Introduction
Royalties and licensing fees represent a significant area of GST litigation and compliance complexity. Whether you are a multinational corporation paying brand usage fees to a foreign parent, a technology company licensing software, or a franchisor receiving royalty payments, understanding the correct GST valuation methodology is critical. This article provides a comprehensive technical analysis of the GST treatment of royalties and licensing fees under the Central Goods and Services Tax Act, 2017, with a focus on valuation rules, related party transactions, and the interplay with transfer pricing regulations.
Statutory Framework for Valuation
Section 15 of the CGST Act – Value of Taxable Supply
The foundational provision for GST valuation is Section 15 of the CGST Act, 2017. Under sub-section (1), the value of a supply of goods or services or both shall be the transaction value, which is the price actually paid or payable for the said supply where the supplier and the recipient of the supply are not related and the price is the sole consideration for the supply.
Sub-section (2) mandates inclusions in the value of supply, which are particularly relevant for royalties:
- Any taxes, duties, cesses, fees and charges levied under any law other than GST laws, if charged separately by the supplier
- Any amount that the supplier is liable to pay in relation to such supply but which has been incurred by the recipient and not included in the price
- Incidental expenses, including commission and packing, charged by the supplier
- Interest or late fee or penalty for delayed payment of any consideration for any supply
- Subsidies directly linked to the price excluding subsidies provided by the Central Government and State Governments
Related Party Definition Under GST
The Explanation to Section 15 defines when persons shall be deemed to be "related persons":
- Such persons are officers or directors of one another's businesses
- Such persons are legally recognised partners in business
- Such persons are employer and employee
- Any person directly or indirectly owns, controls or holds twenty-five per cent. or more of the outstanding voting stock or shares of both of them
- One of them directly or indirectly controls the other
- Both of them are directly or indirectly controlled by a third person
- Together they directly or indirectly control a third person
- They are members of the same family
Crucially, persons who are associated in the business of one another in that one is the sole agent or sole distributor or sole concessionaire of the other shall be deemed to be related.
Valuation Rules for Royalties and Licensing Fees
Rule 28 – Value Between Distinct or Related Persons
Rule 28 of the CGST Rules, 2017 is the most critical provision for royalty valuation. It provides that the value of supply between distinct persons or related persons shall be:
- (a) The open market value of such supply
- (b) If open market value is not available, the value of supply of goods or services of like kind and quality
- (c) If value is not determinable under (a) or (b), the value as determined by application of Rule 30 or Rule 31
The Critical Proviso: Where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of the goods or services.
This proviso has significant implications for royalty payments between related parties where the recipient can fully utilize the ITC. In such cases, even if the royalty rate is lower than what an unrelated party would pay, the declared value is accepted as open market value.
Rule 27 – Consideration Not Wholly in Money
Where royalties are paid partially in kind or through non-monetary consideration, Rule 27 provides the valuation hierarchy:
- Open market value of such supply
- If not available, sum total of consideration in money plus equivalent amount for consideration not in money
- If not determinable, value of supply of like kind and quality
- If still not determinable, application of Rule 30 or Rule 31
Rule 29 – Value Through an Agent
Where royalties are paid through an agent, the value shall be the open market value of the goods being supplied, or at the option of the supplier, ninety per cent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person.
Rule 30 – Value Based on Cost
Where value cannot be determined by preceding rules, the value shall be one hundred and ten per cent of the cost of production or manufacture or the cost of acquisition or the cost of provision of such services.
