Volume 3, Issue I

18th January, 2010

Tax Alert
Doing business with India– Foreign companies now need to procure PAN

Under the current Indian income tax regime, the payer is required to withhold taxes in India in respect of payments made to non residents/foreign companies. The withholding tax rate applicable is the rate as per domestic tax laws of India or the rate as per the India’s tax treaty with overseas country, whichever is more beneficial to the non resident taxpayer.

The domestic tax laws provide for the following consequences for non/lower withholding of taxes by the Indian payer in respect of payments made to foreign company:

  • Disallowance of the expenditure itself if taxes not properly paid;
  • Interest @ 1% per month & penalties for non deduction/non payment of taxes
The Finance (No.2) Bill, 2009 had introduced a new section 206AA in the Income-tax Act, 1961 (ITA), which provides that every recipient of income is required to furnish its Permanent Account Number (PAN) i.e. tax registration number to the payer.

Recently, the Indian Tax Authorities have been closely monitoring withholding tax compliances in India. In this regard, the government has recently introduced new rules whereby each and every foreign remittance would have to be reported/intimated to tax authorities before making the payment.

New Amendment

In addition to above measures, the recent Finance (No.2) Bill, 2009 had introduced a new section 206AA in the Income-tax Act, 1961 (ITA), which provides that every recipient of income is required to furnish its Permanent Account Number (PAN) i.e. tax registration number to the payer.

If the recipient fails to provide the PAN, the withholding tax rate, if applicable, would be higher of the following rates:

i. Rate specified in the relevant section depending on the nature of payment;
ii. Rates in force (rate specified in the ITA or under the tax treaty);
iii. Rate of 20%.

The importance of PAN has also increased due to the fact that in the absence of PAN, the Indian tax authorities will not entertain an application from the recipient for a lower withholding tax rate. Moreover, the PAN is required to be indicated in all correspondence, bills, vouchers and other documents exchanged between the recipient and payer.

The amendment would apply to payments / credits made on or after 1 April 2010.

Implications for foreign companies / non-residents

The current tax rate under the domestic tax laws for royalties and fees for technical services generally is 10% (plus applicable surcharge and education cess) of the gross amount. The tax treaties also generally provide for a tax rate of 10% / 15% of the gross amount. Even in case of interest, many Indian tax treaties provide for a lower withholding tax rate of 10% / 15%. In several cases, foreign companies do not apply for a PAN in India since they earn only such passive income or they do not have business operations / Permanent Establishment in India.

Now, with the above amendment, in the absence of PAN, notwithstanding the fact that a lower rate is provided under the ITA or the tax treaty, tax is required to be withheld @ 20% in India.

The above provision seems to have the effect of Indian laws having an extra territorial jurisdiction whereby the foreign companies and non residents are obligated to comply with the laws of India. Questions are being raised regarding the validity of these provisions since the provision requires compliance in India overriding even the provisions of tax treaties and ignoring practical difficulties faced by foreign companies in respect of tax registration and compliance.

In practice, it is quite unlikely, that Indian companies would consider these arguments while withholding taxes given the punitive consequences for withholding lower taxes in India.

Credit for such excess tax withheld may not be available to the foreign company in its home country since the taxes are not withheld as per treaty provisions, Thus if foreign company does not have PAN at the time of receipt of the income, it would later have to apply for PAN and file return of income in India to claim refund of such excess tax.

In any case, irrespective of whether a refund is due or not, technically, the Indian law requires all the foreign companies to file return of income, in case of income being earned from India – even if the applicable taxes have been paid in India. Till date, most foreign companies are practically not complying with the said provision and even the tax authorities do not have any mechanism to monitor the same. However, with the introduction of the above provision, the tax authorities can easily scrutinize the compliances by foreign companies in India based on the PAN allotted to foreign companies. Filing of return of income in India would be accompanied by host of other compliances1.

[1Foreign companies are required to inter alia undergo tax audit under section 44AB if turnover / gross receipts exceed INR 4 million (business) / INR 1 million (profession) and comply with the transfer pricing provisions (including maintenance of documentation and filing report from Chartered Accountant in Form 3CEB). ]

Implications for Indian residents

In net off tax contracts wherein Indian companies are required to bear the foreign company’s income-tax liability in India, foreign company would generally be reluctant to obtain a PAN and / or file an Indian income-tax return. In such a scenario, considering the provisions of the above amendment and the grossing-up provisions, the cost for the Indian companies would typically be 125% of the contracted amount (based on grossed up value).

Also, the said amendment would apply to payments to Indian residents as well. Consequently, Indian companies should not only procure PAN while making payments but also intimate its PAN to all persons who withhold tax from payments to the company.

Way forward

  • Initiate the process for obtaining PAN for foreign group companies;
  • In contracts where tax is to be borne by the Indian company, with unrelated foreign companies, the contracts should stipulate that the foreign companies would obtain PAN;
  • In future contracts with unrelated foreign companies the above mentioned new requirement may be highlighted to ensure that they are aware of the Indian tax requirements.

How we can help?

  • Assist Foreign companies in applying and procuring PAN in India;
  • Advising on the withholding tax implications and also suggesting ways and means, if any to legally minimize the withholding tax liabilities;
  • Preparing and filing Return of Income in India;
  • Assistance in representing before the Indian Income Tax Authorities, if the case is picked up for detailed audit;
  • Other compliances, if any, as required under the regulations from time to time