In today’s Finshots, we talk about the rising royalties that foreign MNCs (Multinational Corporations) expect from their Indian subsidiaries and the debate around it.

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The Story

During the 1970s and 1980s a lot of MNC IPOs (Initial Public Offerings) flooded the Indian market. And this wasn’t something they did by choice.

India had about 850 MNCs at the time. And the then government’s socialist policies meant that they wanted to control most of the businesses by flinging foreign ownership out of the country. This got them to put a limit on foreign shareholding in Indian companies. So no foreign MNCs could hold over 40% of an Indian company’s shares.

Now you’d imagine that this policy didn’t go down well with a lot of popular MNCs. They’d lack control over their own Indian arms and would have to run their companies according to the Indian government’s whims and fancies. And about 70 of them including folks like Coca-Cola, IBM and Kodak packed their bags and made their way for the exit.

But there were still a few others that were willing to take the chance. So they used the only option they had ― reducing stake in their own companies and offloading these shares to the public via IPOs.

That’s exactly why you’ll see that big names like Nestle, Colgate and Castrol rolled out their IPOs during this period.

And while they’ve made their mark in the market by understanding Indian consumers over the decades, many of these MNCs seem to be irking investors who own a stake in these companies.

What’s bothering them?

Well, a problem called royalties.

You see, MNCs who have their listed arms in India share a parent-subsidiary relationship. The products that these companies sell aren’t really the brainchild of their Indian subsidiaries. Rather it’s the parent’s research, development and technology that helps bring a new product to life. The Indian arm might then just use their brand name, licences, manufacturing processes and unique recipes to make or assemble these products locally. This makes their lives simpler because they don’t have to build anything from scratch. They focus on distribution and marketing the product.

Sure, they might have to innovate, keeping the specifics of the Indian market in mind. But the basics are pretty much sorted out, thanks to the parent company. This indirectly ensures that the Indian subsidiary not only operates efficiently but also scales up much faster.

But this ease comes with a price called royalty. Simply think of it as a fee that the parent company charges its subsidiary for using its patents, copyrights, brand names, trademarks and other intellectual property.

And while the payment seems fair at first sight, investors have a problem here.

A few days ago, most of Nestle India’s institutional investors who hold 20% of its shares, turned down its Swiss parent’s proposal to increase royalty payments by about ₹600 crores over the next 5 years.

Their point is simple. Paying higher royalties will reduce profits. And that means the company could end up sharing a lot less in the form of dividends. It could also affect their returns because lower profits could pull down the company’s stock price.

Now, here’s a question you might want to ask, “Hey, didn’t you just say that paying royalties to MNCs makes operations simpler for their Indian subsidiaries?”

Sure, they do. But the thing is that it’s hard to weigh out the benefits against the cost of higher royalties. What’s more uncertain is that you don’t really know what kind of extra operational support a parent might give its subsidiary in exchange for this higher price. So yeah, that’s what investors are concerned about. They aren’t sure of how it’ll benefit them. It’s a sort of a trust issue.

But here’s the thing. This debate over paying higher royalties isn’t new. In fact, investors and analysts have been sceptical about it for over a decade now.

And that’s because before 2009, the government had a policy that capped the amount of royalties Indian subsidiaries could pay their parent companies. They weren’t allowed to pay more than 5% of their domestic sales or 8% of their exports. This made sure that the Indian entities had more money in their coffers to invest in themselves and expand their business.

But slowly the government began to realise that these restrictions could discourage foreign companies from setting foot or expanding in India. And royalty payments weren’t capped anymore. Foreign companies could ask for whatever percentage they thought was fair, as long as they took an approval from shareholders if it crossed 5% of their domestic arm’s revenues.

And that opened a can of worms for Indian entities whose royalty payments rose at a fast clip. For context, a study by Institutional Investor Advisory Services (IiAS), a proxy advisory firm, found out that between 2012 and 2019 royalty payments of 31 companies it analysed doubled to a whopping ₹8,300 crores! The top five MNCs alone accounted for nearly 80% of all royalties paid.

If you look at it from the point of view of a company’s profits, it could also be extremely extortive too. Just look at Maruti Suzuki’s royalty payments to its Japanese parent Suzuki Motor Corporation. Although the royalty was just about 3.75% of its net sales in FY23, it was 40% over the previous year and a little over 40% of its profit before tax.

And this isn’t just bad for these Indian entities and their investors, but also for the country’s foreign currency outflows. It could simply impact the value of the Indian Rupee, which depreciates when such payments increase.

So what’s the solution, you ask?

Well, a few years ago, the government did think about reintroducing caps on royalties. But there hasn’t been much chatter about it ever since.

So, the alternative at least for now is a sort of understanding between MNC parent companies and their subsidiaries. Something similar to the Tata Group’s. Look, Tata group has an agreement with its group companies which restricts royalty payouts to a maximum of ₹200 crores or 0.25% of the annual revenue. That makes sure that royalties don’t go overboard and also remain tied to the companies’ operational performance.

So yeah, maybe, just maybe the latest shareholder dissent at Nestle India could be a precedent to strike arrangements like these until the government does something about it.

But will MNCs give into it, is something we’ll have to wait and see.

Until then…

Correction: An earlier version of this story mentioned that Tata Group restricted royalty payouts of its group companies to a maximum of ₹75 crores or 5% of profits. While this was the earlier threshold, Tata Sons has recently revised the limit to ₹200 crores. We regret the error.

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