Applicability of TDS on payments to foreign companies: Analysis

Note by Author

Today, I received a call from a corporate client. He questioned that 'I had made a payment to a UK-based company, but received a TDS notice. What shall I do now?' Deducting TDS is mandatory for foreign payments in a few cases, let’s discuss in this article. Happy Reading

Introduction

Now a days, cross-border transactions have become very common, we Chartered Accountants provide services to offshore clients and on the other hand few companies take consultancies from abroad, hence whether payments are made for availing professional services, technical consultancies, software licences, or even royalties. However, any payment that is made to a non-resident is not just a simple business transaction, it triggers withholding tax obligations in India as per Section 195 of the Income-tax Act, 1961, in simple terms we say it TDS or Tax deducted at source.

Failure to comply this provision of Income tax will result in disallowance of 100% expenses under Section 40(a)(i), interest under Section 201(1A), and many penalties. Therefore, knowing the correct TDS rate and process is important, the same thing I will discuss in this article in detail.

Sections we are going to discuss

Section 40(a)(i)disallows certain expenses like interest, royalty, fees for technical services, or any other sum chargeable to tax in India, when paid to a non-resident, if tax was deductible under Section 195 have not been deposited. The whole expense is liable to be added back to taxable income in that year, though it can be claimed in the year the TDS is actually paid.

Section 201(1A)charges interest of 1% per month for delay in deduction, and 1.5% per month for delay in depositing after deduction, it is calculated from the due date of TDS until actual deduction/payment is made.

Section 195(1)requires TDS on any payment (other than salary) to a non-resident, which is chargeable to tax under the Income tax Act.

Section 90(2) says where double taxation avoidance agreement (DTAA) exists, the provisions of the Income tax act or the DTAA, whichever is more beneficial to the assessee shall apply.

Section 195(2) gives the facility to apply to the Assessing Officer for determination of appropriate proportion of sum chargeable to tax, while Section 195(3) gives them facility to apply for nil/lower deduction certificate.

Rule 37BC gives relaxation from higher TDS rate due to non-availability of PAN for certain payments.

Process for determining TDS

I am here going to discuss the checklist to ensure correct compliance related to payment of TDS to foreign entities

First of all, we need to check whether those payments are taxable in India as the main condition is that the payment must have a nexus with India (source rule under Section 9). If it is not income chargeable to tax in India like certain export reimbursements, payments for services performed outside India, then in that case Section 195 is not applicable, for these cases, a certificate from Chartered Accountant must be obtained or AO determination under Section 195(2) will also work.

After that we need to check if India has a DTAA with the recipient’s country, for that we need to refer to the CBDT DTAA list.

After that we need to identify the article covering the nature of income like article 12 deals with royalty & fees for technical services, article 7 deals with profits from business and article 15 deals with independent personal services

Note: the TDS rate is prescribed in the DTAA for that specific income

After getting the DTAA rate, we are supposed to check the rate prevailing in domestic law, for that we must refer to Part II of first schedule of the finance act which deals with current rates, and is amended from time to time, so a normal google search may not work.

The common rates under the act for royalty or FTS is 10% + surcharge + cess, whereas for interest, it is 5%/20% depending on the nature of income

In case the PAN is not available, Section 206AA applies (which gives 20% rate), unless Rule 37BC relaxation applies.

Note: Rule 37BC of the income-tax Rules grants relief to certain non-residents (other than companies or foreign companies) from furnishing PAN in India, provided they furnish specified details such as name, email, contact number, address in country of residence, tax residency certificate, and tax identification number of that country (or equivalent). Where these conditions are met, the payer may deduct tax at the applicable rate under the act or DTAA without applying the higher rate prescribed under section 206AA.

Then we need to compare rate in DTAA and that in Income-tax act by apply Section 90(2) to select the lower (more beneficial) rate.

For example: rate for royalty as per the income tax act is 10% + surcharge + cess i.e. effective rate is 10.92%, whereas the rate as per DTAA is 10% without any surcharge/cess Result, hence in this case the rate as per DTAA is lower, So, in this case apply DTAA provisions.

