Why is India worried about royalty payments to foreign companies?

Traditionally, governments across the globe have been sensitive to outflows of capital from their countries. However, it is recognised that a country must provide some flexibility in capital outflows to encourage multinational corporations to invest in the country in order to create jobs, offer goods and services and increase socio-economic development. In return, such corporations are expected to provide advanced technology and training to increase the skills of the country's workforce. Hence, although governments allow domestic companies to pay royalties for IP rights and technical know-how to foreign companies, regulators try to ensure that the payment of royalties does not result in unnecessary outflows of capital.

The Indian government is grappling with this issue as it strives to reduce its deficit, control inflation and currency depreciation, and increase foreign direct investment (FDI). Before December 2009 an Indian company could make automatic payments to a foreign company for the transfer of technology or licensing IP rights only if the transfer fees were up to $2 million or if the royalty (other than for trademarks and brands) was up to 5% of domestic sales or 8% of export sales. For royalties on trademarks and brands, the limit was up to 2% of exports or 1% of domestic sales. Where the fees or royalties were higher than these limits, the proposed payment required prior government approval. However, in December 2009 the rules for royalty and fee payments were relaxed and the limits were removed in order to create an economic environment conducive to technology transfer and FDI into India. It was also thought that by removing the prior approval requirement, transaction costs would be reduced and transparency would increase.

In reality, however, the changes have resulted in an increase in payments to foreign companies without commensurate benefits accruing to the Indian companies making the payments. According to the Department of Industrial Policy and Promotion, total royalty payments have increased from 13% of FDI into India in 2009-2010 to 18% in 2012-2013, thereby substantially reducing the benefits of FDI. In the case of a subsidiary paying royalties to a parent company, the increase in the percentage of royalties being paid may result more from the diversion of profits earned by the Indian subsidiary than from any additional value provided by the parent company. Already, a number of Indian subsidiaries of multinational corporations have announced a phased increase in the percentage of royalties being paid to their parent companies. Further, because in India royalty payments are deductible for the computation of earnings before tax, this also results in a decrease in direct tax collections from the Indian subsidiary. While royalties do attract withholding tax, depending on the tax residency status of the parent company and any applicable double taxation avoidance agreement, the effective withholding tax may be nil. Moreover, concerns have been raised regarding the costs imposed on minority shareholders of Indian subsidiaries by allowing parent companies to take a portion of the earnings before tax as royalties.

All of these factors have led to government discussions regarding the reintroduction of curbs on royalty payments. According to media reports, the Department of Industrial Policy and Promotion is likely to release a discussion paper within the next few months asking for suggestions from stakeholders as to how best to deal with this issue. While some form of restriction is likely to be introduced, it may not be in the same form as presented previously. A number of options are available to the government – for example:

• making royalty payments non-tax-deductible, particularly for royalties on trademarks and brands;
• linking royalty payments to value addition from the foreign companies; and
• regulating the amount of royalty payments that can be made to a related company.

Given that India needs to attract more FDI, it is hoped that the government will arrive at a solution that is reasonable and does not undermine investor confidence, while addressing domestic concerns.