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The Supreme Court software case- changing the withholding regime in respect of non-residents?
By D P Sengupta
May 31, 2021

ALTHOUGH the current Income Tax Act that we have in India is a complicated legislation, ITA 1961 framed with inputs from luminaries like Nani Palkhivala, is primarily based on the Indian Income Tax Act, 1922.

Under the Raj, the governing Act was the Income Tax Act, 1922 that was amended from time to time to meet with changing circumstances or tighten the provisions due to abuse or non-compliance. The provisions of deduction of tax at source were limited to certain items and have been extended over time to cover as many aspects as possible. In that connection and in the context of the decision of the Supreme Court in the case of Engineering Analysis, it will be instructive to trace the origin of the current section 195 in relation to payments to non-residents.

The then government had in 1935 constituted a committee, popularly known as the Ayers Committee to make an investigation of the Indian Income Tax system in all its aspects and to report upon both the incidence of the tax and the efficiency of its administration. The committee that submitted its report in 1936 was stated to be inspired to secure the fairest possible treatment of the honest tax payer and at the same time to strengthen the Department in dealing with fraudulent evasion and legal avoidance. This committee in Chapter-X of their report dealt with the issue of deduction of tax at source. It considered a proposal for compulsory deduction of tax at source on all payment of interest other than interest on securities and decided that the best course would be to use section 20A and rendering it compulsory by the payer to submit returns containing the names and addresses of the resident recipients when the interest exceeded INR 100.

More pertinent, is the observation of the Committee in respect interest paid to non-residents. In that regard, the committee observed (in Section 1(b) of its report):

"Considerations differing from those applicable to residents arise in case of non-residents. In the former, it is a question of taxation by deduction as against direct assessment, whilst with the latter, it is a case of taxation by deduction as compared with no assessment at all in the majority of cases. The attempted use of section 43 of the Act to obtain tax through the payer of interest in such cases is of doubtful validity and, moreover, may result in a demand for tax being made upon him when he has no power of recovery.

 

We therefore recommend that it be enacted that interest paid to a non-resident should be subject to deduction of tax at the 'standard rate' with the obligation upon the payer to make a return to the Income Tax Officer of such interest and to account of the tax on the lines laid down in section 18(6) of the Act. When the contract for payment of interest by a resident to a non-resident is made outside British India, so that the resident has no right of deduction of tax, it is suggested (…)that such interest should not be allowable as a deduction in computing profits."

As for the genesis of section 195, we may note the following observation of the Committee in respect of - 'Other payments' as follows:

 

The recommendations of the Committee were given effect to through the Income Tax (Amendment) Act, 1938 and existing sub-sections (3A),(3B),(3C) was renumbered as (3B),(3C),(3D), and (3E). The following new sub-section (3A) was added:

(3A) Any person responsible for paying to a person not resident in British India any interest not being 'interest on Securities', or any other sum chargeable under the provisions of this Act, shall, at the time of payment, unless he is himself liable to pay income-tax thereon as an agent, deduct income-tax at the maximum rate.

This is the progenitor of the now famous section 195. What is interesting to note that even under the colonial rule, there was concern about due taxes not being paid in India and as noted by the Committee, deduction of tax at source was considered an effective solution.

Through the Indian Income-tax Amendment Act, 1953, some further changes were made and the numberings were altered. The main provision was now contained in section 18(3B) as follows:

(3B) Any person responsible for paying to a person not resident in the territories any interest not being "interest on securities" or any other sum chargeable under the provisions of this Act, shall, at the time of payment, unless he himself is liable to pay any income-tax and super-tax thereon as an agent, deduct income-tax at the maximum rate and super-tax at the rate applicable to a company, or in accordance with the provisions of sub-clause (b) of sub-section (1) of section 17, as the case may be:

Provided that (…)

Provided further that (…)

We may also note the contents of section 18(3C)-

"Where the person responsible for paying any sum chargeable under this Act other than interest, to a person not resident in the taxable territories, considers that the whole of such sum would not be chargeable in the case of the recipient, he may make an application to the Income-tax Officer to determine, by general or special order, the appropriate proportion of such sum so chargeable and upon such determination tax shall be deducted therefrom by the person responsible for making such payment in accordance with the provisions of sub-section 3B."

With this background we may now turn to the development of jurisprudence relating to the application of section 195 by the Supreme Court. There are many issues that arise in connection of TDS from remittance to non-residents. But one particularly troubling one relates to the use of the words 'sum chargeable to tax'. Tax is required to be deducted if the other sum is chargeable to tax. But who will determine the chargeability? What happens when only a part of the amount is chargeable to tax in India, will the payer determine what amount is to be withheld? Will the withholding be on the entire amount or only on a part?

The use of the words 'sum chargeable to tax' both under the 1922 Act and also under the ITA 1961 has generated litigations and the matter has reached the Supreme Court on a number of occasions.

