Phone companies may rework royalty pacts to avoid probe, say experts

The scrutiny around royalty payments could force global smartphone firms, including Chinese companies, to relook at their agreements with patent holders to include conditions for regional subsidiaries to pay their share to avoid any probe by Indian authorities, said legal experts.

They say the Enforcement Directorate’s investigation into Xiaomi India's royalty payments has larger implications for overseas companies including rival Chinese ones, creating an uncertain environment, and could hurt the larger electronics manufacturing ecosystem.

The ED has termed Xiaomi India’s royalty payments as illegal and a violation of the Foreign Exchange Management Act (FEMA), saying it is registered as a reseller and thus, shouldn’t be making royalty payments, especially as such pacts are between the company’s Chinese parent and the patent holder. The ED has subsequently frozen the company’s bank assets worth over Rs 5,500 crore, which Xiaomi India has challenged in court. The order has been reserved by the Karnataka High Court.

Legal experts ET spoke to said Chinese companies will need to relook at the licence agreements, upon fears of an impending investigation, and ensure they are comprehensive and expressly contain clauses dealing with terms and conditions of royalty payments, providing descriptions of intangibles and benefit accrued.

"Whether royalty is embedded in import/sales price, and details of the owner of the parent, etc. are included. Also, proper valuation reports and justifications are required, more so if the remittance is more than in accordance with standard computation," said Vikrant Singh Negi, partner, DSK Legal.

The ED has also charged Vivo India for money laundering, alleging more than 50% of its turnover has been transferred to China to avoid paying taxes in India. Oppo too has been charged by the Directorate of Revenue Intelligence for customs duty evasion to the tune of Rs 4,389 crore.

All three companies have denied any wrongdoing. Vivo and Xiaomi have also dragged the ED to court.

The scrutiny around royalty payments by government agencies can also have a larger impact on the patent licensing ecosystem, which serves as the backbone for regional subsidiaries to get their product manufactured from contract manufacturers using standard essential patents under licences signed on a global level, legal experts said.

"These are global players. In most of these cases, these are global patent licensing agreements. They are not region to region specific, said Yogesh Pai, associate professor at National Law University.

Another Delhi-based legal expert said that it Was quite possible that the global licensing agreements will have provisions to ask the regional subsidiaries to pay up their part of the royalties from their books.

Subhash Bhutoria, partner at DSK Legal, said it is also legally possible to have separate agreements for IP licensing for parent and subsidiary companies.

"This (scrutiny into royalty payments) impacts the entire patent licensing ecosystem. Not only for the manufacturing industry in India, but also the patent owners as well, who will not be able to collect royalties from an important market like India. Especially where manufacturing intended for exports is becoming a big base, with the PLI scheme," said another Delhi-based IPR lawyer.

The agreements are made to accommodate the fact that one can do the manufacturing yourself, or have it made by others. Under the new logistical construct around the world, brands don't manufacture themselves, but rely on OEMs for it. From an ease of doing business perspective, it is certainly very problematic for the Chinese brands, he said.

"Everyone will relook into how their business is being conducted. They will be very serious about complying with the laws of the land, which every company is doing. But giving out this signal that there is some kind of government scrutiny going on, it could be a little counter-intuitive to the fact India wants to attract more investors for manufacturing," said Tarun Pathak, research director at Counterpoint Research.