Like other countries, India imposes a withholding tax on payments to non-residents in certain circumstances. A distinguishing feature of India's withholding tax is that it is a provisional collection of tax and not a final tax. The tax withholding is tentative and subject to determination on audit, as observed by the court in Tata Engineering and Locomotive. Generally, a non-resident who might have suffered withholding tax is not exempted from filing a return of income. The income return will need to disclose the income and the tax payable, against which the tax withheld may be claimed as a credit.

The government uses withholding tax to collect a portion of tax in advance.

The principal provision in the Indian Income Tax Act dealing with withholding tax on payments to non-residents is Section 195. Any person responsible for paying to a non-resident or to a foreign company any interest or other sum chargeable under the Income Tax Act is required to withhold tax on that payment. The withholding requirement is triggered at the time the income is credited to the account of the payee or at the time of payment, whichever is earlier. The tax is deducted at the rates in force.

Section 195 applies to payments to non-residents or foreign companies irrespective of whether the payment is in foreign currency or Indian currency. Whether an entity is a non-resident or a foreign company would need to be determined in accordance with the applicable rules and definitions.

Persons responsible for withholding

The withholding requirement is imposed on any person responsible for paying a non-resident. One question that arises is whether the requirement applies if the payer is a non-resident, that is, in cases of payments from one non-resident to another. There are several situations where payment by one non-resident to another could be taxable in India in the hands of the payee. The question is whether in these cases the payer is obliged to comply with the withholding tax requirements. The argument propounded by non-resident payers has been that Section 1(2), of the Income Tax Act, extends to the whole of India and so cannot have extraterritorial operation for a procedural requirement such as withholding. The view of the revenue authorities on the other hand has been that, in the absence of a limitation in Section 195 restricting its operation to cases where the payer is a resident, the Section applies to non-resident payers if the other conditions laid down in the Section are fulfilled. The matter has been considered by the Income Tax Appellate Tribunal and the Authority for Advance Rulings in certain cases. The cases of P No 15 of 1998, Babcock Power (Overseas Projects) and Satellite Television Asian Region all held that the withholding requirement extends to non-resident payers.

Payments liable for withholding

The withholding requirement applies to sums chargeable under the provisions of the Income Tax Act. If the payment is not chargeable to tax, withholding tax will not apply. An issue that arises in this context is whether the withholding requirement will apply to cases where a gross amount is paid and the recipient is taxable on the net income after deduction of expenses. In the case of Transmission Corporation of A P, the Supreme Court held that the withholding requirement would extend to these payments as well. In these situations, Section 195(2) provides a facility for the payer to approach the assessing officer to determine the amount that is chargeable to tax.

The revenue authorities have taken the position that, even if the payment is not chargeable to tax, the payer must withhold tax unless it has obtained a determination of nil withholding under Section 195(2). The Tribunal upheld this view in the case of Cheminor Drugs. However in the case of SOL Pharmaceuticals, the Tribunal held that, if the payment is not chargeable to tax, there is no need for the payer to approach the assessing officer under Section 195(2). The Tribunal took a similar view in the case of Maharashtra State Electricity Board and recently in A P Power Generation Corporation.

Time of withholding

The withholding obligation is triggered at the time income is paid or is credited to the account of the payee. If the credit is given to any other account, such as a suspense account, it will be deemed credited to the account of the payee. However, the withholding requirement is triggered only if the amount credited or paid represents income. If a provisional credit is made in an account without income having accrued, the withholding requirement will not apply. In the case of Flakt (India), the Authority for Advance Rulings found that, under the India-Sweden Tax Treaty, payment of royalties is not a pre-condition for incidence of income tax and so the withholding would be required at the time of making a provision in the accounts and could not be deferred to the time of remittance. On the other hand, in the case of Motor Industry Company, the court held that merely crediting the amount to a suspense account without any liability to pay the foreign company would not attract any liability to withhold tax under Section 195.

In the case of A P Power Generation Corporation, the assessee had made arrangement to pay a foreign company through an irrevocable letter of credit. The payment was made by the bankers on behalf of the assessee. The assessee accounted for the payment in the subsequent year. The Tribunal held that the delay in the entry into the books of account for whatever reason did not erase the fact that the payment had been made in the earlier year and, once the payment is made, liability for withholding tax under Section 195 is attracted.

In the case of C J International Hotels, the Tribunal held that, to deduct tax, the Revenue cannot tinker with the method of accounting employed by the assessee tax-deductor. If the payee's account is not credited at the time of accrual of income and accounting is done on a cash basis, the liability to deduct tax under Section 195 will arise only at the time of payment. Mere accrual of income in the hands of a foreign company could not be enough reason to impose tax deductor's liability under Section 195.

