TO a large extent, non-resident taxation depends on enforceability. Payments once gone out of India may be gone forever unless there is a mechanism for capturing the tax element in such payments. In that view of the matter, in case of payments to non-residents, failure to deduct tax at source in respect of payments of interest, royalty, fees for technical services or other sums entailed disallowance of the payment itself in the hands of the payer under Section 40(a)(i) of the IT Act.

A provision similar to section 40(a)(i) existed even in the 1922 Act. However, its scope has been expanded over time. Initially, the disallowance was only in respect of interest and that too only when there existed no one in India who could be held to be an agent. In 1989, the condition of existence of agent was removed and the provision was also extended to payments from royalty & FTS.

There was no such provision for disallowance however for similar payments from residents to residents. In an attempt to increase the tax base, the provisions of the tax deduction at source have been expanded from year to year with various types of payments being brought to the list of payments that are subject to deduction of tax at source. Nevertheless, it also had to be ensured that the provisions of the expanded scope of TDS were properly enforced. Therefore, with a view to increase the compliance of the TDS provisions, by the Finance No (2) Act of 2004, the provisions of section 40(a)(i) were also extended to payments made to resident taxpayers as well through a newly introduced clause 40(a)(ia). The disallowance was in respect of interest, commission, brokerage, rent, and royalty, fees for professional services or fees for technical services or amounts payable to a contractor or sub-contractor.

While presenting his first budget, Mr Arun Jaitley, the Finance Minister has mentioned that this provision (Section 40(a)(ia)) has caused hardship in some cases. To quote the Minister:

“Currently, where an assessee fails to deduct and pay tax on specified payments to residents, 100 percent of such payments are not allowed as deduction while computing his income. This has caused undue hardship to taxpayers, particularly where the rate of tax is only 1 to 10%. Hence, I propose to provide that instead of 100 percent, only 30% of such payments will be disallowed.”

Although from the speech of the Minister, it is not clear as to whether the relaxation is in respect of any particular class of assessees, in the Finance Bill, it is seen that this amendment is only in section 40(a)(ia).

The Memorandum to the Finance Bill however acknowledges that the provision was useful in enforcing compliance. “Section 40(a)(ia) has proved to be an effective tool for ensuring compliance of TDS provisions by the payers. Therefore, in order to improve the TDS compliance in respect of payments to residents which are currently not specified in section 40(a)(ia), it is proposed that the disallowance under section 40(a)(ia) of the Act shall extend to all expenditure on which tax is deductible under Chapter XVII-B of the Act.” Thus, the ambit of the provision has, in fact, been extended for payments to residents although the disallowance is now restricted to 30% of the total payment.

In so far as TDS from payments to non-residents are concerned, the Bill does propose a change. In case of payments made to resident, the deductor is allowed to claim deduction for payments as expenditure in the previous year of payment, if tax is deducted during the previous year and the same is paid on or before the due date specified for filing of return. However, in case of disallowance for non-payment of tax from payments made to non-residents, till now, this extended time limit of payment up to the date of filing of return of income under section 139(1) was not available. Now the same provision has been extended to payments to non-residents also and the two provisions have been brought at par on this score.

In the context of these changes in the provisions relating to disallowance for non-deduction and non-payment of tax at source, it is interesting to note the decision of the Tribunal in the case of Herbalife International Private Ltd. (2006-TII-15-ITAT-DEL-INTL).

In this case, Herbalife India International Pvt Ltd, a 100% subsidiary of Herbalife International, USA entered into an administrative service agreement with a group company, Herbalife International of America, Inc. In exchange of various services stipulated in the agreement, the assessee paid administrative fee. One of the issues involved in the case was whether for the assessment year 2000-2001, the payment of such administrative fee without deduction of tax at source could be disallowed in terms of section 40(a)(i). The Assessing Officer had held that the payment for data processing services, accounting services, marketing services, financial services as well as miscellaneous consultancy services, represented fees for technical services as per the provisions of Section 9(l)(vii) and since no tax was deducted at source, the same was to be disallowed u/s 40(a)(i). The CIT (A) upheld the order of the AO holding that the payment represented FTS. He also rejected the contention that the amounts represented reimbursement of expenses.

On further appeal to the Tribunal, the taxpayer argued that the amount in question could not be taxed since it amounted to reimbursement; besides the amount did not represent fees for technical services under the domestic law as also under Article 12(4)(b) of the DTAA between India and the USA. More importantly, the taxpayer took an alternate argument before the Tribunal for the first time that in any case, in view of Article 26(3) of the India-USA DTAA [corresponding to Article 24(4) of the OECD Model], the provisions of section 40(a)(i) could not be applied and no disallowance could be made.

Article 26(3) of the Indo-US DTAA treaty states as follows:

“3. 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.”

