In the ever-evolving world of defence technology and innovation, Micro, Small, and Medium Enterprises (MSMEs) play a pivotal role. These enterprises are not just the backbone of the defence sector but also the engines driving research and development (R&D) in cutting-edge technologies. However, recent reports have highlighted a growing concern among these defence MSMEs, the issuance of Goods and Services Tax (GST) notices related to their R&D activities. The imposition of GST on R&D efforts has sparked a wave of confusion and criticism with many dubbings it as a "tax on R&D grant".

The imposition of GST on R&D efforts has sparked a wave of confusion and criticism with many dubbing it as a 'tax on R&D grant'

Mostly, the government funded project in grants are for the development of new systems/sub-systems which involves the initial R&D for the technology needed. It is therefore undesirable to tax that development which itself comes from the government to support the industry/MSMEs for the solutions.

As reported, a MSME received a GST notification to pay 18 per cent tax under Section 13(2) of the CGST Act, 2017. The said MSME had received government grant for the R&D activities, leading to the prototype or final products.

The Role of Defence MSMEs in R&D

India's defence sector has long relied on its MSMEs for providing critical components, technological solutions, and services. These enterprises contribute significantly to the national defence infrastructure, helping to modernise the armed forces and drive innovation in the sector. In fact, in the overall production of ₹1.27 lakh crore, the private sector's share in defence production is 22 per cent in FY24. Building on that, the country's defence production is aimed to reach a target of ₹3 lakh crore by 2029.

Defence MSMEs argue that imposing GST on R&D not only creates an additional financial strain but also disincentivises innovation, which is critical for the country's strategic interests

Many of these MSMEs are involved in R&D, developing new technologies for weapons systems, electronics, and other defence applications. Through their research, these companies are not just working on national security but also contributing to India's technological advancement. Their efforts often require considerable financial investment, resources, and expertise, pushing the boundaries of innovation.

According to the government's notification issued on October 8, 2024 on R&D related activities, there are clear guidelines that academic and research institution including the universities, laboratories and scientific institutions shall be exempted from the tax by the GST Council.

GST Notices: A Growing Concern

Recently, several defence MSMEs involved in R&D activities have started receiving notices from the GST authorities. These notices question the applicability of tax exemptions or seek payments related to the services and goods involved in R&D processes. The notices have caused confusion among small and medium-sized businesses, many of whom were unaware that their R&D activities might be subject to GST.

The GST framework was designed to streamline the taxation system, but for MSMEs, especially in niche sectors like defence, the application of tax rules can be complex and burdensome. Defence MSMEs argue that imposing GST on R&D not only creates an additional financial strain but also disincentivises innovation, which is critical for the country's strategic interests.

Imposing GST on R&D activities, they argue, directly contradicts the government's vision of fostering innovation and self-reliance in the defence sector

A Tax on "R&D Grant"

The crux of the issue lies in the argument that R&D is a crucial area where governments worldwide typically provide incentives, not penalties. In the context of India, where the defence sector is constantly evolving to meet the challenges of modern warfare, the demand for constant innovation is high. As the government promotes initiatives like 'Make in India' and 'Atmanirbhar Bharat,' these MSMEs are expected to take on larger R&D responsibilities.

Imposing GST on R&D activities, they argue, directly contradicts the government's vision of fostering innovation and self-reliance in the defence sector. The additional tax burden is seen as a disincentive for smaller companies who may lack the financial muscle to bear the brunt of such levies. Rather than encouraging them to take risks and invest in innovation, the government's tax policy risks stifling the very creativity that the country depends on.

Governments across the world incentivise defence-related R&D activities, offering tax breaks, grants, and other forms of support to companies contributing to national security

In fact, the government has focused on the budgetary allocation to Defence Research and Development Organisation (DRDO) by raising it to ₹23,855 crore in FY 2024-25. Out of this allocation, a major share of ₹13,208 crore is allocated in strengthening the DRDO for new technology with special focus on fundamental research and hand-holding of the private parties through Development-cum-production partner. The allocation to Technology Development Fund (TDF) scheme stands out to be ₹60 crore which is specially designed for new startups, MSMEs and academia attracting the young bright minds interested in innovation and developing niche technology in collaboration with DRDO. The Government has also increased the allocation on innovation in defence through iDEX which is ₹518 crore in the current fiscal year.

Impact on MSMEs and Innovation

The burden of GST on R&D has several potential negative effects. First, it increases operational costs for MSMEs, which may already be operating on tight margins. This can discourage investment in R&D or even halt ongoing projects, particularly for smaller enterprises that rely on grants and subsidies to fund their work. The added complexity of navigating the GST system also diverts attention and resources away from research and development, further slowing the pace of innovation.

To maintain the momentum of innovation in the defence sector, it is essential for the government to reconsider its approach, offering clearer guidelines and tax exemptions to encourage rather than hinder R&D efforts in the critical defence industry

Additionally, this tax burden could deter new entrepreneurs and startups from entering the defence R&D space, as the financial and administrative barriers to entry grow higher. Startups, which are often the birthplace of disruptive technologies, may choose to abandon defence innovation projects or avoid entering the market altogether.

Government's Role in Addressing the Issue

Given the critical role that defence MSMEs play in advancing national security and technological innovation, it is essential for the government to reassess the GST rules that apply to these entities. Many experts argue that R&D activities, especially those related to defence, should be exempt from GST to foster a more conducive environment for growth and innovation.

Governments across the world incentivise defence-related R&D activities, offering tax breaks, grants, and other forms of support to companies contributing to national security. India can follow suit by offering similar measures, including exemptions from GST for R&D activities related to defence.

Moreover, providing clarity in the GST framework for defence MSMEs can help eliminate confusion and ensure these enterprises can focus on their core mission—innovation and development of world-class technologies. It is crucial to ensure that the policies in place not only support the growth of the defence sector but also safeguard the interests of small and medium businesses contributing to that growth.

Defence MSMEs in India are at the forefront of technological innovation and play a vital role in strengthening the nation's defence capabilities. However, the recent wave of GST notices targeting R&D activities has raised concerns within the sector. The imposition of GST on defence R&D hampers growth, discourages investment, and creates financial burdens for small businesses. To maintain the momentum of innovation in the defence sector, it is essential for the government to reconsider its approach, offering clearer guidelines and tax exemptions to encourage rather than hinder R&D efforts in the critical defence industry.

 

Manish Kumar Jha is a Consulting & Contributing Editor for SP's Aviation, SP's Land Forces and SP's Naval Forces and a security expert. He writes on national security, military technology, strategic affairs & policies.