By Naveen Aggarwal, Partner, Tax, KPMG India
Royalty payments by Indian entities to their foreign affiliates have become a bone of contention with regulators and minority investors in the recent past. The recent debate over increase in royalty rates and the regulatory clampdown on certain intra-group payments has further amplified the issue.
India continues to import and use foreign intellectual properties. The license fees paid increased exponentially to $8.63 billion in 2021, 72% more than the fee paid in 2015.
During the same period, although the receipts for use of Indian IP increased from $466 million to $870 million (bit.ly/3KEmmVP), the contribution of this segment is a mere 10% of the total outflows. During the last decade, India’s gross R&D expenses stayed at 0.7% of its GDP, much lower than its peers.
While royalty is a common practice for licensing IP, the tax authorities and minority shareholders perceive it as a profit extraction tool employed by foreign shareholders, leading to a near-term decrease in trust and confidence in such companies.
This begs the question how much royalty is fair, and how does one determine if it is discriminatory to minority shareholders.
MNCs globally and in India charge royalty for access to their brands, technology, and processes, which help the licensees to operate efficiently and scale up faster.
India, for several years now, has been toying with the idea to reintroduce caps on royalties after 2009, when the restrictions on such payments were removed. Presently, these foreign royalty payouts are subject to a rigorous tax scrutiny, especially from a transfer pricing lens, to ensure it is reasonable and at arm’s length.
Meanwhile, rising royalty payments to related parties are also being seen as a corporate governance concern. Based on the Kotak Committee’s recommendations, Sebi has provided that royalties exceeding 5% of the consolidated turnover should be pre-approved by minority shareholders. Payments to related parties below 5% only require approval of the audit committee or the board of directors.
Minority shareholders often become apprehensive and resistant when MNCs increase their royalty payouts, fearing that higher royalty payments will erode the entity’s profits and, in turn, erode their wealth. Furthermore, the regulators and investors often perceive those royalties are paid for old technologies or used as profit-shifting tools in cases where substantial value is generated by the subsidiary’s operations and its growth contributes significantly to the parent entity’s wealth.
However, the concerns of shareholders sometimes may not consider the long-term benefits that the use of IP can provide. It is a well-known fact that IPs have become increasingly important for present-age businesses, and companies that do not have a strong technology or brand risk losing out on growth and market share.
As per a recent study, contribution of IPs to the market value of S&P 500 companies has significantly increased from 17% in 1975 to 90% in 2020.
Therefore, a focus solely on short-term financial impact may be myopic and may fail to recognise the strategic and long-term value of the IP.
Even though some companies appear to have localised global brands, such localisation efforts are curated centrally, and may not be entirely locally driven. To maintain a strong and recognisable brand identity, it is important for businesses to ensure that its branding and messaging is consistent across different regions. This is often driven through centralised research and development efforts to avoid duplication across regions.
Additionally, the risk for the licensee is lower since there is lower upfront capital or expenditure laid out.
MNCs should substantiate the need and potential benefits for any change in royalty rates. Other relevant factors include the nature of IP, the rate of technology obsolescence, R&D spend of the group, rates charged between unrelated parties in arm’s length situations, and more. These factors vary between technology, brand, or other forms of IPs. A robust analysis of these factors will go a long way in establishing the rationale for such changes.
Overall, the disparity between royalty outflows and the royalties received by Indian companies for their IPs also highlights the need to revive India’s R&D investment climate through incentives and stronger IP protection laws. Taking a leaf from of the initial success of the Production Linked Incentive (PLI) scheme to promote manufacturing, the government should leverage India’s position as a key player in the global R&D value chain by creating a conducive environment for innovation and development of IPs in India.