We find such a reference in one case: Aggarwal Chamber of Commerce Ltd v Ganpat Rai Hira Lal - 2002-TII-76-SC-INTL that was decided in 1958. In that case a non-resident commission agent for one Ganpat Rai entered into a forward contract with a Hapur firm of commission agents. There was no dispute that income arose in British India as a result of the transactions and the Hapur firm deducted tax at source. In the liquidation proceedings, the taxpayer took the plea that it had no taxable income in India. In that context, the SC examined the scheme of the Act and observed:

"If the Hapur firm rightly paid the tax on the profits, the respondent cannot be allowed to challenge the amount on the ground that his total world income was not taxable and he was entitled to his profits without deductions. That is a question which has to be agitated by the non-resident assessee at the time of his assessment. Those persons who are bound under the Act to make deduction at the time of payment of any income, profits or gains are not concerned with the ultimate result of the assessment. The scheme of the Act is that deductions are required to be made out of "salaries", "interest on securities" and other heads of "income profits and gains" and adjustments are made finally at the time of assessment. Whether in the ultimate result the amount of tax deducted or any lesser or bigger amount would be payable as income-tax in accordance with the law in force would not affect the rights, liabilities and powers of a person under s.18 or of the agent undress.40(2) and 42(1)."

The most famous case to be decided by the Supreme Court in relation to section 195(1) was the case of Transmission Corporation of AP Ltd - 2002-TII-01-SC-INTL. Here, the Andhra Pradesh State Electricity Board made certain payments to non-residents against the purchase of machinery and equipment and also against the work executed by the non- residents for erecting and commissioning the machinery and equipment. It made payments to the non-residents without deduction of tax at source.

The lower appellate authorities allowed the appeals with the observation that the words "any other sum chargeable under the provisions of this Act" occurring in section 195 of the Act do not contemplate inclusion of trade receipts in their ambit and that section 195 applies only to cases where the sums paid are "pure income profits". However, the High Court held in favour of revenue. When the matter reached the SC, it clarified as follows:

"it is true that in some cases, a trading receipt may contain a fraction of the sum as taxable income, but in other cases such as interest, commission, transfer of rights of patents, goodwill or drawings for plant and machinery and such other transactions, it may contain a large sum as taxable income under the provisions of the Act. Whatever may be the position, if the income is from profits and gains of business, it would be computed under the Act as provided at the time of regular assessment. The purpose of sub-section (1) of section 195 is to see that the sum which is chargeable u/s 4 of the Act for levy and collection of income-tax, the payer should deduct income-tax thereon at the rates in force, if the amount is to be paid to a non-resident. The said provision is for tentative deduction of income-tax thereon subject to regular assessment and by the deduction of income-tax, the rights of the parties are not, in any manner, adversely affected. Further, the rights of the payee or recipient are fully safeguarded under sections 195(2), 195(3) and 197. The only thing which is required to be done by them is to file an application for determination by the AO that such sum would not be chargeable to tax in the case of the recipient, or for determination of the appropriate proportion of such sum so chargeable, or for grant of certificate authorising the recipient to receive the amount without deduction of tax, or deduction of income-tax at any lower rates or no deduction. On such determination, tax at the appropriate rate could be deducted at the source.

However, the obligation of the respondent-assessee to deduct tax u/s 195 is limited only to the appropriate proportion of income chargeable under the Act."

The GE India case:

In GE India - 2010-TII-07-SC-INTL, the issue involved was also relating to deduction of tax at source from payments made to non-residents in respect of the imports of shrink-wrapped software. In this case, the High Court agreed with the interpretation of the tax department that in terms of the decision of Transmission Corporation, unless the payer makes an application under Section 195(2) and has obtained a permission for non-deduction of the TDS, it was not permissible for the payer to contend that the payment made to the non-resident did not give rise to "income" taxable in India and that, therefore, there was no need to deduct any TDS.

The Supreme Court referring to the scheme of the Act and the provisions relating to TDS pointed out that if the contention of the Department that the moment there is remittance the obligation to deduct TDS arises is to be accepted then the words "chargeable under the provisions of the Act" in Section 195(1) are obliterated. Followed to its logical conclusion, the payer has to deduct and pay tax, even if the deduction comes out of his own pocket and he has no remedy whatsoever, even where the sum paid by him is not a sum chargeable under the Act. Referring to Section 195(2), the Supreme Court held that is not merely a provision to provide information to the ITO(TDS). It is a provision requiring tax to be deducted at source to be paid to the Revenue by the payer who makes payment to a non-resident. Therefore, Section 195 has to be read in conformity with the charging provisions. The SC also pointed out that it is because of this scheme of the Act that the CBDT had issued circular no 728 of 1995 that the deductor can take into account the DTAA while deducting TDS.

