Xiaomi royalty issue should be India’s cue to end tax arbitrage

An ugly spat broke out last week over Enforcement Directorate (ED)’s freezing of bank accounts of Xiaomi India Private Ltd to the tune of about ₹5,550 crore and Xiaomi accusing the ED of resorting to strongarm tactic.

The Karnataka High Court, however, has stayed the ED order under the condition that Xiaomi will not make further payment of royalties to foreign companies and would use its unfrozen bank accounts only for Indian payments Royalty indeed is at the heart of the issue.

Royalty payments – the bone of contention

The sluice gates of royalty payments to foreign collaborators were opened after the government liberalised the Foreign Direct Investment (FDI) policy in 2009. It had removed the cap and permitted Indian companies to pay a royalty to their technical collaborators without seeking prior government approval. Before 2009, royalty payments were regulated by the government and capped at 8 per cent of exports and 5 per cent of domestic sales in the case of technology transfer collaborations. They were fixed at 2 per cent of exports and 1 per cent of domestic sales for use of trademark or brand name.

Also read: ED seizes Xiaomi India’s assets worth over ₹5551 crore

The government found in 2017 that the ‘licentious’ royalty regime had resulted in quantum jump in royalty remittances and with a view to rein it in, the Department of Promotion of Industry and Internal Trade (DPIIT) had proposed last year that royalty payments should be capped at 4 per cent of domestic sales and 7 per cent of exports for the first four years; and for the next three years the limit should be 3 per cent of local sales and 6 per cent of exports.

In its considered opinion, therefore, royalty cannot be paid in perpetuity and must come to a stop after seven years.  The Finance Ministry, however, was at loggerheads with the DPIIT and it scuttled the proposal on the ground by arguing that it would send a wrong message to foreign investors.  The final word, obviously, is yet to be said on the issue.  It keeps resurfacing every now and then.

Is royalty a ruse for fund diversion?

To be sure, Research and Development needs to be encouraged and rewarded. Patents are granted to inventors to recognise their inventions as well as to enable collection of reward generally for 20 years in the form of royalty from the licensed users. But then, patenting is not compulsory though desirable with copycats and peeping toms lurking around dangerously.

The point is royalty can be paid even without the technology being patented.  And the more germane point is that state-of-the-art technology commands good royalty. Blockbuster drugs costing humungous sums on research spread, often over decades, beget good royalty from licensees.

The case for payment of royalty for technology is indisputable but the question is for how long and at what percentage.  If you leave the two determinants to market forces, the possibility of abuse of the licentious or permissive regime lurks as suspected by the Indian government. It suspects that royalty is a convenient ruse for camouflaging diversion of funds and undue enrichment of the foreign collaborator.

Even genuine collaborations like the one obtaining between Maruti Suzuki and Suzuki Japan have raised eyebrows and caused heartburn. That a hefty sliver 5.5 per cent of its annual sales is paid as royalty to the Japanese parent nearly four decades after the first car rolled out is cited as evidence of India getting a raw deal and its precious foreign exchange reserves getting drained pro tanto.

Component import economics

The continued import of key components like the gear box from the company’s Japanese factory lends credence to the charge that foreign parents fleece their own Indian babies. When key components are imported, there is obviously a lesser justification for royalty. Be that as it may.

It is not only the royalty regime that beckons both mindboggling royalties and illegal transfers wearing the veneer of royalty. Tax arbitrage – 20 per cent tax on dividends on foreign companies vis-à-vis the soft 10 per cent tax on royalties earned by foreign companies from Indian businesses – also provides the gravitas.

It is believed in knowledgeable quarters that foreign parents especially owning 100 per cent Indian subsidiaries don’t mind taking their rewards in the form of royalty in preference to dividend, thanks to this tax arbitrage.

Also read: ‘Untrue’: ED dismisses Xiaomi’s allegations of threat during probe

Coming back to Xiaomi India, ED stepped in on being tipped off by the Income Tax department. Both suspect payment of humungous royalties for no services rendered or no technology transferred especially to the two US companies who were paid in addition to the Chinese parent. Xiaomi has, however, vehemently denied saying it believes its royalty payments “are all legit and truthful” and were made for “in-licensed technologies and IPs used in our Indian version products.”

While the judiciary would do its job, the government must do its work. For too long, it has allowed things to drift.