (ii) & (iii) below. …

(ii) The imports and/ or procurement from bonded warehouse in DTA or from international exhibition held in India shall be without payment of duty of customs leviable thereon under the First Schedule to the Customs Tariff Act, 1975 and additional duty, if any, leviable thereon under Section 3(1), 3(3) and 3(5) of the said Customs Tariff Act.

In addition, the panel also noted the objective of schemes which is “to promote exports, enhance foreign exchange earnings, and attract investment for export production and employment generation”. The panel also noted that schemes impose export obligation and net foreign exchange requirement on participants. With respect to the second step, the panel identifies tax structure including Section 12 of Customs Act 1962 listing import duty for listed products. Section 3(1), 3(3) and 3(5) of Customs Tariff Act which provide for the imposition of additional duty equivalent to the level of excise duty, sales tax, local taxes and other charges applicable on domestic goods as a normative benchmark against which customs duty treatment under the schemes must be assessed. With respect to the third test, as the above-mentioned taxes including customs duty and additional duty identified benchmark tax structure for revenue from like goods are foregone in case of importation of the same goods by participating units. Therefore, the panel concluded that exemption from customs duties levied on the importation of capital goods under schemes qualifies as revenue foregone by India under Article 1.1(a)(1)(ii), provide a financial contribution.

Once it is established that scheme provides financial contribution qualifying as subsidy, contingent in law or in fact, it needs to be determined whether financial contribution in the form of subsidy, e.g. exemption on customs duty and excise duty and refund for GST, confers a benefit for establishing that contingent subsidy qualifies as prohibited subsidy. The panel held that the relevant question for determining whether benefit has been conferred is “whether the ‘financial contribution’ makes the recipient ‘better off’ than it would otherwise have been, absent that contribution”. Therefore, the tax departments need to be careful while giving tax reliefs to manufacturing entities having taxes long overdue. 

However, it also needs to be determined whether subsidy falls under the exemption of footnote 1 of SCM agreement, which clearly states that “remission of such duties or taxes in amounts not in excess of those which have accrued, shall not be deemed to be subsidy”, read together with Annex I(i). The panel held that there is no dispute about whether customs duty exemption under EOU/EHTP constitutes an exemption or remission of import charges. The panel noted that schemes exempt payment of customs duties for “all types of goods, including capital goods, required for its activities”, which seems to be included goods in addition to imported inputs that are consumed in the production of the exported product. Hence, EOU/EHTP scheme does not meet the conditions of footnote 1 read together with Annex I (i).

The outcome will affect Indian electronics manufacturing industry dealing with IT products, as India will have to reduce its incentives. India has already made a move towards a low rate of taxation and minimum incentives by introducing reduced taxation scheme for new and existing manufacturing units. In response to the panel report in the India-US export subsidy case, India is expected to reduce the incentives for electronic manufacturing unit so that India does not violate the SCM Agreement. However, India has recently challenged the adjudication made by the panel report, on the issue of the limited exemption that can be provided under the SCM Agreement, before the Appellate Body, which is defunct in lieu of appointment of Appellate body members being blocked by the United States of America. 

EXTENDING LIST OF PRODUCTS UNDER AGREEMENT IN INFORMATION TECHNOLOGY

The ITA was entered by the member states to reduce trade barriers by completely removing tariff measures for IT products for boosting trade in IT products among member states and non-member states. With the advantage of increasing the trade in IT products, ITA had a negative impact on states with less capacity for competing with foreign imported goods. China took advantage by not entering into an agreement at the firststance and was able to build capacity by getting access to other markets with no tariffs as IT was plurilateral agreement and signatory states have to provide similar tariff measures for both members and non-member states.

The need for extending the list of products was felt after a dispute arose between the European Union and the other WTO member states regarding classification of products like flat-panel television sets, set-top boxes and modems as envisaged in the list of products under ITA-1. The dispute highlighted the problem of mismatch between classification by a custom procedure based on descriptive illustrations of products and classification under ITA based on the purpose or intent of the products. With the increasing amount of digitalisation of range of products including mobile phones, television sets, display screens, speakers, watches, the disagreements among member states was bound to arise which raised the question of intent of signatories at the time of signing the ITA-1 regarding tariff treatment of advanced IT products.