Royalty vs. Licensing Fee – Distinct Tax Treatments
Royalty Payments
A royalty is typically a payment made for the use of intellectual property, including patents, trademarks, copyrights, know-how, or natural resources. Under GST:
- Royalty payments for the use of IP rights are treated as a supply of services
- The place of supply for cross-border royalties determines whether IGST or reverse charge applies
- For royalties paid to a related party outside India, valuation under Rule 28 applies
Licensing Fees
Licensing fees are payments for the right to use intellectual property or other assets. Key distinctions:
- Software licensing: Pre-packaged software on physical media is treated as goods (HSN 8523) at 18% GST; custom-developed software and SaaS are treated as services (SAC 998311, 998315) at 18% GST
- Technology licensing: Treated as services under SAC 997331 (Licensing services for the right to use computer software and databases)
- Franchise licensing: Franchise fees are taxable as services under SAC 997337
The Transfer Pricing Conundrum
When GST Valuation and Transfer Pricing Collide
A significant area of contention arises when transfer pricing adjustments under the Income Tax Act interact with GST valuation. Key considerations:
Distinct Purposes: Transfer pricing under the Income Tax Act aims to ensure that profits are not shifted out of India through related party transactions. GST valuation aims to determine the correct taxable value for indirect tax purposes. While both use the "arm's length" concept, the methodologies and objectives differ.
The 0.25% Benchmark: In the Mahindra & Mahindra brand usage fee case, the Authority adopted a benchmark royalty rate of 0.25% of revenue based on precedent in the Tata Sons Ltd. case.This demonstrates that GST authorities are increasingly looking at industry benchmarks and precedents.
Transfer Pricing Study as Evidence: A robust transfer pricing study prepared under Section 92 of the Income Tax Act can serve as valuable evidence in GST proceedings to justify royalty rates. However, GST authorities are not bound by transfer pricing determinations.
Practical Compliance Strategies
Documentation is Key: Maintain comprehensive documentation including:
- Transfer pricing study reports
- Industry benchmarking analysis
- License agreements with clear royalty computation mechanisms
- Evidence of ITC utilization by the recipient
Consider Advance Ruling: Given the complexity, obtaining an advance ruling under Section 97 of the CGST Act can provide certainty. The Authority for Advance Ruling can determine:
- Classification of the supply
- Applicability of notifications
- Determination of time and value of supply
- Admissibility of input tax credit
Cross-Border Royalties: For royalties paid to non-residents:
- Determine the place of supply under the IGST Act
- If the supply is from a place outside India to a place in India, it is an inter-State supply attracting IGST
- The recipient may be liable to pay tax under reverse charge
- Consider DTAA implications for withholding tax
Common Pitfalls and How to Avoid Them
Pitfall 1: Treating All Royalties as Taxable at the Same Rate
Not all royalties are taxed identically. The nature of the IP, the location of the supplier and recipient, and the terms of the agreement all affect the GST treatment. Seek professional advice to determine the correct classification and rate.
Pitfall 2: Ignoring Related Party Valuation Rules
Many companies assume that the invoice value between related parties is automatically accepted. This is incorrect. While the proviso to Rule 28 provides relief where the recipient has full ITC, this is not always the case. Where the recipient cannot fully utilize ITC, open market value must be determined, potentially leading to significant tax demands.
Pitfall 3: Failing to Document the Valuation Methodology
In the absence of documentation, tax authorities may reject the declared value and substitute their own valuation. Maintain a contemporaneous valuation report that justifies the royalty rate and methodology.
Pitfall 4: Overlooking the Impact of Transfer Pricing Adjustments
Transfer pricing adjustments can have GST implications. If the income tax authorities make a transfer pricing adjustment increasing the royalty income, the GST authorities may also seek to increase the taxable value. Coordinate between tax and GST advisors to manage this risk.
Call to Action
Navigating the complex intersection of GST valuation, related party transactions, and transfer pricing requires specialized expertise. Anuj Desai & Associates provides comprehensive GST advisory services including:
- Valuation analysis for royalties and licensing fees
- Transfer pricing and GST integration
- Advance ruling applications
- Representation in GST audits and assessments
- Litigation support before GST authorities, tribunals, and courts
Contact us:
- Email: office@anujdesaiassociates.com
- Phone: 9619456656
- Website: https://anujdesaiassociates.com
- LinkedIn: linkedin.com/in/ca-anuj-desai-122547230