"The Commerce and Industry ministry has circulated a Cabinet note for inter-ministerial consultation," sources said.
The proposal to raise FDI cap in defence from 26 per cent to 100 per cent is aimed at giving a boost to the manufacturing activities.
As per the 15-page Cabinet note, which was circulated today, portfolio investors, including FIIs, would be permitted to invest only up to 49 per cent.
Further, the note said that a foreign company can even take over a domestic entity provided it brings in state-of-the art technology.
This is the first major initiative of the ministry after new Commerce and Industry minister Nirmala Sitharaman took charge this week.
Sources said that permitting FDI in the sector "will hugely help in reducing import bill for defence equipment, will help in boosting manufacturing and creating jobs".
The UPA government had pegged FDI in the defence sector at 26 per cent but allowed Cabinet Committee on Security (CCS) to approve proposals entailing higher investments.
In May 2010, DIPP had rolled out a discussion paper suggesting increase in FDI cap for the defence sector.
India opened up the defence equipment industry to private sector in May 2001, but restricted foreign participation to 26 per cent in this capital-intensive and sensitive sector.
India is one of the largest defence importers in the world with a minuscule component of exports.
It ranks among the top ten countries in the world in terms of military expenditure. India at present imports over USD 8 billion worth of defence equipment and its defence budget is growing at an average of 13.4 per cent annually since 2006-07.
"The bulk of the domestic production is met either through the Ordnance Factories or the Defence PSUs. Even when defence products are manufactured domestically, there is a large component of imported sub-systems," DIPP had said.