In this article, Akanksha Mathur of National Law University, Delhi discusses royalty payment outflows from India.

What are Royalty Payments?

A royalty is a payment made by one party, usually a licensee or franchisee, to the legal owner of a particular property, patent, copyrighted work, license or franchise for the right to use it for the purpose of ongoing use to generate revenue. It is essentially a payment made by a party who wishes to use the property of another for profit-generation for the use of this property.

Royalty is an ongoing fee that is usually paid monthly or quarterly. It is usually calculated as a percentage of gross sales.

Royalty payment outflows are payments made by domestic companies to their foreign parent firms or by Indian citizens to foreign entities for the use of a property, patent, copyrighted work, license or franchise.

Royalty payments are made for acquiring a valuable technique or knowledge which helps a person to nourish his sales.

Regulating Royalty Payments in India

Different provisions have been issued by the government of India regulating royalties.

• Trademark/Brand Names

  • Press Note 6 of 1992 issued by Ministry of Commerce and Industry allowed Indian residents to use and purchase a trademark/brand owned by a foreign resident.
  • Press Note 9 of 2000 issued by Ministry of Commerce and Industry allowed the use or purchase of a brand/trademark by an Indian Resident without the transfer of technology, through an assignment or otherwise from a foreign resident under the automatic route (i.e. without prior approval) on the condition that royalty may be paid only up to the extent of 2% of export and 1% of domestic sales.

These limits have now been lifted following the shift to liberalise the Indian economy in 2009.

• Intellectual Property Rights with Technology Transfer under the Technical Collaboration Agreement

  • Royalty is permitted on any IPR with technology transfer under the automatic route, provided the payment does not exceed 5% on domestic sales and 8% on exports and lump-sum payment does not exceed $2 million.
  • The procedure for calculating royalty was given by the government in Press Note 18 of 1997 issued by Ministry of Commerce and Industry as follows-
    • The royalty will be calculated on the basis of the net ex-factory sale price of the product exclusive of excise duties minus the cost of the standard bought-out components and landed cost of imported loaf components irrespective of the source of procurement, including ocean freight, insurance, custom duties etc The payment of royalty will be restricted to the licensed capacity plus 25% in excess thereof for such items requiring industrial licensed. In case of production in excess of the quantum, prior approval of Government will have to be obtained regarding the terms of payment of royalty in respect of such excess production.
    • The royalty would not be payable beyond the period of the agreement, if the orders had not been executed during the period of agreement. However, where the order has been booked during the period of agreement, but executed after the period of agreement, royalty would be payable only after the Chartered Accountant Certifies that the orders have been firmly booked and execution began during the period of agreement and the technical assistance was available on a continuing basis even after the period of agreement.
    • The lump sum shall be paid in three installments detailed below unless otherwise stipulated in the approval letter – First 1/3rd after the agreement is filed with Reserve Bank of India, Authorised Foreign Exchange Dealer; Second 1/3rd on delivery of technical documentation; Third and final 1/3rd on commencement of commercial production of four years after the agreement is filed with RBI/Authorised Foreign Exchange Dealer, whichever is earlier. The lump sum can be paid in more than three installments subject to completion of the activities as specified above.
  • The remittances for royalty for IPR now fall under Foreign Exchange Management (Current Account Transactions) Rules, 2000

Disclosure Norms for Royalty Payments Under Various Laws

The disclosure norms for royalty payments have evolved along with different regulations devised by the government-

• Foreign Exchange Management Act, 1999

Under FEMA, the royalty computation was required to be certified by a statutory auditor on a financial basis and be submitted to the RBI. If any remittance was required to be made otherwise than in accordance with standard computation, the prior approval of the government was necessary.

• Income Tax Act, 1961

A certificate is required under Form 15CB from a statutory auditor to authenticate that the correct rate of TDS has been applied and remitted to the government under the Double Taxation Avoidance Agreement (DTAA) framework.

The e-filing of an undertaking under Form 15CA is also mandatory.

• Indian GAAP

Indian Generally Accepted Accounting Principles require an AS-18 form to be filed of the payments are made to an associated enterprise, along with disclosure of any material transaction.

• Foreign Exchange Management (Current Account Transactions) Rules, 2000

Under Rule 4 of the Foreign Exchange Management (Current Account Transactions) Rules, 2000, prior approval of the ministry of commerce and industry was required for drawing foreign exchange for remittances under technical collaboration agreements where payment of royalty exceeds 5% on domestic sales and 8% on exports, and lump-sum payment exceeds $2 million.

However, this policy was changed with effect from December 2009 when the government permitted payments for royalty, lump sum fee for the transfer of technology and payments for use of trademark/brand name without prior approval, using the automatic route.

Various Ways in Which Royalties Can Be Calculated

Royalties are traditionally established as a percentage of the gross sales, but there are variations in how the royalties can be structured.

• Fixed Percentage

Taking a fixed percentage of the gross sales is the most common way of calculating royalties. The gross sales are adjusted for taxes, returns etc. and is reported. A fixed percentage of the adjusted gross sales is calculated as royalty. This is done on an ongoing basis, usually monthly or sooner, and is the easiest fee structure to administer.

• Variable Percentage

  In the variable percentage system, the percentage of sales is not kept fixed. Rather, it increases or decreases with increasing sales.

  • Increasing PercentageUnder this system, a higher royalty rate is demanded as sales increase. This is usually done to provide additional compensation to the owner of the property for granting a market which is expected to traditionally have superior performance.