In the EU tariff treatment of IT products case, it was disputed that European Communities were not providing duty-free access to the market for products including “flat panel display devices” (hereinafter ‘FPD’), “set-top boxes which have communication function” (“hereinafter ‘STBC’) and “multifunctional digital machines” (hereinafter ‘MFM’). EU had argued that paragraph 3 of ITA annexe is the guiding principle for negotiators to update the listed products under ITA and resolve ambiguity in customs classification with respect to convergence of ITA and recent development in technology. However, the panel held that paragraph 3 dealing with products that fall outside current coverage of the ITA provides little guidance on key interpretative clause about the inclusion of additional products with future development of technology or exhausting by the tariff lines included in the annexe to the schedules.

The products covered under dispute are basically the advanced version of non-IT products with IT-based components as additional parts which add value to the overall performance of the product. As ITA was not designed to incorporate such developments in technology, EU and other member states felt the need for revising the list of products covered under ITA to avoid an influx of disputes on such matters, which led to negotiations for the inclusion of new products under ITA that is referred to as ITA-2. 

India had made its reservation against the expansion of the list of products to include advanced IT products by arguing that intent of the agreement does not raise legitimate expectations for signatories with the possibility of inclusion of additional products. Amid the possibility of the dispute being raised against India for denying the benefit to products under ITA-2, India decided against joining ITA-2. Recently, EU has filed a complaint against India for custom duties levied on import of ICT products. At the same time, India is also facing a tough time to garner support against e-commerce rules being negotiated under the WTO, which would impact India’s plan to impose data localisation under e-commerce policy, the draft of which has already been published. 

The negotiations around the extended list of products for ITA-2 has been a game-changer for negotiating member states, otherwise being left out of the negotiating process. With the current approach of classification and list of products under ITA-1, the tariff-free trade has covered only 67 % of total trade in IT products. Whereas it has been projected that expanding the list of products under ITA-2 will increase that coverage by 16.7 % of trade volume to the tariff-free trade. Further, it has been deduced that expanding the list of products will extend the tariff-free trade in IT products to a larger extent than the situation where non-signatories like Argentina, Mexico, Brazil, Chile, South Africa and Russia to join the ITA-1 with current product coverage. The issue of whether the inclusion of more countries in the plurilateral agreement should be preferred over the expansion of products is debatable if the democratisation of the industry is considered, however, empirical data shows that expansion of the list of products will extend the benefit to larger trade volume.

However, the approach of classification under ITA-2 has remained the same which would attract more disputes under the WTO regime, as the parties have a different classification in the customs system and criteria for classifying under ITA agreement. Further, India has been affected a great deal by the expansion of the list under ITA-2 when it comes to share in the trade of IT products, as the cost of input for the production of advanced IT products will be reduced in countries incorporating tariff-free treatment for additional products under ITA-2. 

Specifically, the limitation of exemption for tax on capital goods like machinery and other equipment as prohibited subsidy under SCM agreement which will be covered under ITA-2 for tariff-free treatment creates an advantage for ITA-2 participating countries. Thus, the Indian electronic manufacturing industry has been affected due to multiple setbacks by losing export subsidy case against US and expansion of the list of IT products under ITA-2. Considering double setback, there is a need for policy revival for the manufacturing sector, specifically the electronics manufacturing industry.

CHALLENGES IN RE-ENERGISING MANUFACTURING SECTOR GROWTH

The Indian electronics manufacturing sector has been facing a slowdown due to regulatory issues and bureaucratic hurdles. The domestic electronic manufacturing is also facing competition from Chinese manufactures who have achieved economies of scale by taking advantage of the threshold period provided under ITA-1 before the obligation of removing tariffs for covered IT products came into force. Thus, Chinese players have been able to establish their market share in different regions, especially Asia. However, China has recently faced a setback in Europe and USA, whereas European Union has committed to building capacity for manufacturing and certification of telecom equipment within EU member states and the ban of Huawei devices by US President.

With respect to the electronics manufacturing industry, the extension of product list under ITA-2 will also result in a reduction of tariffs dealing with input supplies for extended products in other markets. Such an effect will make the cost of production for an extended list of IT products in other markets to be reduced, hence making industry in these markets more competitive against the Indian manufacturing units.  

