Should the govt cap royalty payments

Updated: May 15 2014, 02:08am hrs
Recent news suggests that the government of India is considering reintroducing the restrictions on royalty payments paid by the Indian subsidiaries to their foreign partners. It is believed that the excessive outflow of funds from the country in lieu of the technology transfers and know-how, use of brand/trademark fees, etc, provided by the foreign sponsors has triggered this move.

Clearly, increasing tax on royalty from 10% to 25% in the previous budget has not met the Centres expectations; given the current double taxation avoidance agreements with most countries, it was not expected too.

Until late 2009, while lump-sum payments for technical collaboration were capped at $2 million, running royalties were capped at 8% of exports and 5% of domestic sales. Similarly, royalty payable for the use of trademark and brand name of foreign collaborator were capped at 2% of exports and 1% of the domestic sales. Caps aside, the approval process was cumbersome, with a higher likelihood of rejection rather than approval.

However, in December 2009, the Indian government liberalised the payment of foreign technology collaborations and royalty fees bringing it under the automatic route to boost FDI.

While this may have brought in the best practices from repositories globally through technical consultancies and services, it has had a few unintended consequences.

Data for royalty and related payments (which include know-how, technical and trademark charges, as well as fees for licences, professional consultancies, managerial and administrative related services and, information and technology related fees) of 25 multinational companies suggests that these payments have gone up substantially without a commensurate increase in either sales or margins.

While in FY09, these 25 companies paid about R1,900 crore as royalty and related payments, this number jumped to over R4,950 crore in FY13. In comparison, net sales have grown by a meagre 71% while the bottom line of these 25 companies has grown by an even lower percentage at 36%.

Does this mean that the earlier royalty ceiling be reintroduced The FY13 data shows only two of the 25 companies would breach the 5% cap on domestic sales and 13 the 2% cap. So, reimposing caps on royalty payments at the earlier levels may not serve much purpose.

I also believe companies are inventive: even if this cap is lowered, companies will structure technical collaboration fees, brand and trademark fees to circumvent the administrative hoops required for approval.

In any commercial arrangement between listed companies and related parties, transparency and disclosures levels are paramount. And so is the requirement to align these arrangements with the companys financial performanceonly then can such payments be justified.

Section 188 of the new Companies Act requires these arrangements be subject to shareholder approval with 75% of the public shareholders voting in favour of the resolution.

At the time of approaching investors, we expect the corporates to build a business case for royalty and related payments which is backed by financial numbers so it supports their case for such payments.

This process will help quantify the impact of such payouts on the companys balance sheet. Should these transactions qualify the arms length test and prove to be critical to companys business operations, we believe the necessary checks and balances can safely be assumed established.

Having scrapped the regulation, it can also be argued that letting companies decide has not worked either. The next step is letting shareholders have their say. Only if this does not have the desired outcome is there scope for regulatory intervention.

Amit Tandon

The author is managing director, Institutional Investor Advisory Services India (IiAS)

In fiercely competitive markets, success depends on production quality, innovation, low costs, and the right marketing strategies. Often, subsidiaries of foreign companies have better access to the intellectual property (IP) rights owned by their parent companies and are often the chosen licensees.

In India, till 2009, payment of royalties was capped at 5% of the domestic sales for technical collaboration and 2% for the use of brandname and trademark. In December 2009, the government scrapped these limits in a bid to promote FDI and technology transfer. This move reposed confidence in foreign providers of technology and IP holders and was hailed by the industry. Recent news reports indicate that the finance ministry is examining a proposal to reintroduce restrictions on royalty payments by Indian arms of foreign companies due to concerns of increased royalty payments.

Royalty is a fee paid for the use of technology, patent, copyright, brandname or anything owned by another entity to achieve increased sales and profitability. When a company uses something owned by another, it is bound to pay for that; it is the valuation that is often debated, especially when the two companies are related. Concerns arise when royalty is demanded for something whose value cant be easily assessed, such as brandname. These concerns are addressed through systemic checks across regulatory channels and there is no need for a blanket cap. Transfer pricing regulations mandate that any international transaction between associated enterprises should be carried out at an arms length price.

Payment of royalty has been a subject matter of rigorous tax litigation on a range of issues, including on what would constitute an arms length payment for the purposes of transfer pricing acting as a deterrent to companies from adopting an unusually high rate of royalty payment.

Introduction of the advance pricing mechanism allows companies to seek guidance on the appropriate rate of royalty for the purposes of transfer pricing which would provide certainty and reduce litigation. The government increased the withholding tax on royalty and fee for technical services paid to overseas entities from 10% to 25% to keep a check on royalty payments. A disproportionate royalty payout would result in an inequitable treatment to the minority shareholders since lower profitability would result in a lower dividend payout with little consequence to the foreign parent. This issue has been a matter of intense debate and the government has sought to address this through the Companies Act 2013.

The new Act attempts to legislate on related-party transactions (RPT), the category in which such royalty payments should fall. In case of an RPT, the Act mandates that a special resolution be passed, but only by members who are not a related party. The introduction of the majority of minority rule promises to lend an independent voice to minority shareholders who would now be the sole decision-makers in conflicting matters. The attempt to raise the bar on corporate governance in the new Act would go a long way in ensuring transparency and equity in the conduct of business. Increased shareholder activism through class action suits which is now introduced and the emergence of proxy advisory firms who keep a close eye on corporate actions could prove to be a significant factor to protect the interest of the minority shareholders.

A liberal royalty regime assists inflows of FDI, and regulatory barriers should not come in the way of sharing of expertise. Any attempt to reintroduce the cap on royalty payments would be viewed as a regressive step by the industry and would take away the obvious advantages as discussed earlier. Policymakers should repose trust on the existing measures introduced by the government to ensure fair play rather than change the game by introducing the royalty cap.

Girish Vanvari

Co-authored by T Krishna, manager, M&A tax, KPMG in India

The author is co-head of tax, KPMG in India. Views are personal