Budget Analysis: FM's royalty tax hike may hurt investor sentiment

Foreign firms operating in India under the royalty model maybe in for some taxing times. In the Union Budget 2013-14, the Finance Minister has hiked taxes on royalty payments from 10 percent to 25 percent. Ashmit Kumar of CNBC-TV18 reports that experts are calling this move retrograde.

The North block has been waxing eloquent on the need for global investors to kick-start growth. And just when the world was hoping for concrete steps to boost investments, the Finance Minister delivered what some see as a low-blow. On February 28, 2013, P Chidambaram, Finance Minister said, “The rate of tax on royalty in the income-tax act is lower than the rates provided in a number of double tax avoidance agreements (DTAA). This is an anomaly that must be corrected.  Hence, I propose to increase the rate of tax on payments by way of royalty and fees for technical services to non-residents from 10 percent to 25 percent." Now the FM also went on to clarify that the rate specified in any applicable DTAA would prevail. However, some experts say this may mean more scrutiny from the taxman. Rohan Shah, managing partner, Economic Laws Practice says, "Knowing fully well that the DTAAs are likely to prevail and the fact that the net rate of taxation is likely to be around 15%, the FM was aware of these facts hence, this is perhaps another indicator that they are likely to dig deeper." The immediate concern is also that once the higher rate becomes applicable, the balance sheets of companies paying royalties could take a hit. For instance, Maruti Suzuki has been paying tax on royalties at 10 percent, when the India-Japan DTAA specifies a cap of 20 percent. So, with this hike, Maruti Suzuki will now pay tax at 20 percent. Similarly, Hindustan Unilever will have to pay 15 percent as specified in the India-UK DTAA. However, companies like ACC, Ambuja Cement and Nestle will continue to pay 10 percent tax, since that's what's specified in the Indo-Swiss DTAA. Experts say the possibility of tax liability going up because of the Budget proposal could deter technology and investment inflows. Another concern is that this hike in royalty tax will affect the way MNCs get tax credit in the home country. This may also rock the investment boat. Nishith Desai, founder, Nishith Desai & Associates, “When the big MNCs pay tax overseas - they have to take it against the IR tax back home. Not providing tax credits will amount to double taxation of the same income - on a gross level.” However, the minority shareholder community is not too worried. They feel royalty-paying companies will be discouraged from paying high royalties to reduce their tax liability, resulting in lower expenses and higher profits. However, this argument could fall flat, since transfer pricing rules governing such transactions ensure arms-length pricing, and this keeps payments to the parent company in check.