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Govt looking to reimpose limits that were removed in 2009; experts say move will be seen as regressive

India may again cap royalty payments that local firms make to their overseas parents to restrict the outflow of foreign currency, a move that experts say will be seen as regressive.

Companies could earlier only remit royalty involving foreign technology transfer up to 5% on domestic sales and 8% on exports, and up to 1% for domestic sales and 2% for exports when no technology transfer was involved, such as on account of brand value. They required the approval of the department of industrial policy and promotion if the payments exceeded these limits.

The department now wants to reimpose these same limits that were withdrawn in December 2009, according to two officials familiar with the matter. They spoke on condition of anonymity.

“The minister is appraised of the matter, the file is with him,” an official of the department said. “Only once he gives the go ahead, the cabinet note can be prepared.”

Some domestic companies sharply increased royalty payments to their parent firms after the government relaxed the rules, according to a December 2012 report by Institutional Investor Advisory Services India Ltd, a proxy advisory firm.

A study of 20 such companies showed that royalty payments to foreign parents tripled to Rs.3,601 crore in 2011-12 compared with Rs.1,196 crore in the year ended March 2008, whereas sales grew by only 70% in the same period.

The government, in the national budget for financial year 2013-14, raised the tax on royalties that domestic companies pay to their parents abroad to 25% from 10%. But the higher tax rate applies only in cases where the foreign parent is based in a country with which India does not have a double taxation avoidance treaty.

If the government does consider such a step, it will be a retrograde one, said J.N. Gupta, a former executive director with capital markets regulator Securities and Exchange Board of India.

“Such moves make investors jittery and are knee-jerk reactions,” Gupta said, adding that it makes more sense to tax a premium on brand value creation rather than new technology coming into the country.

Companies such as Hindustan Unilever Ltd and Switzerland-based Holcim Ltd’s Indian units, ACC Ltdand Ambuja Cements Ltd have increased royalty fees to their parents in the past few months.

In December, Hindustan Unilever said it will increase royalty payments to its parent, UK-based Unilever Plc., the world’s second-biggest consumer-goods company, from about 1.4% of net sales to 1.9% in the year to March, and then steadily raise this to 3.15% in fiscal year 2018.

ACC and Ambuja Cements agreed to hike royalty payments to Holcim to 1% of net annual sales from January from around 0.6% earlier. Shareholders of both firms have opposed the plans.

“The fact that the government is considering such a move indicates that it is looking to bring in some capital controls given the adverse movement in the currency market,” said Sunil Jain, a tax partner at law firm J. Sagar associates. “It will have a destabilizing effect.

We have only recently started giving positive signals to foreign investors and emerging from the effects of retrospective amendments to tax laws. This will look like a regressive step.”

The rupee has lost more than 14% this year against the dollar after touching a record low of 68.85 on 28 August. The country’s current account deficit widened to 4.8% of gross domestic product in 2012-13, compared with 4.2% in the year ended March 2012.

If the measure to limit royalty payments is on the cards, it will be a double whammy, said Mukesh Butani, chairman of BMR Advisors, a consultancy.

“The government has already increased the tax rates on royalty payments in this year’s budget. Over and above that, if the government is looking at bringing exchange-control restrictions, it will face a challenge managing sentiments,” Butani said. “But the finance minister had assured last month that as far as current account transactions are concerned, there will be no restrictions.”

Royalty payments by domestic companies already face many impediments, Jain said.

“The government has increased the withholding tax on royalty to 25% from 10%, though in most of the cases tax treaty rates that are around 10-15% will apply,” he said. “There are also transfer-pricing implications. Companies have to benchmark royalty with those paid by other companies.”

“Also, there will be sufficient paper trail to monitor such payments given that the income-tax department now requires domestic entities to disclose international transactions with group companies even if they do not have any impact on profits,” Jain added.

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