There’s a case for heavy taxes on royalties that MNC units pay their parents

Even as revenue growth for companies in India has reduced its pace to a canter, royalty payments sent abroad by several Indian offshoots of multinational companies (MNCs) are galloping ahead. In several cases noted by market regulator Sebi, royalty payments exceed dividends. In fact, the higher the firm’s expense on royalty payments, the lower the profit and thus lower the possible dividend outgo from it.

In 2023, the Indian government increased the withholding tax on royalty payments and fees for technical services from 10% to 20%. In fact, there is a strong case for raising the normal tax on royalty payments to the applicable corporate-tax rate. On some types of royalty-payment hikes that have no rational basis, the tax rate on the incremental payout could go as high as 100%.

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To curb excesses in this practice, it is not enough for Indian rules to require that locally listed units of MNCs get shareholder approval for raising royalties. Accountability to equity holders needs to be equitable and sharp, no doubt, but we need fiscal action as well.

All royalty claims are not equal. Those paid for intellectual property (IP) licences are the most legitimate. Patents and other forms of IP have a definite life expectancy; by the time they expire, companies are expected to have fully recouped their investment in them and earned a decent return. While trademarks need renewal, a brand name with special consumer appeal might be what sets a product apart from its competitors.

In such cases too, brand strength may justify a royalty. But when it comes to brands that most of us can hardly even recall, let alone identify with or value, the logic weakens. It’s hard to see why Hindustan Unilever Ltd (HUL) would’ve paid its parent Unilever royalty on its Knorr label slapped onto flour and the like (before Unilever sold off its flour and salt business in 2023), for example.

That name of German origin was no match for its own homegrown atta brand Annapurna, which it offloaded last year along with Captain Cook salt. On the whole, it is unclear how local MNC units justify their rising royalty bills. It might be argued that royalty payment excesses will self-correct.

Also read: Why royalty payout to parent firm as a percentage of revenue needs to be relooked

After all, if any company were to load its product pricing with a liberal slather of royalty, a local competitor that is not so burdened, but has invested in brand credibility, would be able to undercut the royalty-paying player and corner a larger share of the market.

This pressure would work only if both play in the same quality bracket, though. A graded tax on royalties, with the rate going up as transfers grow as a percentage of revenues, would not only deter local MNC units from overpaying parents, but also magnify the self-regulatory power of market competition.

What’s logged as an expense by the Indian unit of an MNC is not a conventional cost, given that it is a decision in which its power equation with the parent may play a big role. In fact, at a conceptual level, royalty is a return on capital invested. Like profits.

Or interest payments in the hands of lenders, which are taxed on these as it amounts to income for them. Royalty should be taxed in India on par with any other form of return on capital.

Levies on royalty should be seen in the same light as taxation of profits, interpreted as what companies owe the government for governance that enables companies to do business and generate returns on capital. All said, while shareholders do need to take a closer look at royalties, fiscal action could be especially effective.

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