As Canada undertakes modernisation of its armed forces, the country’s offset requirements remain somewhat tricky to navigate.
Canada is currently engaged in what could be described as a once in generation defence modernisation programme. For the first time in many years, the Canadian Forces are moving forwards on a range of significant defence procurement programmes, and they have the funding to make these programmes a reality. Inevitably, taking these acquisition programmes from concept to completion is a complicated process. The answer to an operational requirement is multi-layered, having the best solution on paper to a requirement is certainly important, but not always enough. Canada, like many other countries, wants more from its defence procurement spending and that brings us to the complicated question of offsets.
The Canadian Department of National Defence (DND) is working to a policy document known as “Strong, Secure, Engaged – Canada’s Defence Policy.” This was first published in 2017 and the objective was to deliver: “The most rigorously costed Canadian defence policy ever developed. It is transparent and fully funded. To meet Canada’s defence needs at home and abroad, the Government will grow defence spending over the next 10 years from CAD 18.9 billion in 2016-17 to CAD 32.7 billion in 2026-27. The long-term funding commitment that underpins this policy will provide the Canadian Armed Forces with the force size and equipment required to achieve excellence across the full spectrum of military operations, from humanitarian assistance and disaster relief, to peacekeeping, to combat. This policy includes long-term investments to enhance the Canadian Armed Forces’ capabilities and capacity.”
The DND states that it is: “The largest department within the federal government in terms of budget and size. In 2021-22, DND’s budget accounted for approximately 7.1% of the total Main Estimates for Canada.” Clearly DND procurement expenditure is strategically significant for the national economic/industrial picture in Canada and, as a result, the DND must seek to maximise the benefits that can be obtained from its procurement expenditure. Added to this if DND expenditure can sustain a robust defence industrial base in Canada, it would provide strategic, economic and industrial benefits. If Canada could meet all of its defence needs from domestic suppliers that would be an excellent proposition, unfortunately that is not possible and so Canada has to turn to foreign suppliers. To ensure that the strategic and economic benefits of defence procurement are not exported overseas as a result of buying from foreign suppliers, Canada has instituted a comprehensive offset policy.
The Bureau of Industry and Security of the US Department of Commerce, describes offsets as follows: “Offsets in defense trade encompass a range of industrial compensation arrangements required by foreign governments as a condition of the purchase of defense articles and services from a non-domestic source.”
For those that become immersed in the world of offsets, that US definition is somewhat limited. The reality of the situation is that offsets are an incredibly complicated and time-consuming process, that, over the years, have become part and parcel of defence acquisition programmes. Offset requirements differ from country to country in terms of scope and complexity. However, meeting national offset requirements is an essential part of conducting defence business. Furthermore, failure to meet offset obligations leaves contractors open to financial penalties and potentially exclusion from future acquisition programmes.
Generally speaking, offsets can be divided into two categories, direct offset and indirect offset. Direct offset, as the name implies, is directly related to the systems being purchased. For example, the purchasing country acquires combat aircraft and then builds them under license, the value of that work is then deducted from the seller country’s total offset obligation. Alternatively, industry in the purchasing country could produce systems or subsystems that are integrated with the combat aircraft being acquired, with the systems becoming a standard fit for said combat aircraft and then exported to other purchasing countries.
For the purchasing country direct offset is very attractive, taking our example of a combat aircraft as a case in point, the purchasing country’s aerospace industry gets work, acquires new technology and expertise, thus improving its defence-industrial capabilities. The involvement of local industry also eases service and support of the equipment, while also creating a knowledge base that could support an upgrade programme at a later date, if required.
Indirect offset offers a completely different set of possibilities to fulfil offset obligations. The obligation could be discharged in numerous ways, for example an aerospace company might award contracts/sub-contracts to industry in the purchasing country for work on other programmes. Other investments in the purchasing country could also be counted against the offset obligation, for example investment in industry or even property. Property investment could for instance involve building a hotel with local partners, with a management contract awarded to a global brand, leading to the initial investment and ongoing profits being counted against the offset obligation. Other options include the purchase of goods and services, from food to fabrics, which can again be counted against the obligation.
With indirect offset, much depends on the country where the offset obligation is owed, specifically what they are prepared to accept in terms of indirect offset. Another important factor in the cost and complexity of dealing with indirect offset are the diverse products that could form part of the offset. A defence company is unlikely to have the knowledge and skills necessary to market and sell foodstuffs or textiles, they will therefore need to transfer title to these goods to an organisation that can successfully sell them, with this activity almost certain to cost the defence company money. Offset inevitably incurs monetary costs for the company with the obligation, which in turn means offset costs have to be accounted for in the original acquisition bid.
In an ideal world a defence company would happily do without offset, it is complex, costly and is not core business. Unfortunately, these days in the majority of cases defence acquisition has moved on from the supplier and/or their home government offering the foreign customer loans or financing to fund purchases. Offset has become a fundamental part in the mechanism of defence exports.
Offset rules and regulations differ from country to country, there is no international standard in this area. Contemporary offset requirements can vary from a little over 50% to over 100% of the value of the original acquisition price. Differences emerge in different countries’ offset strategies depending on the objectives that the purchasing country seeks to obtain from offset. For some it is about compensating for the outflow of funds to a foreign supplier, achieving local industrial participation and acquiring advanced technologies, while using indirect offsets for various purposes such as the encouragement of non-traditional exports. Others see offset as providing much more than that, beyond the economic and industrial aspects, believing that, if used correctly, offset can deliver significant societal benefits as well.
