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Timing of India Withholding Tax on Royalty/Technical Service Fees for overseas entities– the Dichotomy continues?

June 22, 2017[2017] 82 taxmann.com 384 (Article)

Withholding Tax in India is often perceived to be a challenging matter by many overseas entities having operations/activities in India. This may be on account of various reasons like lock up of funds in India (on account of taxes withheld) where a position of non-taxability of income is adopted, mismatch between the year in which taxes are withheld by the Indian payer of income vs. the year in which the income is offered to tax in India, challenges with claiming credit for taxes withheld in India in the home country.

One of the issues on which there has been some judicial debate is the point of time when withholding tax obligation triggers for an Indian payer of income in relation to a Royalty/Technical Service fee ('Service fee') payment proposed to be made to an overseas entity.

So as to set a context to the issue which is discussed in this article, to start with, it may be relevant to make a quick note of the fact that Sections 5 and 9 of the Income-tax Act, 1961 ('IT Act') are provisions dealing with scope of incomes chargeable to tax in India in principle, whereas, Section 145 of the IT Act governs the timing of taxation of the incomes in India (i.e. based on the cash or mercantile system of accounting regularly followed). Section 195 of the IT Act deals with withholding tax obligations in relation to payments proposed to be made to non-residents which are chargeable to tax in India.

Where there is a mismatch between the year in which taxes are withheld by the Indian payer and the year in which the income is offered to tax in India and/or in the home country by the overseas entity, there may potentially arise a challenge in relation to the below mentioned areas:

1.   Claim of credit for taxes withheld while filing the Indian Income Tax return;
2.   Claim of credit for taxes withheld in India in the home country.

In this context, we believe that a recent ruling of the Ahmedabad Tribunal in the case of Saira Asia Interiors (P.) Ltd. v. ITO, TDS [2017] 79 taxmann.com 460 merits discussion; in a nutshell, the Ahmedabad Tribunal has held that the liability to withhold tax on a royalty payment to an overseas entity would arise at the time of actual payment to the overseas entity and not at the time of accounting for the same in the books of accounts of the Indian payer.

In this article, we have attempted to summarise the ruling for quick reference and also evaluate some of the contentious issues involved around the matter in dispute in the instant case.

Given below in the ensuing paragraphs are the key facts of the case, the arguments of the tax payer and the Indian Revenue authorities in support of their respective contentions, the ruling of the Ahmedabad Tribunal and most importantly, the rationale behind the ruling.

Key facts of the case:

  The Indian Company ('I Co.') was liable to make payment for some Technical-Know-How to an Italian resident Company ('F Co.').
  The liability for the payment was accounted for in the books of account by I Co.during the financial year under consideration; however, the payment was made bit later i.e. in the immediately subsequent financial year. The tax on such payment was duly deducted and deposited with the Indian Government at the time of making the payment to F Co.
  The Assessing Officer ('AO') raised a demand for interest under section 201(1A) of the Act on the I Co. by treating the due date for depositing tax as seven days from the end of the month in which amount was credited in the books of account.
  On further appeal, the Commissioner of Income-tax (Appeals) ['CIT(A)'] rejected the stand adopted by I Co.on the basis thatthe IT Act provides a clear mandate for the payers to deduct tax at source at the time of credit of liability in the books of account or at the time of actual payment, whichever is earlier.Also,the CIT(A) observed that there are no provisions in the Tax Treaty, which are relevant for determining the withholding tax liability of the payer.

Arguments put forth by the I Co:

  It was contended by the I Co. that the withholding tax obligation in relation to the payment made to F Co. did not arise at the time of accounting for the liability in the books of account, as the same was liable to tax in the hands of F Co. only at the time of actual payment in terms of Section 195(1) of the IT Act read with Article 13 of the India – Italy Tax Treaty.

Arguments put forth by the Indian Revenue authorities:

  The Revenue contended that the I Co. was liable to withhold the tax on the payment made to F Co. at the time of credit in the books of account or actual payment, whichever was earlier as per the provisions of the Act.
  Further, as the I Co. had applied beneficial tax rate as provided in the Act, the I Co. could not take recourse to Tax Treaty to determine the point of withholding tax on royalty payment made to the F Co.