The Indian government needs to take advantage of the opportunity provided by expansion of products and divert the funds from providing an exemption for capital goods to providing targeted incentives for Research & Development to come up with innovative IT products that are being covered under ITA-2. At present, Start-up India initiative is targeted to provide an incentive in the form of tax exemption for the investment made in start-ups by Venture Capital, tax holiday for entities falling under definition of start-up under start-up India scheme as updated by Department for Promotion of Industry and Internal Trade. However, more than 12,000 start-ups recognised under the said scheme have been able to generate only 120 granted patents, which is not only 1% of success rate after providing a plethora of incentives.

The R&D incentives should be targeted towards achieving better products in different sectors that are undergoing ICT transformation which include automobile sector, electricity transmission equipment, electric vehicle sectors, smart home devices, home appliances, solar energy, etc. In addition, the government also needs to provide support for patent filing expenses in foreign jurisdictions apart from filing fees for India patent application, which will help the industrial units in building research capacity for different markets, which can be commercialized to further grow investment in R&D by the Indian electronic manufacturing entities. At present, the Indian government is providing subsidy for in-house R&D departments of domestic players, however, coverage of the said policy is not sufficient to attract investment directed towards R&D. In addition, the R&D subsidy is regulated under the SCM Agreement as an actionable subsidy and can be challenged if R&D subsidy is granted for a specific industry that causes harm to the domestic industry of other member states. However, the SCM agreement provides the flexibility of special treatment with respect to the actionable subsidy that includes R&D subsidy.

Apart from the incentives for R&D, the government needs to create a platform where entrepreneurs and students can collaborate to develop products and solutions that are targeted towards solving social and environmental problems. Such projects can attract investment from venture capital firms and angel investors. The government should come up with a policy where such investments can be provided returns proportionate to the impact of products and solution in target sector e.g. if a product was designed to reduce the carbon footprint of specific sector, the remuneration can be decided based on performance of the product in the resultant reduction in carbon emission after deployment of said product/solution.

Specifically, the product of R&D in the form of patented invention can provide bargaining power for domestic players to negotiate terms and condition of technology transfer with reduced royalty rates. Thus, the tax incentives for incentivising innovation will result in a reduced burden of royalty cost which is a major component of inputs used by the manufacturing sector. Although, the knowledge production has become centralised due to the imposition of a minimum standard of protection on member states under the TRIPS regime. However, the capacity developed in R&D can grow exponentially by the South-South Partnership as a collective effort for combatting domination of transnational corporates in knowledge economy under TRIPS regime. Such a partnership will be essential for decentralising the knowledge economy, specifically the ICT sector, and create an incentive for small and medium entities to participate in the knowledge economy. 

DEFINITION OF START-UP UNDER START-UP INDIA SCHEME

Recently, the Department for Promotion of Industry and Internal Trade (hereinafter ‘DPIIT’) has amended the definition of ‘start-up’ by broadening the scope to include entity for which ten years has not elapsed since its inception. Further, the turnover limit for an entity to be recognised as a start-up has been extended to Rs 100 crore, which would expand the scope to start-ups which have received few rounds of funding. The unnecessary expansion of the scope of definition was welcomed by venture capital firms and start-up founders, however, was intended towards industry backlash against the handling of angel tax issue by the government. 

The government should be wary of bringing such amendment, as there is no reasonable ground to expand tax incentives and concessions to well-established start-ups, which will result in over-dependency of start-ups on these benefits throughout their lifetime of establishing in the market. Further, the start-ups are also eligible for expedited examination process under which patent can be granted within one year from the date of filing the patent application provided it satisfies the statutory requirement for granting patent under Indian Patent Act, 1970.

In addition, the third criterion for determining whether entity falls under the definition of start-up, i.e. entity needs to be engaged in the development of Intellectual Property or any new business model which generates employment, has been left open-ended for DPITT to exercise discretion in recognising the start-ups. Such an approach has resulted in scenarios where entrepreneurs with political connections are getting such recognitions, which means that the state funds are being utilised in satisfying entrepreneurship zeal of elitist and politically connected individuals.