    While this form of a royalty structure is rare, it provides a way for a franchise to charge more for a location with a higher sales rate.

  • Decreasing PercentageThis structure requires the payment of a lower percentage of gross sales as the total sales increase, with the belief that reducing the percentage of royalty charged is only fair as gross sales increase. Moreover, this also acts as an incentive for increased performance while providing an acceptable rate of return. It also encourages a more accurate report of sales.

• Minimum Fee Structures

  • Minimum RoyaltyThe minimum royalty structure is used by the owner in order to impose financial performance standards or earn a greater return. When this structure is used, the franchisee has to pay a higher fixed minimum or percentage royalty based on sales. The royalty sees periodic increases based on the Consumer Price Index, or otherwise.
  • Fixed RoyaltyUnder this structure, the royalty is fixed and is not affected by per unit sales. This system assured a fixed return to the franchisor while the franchisee is able to receive the full benefits of increased unit sales. The fixed fee is adjusted frequently on the basis of the Consumer Price Index, or may be done on any other basis.

    It is not very commonly used as it may require the franchisee to pay a higher cost than they can afford, and the owner may not get a proper return based on a higher volume of sales.

• Transaction-Based

Transaction-based fees are popular in certain industries, such as the hospitality industry. Under this, royalty is charged for every transaction made through a central system, such as a central reservation system or call centre.

Taxation on Royalty Payments and Outflows Under GST

The Goods and Services Tax was introduced to overhaul the tax regime in India and integrate it into one single regime in order to increase the ease and lower the cost of doing business in India.

It is a destination-based tax wherein the burden of payment falls on the end user who consumes the goods or services. The tax is received by the State where the good or service is consumed, rather than the one where it is produced.

• Generally, it is the supplier of goods or services who is liable for the payment of GST. However, in specified cases, the government can notify certain goods on which the liability to pay the tax is placed on the recipient of goods and services under the Reverse Charge Mechanism. This is done under Section 9(3) of the CGST/SGST Act and Section 5(3) of the GST Act.
• Under a notification issued by the government, GST is applicable on the supply of services by an author, music composer, photographer, artist or the like by way of
  transfer or permitting the use or enjoyment of a copyright covered under Section 13(1)(a) of the Copyright Act, 1957 relating to original literary, dramatic, musical or artistic works to a publisher, music company, producer or the like.

Essentially, royalty payments under GST are subjected to the Reverse Charge Mechanism.

Effect of Royalty Outflows from India on the Economy

Governments traditionally are sensitive to capital outflows from their countries. Prior to 16th December 2009, the government had been pursuing a protectionist agenda under which they had limited the amount of royalty payment that could have been made from India to foreign citizens and entities. These could not exceed 5% of the domestic sales and 8% of the exports, with any lump-sum payment not exceeding $2 million in the case of IPR without any technical transfer, and 2% of the exports and 1% of domestic sales in case of royalties for a trademark or brand.

These limits and caps were instituted by the Indian government in order to reduce its deficit, control inflation in the economy, inhibit currency depreciation and increase foreign direct investment.

It came to be recognised that some flexibility was required in capital outflows to encourage multinational companies to invest in India to create jobs, offer goods and services and increase socio-economic development. These caps thus came to be removed following a shift to liberalise the Indian economy, with effect from 16th December, 2009. Indian companies were allowed to pay royalties to their foreign technical collaborators without needing to seek prior government approval.

Following the removal of this cap, royalty outflows from India consistently increased as a percent of FDI flows, rising from 13% in 2009-10 to 18% in in 2012-13 and thus reducing the efficacy of FDI.

High royalty outflows end up negating the effect of FDI inflows on the economy. These are also required to fund the country’s current account deficit.

Impact of High Royalty Payments

Royalty payments reflect a lot about the internal structures of governance of corporates, revealing their arbitrary nature. Companies follow no uniform policies for the disclosure of royalties, every company putting them under different heads. They perform hikes, giving no reason for them beyond having done ‘due diligence’. To evade the new provisions under Companies Act in 2015, they rapidly passed resolutions increasing their share of royalties.

In taking these decisions, multinationals have time and time again disregarded minority stakeholders, not even bothering to seek their opinions on these matters or explain their decisions. By implementing hikes and increasing royalty payments to the parent, profits are reducing, thus decreasing the dividends for shareholders.

It is also important to consider the position of royalties as extortionate payments extracted by multinationals from underdeveloped and developing countries. They result in the outflow of foreign exchange and reduce the revenues from taxation. Ignoring the larger public interest, royalty payments act as a drain on the economy.

Royalties have thus increasingly been used by multinationals as a tool to insulate their profit margins from the financial performance of their local arms by securing a source of surplus and returns for themselves. This has been done in order to protect their revenues from falling sales and the uncertainties of the market.

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References

1. http://webcache.googleusercontent.com/search?q=cache:http://www.lealte.com/articles/QUERYW~1.pdf&gws_rd=cr&dcr=0&ei=wyZLWvHSBI2UvQSXsK6wDA
2. https://www.caclubindia.com/articles/statutory-background-for-royalty-payment-in-india-6609.asp
3. http://www.cbec.gov.in/resources//htdocs-cbec/gst/reverse-charge-mechanism-08aug2017.pdf;jsessionid=E578AE31C8CCE18633F30156CA975B0E
4. https://rupeindia.wordpress.com/2014/03/09/royalty-payments-the-royal-treatment-of-foreign-companies-in-india/