The Tribunal's ruling/key observations:

In summary, the Tribunal has held that the liability to withhold tax on royalty arises at the time of actual payment to F Co. and not at the time of accounting for the same in the books of accounts of the Indian payer.

While ruling so, the key observations of the Tribunal are summarised below for reference:

  The decision to withhold tax from credit or payment to F Co. is dependent on the tax liability in the hands of F Co.
  Therefore the withholding provisions under the IT Act are to be read in conjunction with the charging provisions under the statute as also in conjunction with the relevant Tax Treaty which overrides these charging provisions.
  As regards the tax liability of the sum in the hands of F Co., as per the Article 13 of the India - Italy Tax Treaty, the same is taxable only at the time when actual payment is made to F Co. In this regard, the Tribunal has placed its reliance on the Mumbai Tribunal's ruling in the case of National Organic Chemical Industries Ltd. v. Dy. CIT [2006] 5 SOT 317. In the said ruling the Mumbai Tribunal had observed that so far as the taxability of royalties and fees for technical services are concerned, twin conditions of 'accrual' as also the 'payment' are to be satisfied.
  In other words, the Tribunal observed that the mere fact that I Co. credits the amount of royalty payable to an Italian resident, would not trigger taxability under Article 13 of the India – Italy Tax Treaty.
  In relation to withholding tax liability in the hands of the I Co., the Tribunal opined that when amount credited by the I Co. was not taxable for F Co. at the time of credit in the books of account per-se, it did not give rise any withholding tax obligations as well under the provisions of Act. In this regard reliance was place on the decision of Hon'ble Supreme Court in the case of GE India Technology Center (P.) Ltd. v. CIT [2010] 327 ITR 456/193 Taxman 234/7 taxmann.com 18, wherein the Supreme Court had held that the obligation to deduct tax at source arises only if there is a sum chargeable to tax under the IT Act (in the hands of the non-resident).
  Further, the Tribunal opined that the adoption of a lower rate under the IT Act does not imply that the payer is required to withhold tax on the amount payable to foreign company at the time of accounting for the same in the books of account in accordance with the provisions of the IT Act.

Some thoughts to ponder over:

While the above referred ruling essentially deals with the timing of trigger of withholding tax obligations in India in relation to a royalty payment made to an overseas entity, the rational eof the Ahmedabad Tribunal' sruling was as follows:

  Withholding tax obligations in India are dependent upon the taxability of the payee in India; Section 195 of the IT Act states that taxes are required to be withheld on "any sum chargeable to tax" in India.
  The year in which a sum is taxable in India for an overseas entity will need to be determined in accordance with the provisions of the IT Act read with the relevant Tax Treaty where applicable.
  Consequently, withholding tax obligations would trigger only in the year in which the payment is taxable for an overseas entity in India.

So as to be able to fully comprehend the issue discussed in the Ahmedabad Tribunal ruling in all its merits, it may be pertinent to evaluate the following two connected aspects in light of the judicial history surrounding the same:

1.   Timing of taxation of Service fee incomes for an overseas entity in India – Whether income earned by an overseas entity in India is to be offered to tax on a receipt basis or on an accrual basis?
2.   Timing of trigger of withholding tax obligation for an Indian payer of income – Whether an Indian payer is required to withhold tax at the time of making payment of the Service fee to the overseas entity or at the time of accounting for the payable/credit to the payee in its books of accounts?

(1) Timing of taxation of Service fee incomes for an overseas entity in India:

Taxability under the IT Act:

  Section 5(2)of the IT Act which deals with scope of incomes taxable for a non-resident in India, provides that income of a non-resident in a given Indian financial year includes income received or deemed to be received in India in that financial year or that accrues or arises or is deemed to accrue or arise in India in that financial year.
  As per Section 9(1)(vi)/9(1)(vii) of the IT Act, Service fee income payable by a resident to a non-resident would be deemed to accrue or arise in India subject to the conditions stated therein.
  As per Section 145(1) of the IT Act, income chargeable under the head 'profits and gains of business and profession' and 'income from other sources' can be computed in accordance with either cash or mercantile system of accounting regularly employed by an assessee.
  On a conjunctive reading of the above referred provisions, it can be said that once the chargeability of income is determined as per Section 5 read with Section 9 of the IT Act in principle, the timing of taxation of the same would be dependent on the system of accounting regularly followed i.e. cash or mercantile (Section 145 of the IT Act).
  The first question that arises here is whether a foreign company is covered within the ambit of Section 145 of the IT Act. In this context, it is pertinent to note the Bombay High Court ruling in the case ofPfizer Corpn. v. CIT [2003] 259 ITR 391/129 Taxman 459 where it was held that Section 145 of the IT Act, providing an option to the assessee to offer income to tax on cash or mercantile basis, is equally applicable to a non-resident. The rationale was that that there is no provision under the IT Act which debars non-residents from following cash system of accounting and Section 145(1) of the IT Act has nothing to do with the accrual of income under Sections 4 and 5 of the IT Act. The High Court further observed that Section 145(1) of the IT Act is a part of the computation machinery, which decides the year in which income is to be offered to tax in India.
  Having said that, it may also be pertinent to evaluate the timing of taxation of Service fee incomes under the Tax Treaty.

