Tax reforms can play a decisive role in supporting growth, by removing distortions, enhancing transparency and ensuring certain level of stability in the area of international taxation. Indian economy has grown at an impressive pace over the past couple of decades as a result of wide-ranging structural reforms however lack of a stable tax regime has raised concerns about it in the last couple of years. Amidst these concerns, the newly elected government received a massive mandate, with the first promising task of reviving the economy and boosting the sentiments of the foreign investors with a more stable, transparent and non-discriminatory tax system.
The recent amendment proposed in Section 40(a)(ia) of the Income Tax Act vide Finance Act (No.2) 2014 provides that, the disallowance on account of failure to deduct tax at source shall be restricted to 30% of the amount of expenditure in case of payments made to a resident. The amendment would be effective from April 1, 2015. The memorandum explaining the Finance (No. 2) Bill, 2014 also reiterates: “In order to reduce the hardship, it is proposed that in case of non-deduction or non-payment of TDS on payments made to residents as specified in section 40(a)(ia) of the Act, the disallowance shall be restricted to 30% of the amount of expenditure claimed.”
An attempt to articulate a tax mechanism with economic objectives sometimes inadvertently results in unintended consequences. This short write-up highlights the concerns hovering over the proposed amendment in Section 40(a)(ia) of the Act which restricts the disallowance of expenditure wherein tax has not been duly deducted at source to 30% of such expenditure only where expenditure involves payments to residents.
The proposed amendment discriminates between the treatment of payments to residents from payments to non-residents since clause (i) of Section 40(a) which deals with non-residents has not been correspondingly amended to provide for a similar reduced disallowance. This article examines the possibility of extending similar treatment to payments to non-residents by invoking non-discriminatory article of double tax avoidance agreements (‘tax treaties’).
Legal framework and analysis
Non-discrimination articles in tax treaties obligate the contracting states to prevent a less favourable taxation to nationals and residents of other states, and can be broadly categorized as following: (1) nationality based discrimination; (2) permanent establishment based discrimination; (3) discrimination based on status of payee; and (4) ownership based discrimination. In the present issue under consideration we are concerned with the third category of non-discrimination. The text of relevant Article [Article 24(4) of the OECD Model] is reproduced hereunder:
“4. Except where the provisions of paragraph 1 of Article 9 (Associated Enterprises), paragraph 7 of Article 11 (Interest), or paragraph 8 of Article 12 (Royalties and Fees for Included Services) apply, interest, royalties, and other disbursements paid by resident of a Contracting State to a resident of the other Contracting State shall, for the purposes of determining the taxable profits of the first mentioned resident, be deductible under the same conditions as if they had been paid to a resident of the first mentioned State.”
This paragraph is designed to end a particular form of discrimination resulting from the fact that in certain countries the deduction of interest, royalties and other disbursements are allowed without restriction when the recipient is resident but restricted or prohibited when he is a non-resident [see end note 1].
In view of the above, disbursements made to a resident of the other contracting state should be deductible in the same manner and to the same extent as if it were payments to a resident of the same state. Thus it prevents indirect discrimination which would arise if the sums were not deductible [see end note 2].
The applicability of the above Article has been dealt with in various decisions rendered in the context of erstwhile regime of Section 40(a)(i). To trace the history, Section 40(a)(i) of the Act, has been in the statute book since inception of the Income-tax Act, 1961. A similar provision existed even in the earlier 1922 Act. The provision initially used to cover payments in the nature of ‘interest’ only. However, in the year 1989, its ambit was widened to cover ‘royalty’ and ‘fees for technical services’ also. Thereafter, in the year 2004, with a view to augment compliance of TDS provisions in the case of residents as well, a new provision Section 40(a)(ia) [akin to Section 40(a)(i)] was introduced in the Act.
In the context of these changes, a ground for the first time was assailed before the Delhi ITAT in Herbalife International India (P.) Ltd. v. ACIT [see end note3], alleging that payment of administrative fee to the parent company, an entity in the US, without deduction of tax in the assessment year 2000-01 could not be disallowed by invoking the provisions of Section 40(a)(i) of the Act, in view of non-discriminatory provisions as contemplated in Article 26(3) of the Indo-US Tax Treaty. The Tribunal observed that the provisions of Section 40(a)(i) of the Act as it existed prior to the amendment in the year 2004 provided for disallowance of payment made to a non-resident only. A similar payment to a resident did not result in disallowance in the event of default of TDS. Therefore, a ‘resident left with a choice of dealing with a non-resident or a resident in business would opt to deal with a resident rather than a non-resident owing to the provisions of Section 40(a)(i)’ and a non-resident was discriminated to this extent. The Tribunal further held that Article 26(3) of Indo-US Tax Treaty seeks to protect against such discrimination and says that deduction should be allowed on the same condition as if the payment were made to a resident. In view of the Tribunal, this Article mitigates the rigour of the provisions of Section 40(a)(i) of the Act. The Tribunal, therefore, held that in view of Article 26(3) of Indo-US Tax Treaty, the revenue authority could not seek to invoke the provisions of Section 40(a)(i) of the Act to disallow the expenditure even on the assumption that the sum in question was chargeable to tax in India.
This ratio-decidendi was later followed by many other Benches of the Tribunal in the cases like DCIT v. Incent Tours (P.) Ltd. [see end note 4], Millennium Infocom Tecnologies Ltd. v. ACIT [see end note 5], Sandoz (P.) Ltd. v. Addl. CIT [see end note 6], Central Bank of India v. DCIT [see end note 7], B4U International Holdings Ltd. v. DCIT [see end note 8], Mitsubishi Corporation India (P.) Ltd. v. ACIT [see end note 9] and Asianet Communications Ltd. v. DCIT [see end note 10].
Applying the above proposition as accepted in Herbalife and other decisions (supra), there appears to be strong judicial support for the view that even in case of payments to non-residents, protected by non-discriminatory article, the disallowance for non-deduction of TDS has to be restricted to 30%. Moreover, in none of these judgments any strong argument has been taken by the department and even explanation 1 to Section 90 of the Act is not suitably worded to guard such a ‘deductibility non-discrimination’.
It is important, however, to note that not all treaties have a non-discrimination article [see end note 11]. Further some tax treaties though have a non-discrimination article but do not contain an equivalent clause on ‘discrimination based on status of payee’ [see end note 12]. Hence, the legal position highlighted above can be invoked only in the case of select treaty countries[xiii] having the relevant non-discrimination clause in the treaties.
[The authors are, respectively, Senior Associate and Director, Direct Tax Practice, Lakshmikumaran & Sridharan, New Delhi]
- Page 411 of Double Tax Conventions & International Tax Law (Second Edition) by Philip Baker
- Pg 396, 397 of Double Tax Conventions & International Tax Law (Second Edition) by Philip Baker
- (2006) 101 ITD 450 (Del.)
- (2012) 53 SOT 308 (Del) (URO) [v] (2009) 117 ITD 114 (Del)
- (2013) 34 taxmann.com 280 (Mum – Trib.)
- (2010) 42 SOT 450 (Mum)
- (2012) 148 TTJ 237 (Mum)
- (2014) 62 SOT 58 (Del) (URO)
- (2010) 38 SOT 158 (Chennai)
- For example Australia, Greece, Oman and Saudi Arabia
- For example Brazil, Canada, Italy, Mauritius
- For example China, France, Germany, Japan, Netherlands, South Africa, Spain, Swiss Confederation, USA etc.