In the globally connected digital economy, Indian companies and individuals are increasingly collaborating with foreign creators, including musicians, designers, software developers, and other intellectual property holders. These collaborations often involve payment of royalties to the foreign party. However, the Indian Goods and Services Tax (GST) regime, particularly the mechanism of reverse charge, adds a layer of complexity to such transactions.
This article aims to demystify the concept of reverse charge in the context of royalty payments made to foreign creators, exploring its legal basis, procedural requirements, compliance obligations, and strategic implications for Indian businesses.
📄 Understanding Reverse Charge Mechanism (RCM)
Under normal circumstances, the supplier of goods or services is responsible for collecting and remitting GST to the government. However, under the reverse charge mechanism (RCM), this responsibility shifts to the recipient of the supply.
Section 9(3) and 9(4) of the Central Goods and Services Tax Act, 2017, and Section 5(3) and 5(4) of the Integrated Goods and Services Tax Act, 2017, provide the legal framework for RCM.
When the supplier is located outside India and the recipient is in India, the transaction is classified as an import of services. As per Section 13(2) of the IGST Act, the place of supply is deemed to be in India if the recipient is located in India. Consequently, the Indian recipient becomes liable to pay IGST under the reverse charge.
🌟 What Constitutes Royalty?
The term "royalty" is widely interpreted in the Indian taxation system. As per Explanation 2 to Section 9(1)(vi) of the Income Tax Act, 1961, royalty includes consideration for:
Transfer of all or any rights in respect of a patent, invention, model, design, secret formula, or process;
Use or right to use any copyright, literary, artistic or scientific work including cinematograph films;
Use or right to use industrial, commercial or scientific equipment;
Transfer of rights in trademarks, designs, or models;
Transmission of any know-how.
In the context of GST, these services are considered as "supply of services" under Schedule II of the CGST Act.
💼 Applicability of Reverse Charge on Royalty
Royalty paid to a foreign entity for the use of intellectual property falls under the ambit of import of services. According to Section 2(11) of the IGST Act, "import of services" refers to the supply of any service:
Where the supplier is located outside India;
The recipient is located in India;
The place of supply is in India.
These conditions are generally met in the case of royalty paid to foreign creators. Therefore, IGST is applicable under the reverse charge mechanism.
💡 Legal Provisions and Judicial Interpretations
Several judgments and advance rulings have clarified the treatment of royalty under GST. For example, in the case of M/s. Sify Technologies Ltd., the Authority for Advance Rulings (AAR) ruled that payment made to a foreign company for use of software was a supply of service, liable to GST under reverse charge.
Moreover, the landmark Supreme Court judgment in the case of Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT (2021) clarified the interpretation of royalty under the Income Tax Act, which has implications on GST treatment as well.
📅 Registration and Compliance Requirements
Any person who is liable to pay GST under reverse charge must obtain GST registration irrespective of the threshold limit.
Registration under GST is mandatory for all importers of services.
The taxpayer must disclose reverse charge liabilities in GSTR-3B and GSTR-1.
Payment of GST must be made in cash (ITC cannot be used).
Once paid, input tax credit can be claimed in the same month.
🎓 Invoicing and Documentation
Even though the foreign supplier does not raise an Indian GST invoice, the Indian recipient is required to:
Issue a self-invoice under Section 31(3)(f) of the CGST Act.
Maintain import agreements and proof of royalty payments.
Document foreign remittance details and the basis for royalty calculation.
These documents are crucial for input tax credit and audit compliance.
🚫 Common Mistakes to Avoid
Non-payment of IGST: Some businesses mistakenly treat foreign royalty as non-taxable.
Delayed registration: Failing to register when liable under reverse charge.
Wrong classification: Misclassifying royalty under goods instead of services.
Improper documentation: Lack of agreement or self-invoice can lead to denial of ITC.
📈 Impact on Cost and Pricing
The tax paid under reverse charge becomes available as input tax credit, thus it may not increase the cost in the long run. However, cash flow may be impacted in the short term since the GST has to be paid upfront before claiming ITC.
Pricing strategies must take into account these temporary cash outflows.
🔧 Practical Steps to Ensure Compliance
Identify all transactions involving foreign creators.
Classify each transaction as supply of service.
Calculate the applicable IGST.
Generate self-invoice for each payment.
Pay the IGST in cash and claim ITC.
Reflect the same in monthly GST returns.
🤝 Coordination Between Legal, Tax, and Accounts Teams
Handling reverse charge on royalty payments requires seamless coordination between legal, tax, and accounts departments:
Legal should vet royalty agreements for clarity.
Tax teams should evaluate classification and RCM implications.
Accounts must ensure accurate invoicing and timely payment.
🤝 Dealing with Transfer Pricing and Withholding Tax
Alongside GST, cross-border royalty payments must also comply with transfer pricing rules under the Income Tax Act, and may attract withholding tax under Section 195.
Double taxation avoidance agreements (DTAAs) play a crucial role in determining the rate of TDS. Businesses must ensure that tax residency certificates (TRCs) are obtained from the foreign entity.
🌟 Conclusion
With increased globalization and the digital economy reshaping the way Indian entities engage with international creators, understanding and complying with reverse charge provisions on royalty is essential. Taxaj Corporate Services LLP can assist in navigating these complexities, ensuring that your business remains compliant while leveraging international creativity.
Proper documentation, timely GST payment, coordination with legal and tax professionals, and continuous monitoring of regulatory changes are key to handling reverse charge mechanisms effectively.
Stay compliant. Stay creative