Modes of payment

The provisions of Section 195 refer to payment in cash, by cheque or draft, or by any other mode. So tax needs to be withheld not only when the payment is in cash or by cheque but also if the payment is made in kind or there is constructive payment, for example, fees deducted by the service provider from the amount due to the assessee. In the case of Kanchanganga Sea Foods, the court held that even if the payment made in kind, the assessee is under obligation to withhold tax under Section 195. Similarly, in the case of Raymond the lead manager of an Indian company's global depositary receipts issue remitted the proceeds of the GDR issue after deducting the amounts payable by the Indian company to the lead manager. The Tribunal held that an adjustment of the amount payable to the resident or deduction of that amount from the amounts due to the resident would be considered under payment by any other mode. Such adjustment or deduction is equivalent to payment. Accordingly, the Tribunal held that the provisions of Section 195 were attracted.

Withholding rates

In computing the withholding tax, the rates in force must be applied. These are the rates specified for withholding under the annual Finance Act or the rates specified under the applicable tax treaty, whichever is more favourable. Under the withholding tax regime described above, the withholding tax will generally equal or approximate the final tax. Consequently, although the recipient of the income will need to file a return and might undergo an audit, ordinarily no further tax should be payable. Situations could arise where the withholding tax is not equal to the final tax. For instance, the payer might have obtained a determination under Section 195(2) and the final tax might be more or less than the tax determined earlier. In this case, the recipient of the income will need to pay the balance of the tax or claim a refund as the case may be. Another situation where the final tax may differ from the tax withheld is where a non-resident earns income by way of royalties or fees for technical services from an Indian concern and this income is attributable to a permanent establishment in India. In this situation, withholding tax is applied at the rate of 10% plus surcharge and cess on the gross amount, whereas the final tax will be 30% or 40% plus surcharge and cess on the net income.

Apart from the facility to the payer to approach the assessing officer for determination under Section 195(2) there are provisions under which the recipient of the income can also approach the assessing officer. For instance, under Section 197, the recipient of income may approach the assessing officer for a withholding certificate at a lower rate or no deduction of tax.

Gross-up of income

In certain arrangements, a contract may provide that the consideration specified as payable under the contract is a net-of-tax consideration and that any tax would be borne by the payer. While this might be the contractual arrangement, the legal position is always that the recipient remains liable to tax on their income. The tax borne by the payer also bears the character of income in relation to the recipient. Consequently, the income has to be grossed up. An issue that has arisen in the past is whether the grossing up should be a one-step grossing or a multiple grossing. In the case of American Consulting Corporation, the court held that a one-step grossing is adequate. However, Section 195A now specifically provides that, where tax has to be borne by the payer, the income must be increased to the extent necessary so that after withholding tax is applied on the increased income, the net amount payable equals the amount specified in the agreement. In other words, multiple grossing should be applied.

Special provisions

Special withholding provisions apply to specified categories of payees or specified categories of income. Interest or long-term capital gains on foreign currency convertible bonds is liable to withholding tax at 10% plus surcharge and cess. Income (other than exempt dividends) on securities payable to foreign institutional investors is liable to withholding tax at the rate of 20% plus surcharge and cess. No withholding tax applies on capital gains payable to a foreign institutional investor.

Appeal against withholding

In case of excess withholding, one course of action is that the recipient of the income claims a refund in the return it is required to file. Another course of action is available in cases where a person has withheld and paid tax and denies their liability to withhold. That person can file an appeal before the Commissioner (Appeals) to be declared not liable to make the deduction. Upon succeeding in an appeal, the tax withholder is entitled to a refund of the tax, as found by the Tribunal in the case of Tata Engineering and Locomotive, rejecting the revenue authorities' contention that only the payee can claim a refund of tax withheld. The Finance Bill 2007 proposes to restrict the appeal to situations where, under an agreement, the tax is to be borne by the payer.

There is a special refund procedure in some cases. According to Circular 790 of April 20 2000 issued by the revenue authorities, when a contract with a non-resident is cancelled and no payment is made or the payment is refunded, and if the payer has already withheld tax and paid it to the government, the payer will be entitled to a refund of the tax.

Other compliance

A person responsible to withhold tax has specific payment and filing obligations. The tax withheld has to be deposited in favour of the government within a specified time. Quarterly returns must be filed. The withholder has to issue a withholding certificate to the payee to enable the payee to claim credit for the tax withheld.

Consequences of default

In case of default in tax withholding or payment, interest and penalties may follow. Also, the expenditure might not be allowed as a deduction in computing the payer's taxable income.

Often the question arises whether the payer's default in withholding tax can be said to continue even if the payee (recipient) has filed the return and paid the taxes due on that return. This issue is not free from doubt. In the case of A P Power Generation Corporation, the Tribunal held that the default continues as long as the assessee-payer or the deductee does not pay the tax that is due. But once the deductee pays tax and files its return, the default comes to an end.

Sunil D Shah
		Sunil Shah is a tax partner at Deloitte Haskins & Sells based in Mumbai.

Ashesh Safi
		Ashesh Safi is a director at Deloitte Haskins & Sells based in Mumbai.