Statutory background for Royalty payment in India
The very nature of the term Royalty indicates a disguised share of profit and it is paid for acquiring a very valuable knowhow or technique that assists a person in nourishing his sales. Let us navigate in the same fashion as we do while comprehending a typical Accounting standard. Firstly there are rules to be observed on Initial recognition, then subsequent measurement and finally disclosure requirements.
To commence with the regulations surrounding the point of initial recognition,
Royalty under Foreign Exchange Management Act 1999:
Royalty agreement has to be carefully drafted so as to incorporate the correct method of computation of Royalty. It may be noted that with effect from 16.12.2009 Royalty is permitted through Automatic route (i.e. without RBI approval necessity) at any percentage without any ceiling (previously it was 5% on domestic sales and 8% on exports). But the condition remains that the standard procedure prescribed by RBI has to be followed and that a certification to this effect will be required from statutory auditor which has to be filed with RBI. The standard procedure is Net Sales minus cost of standard bought out components minus Landed cost of imported components (irrespective of the source of procurement) including ocean freight and insurance. The word used is component instead of raw material for the simple reason that Royalty is payable on the value addition generated on a sub part through materials and further processing which is due to the know how acquired from a third party.
Royalty under Customs Act, 1962:
Royalty which is conditional to the sale agreement as payable by the buyer either directly or indirectly is to be added to the Invoice price under the Customs (Valuation of Imported Goods) Rules, 1988.
Royalty under Service Tax law:
Royalty is categorised under Intellectual property service payments by the Finance act 1994. Service tax @10.3% (existing) as well as R&D Cess @ 5% is payable with the facility to set off the R&D Cess against the Service tax liability and this Service tax is available as Cenvat credit. Payment of Service tax @ 10.3% and ignoring the R&D cess is not an excuse. Since in current scenario most of the Royalty payments are cross border transactions, service tax often happens to be the liability of the Indian resident. Further the ST liability is attracted upon credit in the books if the payment is to an associated enterprise.
A recent noteworthy development is that the Government has released the draft on Point of Taxation (For services provided or received in India) rules 2010. (Details found in http://allindiantaxes.com/st-draft-cir-2010-1.php
). It should supply enough clarity on lot many grey areas in the service taxation.
TDS on Royalty payments under IT Act, 1961:
Royalty payments are subjected to TDS under Sec.195 if they are to non residents or under Sec.194J if they are paid to residents. DTAA with the respective country comes into picture to restrict the tax rates if it is a foreign payment. As such the current TDS rate where the payment exceeds Rs.1 crore is @10.5575% and below Rs.1 crore is @10.3%. An important aspect to notice here is in the case of a cross border transaction Service tax is not to be added to the basic amount to compute TDS unlike how it is being done for local payments. The fundamental point of distinction here is the Service tax liability as per law is that of the service recipient hence there is no justice on subjecting the service provider to TDS on the service tax portion.
The conclusion at this point is that the initial recognition will be as per the standard procedure prescribed by RBI.
Let us enter the second phase which is the subsequent measurement,
Royalty accounting under Indian GAAP:
At the moment there is no dedicated accounting standard for Royalty as such. But currently AS-26 does cover an intangible asset accounting at Cost and further amortisation depending upon the available legal right period with a rebuttable presumption of 10 years (this presumption is said to vanish under the forthcoming converged Indian AS equivalent to IAS-38). This is of course subject to fulfilment of the asset recognition criteria. Also foreign exchange fluctuation on the outstanding Royalty payable as a monetary item will have to be dealt with as per AS-11(Effect on foreign exchange fluctuations).
Subsequent treatment under Income Tax act, 1961
Royalty or in other words the Knowhow payment is specifically governed by Sec.35AB and all it requires is deferment of the expenditure over a period of 6 years. Is there a circumstance where an assessee can opt for 100% deduction under Sec.37 which is the residual rule? Normally this isnt a possibility. Let us examine this pending case law. In CIT vs. Mastek ltd there is a dispute on the claim of Royalty under Sec.37 by the assessee vis--vis the IT department. The assessee contended that the payment is for a duplication of particular software and hence a revenue expenditure. But the department questioned the fundamentals on the nature of the activity by quashing the claim of duplication. The Gujarat High court refused to decide on the question of law involved but Supreme Court remitted the case back to the High court insisting on a decision based on facts and circumstances. But the bottom line remains that that acquisition of software as such is a capital expenditure whereas acquiring a mere access to the software is only revenue expenditure. Duplication of software is a current activity after receiving the originator permission which gives only short term economic benefits to the person availing the service; hence if any royalty is paid it is not to be equated to a payment for passage of technical knowhow. Hopefully if the activity is really proved to be duplication, the assessee should win the case.
After all if the amortisation periods differ as per the GAAP records and those for IT purpose there is a timing difference (deductible differences as per IFRS) and there is a necessity for deferred tax accounting under AS-22.
The conclusion comes with Disclosure Requirements,
By Disclosure Requirement the article intends to mention the reporting requirements pertaining to Royalty.
From FEMA 1999 perspective, the payer is supposed to get the Royalty computation certified by his statutory auditor and submit the same to RBI. The standard computation procedure mentioned in one of the above paragraphs above is to be observed on a financial year basis. If at all the assessee has to remit otherwise than in accordance with the standard computation, prior approval of Government is necessary. There is no requirement for registering the Technology transfer agreement.
For the purpose of Income tax law, the assessee should get a certificate in Form 15CB from statutory auditor. This certificate is only to authenticate the fact that correct rate of TDS has been done and remitted to the Government within the DTAA framework. Also an undertaking in Form 15CA is required to be e-filed to the department.
From GAAP perspective, the reporting requirements are special, if the payment is to an associated enterprise (i.e. related party). AS-18 will govern the same. Even otherwise as a material transaction disclosure is mandatory under Indian GAAP.
If it is a cross border transaction, the assessee being the service recipient may get registered under Service tax act and file the half yearly service tax return under respective head.