Taxability under the Tax Treaty:

  In most Tax Treaties, the Article dealing with Service fee incomes reads as "Royalty/fees for technical servicesarising in a Contracting State and paid to a resident of the other Contracting State".
  The moot point here is whether basis the word "paid" as used in Tax Treaties, an overseas entity which say regularly adopts a mercantile system of accounting for Service fee incomes, can adopt a stand to offer incomes for tax in India on a receipt basis.
  While there are a plethora of judgments on this issue, it is worthwhile to note that in 2012, in one of the first rulings on the subject by a High Court, the Bombay High Court in the case of DIT v. Siemens Aktiengesellschaft [IT Appeal No. 124 of 2010] held that as per the India-Germany Tax Treaty, the assessment of royalty or any fees for technical services ought to be made in the year in which the amounts are received and not otherwise.
  However, it is important to note here that the Supreme Court has admitted the Special Leave Petition filed by the Revenue against the above High Court ruling and the same is pending disposal.
  In 2013, the Mumbai Tribunal in the case of Johnson & Johnson v. Asstt. DIT (International Taxation) [2013] 60 SOT 109 (URO)/32 taxmann.com 102 (Mum.), adoptinga literal interpretation of the words "paid" and "received" as used in Tax Treaty, held that the assessee's contention that amounts cannot be taxed on an accrual basis is correct.
  However, in 2004, the Authority for Advance Rulings ('AAR') in the case of Flakt (India) Ltd., In re[2004] 267 ITR 727/139 Taxman 238 (AAR - New Delhi) did not accept the reliance of the assessee on the word "paid' as used in the Tax Treaty and took a contrary view to the effect that Article 12 does not particul arise the stage at which tax can be levied in India. The AAR observed that such income is to be taxed in accordance with the domestic tax law of India.

(2) Timing of trigger of withholding tax obligation for an Indian payer of income:

  Having had a look at the judicial history in the context of taxation of Service fee incomes for an overseas entity in India, it would also be relevant to take cognizance of the rulings on timing of trigger of the corresponding withholding tax obligations for the Indian payer of income.
  As per the Section 195(1)of the IT Act, any person responsible for paying any sum that is chargeable under the provisions of the IT Act (not being "interest on securities" or "Salaries") to a non-resident is required to deduct tax thereon, at time of payment or credit of such liability in the books of account, whichever is earlier.
  The key issue in debate is whether withholding tax obligations being dependent upon with the taxability of the payee would trigger only in the year in which the payee is taxable in India under the IT Act read with the Tax Treaty OR, whether the obligation triggers at the time of credit to the payee in the books of accounts or payment whichever is earlier as provided under Section 195(1) of the IT Act.
  Judiciary is widely divided on this issue. We have attempted to summarise the conclusions of some key rulings below for ready reference:
Ruling Year Citation Key Findings
Broadcom India Research (P.) Ltd. v. Dy. CIT [2015] 68 SOT 138/(URO)/55 taxmann.com 456 (Bang.)
  In this case, the Tribunal analysed the wordings of section 195(1) of the Act in detail.
  The Tribunal observed that a plain reading of section 195(1) shows that the first part of the section talks about the chargeability of the sum in question and the second part talks about the point of time at which tax is required to be deducted, if such sum is chargeable to tax.
  Once the chargeability of the sum in question is determined, then I Co. is required to deduct tax at time of payment or credit whichever is earlier, as per the provisions of section 195(1) and year of chargeability of income in the hands of non-resident would be irrelevant.
  While dealing with the issue in relation to timing of triggering withholding tax liability in case of credit or payment to foreign company, the Bangalore Tribunal distinguished case law relied by the assessee which were rendered in the context of taxation of income in the hands of a non-resident and which were not in the context of point time at which withholding tax liability gets triggered on credit or payment to a foreign company.
  The Tribunal also distinguished the Supreme Court ruling in the case of CIT v. Eli Lilly & Co. (India) (P.) Ltd. [2009] 312 ITR 225/178 Taxman 505 on the ground that the said decision was not concerned with the year of taxability of sum in the hands of a non-resident.