From the order of the Tribunal, It is not known what exactly were the arguments taken by he Revenue in this regard. The Tribunal however went on to decide the case mainly on the ground of the non-discrimination article observing that If applicability of Article 26(3) of DTAA between India and USA in the context of S.40 (a)(i) is decided in favour of the assessee, the other questions about the chargeability of the payments to tax in India can be decided in the appeal pending before other Benches.

The Tribunal pointed out that Article 26(3) of the Indo-USA DTAA was pari-materia with Article 24(4) of the OECD Model. The Tribunal referred to the following commentary on this provision:

"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 allowed without restriction when the recipient is resident, is restricted or even prohibited when he is a non-resident…”

The Tribunal pointed out that in the relevant assessment year 2000-2001, section 40(a)(i) stated as follows:

“S.40 : Notwithstanding anything to the contrary in Sections 30 to (38), the following amounts shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession", -

(a) in the case of any assessee -

(i) any interest (not being interest on a loan issued for public subscription before the 1st day of April, 1938), royalty, fees for technical services or other sum chargeable under this Act, which is payable outside India, on which tax has not been paid or deducted under Chapter XVII-B…”

The Tribunal pointed out that the provisions of Section 40(a)(i) as it existed prior to the amendment in 2004 provided for disallowance of payment made to a non-resident only where tax is not deducted on such payment at source. A similar payment to a resident did not result in disallowance in the event of non-deduction of tax at source. The Tribunal therefore concluded that a ‘non-resident left with a choice of dealing with a resident or a non-resident in business would opt to deal with a resident rather than a non-resident owing to the provisions of Section 40(a)(i)’. The Tribunal held that a non-resident was therefore discriminated to this extent. The Tribunal held that Article 26(3) of Indo-US DTAA seeks to provide against such discrimination and says that deduction should be allowed on the same condition as if the payment were made to a resident. According to the Tribunal, Article 26(3) of the DTAA thus neutralizes the rigour of the provisions of Section 40(a)(i). The Tribunal pointed out that by virtue of the provisions of Section 90(2) the law, which is beneficial to the assessee to whom, the DTAA applies, should be followed. Therefore, the Tribunal held that in view of Article 26(3) of Indo-US DTAA, the Assessing Officer could not seek to invoke the provisions of Section 40(a)(i) of the Act to disallow the claim of the assessee even on the assumption that the sum in question was chargeable to tax in India. 

Ever since the decision in Herbalife, various Benches of the Tribunal in a number of cases have followed its ratio. [See for example, Millennium Infocom (2008-TII-16-ITAT-DEL-INTL), Menlo Worldwide Forwarding India Pvt Ltd (2010-TII-164-ITAT-DEL-INTL), SMS Demag (P) Ltd (2010-TII-12-ITAT-DEL-INTL), Peoplesoft India Pvt Ltd (2012-TII-75-ITAT-MUM-INTL), Incent Tours Pvt Ltd (2012-TII-54-ITAT-DEL-INTL), Sandoz Pvt Ltd (2012-TII-215-ITAT-MUM-INTL), and Mitsubishi Corporation India Pvt Ltd (2013-TII-189-ITAT-DEL-TP) etc.] It is not known whether Revenue has challenged the decision. As yet, there is no decision of any High Court on the point.

There are of course decisions of both Tribunal and AAR relating to higher tax rate charged on foreign banks. This has been justified by the AAR in the case of Société Générale (2002-TII-55-ARA-INTL) on the ground that foreign banks and Indian banks work in different circumstances. Moreover, Explanation 1 to section 90 added by Finance Act clarifies that levy of tax at a higher rate on foreign company shall not be regarded as a less favourable charge. There are similar clarifications in some of the treaties as well.

The arguments taken by the DRs in various cases before the Tribunal are also based on nationality non-discrimination reasoning. (See, for example, Peoplesoft India Pvt Ltd). However, Article 26 deals with four types of non-discrimination - nationality non-discrimination, PE non-discrimination, deductibility non-discrimination and ownership non-discrimination. Explanation 1 to section 90 can tackle only the first kind of non-discrimination. In particular, the deductibility non-discrimination provision does not refer to the circumstances being similar. Thus, even though residents are subject to worldwide taxation while non-resident taxation is restricted, it is not clear whether the similarity of circumstances contemplated in other types of non-discrimination can be imported in the deductibility non-discrimination provision.

Therefore, the Tribunal is likely to take a view that the proposed provision of section 40(a)(ia) being more beneficial to resident taxpayers, is discriminatory since the disallowance of expenditure in case of non-compliance with the TDS provision will be only 30% in case of payments to resident whereas the same will continue to be disallowed completely in the case of payments to non-residents in terms of the existing 40(a)(i).

It is not known whether it was a conscious decision to restrict the rigours of disallowance only in case of payments to resident taxpayers. If so, some kind of explanation will be necessary in view of the stand taken Tribunal in various cases.