The exchange of technology and skills is a crucial driver of economic progress for any nation. Various countries, based on their level of maturity, often look to boost their domestic industries by importing technology and skills that may not be readily available locally. India, like many other economies, has relied on technology imports to foster its economic development.
Before April 1, 2023, non-resident taxpayers were liable for a 10% tax rate (plus surcharge and cess) on their royalty and fees for technical services (FTS) income as per section 115A of the IT Act. This rate was widely considered reasonable, resulting in an effective tax rate of 10.92% for foreign companies. In 1976, the Indian Government introduced a tax on royalties and fees for technical services in domestic tax law, imposing a withholding tax rate of 40% and 20%. However, over time, to reduce the cost of technology for Indian concerns, the withholding tax rate on payments to non-residents was gradually lowered, reaching 10% by 2005.
However, the Finance Act 2023 brought an amendment, raising the tax rates on royalty and FTS income to 20%. Consequently, foreign companies are now subject to an effective tax rate of 21.84%. This significant and unexpected change has significant implications for taxpayers and has sparked discussions and debate, given the importance of the free flow of technology and technical knowledge for the growth of any economy. The new withholding tax rate of 20% has raised concerns about the impact it may have on foreign companies' willingness to invest in India and on the country's ability to attract the latest technology and expertise from non-resident entities.
Consequently, non-residents looking for a lower rate will now be required to take advantage of applicable tax treaties, leading to the necessity of filing tax returns in India to claim treaty benefits. Some of the key tax treaties India has with countries like Singapore, France, Germany, Japan, Malaysia, Luxembourg, and the UAE provide a 10% tax rate on royalties and fees for technical services earned from India. the current amendment brings renewed attention to these tax treaties as businesses seek to minimise their tax liability and navigate the updated regulations.
Under normal circumstances, the responsibility for paying the withholding tax lies with the Indian company. As a result, businesses in India are carefully considering the impact of this amendment on their financial policies. However, it's important to note that the new 20% tax rate under the Income Tax Act can be mitigated by the existing tax treaty, which maintains the rate at 10%.
Despite the existence of these agreements, experts point out that the higher withholding tax rate will still impose a heavier compliance burden on companies. They will need to obtain the tax residency certificate and related documentation from foreign firms to avail themselves of the lower tax rate provided by the treaty. This may result in increased administrative efforts and costs for India Inc, the companies operating within the country.
While the change in the withholding tax rate may seem like a reversal at first glance, it is essential to consider the broader perspective. Access to technology remains crucial for India's growth, and the increased compliance burden and potential tax costs may be seen as challenges. On the other hand, this move could also incentivise greater and faster development of cutting-edge technology within India.
In recent years, India has made significant strides in improving its business environment, attracting foreign investment through regulatory reforms and incentives for startups and domestic companies. One common practice by Indian subsidiaries is paying royalties to their foreign parent companies for the use of intangible assets, such as trademarks, technical know-how, and brand equity. While such payments facilitate essential collaborations and technology transfers, they often come under scrutiny from enforcement and tax authorities.
In the realm of Indian taxation, Section 9 of the Income-tax Act, 1961 plays a crucial role in determining the categories of income deemed to accrue or arise in India. One such category includes royalties and fees for technical services (FTS). As per the Act, royalty income is deemed to accrue or arise in India when it is payable by the Indian Government, a resident individual (unless for income sourced outside India), or a non-resident for business, profession, or income source in India.
The Act further defines 'royalty' under Section 9(i)(vi) as consideration received for the transfer of rights in patents, trademarks, copyrights, and other intangible properties. This also includes imparting technical or commercial information and rendering services related to patents and copyrights.
While royalty is a common practice for licensing intellectual properties, tax authorities and minority shareholders perceive it as a profit extraction tool utilised by foreign shareholders. Both globally and in India, MNCs charge royalties for access to their brands, technology, and processes, which benefit the licensees by enabling more efficient operations and faster scaling. However, rising royalty payments to related parties are being seen as a corporate governance concern, prompting SEBI's recommendation that royalties exceeding 5% of consolidated turnover should be pre-approved by minority shareholders.
India's continued reliance on imported foreign intellectual properties is evident in the exponential increase in license fees paid, reaching a staggering $8.63 billion in 2021, a 72% rise from 2015. Conversely, receipts earned from the use of Indian IP abroad amounted to only $870 million during the same period, accounting for a mere 10% of the total outflows. This disparity indicates the need to reevaluate the country's research and development investment.
On the positive side, the higher withholding tax rate is expected to increase government revenue, funding developmental projects and social welfare initiatives. Additionally, it may spur domestic innovation by encouraging more investment in R&D, leading to the creation of indigenous technology and intellectual property within India. Furthermore, the amendment could foster technology transfer agreements and collaborations between foreign and Indian companies, promoting skill development and knowledge exchange.
To maximise the advantages of the higher withholding tax rate while addressing the challenges, striking a balance between short-term financial concerns and recognising the strategic and long-term value of IPs is crucial. Companies often curate their global brands centrally to maintain consistency across regions, safeguarding a strong brand identity and market position. Moreover, a robust analysis of factors like the nature of the IP, technology obsolescence, R&D spending, and arm's length rates should be undertaken by MNCs to justify any changes in royalty rates. Understanding the tax implications of royalty and FTS payments is crucial for residents and non-residents to ensure compliance with Indian tax laws.
To address the disparity between royalty outflows and receipts for IP use, India must revive its R&D investment climate through incentives and stronger IP protection laws. Drawing inspiration from the success of the Production Linked Incentive (PLI) scheme in promoting manufacturing, the government should consider a conducive environment for innovation and IP development, establishing India as a key player in the global R&D value chain on the lines of many such policy endeavours.