While royalty payments are nothing new and most MNCs with a global parent do pay royalties, the quantum of royalties has come under question in recent times. Just a few months back, there was the entire debate about how much royalty payments should be permissible. There have been two diverse thoughts on the subject. On the one hand, the Ministry of Finance is not keen to get into the micros as it needs to attract foreign capital and technology. On the other hand, SEBI is worried about the loss of value to the existing share holders, especially small investors, due to royalty payouts. How big is the issue?
It is actually quite big
SEBI is keen to peg the total royalty payments at 2% of the net sales of the Indian company. Currently, there are a lot of large companies with global partners which pay differing amounts to the parent as royalties. Consider the numbers. Hindustan Unilever pays less than 2% although it does pay additional 1% to Unilever for use of central services. But the numbers are much higher for others. For example, Colgate pays out 4.97% of sales as royalties while Nestle and Maruti pay 4.36% and 4.72% respectively. This is the norm for most of the MNC players operating out of India. Kotak Committee suggested capping royalties at 5% but SEBI is keen to peg it at 2% and then relax it on a case-by-case basis. Actually SEBI may have a case on hand!
Why SEBI is justified?
It needs to be remembered that the royalty is paid as a percentage of sales revenues. The impact on profits will depend on the pre-tax margin. For pre-tax margin of 50% the impact of 5% royalty is nearly 10% reduction in profit but for a MNC with net margins of about 20%, the impact on the pretax profit is about 25%. That is a very large impact, especially in the absence of an acceptable model to measure and justify the royalty payments. Since the royalties take away a chunk of the pre tax profits of the Indian company, it turns out to be unfair to the Indian shareholders. In the process, the company tends to create more value for its global parent than to the Indian shareholders to whom the local unit has sold shares. That is the reason SEBI has insisted on a lower cap of 2% on royalties!
A transparent model
The actual answer could lie in a more transparent model for such royalties where the same can be correlated to the benefit derived from the association. Currently it is arbitrary. SEBI is willing to look at an arrangement wherein the cap is kept at 2% for generic cases which can be enhanced if there is genuine technology transfer to the Indian side of the business. Royalties have long been a bone of contention for global players. It is time SEBI looks at an acceptable model for the same! ©