Royalty payment has been a matter of intensive discussion in India as well as internationally. Recently, the Organisation for Economic Cooperation and Development (OECD) published discussion paper on Base Erosion and Profit Shifting (BEPS) in which it is suggested that they are looking at developing “rules to prevent BEPS by moving intangibles among group companies.
This will involve:
(i) adopting a broad and clearly delineated definition of intangibles;
(ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation;
(iii) developing transfer pricing rules or special measures for transfer of hard-to-value intangibles; and
(iv) updating the guidance on cost contribution arrangements.”
Obviously, identification of intangibles and payments therefore has assumed very high importance in the area of transfer pricing and international taxation. The OECD defines the term “intangible” as “something which is not a physical asset or a financial asset, and which is capable of being owned or controlled for use in commercial activities”. This term remained undefined under the Indian tax laws for a long time. By an amendment introduced in 2012 the term “intangible property” was defined in the Income-tax Act, which is quite broad in scope.
Royalty is payment for the use of or right to use an intangible. Normally, an intangible is crucial for a group when it attempts to be ahead of its competitors. Protecting it becomes a top priority. Due to this, most of the time it is given to entities within the group. The burden to establish the genuineness of the payment and the arm’s length price of the same is much heavier than many other transactions.
In order to determine arm’s length conditions for the use or transfer of intangibles it is important to consider as part of the comparability and functional analysis:
(i) the identification of specific intangibles;
(ii) the identification of the party(ies) that should be entitled to retain the return derived from the use or transfer of the intangibles;
(iii) the nature of the controlled transactions and whether they involve the use of intangibles and/or lead to the transfer of intangibles between the parties; and
(iv) the remuneration that would be paid between independent parties for the use or transfer of such intangibles.
In India payment of royalty has been one of the most litigated issues under transfer pricing. There have been several decisions by the Income Tax Appellate Tribunal (ITAT).
With regard to payment of royalties, MNEs often enter into agreements allowing use of brands, trademarks, know-how, design, technology etc. by their subsidiaries or related parties in India. Such payments can be in a lump sum, periodical payments or a combination of both types of payments. It is an internationally agreed position that intellectual property, which is owned by one entity and used by another entity, generally requires a royalty payment as consideration for the use. However, the important issue in this regard is the determination of the rate of royalty. The main challenge in determining the arm’s length royalty rate is to find comparables in the public domain with sufficient information of the type required for comparability analysis. The Indian experience suggests that it is impossible to findcomparable arm’s length prices in most cases. The use of the Profit Split Method as an alternative is generally not a feasible option due to the lack of requisite information.
The Indian tax administration has noticed serious difficulties in determining the rate of royalty charged for the use of brands and trademarks in certain cases. In some cases the user had borne significant costs in promoting the brand/trademark, and to promote and develop customer loyalty for the brand/trademark in a new market. In these cases, the royalty rate charged by the MNE will depend upon the cost borne by the subsidiary or related party to promote the brand and trademark and to develop customer loyalty for that brand and product. In many cases no royalty may be charged by, for example, the local subsidiary in the uncontrolled environment and the subsidiary would require arm’s length compensation for economic ownership of marketing intangible developed by it and for enhancing the value of the brand and trademark owned by parent MNEs in an emerging market such as India.
In many cases, Indian subsidiaries using the technical know-how of their parent company have incurred significant expenditure to customize such know-how and to enhance its value by their R&D efforts. Costs of activities, such as R&D activities which have contributed in enhancing the value of the know-how owned by the parent company, are generally considered by the Indian transfer pricing officer while determining the arm’s length price of royalties for the use of technical know-how.
The Indian transfer pricing administration has also noted significant transfer pricing issues in cases of co-branding of a new foreign brand owned by the parent MNE (a brand which is unknown to a new market such as India) with a popular Indian brand name. Since the Indian subsidiary has developed valuable Indian brands in the domestic market over a period of time, incurring very large expenditure on advertisement, marketing and sales promotion, it should be entitled to arm’s length remuneration for contributing to increasing the value of the little known foreign brand through co-branding it with a popular Indian brand and therefore increasing market recognition.
By- Raghav Gupta
Partner | Transfer Pricing
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Tags Income Tax