The Canadian Example
Canada provides an excellent example of a nation that seeks to maximise the benefits of its offset policy covering economic, industrial and social sectors. Offset in Canada is known as the Industrial and Technological Benefits (ITB) Policy, this policy is designed to leverage: “defence and Canadian Coast Guard procurements to contribute to jobs, innovation and economic growth across the country. The ITB Policy contractually requires companies awarded defence procurement contracts to undertake business activity in Canada equal to the value of the contracts they have won.”
Thus, Canada operates a 100% offset policy on all procurements over CAD 100 million in value, unless trade agreements or national security exceptions come into play. Defence procurements valued at between CAD 20 million and CAD 100 million can be reviewed to establish whether they will be subject to the ITB Policy.
Administration of the ITB Policy comes under the Innovation, Science and Economic Development (ISED) department of the Canadian government. To conform with the objectives of the ITB Policy, foreign companies seeking to bid on programmes must also include an economic proposal known as the ‘Value Proposition.’ This is important, as: “the Value Proposition is a weighted and rated element of the bid selection process and is scored alongside technical and cost requirements.” Following this process, then: “ISED determines the economic benefit requirements for each Value Proposition on a procurement-by-procurement basis. These requirements are evidence-based and developed through market analysis and industry engagement.”
The Value Proposition has what are described as ‘five pillars,’ these are:
1. Work in the Canadian defence industry.
2. Development of Canadian suppliers.
3. Research and development (R&D).
4. Exports and skills development.
This translates into supporting the long-term growth and sustainability of Canada’s defence industry, supporting the growth of prime contractors and suppliers in Canada, including small and medium businesses (SMBs) in all regions of the country, enhancing innovation through R&D in Canada, increasing the export potential and international competitiveness of Canadian-based companies, and finally, filling skills and training gaps within the Canadian economy to support increased innovation.
The ITB Policy exists to deliver “positive economic outcomes,” but as previously mentioned it also has social implications. Since May 2018 ISED has amended the Value Proposition to include a mandatory Gender and Diversity Plan, in order to meet the Canadian government policy of “advancing gender equality, diversity, and inclusion.” ISED notes that the Gender and Diversity Plan is not an evaluated component of the ITB at this point. Nonetheless states that: “bidders are required to describe their approach to achieving gender balance and increasing diversity within their Canadian corporate structures and broader supply chains in Canada.”
All of this demonstrates that there are lots of moving parts for a company to consider as it seeks to win defence business and comply with the ITB Policy. From the Canadian perspective the ITB Policy is demonstrably successful, ISED describes it as “a powerful tool for driving economic growth, investments and innovation in Canada.” According to ISED since the ITB Policy came into effect in 1986: “Canada has leveraged billions of dollars in investment, resulting in defence sector growth and spillover benefits to the broader Canadian economy. Prime Contractors on procurements where the ITB Policy applies are obligated to make investments equal to the value of their contract. These investments benefit Canadian companies, post-secondary institutions (note: these are higher educational institutions), and charities/not-for-profit organisations.”
Meeting the Challenge
The ITB Policy is a fundamental part of the Canadian defence procurement environment, there is no escaping it if you want to do defence business in Canada. The title of this article referred to the offset policy as the “Offset Maze”, and there is no doubt that the ITB Policy is a complex policy to navigate.
However, working under ITB need not be that challenging, the key is to establish long-term relationships with Canadian companies that can meet the requirements of the Value Proposition for both current and future programmes. For Canadian companies the ITB Policy is a proven winner, but according to Mike Lewis, Managing Director of Raytheon ELCAN, it can also be a winning proposition for companies seeking to do business in Canada. The key is making ITB compliance a fundamental part of the planning process for a Canadian requirement right from the start. To make that work, it is critical to identify a credible Canadian partner company at the outset and then to work with them to develop the best possible ITB solution. Putting together the ‘best possible ITB solution’ can be a real difference maker in winning a procurement contract.
By working with Canadian companies such as Raytheon ELCAN, foreign companies can also take advantage of their Canadian supply chains giving them access to a wide range of small and medium businesses across the country. These supply chains include minority and First Nations-owned companies, additionally Raytheon ELCAN itself is deeply invested in diversity, equity and inclusion programmes both internally and amongst its suppliers. All of this contributes for the basis for effective ITB solution.
Mike Lewis added that Raytheon ELCAN is much more the just a long-term strategic partner for foreign companies seeking to meet the requirements of the ITB Policy. Relationships that started with foreign companies on the basis of ITB issues have grown to become long-term commercial relationships as Raytheon ELCAN’s optics capabilities were discovered and utilised. For many, Raytheon ELCAN is known for its SPECTER family of infantry weapon sights, but the capabilities of the company have become significantly broader, comprising of a range of precision optics solutions for defence, commercial and space applications.
To conclude, the Canadian government and Canadian industry have long realised that to remain competitive across critical economic sectors that they must invest in skills development and training. They must also invest in their educational system, particularly in the science, technology, engineering, and mathematics (STEM) fields. This creates a workforce that works on today’s high technology programmes and also provides the innovation skills base for the programmes of tomorrow. The ITB Policy also contributes to education, skills development and training, demonstrating how today’s offset programmes can have a significant impact far into the future.