The decision of the SC is unexceptionable in pointing out that the deduction has to be in respect of amounts chargeable to tax only. In fact, in Transmission Corporation also, the SC had clearly stated that although there was obligation to deduct the same was limited to the amount chargeable to tax. However, there seems to be a difference in the understanding of the

PILCOM

The PILCOM -2020-TII-05-SC-INTL case concerned the world cup cricket organised by the ICC and Jointly hosted by India, Pakistan and Sri Lanka. Various payments were made to the ICC and to the Cricket Control Boards and Associations of different ICC member countries, from its two London Bank Accounts without deduction of tax at source. The Tribunal finally held that tax was applicable on the guarantee money payments made to ICC member countries, notwithstanding the existence of Double Taxation Avoidance Agreement with some of these countries. However, the Tribunal deleted the taxability on other payments made by way of transfer from London to Pakistan and Sri Lanka on account of ICC trophy for the qualifying matches between ICC associate members that were held outside India and on the guarantee, money paid to South Africa and the UAE. In essence, the Tribunal deleted all the payments that did not accrue or arise in India. On appeal the High Court, confirmed the order of the Tribunal. On further appeal, the SC concurred with the High Court in its reasonings.

The SC pointed out that to the extent the payments represented amounts which could not be subject matter of charge under the provisions of the Act, appropriate benefit already stands extended to the appellant by the lower appellate authorities. More important in the present context is the following observation:

"We now come to the issue of applicability of DTAA. As observed by the High Court, the matter was not argued before it in that behalf, yet the issue was dealt with by the High Court. In our view, the reasoning that weighed with the High Court is quite correct. The obligation to deduct Tax at Source under Section 194E of the Act is not affected by the DTAA and in case the exigibility to tax is disputed by the assessee on whose account the deduction is made, the benefit of DTAA can be pleaded and if the case is made out, the amount in question will always be refunded with interest. But, that by itself, cannot absolve the liability under Section 194E of the Act."

The legal position that sems to have emerged from the above cases is that at the time of deduction of tax at source, unless there is no income element in the amount involved, tax should be deducted by the payer in terms of the domestic law and benefits of the DTAA can be always claimed by the taxpayer.

 

"It will be seen that section 194E of the Income Tax Act belongs to a set of various provisions which deal with TDS, without any reference to chargeability of tax under the Income Tax Act by the concerned non-resident assessee. This section is similar to sections 193 and 194 of the Income Tax Act by which deductions have to be made without any reference to the chargeability of a sum received by a non- resident assessee under the Income Tax Act. On the other hand, as has been noted in GE Technology (supra),

With respect, the above observation of the Supreme Court does not seem to be correct. Both sections 193 and 194 relate to deduction of tax at source in respect of payments of income to residents. Besides, as has been held in the various decisions discussed earlier, the entire chapter on deduction of tax at source is only a means of collecting tax from the taxpayer and tax can be collected only if the same is chargeable to tax under the Act. Whether under section 194E or section 195, the same principle should apply.

It goes without saying that withholding is a particularly effective means to fight international tax avoidance and evasion. Source countries extensively take resort to withholding even when they do not get to tax the whole income of the non-residents in terms of tax treaties particularly in respect of passive incomes. In that context, the latest judgement of the Supreme Court in the context of TDS is particularly troubling in case of payments to non-residents and in determining the interaction of the withholding provisions with the tax treaties.

We must note that there are practical problems for the payer when examining the eligibility of a claim of DTAA. For the purpose of determining the rate at which tax is to be deducted, it is easy to refer to the DTAA and if the rate prescribed in the DTAA is lower, the same can be applied. This is also acknowledged by the CBDT through circulars. However, even in these cases, the lower rate of the DTAA, if any, is available only to a beneficial owner and it is not possible for the payer to make such a determination. Circular No 728 referred to by the Supreme Court seems to be addressed to the officers of the department and not to the withholding agents because the tax officer has the authority to determine as to who the beneficial owner is and once he is satisfied that the recipient is the beneficial owner, then and then only the lower rate as prescribed in the relevant treaty can be applied, else the domestic rate should be applied.

Moreover, there are many other issues that arise in the application of the provisions of a DTAA. Some of these are the limitation of benefits, determination of residence, characterisation of the income involved, existence of PE, determination of beneficial ownership and the like. These are or at least should be the exclusive domain of the tax authorities. It is inconceivable that a third party like a payer would determine such complex factual and legal issues particularly involving non-residents and once money goes out of the country, it is often difficult to retrieve the situation.

The latest decision of the Supreme Court may create complete chaos if tax practitioners relying on the same start interpreting tax treaty provisions without any reference to the tax department at all. It is high time for the CBDT to take a comprehensive relook at such an important provision and take necessary remedial measures.

 
 
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