Finally, after that we need to collect documentation, like if DTAA rate is applied, in that case we need tax Residency Certificate from foreign recipient as per Section 90(4) of Income tax act, form 10F from the recipient, the self-declaration for beneficial ownership and absence of PE in India and in case the rate given in act is applied, in that case DTAA documents are not needed, but maintain invoice, agreement, tax computation for records.

Compliance and filings required

First one is form 15CA, which is needed to be filed by remitter or payer, next one is the form 15CB which is the Chartered Accountant’s certificate detailing the nature of payment, rate of TDS, and the legal basis.

TDS related forms include form 27Q which is the quarterly TDS return for non-resident payments, and form 16A which is the TDS certificate to be issued to the foreign recipient.

At the time of remittance

We need to deduct TDS at the time of credit or payment, whichever is earlier, then deposit TDS within 7 days of the month-end (or by 30 April for March deductions) also maintain proof of remittance and compliance for the purposes of tax audit and FEMA.

Treatment in case of reimbursements

Pure reimbursements, without any element of profit shall not be taxable, but they require a proper documentation and assessing officer followed with CA certification to avoid any future disputes.

Treatment in GST & Withholding taxation

In GST, Sec. 5(3)IGST Act, 2017 says that IGST shall be charged under reverse charge mechanism on import of services, and ITC for the same shall be available if used in course of business and not blocked under Sec. 17(5).

Income-Tax or withholding tax to be treated as per section 195 of income tax act, 1961, in case of non-compliance the amount will be disallowance u/s 40(a)(i) along with interest & penalty is liable to be imposed.

Foreign Tax Credit (FTC)

The foreign company may claim FTC in its home country for the TDS that is deducted in India, it is subject to local laws of that country.

Illustrations

Illustration 1: Payment made to Singapore for technical services, rate as per act is 10% plus applicable surcharge and cess = 10.92%, rate as per DTAA (India-Singapore) is 10%

Assuming TRC & Form 10F obtained, DTAA rate of 10% to be applied, the payer must file 15CA/15CB and deduct TDS @ 10%.

Illustration 2: Payment made to Dubai for consultancy services, here, UAE DTAA may classify under “Independent Personal Services” if no PE in India, this will result in no deduction of TDS if services performed entirely outside India & no PE.

Judicial Precedents

GE India Technology Centre Private Ltd. Versus Commissioner of Income Tax & Anr. - 2010 (9) TMI 7 - Supreme Court
In this case law, the Supreme court held that TDS under section 195 applies only when the payment made to a non-resident is chargeable to tax in India. The payer’s obligation to deduct tax arises only if the sum paid has a taxability nexus under the Income tax act/DTAA.

ISHIKAWAJIMA-HARIMA HEAVY INDUSTRIES LTD. Versus DIRECTOR OF INCOME-TAX - 2007 (1) TMI 91 - Supreme Court
In this case law, the supreme court applied the territorial nexus principle, ruling that offshore services executed entirely outside India cannot be taxed in India merely because they are connected to an Indian project, unless the services are rendered and utilised in India.

Vodafone International Holdings BV. Versus Union of India & Anr. - 2012 (1) TMI 52 - Supreme Court
In this case law, the supreme court held that source-based taxation applies where income arises from assets situated in India, but in this case, the offshore share transfer of a foreign company holding Indian assets was not taxable in India as it was a genuine offshore transaction without direct transfer of Indian assets.

Penalties for non-compliance

Section 201(1) deals with deemed assessee in default, liability to pay TDS not deducted, Section 201(1A) deals with interest chargeable at the rate of 1%/1.5% per month, Section 271C deals with penalty leviable that is equal to amount of TDS that has not been deducted or short deducted, and section 40(a)(i) deals with disallowance of entire expense in computation of business income.

Conclusion

While making payments to foreign companies, it is important to first determine whether the sum is chargeable to tax in India under the Income-tax Act read with the applicable DTAA, as TDS under Section 195 is attracted only in such cases. Proper classification of income, application of the correct rate (whichever is more beneficial between the Act and the DTAA), and compliance with documentation requirements like TRC, Form 10F, and beneficial ownership declarations are essential to avoid disallowance under Section 40(a)(i), interest, and penalties. Simultaneously, GST implications under the reverse charge mechanism must be evaluated to ensure seamless input tax credit claims.

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