Investors protest Rise in Royalty Rates paid by Asian Subsidiaries of MNCs: The Trend continues

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Readers may remember a piece of news that I had carried in the blog few months back (see here and here) about the new relaxation in the Indian regulatory norms about the ceiling of payment that Indian branches of MNCs can make to their parent companies by way of royalties and technology transfer fees. The apprehension at that point of time was how this relaxation could be exploited by the MNCs to milk the profit out of their Indian offices and deprive the shareholders of such branches of their rightful dividends in the process. A recent post in the IP finance blog by Rob Harrison, about an article published in the London Financial Times, has highlighted a couple of days back further developments regarding the same problem that promises to be rather interesting.

The recent trend that has been observed in the market indicates a rise in the royalty rates that the Asian subsidiaries of MNCs are paying to their parent companies abroad. The matter came to light when several investment funds, who had been buying shares in the locally listed Indian subsidiaries of MNCs like Unilever and Nestle, expressed concerned at the siphoning of funds that was taking place in these subsidiaries. The funds were being channeled to the parent MNCs mostly as royalty rates for the use of "shared services" like R&D, marketing, branding etc.

Harrison had opined in his post that the rise in case of MNCs such as Unilever did not appear to be too surprising or unreasonable. This was because the usual rate paid to parent companies to recognize the company’s goodwill as well as patents and know-how (especially in industries focused on innovation) was between 5% and 8% and Unilever originally used to pay only 3.5%, which it had recently increased to 8%. Having said that, the rise obviously cuts into the dividend returns that the stockholder of Unilever’s Indonesian subsidiary had been accustomed to be getting and hence they have obviously made their displeasure known against such a move. Unilever, on the other hand, has sought to justify the increase by stating that it is required for cost recovery and that the royalties are subject to the same level of tax both at home as abroad.

There’s another interesting point to which Harrison has drawn the readers’ attention. It seems that the rise in royalty payment to UK companies has coincided with the introduction of the patent box regime in the UK, which has reduced the taxes payable on revenue derived from patented products from the earlier 23% down to a considerably lower 10%. Harrison’s observation clearly makes sense as under the circumstances, the parent companies would obviously be seeking repatriate greater sums of money in the form of patented product-revenue from their subsidiaries –which in turn creates a clash of interests between the investors in the locally-quoted subsidiaries who are interested in deriving the maximum profit from those subsidiaries and the parent company that is interested in such repatriation of profits in a tax-efficient fashion. These locally-quoted subsidiaries have always been regarded as well-governed, a fact which surely accounts for the premium that they enjoy on their share price; at the same time, they have also obtained the advantages from an undervaluation of the use of the parent company’s intellectual property. Instance has been cited of the Swiss company Holcim, which used to pay only a meager 1.5% as royalty payments till date and even the rise to 5% will still prove to be comparatively beneficial to Holcim given the usual market expenditure for the level of technological innovation that it puts to use.

The Financial Times article finally voices the same caution that has been reflected in the earlier posts in this blog, viz. that the local authorities must reconsider their evaluation of this trend and long-term effects thereof –strictly from the taxation point of view, this is bound to bring down the subsidiary’s locally taxable profit margin, which may not be so palatable for the country wherein it operates. However, thus far, the rates that are being negotiated at present are still well-near the market rate for usage of technology and nothing exorbitant so far, a point Harrison emphasizes in the concluding part of his post.