FDI in India’s defence sector: Looking beyond the cap

India’s defence foreign direct investment (FDI) policy reflects cautious, incremental liberalisation, balancing capital and technology against national security. Despite years of reform and record exports (~USD 2.6 billion, 2024-25), equity inflows remain muted at USD 26.5 million against USD 765 billion total inflows over 25 years.

This gap between headline policy and actual inflows warrants scrutiny. The FDI cap is not the constraint, it is merely one of three gates, and the most straightforward. The difficulty lies in the interplay of licensing, the consolidated FDI policy 2020 (FDI Policy), and procurement architecture, examined below, gate by gate.

Unlike most manufacturing sectors, defence manufacturing requires prior government licensing: an industrial licence under the Industries (Development and Regulation) Act, 1951 (IDRA), or an Arms Act, 1959 (Arms Act) licence, depending on the item. Either licence renders a company FDI-eligible under Press Note No. 1 (2019), whose annexures list eligible items like - platforms, drones, systems and equipment under the IDRA and arms, ammunition, tanks and armoured vehicles under the Arms Act.

FDI applications are processed by the Department for Promotion of Industry and Internal Trade (DPIIT), with the Ministry of Defence (MoD) and Ministry of External Affairs. Given defence projects’ long gestation cycles, industrial licence validity extends to 15 years (extendable by 3 years), within which production must commence, while Arms Act licences subsist for the company’s lifetime, subject to establishing a facility within 7 years (extendable by 3 years). This licensing gate underpins the FDI Policy and the procurement framework.

Paragraph 5.2.6 of the FDI Policy, as substituted by Press Note No. 4 (2020 Series) and given effect through the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules), sets the sectoral cap at 100%, permitting investment up to 74% under the automatic route and, beyond 74%, under the government route wherever likely to result in access to ‘modern technology’ or for other reasons to be recorded.

The headline cap, however, masks a distinction between greenfield and brownfield structures. The 74% automatic route is available only to companies seeking new industrial licences. For a company not seeking a licence, or already holding government approval for defence FDI, fresh investment is permitted under the automatic route only up to 49%, subject to filing a declaration with the MoD within 30 days of the change in shareholding. Investment above 49% in such cases requires prior government approval. FDI beyond 74% is permitted under the government route where likely to result in access to “modern technology” - a phrase that remains undefined.

This distinction favours greenfield investment. An investor building a new licensed entity has a clear path to 74% under the automatic route; an investor in an existing licensed entity - typically the faster route - faces a lower ceiling of 49% under the automatic route. Since most investible Indian defence capability resides in already-licensed companies, the 2020 liberalisation, left much of the addressable market at the lower threshold.

Press reports in January 2026 indicated that the Government was considering bridging this gap by raising the automatic route limit for existing licensees to 74%, and deleting the “modern technology” condition, which, despite its prominence, has never been defined or accompanied by any guidelines.

The “modern technology” condition: The FDI Policy permits investment beyond 74% under the government route “wherever it is likely to result in access to modern technology” or “for other reasons to be recorded”. Neither term is defined in the FDI Policy, the NDI Rules, or elsewhere, leaving applicants without a framework to assess eligibility.

This gate carries two layers of scrutiny: foreign investment requires Ministry of Home Affairs security clearance, and the investee must demonstrate self-sufficiency in product design and development, with maintenance and life-cycle support facilities in India. The government reserves an open-ended right to review an investment affecting national security, regardless of threshold or entry event.

At this gate, the headline equity cap meets its practical limit. As the primary buyer in India’s defence market, the government of India regulates capital acquisitions by the armed forces through the Defence Acquisition Procedure, 2020 (DAP 2020), which ranks vendors by procurement category, with a clear preference for indigenously designed and manufactured products.

Positioning within the highest-priority indigenous categories is a market-access prerequisite. Buy (Indian-IDDM), Make-I, Make-II and the Strategic Partnership model cap foreign shareholding at 49%, prohibiting pyramiding regardless of the FDI Policy’s higher ceiling. The 74% ceiling is relevant only to lower-priority categories - Buy (Indian), Buy and Make (Indian), Buy (Global - Manufacture in India) and Make-III - where Indian-vendor status requires no majority ownership. For a foreign investor, the effective cap for India’s most consequential procurement opportunities is 49%.

The ‘Strategic Partnership’ model and the ‘pyramiding’ question

For complex platforms such as fighter aircraft, helicopters and submarines, the DAP 2020 Strategic Partnership model requires a selected Indian private entity to partner with the MoD as system integrator, capping foreign investment at 49% and barring “pyramiding”. Key managerial personnel must be resident Indians within the controlling group, with indirect foreign investment computed on a look-through, proportionate basis. “Pyramiding” remains undefined; DAP 2020 aligns “control” with the Companies Act, 2013, but neither it nor the draft DAP 2026 clarifies pyramiding’s scope. A conservative reading would treat multi-layered indirect investment as pyramiding, creating uncertainty for multi-tier holding structures.

Regarding countries sharing a land border with India, the framework under Press Note No. 3 (2020 Series) (PN 3 of 2020), as amended by Press Note No. 2 (2026 Series) (PN 2 of 2026), effective from May 2, 2026, assumes relevance.

Two aspects are specific to defence. First, government approval is triggered independently where land-border persons can exercise control over the investor entity, or ultimate effective control over the Indian investee, by any means, a threshold extending beyond equity ownership to include contractual and structural arrangements. Second, Pakistani citizens and entities remain entirely barred from investing in defence; the government route is available to them only in sectors other than defence, space and atomic energy.

In February 2026, the MoD released a draft Defence Acquisition Procedure, 2026 (DAP 2026), proposing several changes bearing directly on the foreign investment calculus. 

The key proposed changes under DAP 2026 are: (i) reducing procurement categories from five to four, deleting Buy (Indian) and raising the Buy (Indian-IDDM) indigenous content threshold to 60%; (ii) redefining indigenous design as ownership of design, source code and architecture; and (iii) potentially barring wholly-owned foreign OEM subsidiaries from “Indian vendor” status, favouring genuine joint ventures.

The FDI cap was never the barrier. What remains is calibration and alignment across the three gates: bridging the greenfield-brownfield asymmetry in the automatic route, clarifying “modern technology” and “pyramiding”, and articulating the interplay between FDI ceilings and vendor-categorisation thresholds.

For the foreign investor, the task is not to await a further increase in the cap, but to navigate the three gates, recognising that the most consequential decisions concern not the quantum of equity held, but one’s position in the procurement hierarchy, how the venture is structured to meet indigenisation thresholds, and how one earns the designation the Government has made the real currency of market access: that of a genuine Indian vendor.

The direction of reform is clear. The task is coherence.

About the authors: Naresh Pareek is a Partner, Aditya Sood is a Senior Associate and Prashant Dound is an Associate at Lex Consult.

Disclaimer: The opinions expressed in this article are those of the author(s). The opinions presented do not necessarily reflect the views of Bar & Bench.

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