Volume 2, Issue 14


24th November, 2009


Tax Alert
Karnataka High Court Ruling on Withholding Tax Obligation for Non-resident Payments
Introduction

In a recent ruling in the case of Samsung Electronics and others1, the Karnataka High Court (HC) has held that the payments to overseas vendors for the purchase of off-the-shelf software are subject to withholding tax. More significantly, the HC held that any payment resulting in any income in the hands of a non-resident would be subject to withholding tax under the Indian Income Tax Act (“ITA”). Unless an order is obtained from the tax authorities for withholding tax at a lower or nil rate, a taxpayer would need to withhold tax on the income at the applic-
The Karnataka High Court (HC) has held that any payment resulting in any income in the hands of a non-resident would be subject to withholding tax under the Indian Income Tax Act.
  able withholding tax rates, even if the income may not be taxable in the hands of the non-resident.

Facts

Samsung India purchased software from a US-based software vendor; to be used in its software development operations in India. In this regard, the second appellate authority in India (Income Tax Appellate Tribunal or “ITAT”), placing reliance on an apex court ruling2, had held that software is “goods” and consequently, income earned by the overseas vendors is “business income”, and in the absence of a Permanent Establishment (“PE”) of such vendors in India, the same is not taxable in India. Also, the ITAT had held that payments for software purchase are in the nature of payments for copyrighted product(s), and not the copyright in the product itself. Hence, the payments in this regard are not in the nature of royalties. Consequently, even the Indian entities were not liable to withholding taxes under the provisions of the ITA, in respect of the payments towards purchase of software.

The tax authorities preferred an appeal before the HC. In this regard, the principal issue before the HC was whether payments made by Indian payers to non–resident software vendors should be treated as royalties or business income; and whether the payers were liable to withhold taxes in respect of such payments, under the ITA as well as the Double Taxation Avoidance Agreement (DTAA) between India and the relevant foreign country. There were more rulings by the ITAT on similar grounds for various other taxpayers, and these ITAT rulings were also clubbed with this case.

Arguments of the Tax Authorities

  • Software payments are in the nature of license fees and hence should be regarded as “royalties” under the ITA as well as the DTAA.
  • The payers are liable for withholding taxes in respect of payments to non-residents under the ITA relying on the Apex Court’s ruling in case of Transmission Corporation 3.

Arguments of the Indian Payers

  • Software payments are in the nature of purchase of copyrighted product(s), and not the copyright in the product. Hence, the payment cannot be treated as royalty under ITA or DTAA. Further, since the payments are for purchase of product(s), the same should be treated as business income for the non–resident vendors. Consequently, since the income to the non–resident does not accrue or arise in India, the same is not taxable in India under the ITA. Similarly, in the absence of PE of the non–resident vendors in India, the same is also not taxable under the DTAA.
  • Since the above payments are not taxable in India, the Indian payers are not liable to withhold taxes in respect of these payments.

HC’s Ruling

  • The HC interpreted the ruling of the apex court in case of Transmission Corporation to mean that payments made to non-residents are liable for withholding tax unless there is a specific ruling / order by the tax authorities exempting such withholding Under the provisions of the ITA, taxes need to be withheld on any payment made to a non–resident as long as the payment is in the nature of “income” in the hands of the non–resident recipient.
  • Provisions relating to withholding of taxes seek to withhold a tentative amount of taxes and are independent of determination of the final tax liability of the non–resident in India.
  • Since the specific ruling / order from the tax authorities was not obtained by the non–resident vendors as well as the payers, it cannot be argued that income was not chargeable to tax in India and consequently, even taxes need not be withheld.
  • If a taxpayer has failed to withhold taxes on payment to a non–resident, the tax authorities can initiate proceedings for collection of taxes and interest from the taxpayer, and this action of the tax authorities cannot be objected merely by arguing that the payment did not result in any taxable income in the hands of the non-resident.
  • The HC refrained from answering the question raised in respect of actual determination of tax liability of non–residents in the instant case.

Our Analysis

Under the ITA, any person responsible for making payment of any sum that is chargeable to tax, is obliged to withhold tax on such sum at the applicable tax rate. This provision has been widely interpreted by a number of benches of the ITAT, as requiring firstly determining if the payment is taxable in India, and only if taxable, was the payer required to withhold taxes in respect of such taxable payment. However, this HC ruling suggests that the payer of any income to a non-resident cannot make such a determination (whether the payment is taxable in India or not); and is required to withhold taxes on the payment, irrespective of whether the same is taxable in India or not, unless an order for nil / lower withholding tax has been obtained from the tax authorities.

This ruling has apparently re-opened the matter which was more or less settled in the Indian context. It may be noted that a HC ruling is generally binding on the lower authorities within the particular state; and has significant persuasive value for other lower courts / authorities.

Although this ruling deals with withholding tax obligations of Indian payers in respect of software payments, it is expected to enthuse the tax authorities who may take a cue from this ruling and may apply the same principles to other cases as well.
The dilemma for the taxpayer would be the extent to which the principles laid down in this ruling should be stretched – whether this should cover only software payments, or should include other payments like purchase of goods, assets, reimbursement of expenses? In fact, the significant fallout of this ruling for Indian entities, apart from the withholding tax liability, could be the disallowance of said expenditure itself.

The situation is further complicated because the HC has not pronounced a ruling on the underlying fundamental issue of taxability of software payments.

All in all, till the time there is clarity on the matter (by way of a ruling by the apex court), the tax authorities may scrutinize cross–border payments in greater depths, thereby imposing significant compliance burden on the resident payers.
Consequently, it becomes extremely important for taxpayers to revisit their withholding tax strategy with respect to cross-border payments, especially in the light of the possible ramifications of this ruling on their tax positions; preferably with the assistance of cross-border tax experts.

Notes:

1 ITA No. 2808 of 2005
2 TCS v/s State of Andhra Pradesh [271 ITR 401] (SC), in context of sales tax laws.
3 Transmission Corporation of A.P. Ltd v/s CIT [239 ITR 587] (SC).