Private startups and various micro, small, and medium enterprises (MSMEs) are beginning to receive notices demanding an 18% tax under the Central Goods and Services Tax (CGST) Act for funding provided by the Ministry of Defence (MoD) for research and development (R&D). Government officials have expressed concern that this approach essentially “taxes innovation,” undermining Prime Minister Narendra Modi’s emphasis on achieving self-reliance in the military sector.
In a recent notification issued on October 8, 2024, the GST Council has exempted government research institutions, universities, and entities registered with the Department of Scientific and Industrial Research (DSIR) from this tax. However, private organizations are still subject to the 18% tax, prompting them to voice their concerns to the MoD.
The MoD actively supports innovation through R&D funding allocated to the Defence Research and Development Organisation (DRDO) and various initiatives like the Innovations for Defence Excellence (iDEX) scheme, aimed at empowering MSMEs to achieve self-sufficiency. This funding initiative was enacted as the central government recognized the challenges faced by defence public sector undertakings (PSUs) in meeting the modern technological demands of the armed forces.
One notice, reported by businessline, indicated that a company was required to pay an 18% tax under Section 13(2) of the CGST Act, 2017, upon receiving an initial installment of a grant intended for an R&D project for the Indian Navy. The startup contested this tax imposition, arguing that they were not providing a service but rather developing and manufacturing a product for the Navy. They maintained that the funds were intended for initial expenses and should not be classified as an advance.
An official from the MoD criticized the taxation of government R&D funds allocated to private firms, labeling it as detrimental to innovation and potentially discouraging startups and MSMEs, who often struggle for financial resources. This situation contradicts the government’s stated commitment to increasing R&D investment, as the 18% CGST effectively siphons capital back from private players.
A representative from the Society of Indian Defence Manufacturers (SIDM) highlighted that the CGST tax on private innovators disrupts the balanced environment that the MoD aims to foster through increased participation from private entities in military hardware and software development under DRDO initiatives like iDEX and the Technology Development Fund (TDF).
This individual called for a re-evaluation of grant-in-aid policies. Another leader from a prominent defence startup indicated that this taxation undermines initiatives like iDEX, which have successfully aided several startups in developing competitive indigenous defence products capable of thriving in the global market.
Sources from the private sector suggested that these notices may arise from confusion among MSMEs regarding how to classify government funding in their financial records. Some may inaccurately categorize grants as ‘revenue’ instead of liabilities, which they are required to settle once their innovations materialize into contracts with the armed forces.
For the fiscal year 2025-2026, the budget allocation for the DRDO stands at ₹26,816.82 crore, which is a 12.41% increase from the previous year’s budget of ₹23,855.61 crore. Of this allocation, ₹14,923.82 crore is designated for capital expenditure and funding R&D projects, including those involving private players. Additionally, the iDEX scheme has seen a significant increase in funding, with an allocation of ₹449.62 crore—almost triple its budget over the past two years.
