[The Viewpoint] Cross-border royalty payments: A legal check

Doing Business 2020, released by the World Bank, acknowledged India as one of the ten economies that improved the most on the ease of doing business after implementing regulatory reforms.

India has, in the past few years, witnessed a plethora of initiatives, such as incentives to start-ups, lower/incentivized tax rates for domestic companies, single-window clearance, ease of doing business in India, etc. These measures have improved the investment climate in India which, resultantly, has culminated in a significant influx of foreign investment in the country. Depending upon the kind and scale of activity proposed to be undertaken by an Indian entity and the extent of ownership sought by the foreign counterpart, the latter can invest in an existing Indian entity or choose to start a new entity.

Indian subsidiaries, like subsidiaries elsewhere in the world, pay royalties to their foreign parents for a variety of reasons. For instance, auto and capital goods makers have to license technical know-how and support via collaboration. Drug companies pay for marketing rights, while consumer goods firms fork out money for brand equity. If the Indian company uses a technology or process or any Intellectual Property (IP) of the parent foreign company, then the Indian company is liable to pay royalties to the foreign company for such use.

Royalty means payment of any kind received as consideration for the use of or right to use any intangible property like copyright, design or model, secret formula or process, trademark, trade name or for information concerning industrial and commercial experience.

More often than not, royalty payments by Indian companies to their foreign counterparts come under scrutiny by enforcement and tax authorities. Back in 2000, Nestlé India was paying an annual royalty fee of ₹56.73 crore accruing to its parent company Nestlé SA in Switzerland. At 43.46 per cent of total profits, the amount came under the scrutiny of India’s Income Tax Department and the company was asked to justify the payment.

Recently in April 2022, Xiaomi Technology India Private Limited landed up in legal trouble as the Enforcement Directorate (ED) seized a whopping ₹5,551.27 crore from its bank accounts in India. It was alleged that Xiaomi India, a wholly-owned subsidiary of the China-based Xiaomi group, contravened the Foreign Exchange Management Act, 1999 (FEMA), which lays down rules for the transfer and receipt of foreign funds in the country. The probe was launched by the ED against Xiaomi India in connection with alleged 'illegal remittances' sent abroad by the company in February 2022, 'in the guise of royalty payments'. It was alleged that these remittances were made by Xiaomi India to three foreign entities which included one Xiaomi group entity and the transfers were made for the ultimate benefit of the Xiaomi group entities. Xiaomi India claimed that the royalty payments made were for the un-licensed technologies and IPs used in its Indian version products.

Funds can be repatriated from one country to another in multiple ways. The obvious implications are that all such repatriation transactions entail foreign exchange risks, compliance with the applicable laws and regulations etc.

This article aims to examine the relevant provisions of cross-border payment of royalty, applicable limits (if any), ramifications of non-compliance with the applicable provisions etc.

Under the FEMA, remittance of royalty payments is considered as current account transactions that are permissible under the automatic route under the FEMA (Current Account Transactions Rules), 2000. Prior to April 2010, such remittances made by Indian resident firms to foreign collaborators were capped at a lump sum of US$2 million and royalty payment at 5 per cent on annual domestic sales or 8 per cent on exports without prior regulatory approvals. If there was no technology transfer, royalty payments were permitted up to 2 per cent for exports and 1 per cent for domestic sales under the automatic route for use of trademarks and brand name. All such caps were removed retrospectively from December 2009. All royalty payments, however, need to be made in accordance with the Current Account Rules.

Xiaomi India filed a writ petition against the ED order of seizure and submitted before the Karnataka High Court that the payments of technology royalties made to three foreign companies situated outside India was not in contravention of the FEMA and the said payments have been held to be lawful by the Income Tax Department, which allowed the same as deductions. Xiaomi India also clarified that the technology royalty payments have been made during the period 2015-16 till date through authorised dealers, and in the absence of any material that Xiaomi India is possessing foreign exchange outside India, the ED order is unsustainable. It was also submitted by Xiaomi India that the condition precedent for invoking Section 37A of the FEMA is that the foreign exchange should be lying in a location situated outside India and should be available for bringing it back to India and in the absence of any material that the foreign exchange is possessed by the petitioner in the foreign country, the order of seizure passed under Section 37A of the FEMA is not sustainable in law.

The High Court stayed operation of the ED order of seizure till the next date of hearing, subject to the condition that Xiaomi India shall operate the bank accounts which were seized under the ED order only for the purpose of meeting the expenses for carrying out the day-to-day activities of the company. It was made clear that this order shall not confer any right on Xiaomi India to make payment in the form of royalty or any other form to the companies located outside India. The interim prayer for permission to make payments to foreign companies located outside India will be considered later by the Court.

It is not uncommon for revenue authorities to often ask taxpayers to demonstrate description of intangibles and the benefit accrued, whether royalty is embedded in import/sales price, and details of the owner of intangibles (foreign enterprise). At the same time, determining arm’s length royalty payment for transfer of intangible property can be a challenging exercise.

Like Xiaomi, another Chinese tech giant, Huawei Technologies, was also investigated by Indian authorities this year. However, the corporation stated that it was fully compliant with all rules and regulations in India. Given the enforcement obstacles that may emanate from cross-border payments, it is vital for businesses to ensure strict compliance with the applicable rules and regulations, including applicable provisions under the FEMA.

In case of cross border royalty payments, while the earlier cap on royalty payments has been removed, such payments do need to be made in accordance with the Current Account Rules. Further, given the stance taken by regulatory authorities, it is advisable for necessary documentation to be in place that substantiate the quantum of royalty payments being made (i.e., valuation reports, executed license agreements containing the terms for royalty payment etc.).

Ashima Obhan is Partner and Akanksha Dua is Principal Associate at Obhan & Associates.

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