Nestle’s Royalty Payments – Impact on Shareholders and Tax Concerns

Nestle India pays royalties to its Swiss parent company, Nestle S.A., for the right to use its intellectual property. This includes patents, trademarks, brand names, and proprietary technologies. These payments compensate the parent company for using its valuable intangible assets, such as advanced technology, marketing support, research and development, and brand reputation, helping Nestle India leverage its established brand and expertise to enhance its business operations.

Nestle India recently proposed increasing the royalty payments to its Swiss parent entity. However, the shareholders of Nestle India rejected this proposal. This blog will explore why the increase in royalty payments to foreign AEs causes headaches for shareholders and local tax authorities.

Table of Contents

1. Introduction
2. The Nestle Tale
3. Why Royalty Payments Worry Shareholders?
4. How Much Royalty Is Fair?
5. How Does the Tax Department Views Royalty Payments?
6. How to Justify Royalty Payments?
7. Conclusion

1. Introduction

Imagine you’ve invented a groundbreaking technology or created a unique brand. Others see its value and want to use it, but instead of selling it outright, you let them use it for a fee. This fee is called a royalty.

Royalties are payments made to use intangible assets like patents, copyrights, secret formulas, trademarks, and trade names. It’s like renting out your invention or brand to others while still owning it. This arrangement allows creators to share their innovations without giving up ownership.

Multinational corporations (MNCs) frequently deal with royalties. They allow new businesses to use their well-established brands, advanced technology, and special processes. For new businesses, this is like having a head start—they can operate more smoothly and grow faster by tapping into the expertise and reputation of these big companies. Royalties are often part of a licensing agreement where payments can be a percentage of sales or profits or sometimes a lump sum.

While royalties are a popular way to share valuable ideas, they also spark debates. Governments and minority shareholders often worry that foreign companies might use royalties to drain profits out of the country, leaving less for local development.

2. The Nestle Tale

Nestle India’s shareholders recently rejected a proposal to increase royalty payments to its Swiss parent company, Nestle S.A. The resolution, which sought to raise the royalty fee from 4.5% to 5.25% of net sales over five years, was turned down by 57.18% of the shareholders.

The proposal outlined a gradual annual increase of 0.15%, intended to take effect from July 1, 2024. Nestle India argued that this adjustment was necessary to cover costs associated with ongoing support from the parent company, including marketing, research, and development. However, the shareholders were unconvinced, largely due to insufficient justification for the hike.

3. Why Royalty Payments Worry Shareholders?

High royalty payments often raise eyebrows among shareholders. These payments using intellectual property like patents and trademarks can drain company profits and reduce shareholder returns.

The crux is hefty royalties, which means less money for growth and dividends. If a company is shelling out large sums to use someone else’s IP, it may shy away from developing its innovations, stalling future growth.

Transparency is key. Shareholders must see how these royalties are set and whether they benefit the company. Excessive royalties can sometimes favour a few, leaving minority shareholders with less benefit or profit.

Royalties should reward IP owners fairly without draining the company’s coffers. Striking this balance protects both innovation and shareholder value.

4. How Much Royalty Is Fair?

The question arises: What’s a fair royalty? The answer is not simple or straightforward.

In the early 1990s, India opened its doors to more businesses, allowing companies to bring their special skills and brand names to India under certain rules. Back then, there were limits on how much these companies could charge for sharing their knowledge or using their brand.

Royalties exceeding 5% of sales or 8% of exports required government approval. This regulation was discontinued in 2009, and currently, there are no government-imposed limits on royalty payments. However, listed entities entering transactions with related parties must obtain prior approval from shareholders if these transactions exceed 5% of the annual consolidated turnover.

Thus, a foreign company, being a related party, can set any percentage it finds fair, but if it exceeds 5% of the listed Indian company’s turnover, shareholder approval is required.

5. How Does the Tax Department Views Royalty Payments?

Royalty payments between related entities, such as subsidiaries and parents, are a red flag for tax authorities. The Tax Department suspects Indian companies may artificially inflate royalties to shift profits to lower-tax jurisdictions.

The controversy over royalty payments usually stems from how the Indian company manages these costs. The main issue is transfer pricing, which becomes tricky when the transaction is between related companies within the same group.

For example, a foreign company might share its technology with its Indian partner, who uses it to produce and sell goods under the foreign brand. In return, the Indian partner pays a fee on their sales, which could be later increased. The Tax Department often challenges these arrangements if the Indian company cannot demonstrate tangible benefits from the deal.

6. How to Justify Royalty Payments?

Transfer pricing rules suggest that royalty payments should satisfy the arm’s length test. However, determining an arm’s length royalty payment for the transfer of intangible property is challenging.

To determine an arm’s length royalty rate, taxpayers can use the Comparable Uncontrolled Price (CUP) method if similar licensing rights exist with independent parties. If not, they can compare similar transactions and adjust for differences. The cost-plus method is also an option if comparables are available. When traditional methods don’t work, profit methods like the Transactional Net Margin Method (TNMM) can be used.

Comparing transactions involving intangibles is challenging because similar transactions might not exist in an open market. The OECD Transfer Pricing Guidelines 2010 suggest considering factors like expected benefits, geographic limitations, and investment costs to determine royalty fairness. Additionally, the nature of the transaction, duration, and agreement terms are crucial.

The ‘Benefit Test’ is also essential for valuing marketing intangibles. It measures a company’s benefits from using the brand value, including increased sales, market share growth, or overall financial gains from royalties. Maintaining detailed records of these benefits is essential to validate them before the Tax Authorities.

7. Conclusion

Intangible assets give businesses a competitive edge, but figuring out fair prices for shareholders and the Income-tax Department is tough without comparable deals to reference.

The absence of clear guidelines regarding royalty payments often leads to disputes that escalate to legal proceedings. Therefore, the government should offer clear guidelines for royalty payments using standard methods. Additionally, the government should consider adding rules for valuing royalties in tax laws, creating safe harbour rules, or specific guidelines to reduce tax litigation.