Further, the recognised start-ups are predominately in the area of e-commerce sector catering to provide online marketplace/platform for foreign brand owners and local manufacturers and service providers who are looking to expand their market. Apart from the e-commerce market, the recognised start-ups deal in sectors like the Internet of Things, Agriculture and Rural Development and Renewable Energy. 

The Indian government has entered into a partnership with various states to encourage innovation partnership between entrepreneurs across borders with aim of achieving growth of innovation in targeted sectors like agriculture, renewable energy, digital health and financial technology. In addition, the Indian government should ensure that such partnerships are focussed on establishing manufacturing units in India, otherwise, it will result in misbalancing the trade deficit, as most of the manufacturing activity might be outsourced to competitive markets. 

Currently, the Indian government provides benefit to start-ups in the form of financial support for professional fees of patent attorney in filing and drafting patent application who are listed as facilitators with the Indian Patent Office. In addition, the government needs to provide financial support for filing patent applications in foreign jurisdictions to ensure the expansion of the market of Indian start-ups considering the exorbitant fees charged by foreign attorneys. However, the government needs to tread carefully with such policy, as such policy might get challenged under the WTO regime.

DATA LOCALISATION UNDER E-COMMERCE POLICY

The Indian government has published draft e-commerce policy which says that personal data of Indian consumers should be stored in local servers, instead of servers housed in data centres at foreign locations. It has been argued that such policy will give a boost to local manufacturers and service providers, as there will be a surge in demand for servers to be installed for supporting storage of consumer data. However, the manufacturing sector does not have capacity to meet the standard requirement for servers, which might be imported from cost-competitive jurisdictions like China. Hence, the importation of Chinese hardware to set up data centres will be a setback for the government in the form of rising trade deficit with China. 

In addition, Indian government has decided against the participating in the negotiation of treaty agreement on e-commerce, which could have been a good opportunity for India to save its interests when it comes to the issues surrounding e-commerce sector including tackle barriers that prevent cross-border sales; guarantee the validity of e-contracts and e-signatures, permanently ban customs duties on electronic transmissions and address forced data localisation requirements and forced disclosure of source code. In view of such setbacks, the Indian government should require a portion of hardware required for setting up data centres to be sourced from domestic manufacturers, instead of merely imposing the requirement of localisation of data centres. However, such a policy might be challenged under the WTO regime violating the national treatment principle. Hence, the Indian government needs to sway cautiously when it comes to policy of localisation of personal data of consumers. 

 CONCLUSION

The electronic industry is a challenging area of every economy because of fast evolving technologies and adaptation of technologies by other industries. Hence, the incentive structure for R&D activity in the area of electronics, communication and information technology is must to survive in this competitive industry. The western countries are already reacting to changing dynamics of this industry by coming up with the policy of regulating in-flow of foreign technologies-based devices into their country by relying on argument national security policy overpowering the economic principle of free trade leading to global efficiencies.

On the other hand, emerging states are catching up with the western states in terms of capacity building for the production of advanced IT products recently classified under ITA-2. Hence, there is a need for incentives for domestic manufacturers to invest in R&D before the players from competitive states capture the opportunity to expand to limit which will drive out Indian manufacturers from the market. With policy of localisation of data becoming reality in future, India will have to seize the opportunity by ensuring that Indian manufacturers have the capacity to capture the electronics goods market by focussing on the quality of products rather than focussing on the production of conventional devices or using conventional manufacturing techniques. The improved quality will automatically increase demand for electronic items manufactured by Indian entities.

Further, the crackdown on export-based subsidy policy of India under the WTO regime has suggested that India should rather focus on creating Intellectual Property that can provide Indian electronic goods manufacturer with a competitive advantage over currently dominating players in future. The incentive structure suggested above can thrive to achieve the objective and give better chance to Indian electronics manufacturing industry to improve their share in global market. Once the capacity of R&D is developed by Indian players, the subsequent growth in market share will become easier because of competitive advantage in the performance of products and manufacturing activities. The increased market share will eventually reflect in the growth of export by Indian manufacturers, hence resulting in reduced trade deficit with developed countries and emerging markets. Therefore, the government should prioritize R&D in the electronic goods sector to improve the health of the domestic manufacturing sector in India.

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