The Hon'ble Supreme Court in the above case had to decide applicability of TDS provisions under section 192 of the Act in respect of salary paid by a foreign company to expatriate employees outside India. The Hon'ble Supreme Court observed that withholding provisions which are in the nature of machinery provisions to enable collection and recovery of tax are not independent of the charging provisions which determine the assessability in the hands of the employee.

Johnson & Johnson (supra)
  The Tribunal while deciding the issue on timing of taxability in the hands of a foreign company, made a passing remark in relation to timing of withholding obligation for the Indian payer.
  The Tribunal observed that the Indian payer maintaining books of account under the mercantile system of accounting can claim a deduction for the royalty payable to non-resident on accrual basis only when tax is deducted thereon(even if the foreign payer offers the same to tax on cash basis).
Flakt (India) Ltd. (supra)
  The AAR held that the deduction of tax need not necessarily be at the time of actual remittance of the said sums but it has to be at a time of making a mere provision thereof in the books of account of the payer, since the requirement of actual payment of 'royalties' is not a prerequisite or pre-condition for triggering the incidence of income-tax, in the India-Sweden Tax Treaty.

As one can see from the above discussions, two clearly divergent views are prevalent judicially on the issue of timing of taxation of Service fee incomes in India for overseas entities and also the consequent withholding tax obligations in relation to the same.

As far as the moot point on taxation of Service fee incomes for overseas entities in India is concerned, one view is that basis the word "paid" used in Tax Treaties, the overseas entity would be taxable in India only in the year in which income is actually received.

A second and contrary view is that cognizance would need to be taken of the fact that while the Tax Treaties used the word "paid", the term is not defined in the Tax Treaties.

The OECD Commentary has given a wide meaning to the word "paid" as fulfillment of the obligation to put funds at the disposal of the creditor in the manner required by contract or by custom. Many Tax Treaties provide that in the absence of a definition provided in the Tax Treaty, the meaning provided in the IT Act shall apply. Also, an amendment has been brought in by the Union Budget 2017 in the Sections90 and 90A of the IT Act, wherein it has been provided that where any term is not defined in the Tax Treaty, but defined in the IT Act, then, the term shall have the same meaning as assigned to it in the IT Act. As per Section 43(2) of the IT Act, the term "paid" includes incurred as per the method of accounting. However, this definition is only for the purpose of Sections 28 to 41 of the IT Act.

As also held by the Ahmedabad Tribunal in the case of Saira Asia Interiors (P.) Ltd. (supra), the first view appears to be a better view (i.e. the term "paid" is to be given a literal interpretation).

On the second aspect around withholding tax, while withholding tax obligations are dependent in principle on the taxability of the payee in India, the question that needs addressal is whether the same triggers in the year in which the overseas entity is taxable in India or, whether the same would trigger at the point of credit in the payer's books of accounts or payment to the payee, whichever is earlier.

While there are two views prevalent on this issue as well, a better view appears to be that withholding tax obligation triggers only in the year when the overseas entity is taxable in India under the IT Act read with the Tax Treaty. The rationale for this view is that there should be an income which is taxable in the first place prior to trigger of any withholding tax obligation; if the "income" comes into being and is taxable for the overseas entity only in the year of receipt under a Tax Treaty, it is only logical that the withholding tax obligation should also trigger at that point of time only.

As one can see, India Courts have interpreted the provisions of the law differently and in that context, the Need of the Hour is for the Government to come up with clarifications on the disputed areas soon. Harmony in the Indian Taxlaw, coupled with certainty on the tax treatment is the ask of the foreign companies today. When this happens, the India Shining story will become reality.

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