1. WHAT IS DESIGN ROYALTY?

Under Sec 9(1)(vi) Income Tax Act and Article 12 of DTAA, Royalty includes:

Consideration for transfer of any right in respect of design, model, plan, drawing, secret formula, technical know-how, industrial commercial scientific experience.

Two types are confused:

A. Outright Sale of Design - You buy drawing and you become owner. It is NOT Royalty. It is Business Profit / Fees for Technical Services. Example: You pay Austrian company AVL one-time Rs 5 Cr for full ownership of engine design drawings.

B. Right to USE Design - Foreign company retains ownership, you get license to use. This IS Royalty. Even if you pay lump sum. This is the banking arrangement.

Case Law: Davy Ashmore India Ltd. (1991) 190 ITR 626 (Cal)

Where transferor retains property right in designs, secret formulae, and allows use, consideration is royalty. Only outright sale is not royalty.

2. RBI / FEMA BANKING ARRANGEMENT - CURRENT RULE

This is the most important for banking.

Pre-2009: Royalty capped at 5% domestic sales, 8% exports for technology collaboration. Need RBI approval beyond that. Design royalty capped at 1% domestic, 2% exports.

Post Dec 2009 Liberalization: No percentage cap. 100% under Automatic Route.

As per AP DIR Circular 2009-10 + FEMA Current Account Transaction Rules:

1. No RBI prior approval needed.
2. Payment through AD Bank under automatic route.
3. Documents required at AD Bank:
   • Form A2 + IP License Agreement + Form 15CA/CB
   • Auditor Certificate - certifying that royalty rate and payment is as per agreement and Income-tax provisions complied.
   • Board Resolution if related party u/s 188 Companies Act.
   • SEBI LODR approval if Royalty to related party > 5% of turnover - need majority of minority shareholders approval.

AD Banker's Role: Bank is not just remitter. Under FEMA, bank must do due diligence - whether royalty is genuine, whether TDS deducted u/s 195, whether valuation is not violating FEMA. ED vs Xiaomi case is based on this.

Case: Xiaomi Technology India Pvt Ltd vs ED (Karnataka HC 2023) - 5551 Cr Seizure
ED held Xiaomi remitted Rs 5551 Cr in guise of royalty to Qualcomm and Beijing Xiaomi via RBI-approved banking channels but without any underlying technical service. Payment was shown as royalty but was actually profit repatriation violating Sec 4 FEMA. High Court stayed seizure but observed: Even if banking channel is RBI-approved, if substance is not royalty, it violates FEMA Sec 37A. This is the biggest case on Royalty Banking Arrangement.

3. HOW TO DESIGN A COMPLIANT ROYALTY BANKING STRUCTURE?

A proper Design Royalty Arrangement has 5 clauses to survive Tax, FEMA, and Transfer Pricing:

Structure 1: Lump-sum vs Running Royalty

• Lump-sum for one-time design transfer - Capital expenditure - amortization
• Running royalty - 2-4% of net sales - Revenue expenditure
  Tax Planning: Running royalty is better for deduction. Lump sum may be treated as capital.

Structure 2: Banking Route
Indian Company -> Auditor Certificate -> Form 15CA/CB -> AD Bank (ICICI/ SBI/HDFC) debits INR -> Converts to USD -> Swift to Foreign Licensor -> File FLA Return with RBI annually + Form FC-TRS if equity linked.

Structure 3: SEBI/DIPP Cap for Listed Companies
IIAS recommendation still followed by audit committees: Design royalty should be capped at 1% domestic sales and 2% exports, payable for 10 years only. Beyond that, need justification.

4. TAXATION & TDS MICRO-ISSUES

• Sec 195 TDS: 10% + surcharge under Income Tax Act, but DTAA rate is lower - US 15%, UK 15%, Germany 10%, Japan 10%. Need TRC and Form 10F.
• Engineering Analysis Case - Supreme Court 2021 (432 ITR 471): Payments for software/design where no copyright transferred is NOT royalty. Supreme Court held in Engineering Analysis Centre of Excellence v CIT that payment for use of software/design drawing without transfer of copyright is not royalty under DTAA. So no TDS if you are only using design for manufacturing.
• GST: Import of design service is liable to 18% IGST under Reverse Charge Mechanism.

5. TRANSFER PRICING CASE LAWS - THE CORE OF ROYALTY BANKING

This is where most arrangements fail.

Case 1: CIT vs EKL Appliances Ltd. - Delhi HC 2012 - Landmark for Royalty Banking
Facts: EKL was making continuous losses but paying 3% royalty to Electrolux Sweden for design.
Revenue said: Loss-making company cannot pay royalty, ALP = NIL.
High Court held: Royalty payment cannot be disallowed merely because company makes losses. If expenditure is wholly and exclusively for business (using foreign brand/design improves sales), TPO cannot determine ALP as NIL. TPO must use CUP or TNMM method, not disallow on commercial wisdom. This saved all MNCs.

Case 2: JCB India Ltd vs ACIT - ITAT Delhi 2023 (APA case)
ITAT held if Assessee has Advance Pricing Agreement (APA) for royalty at 4%, TPO must accept APA parameters and cannot make separate adjustment. Banking arrangement approved in APA is final.

Case 3: Royalty paid as per Govt/RBI approval will be treated as at arm's length - ITAT
In many cases like Maruti Suzuki, ITAT held royalty paid as per Press Note 2 (2000) i.e. within RBI approved rate (5%/8%) shall be taken as at arm's length. No TP adjustment.

Case 4: Praxair India - ITAT 2024
Assessee paid 4% royalty on net sales. AO restricted to 1% citing internal CUP. ITAT deleted adjustment because TPO did not bring comparable uncontrolled transaction for design.

Case 5: Technical Design is Royalty even if no intangible owned by Indian Co - TPO v Assessee (2014) 6 TMI 317
TPO held royalty not required because assessee owns no intangible. ITAT reversed - Technical design provided by AE for manufacture IS intangible service, royalty is justified.

6. CAPITAL vs REVENUE - OLD BUT CRITICAL

Case: CIT v. Jonas Woodhead & Sons / Alembic Chemical Works (1989) 177 ITR 377 SC
Supreme Court held: If royalty is for acquiring enduring technical know-how to set up new plant, it is capital. If it is for use of design in existing business, it is revenue u/s 37(1).
Test: Is it for setting up business or running business?

Case: Climate Systems India Ltd. v. CIT
Royalty for technical assistance for existing product line = Revenue.

Case: CIT v. Andhra Petrochemicals Ltd. - AP HC
Amount paid as lump sum for supply of technical know-how, machinery installation is part of total consideration for plant, not royalty, not liable to tax as royalty if no separate service in India.

7. MODEL CHECKLIST FOR YOUR BANKING ARRANGEMENT

If you are drafting Design Royalty Agreement for your company, ensure:

1. Agreement says "Licensor retains ownership of Design/IP" - else it becomes sale of know-how and TP scrutiny different.
2. Define Net Sales clearly - exclude taxes, scrap, inter-company sales.
3. Clause: "Royalty payable even in case of loss" - to protect under EKL Appliances.
4. Sub-license restriction + Confidentiality + Improvement clause.
5. Banking: Mention AD bank, FEMA compliance, 15CA/CB responsibility on licensee, DTAA benefit.
6. Tenure: Max 10 years for design as per industry practice.
7. Audit Trail: Keep evidence of benefit - emails showing foreign AE provided 2D/3D drawings, visits, technical support hours log. This is what TPO asks.