A sunset for royalty payments

A sunset clause in the royalty agreement can help blunt the criticism of royalties as both a tax arbitrage tool and a way to move money out of India

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Royalties are being seen by authorities and shareholders in India as profit and cash suction instruments leading to a trust deficit. (IE)

By Rameesh Kailasam

Intellectual property (IP) rights have gained unprecedented importance in the commercial space. Entities that do not own IP rights themselves can still benefit from them through licensing. Indian subsidiaries of most foreign conglomerates are no exception to this, and wherever possible, gain advantage in the domestic markets by licensing world-famous brands and the latest technologies owned by their parent companies.

When the Indian economy opened up in 1991, the government allowed the remittance of royalties for use of technologies and/or brands within prescribed limits and subject to certain conditions under the automatic route (where prior government approval was not required) and this witnessed further relaxations until 2009 when the government removed all restrictions—including the cap on royalties. Before this, the royalty payments were regulated by the government and capped at 8% of exports and 5% of domestic sales in the case of technology transfer collaborations. In addition, they were fixed at 2% of exports and 1% of domestic sales for the use of trademark or brand names.

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In 2017, the government found that the royalty regime resulted in a quantum jump in royalty remittances. To rein it in, the department of promotion of industry and internal trade (DPIIT) proposed in 2021 that royalty payments should be capped at 4% of domestic sales and 7% of exports for the first four years, and for the next three years the limit should be 3% of local sales and 6% of exports.

Policymakers seem to have a strong view that the royalty route, many times, has and continues to be used to evade local taxes, an effective tool for benefiting from tax arbitrage and an excuse to move money out of India. The domestic point of view is also that it makes the Indian companies become less competitive as the playing field gets unfair and uneven. Experts also believe that the results of increased royalties are therefore damaging for the domestic Indian companies as it hurts their earnings, decreases the chances of a healthier dividend roll-out to minority shareholders, along with a sizeable loss to the exchequer. Recently, the Union Budget increased the tax rate from 10% to 20% for incomes earned in the nature of royalty and fees for technical services, which seems to be an effort to address part of the problem around routing.

While payment of royalty for technology innovation may be considered necessary, the question that arises is for how long and at what percentage. Sunset provisions can be ideally be included in royalty agreements, as they reflect the principle that intellectual property rights are not meant to be perpetual. When the sunset provision is triggered, the royalty payments stop and the IP rights may also become available for others to use. The length of time for the sunset provision to come into force can vary depending on the IP, industry and other factors, as IP laws aim to balance the interests of creators with those of society. While creators are granted exclusive rights to their works for a limited time to foster innovation, ultimately these rights should benefit society by allowing for new creations and knowledge dissemination. This will also benefit consumers by reducing the cost of products or services that use IP.

Indian policymakers have, in the past, appealed to various sectors, including automotive, to find ways to reduce payments to the foreign parent companies for use of technology or brand names. It has also been observed that the royalty outflows were considerably high even for old and obsolete technologies that were on their way out. At the moment, India does not restrict the amount that can be paid as royalty, and any payment by a locally listed company exceeding 5% of revenues requires shareholder approval. The huge payouts can be understood by the fact that in many cases these run into millions of dollars per company.

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A study by proxy advisory firm Institutional Investor Advisory Services (IiAS) shows that for 31 companies that were covered in its report, royalty payouts doubled between 2012-2019 to a whopping `8,300 crore, with the top five MNCs accounting for nearly 80% of the aggregate royalty paid.

It is important to mention that royalty payments by multinational corporations (MNCs) contracted by 10% in FY21 compared to a contraction in pre-tax, pre-royalty profits of 5%. as well as in FY20 they had contracted by 9.5%. During the pandemic many surprisingly paid out extraordinarily high dividends to their parent companies.

Royalties are being seen by authorities and shareholders in India as profit and cash suction instruments leading to a trust deficit.

This also fundamentally triggers the need for Indian companies and startups to invest and deploy bright Indian minds into R&D so that we as consumers will be able to get access to world class products emanating out of India and will naturally bring down the consumption of products that involve repatriation of such large royalties overseas.

The writer is CEO,

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First published on: 11-05-2023 at 04:15 IST