India being a developing economy always encouraged import of technical know-how and technical services to promote and facilitate growth in Indian industry. In line with the same, S. 115A provides for taxation of royalty and fees for technical services (FTS) at a reasonable rate of 10 per cent for a long time before it was amended through Finance Act, 2013 to increase the rate of taxation to 25 per cent. We also have S. 206AA in the statute book, introduced through Finance Act, 2009 making it effective from 1st April, 2010 which provides for mandatory requirement of furnishing PAN even by a non resident. It is to be noted that S. 206AA mandates higher rate of withholding tax of 20 per cent against payments to non residents who do not possess PAN. It is common in many contracts that the nonresident insists on net of tax payments which makes the resident tax payer bear taxes and gross up such payments u/s 195A of the Act. In this article I would like to deal with the combined impact of S. 195A and S. 206AA in cases where such non residents do not have PAN in India and highlight the incompatibility which continues even after the proposal in Finance Bill, 2015 to reduce the rate of taxation on royalty/FTS payments to non residents to the original rate of ten per cent.
S. 115A was introduced by Finance Act, 1976 and the rate of taxation of royalty and FTS has been 10 per cent. An amendment was brought in through Finance Act, 2013 to increase the rate of taxation of royalty and FTS received by a foreign company from a resident tax payer from 10 per cent to 25 per cent. Hon’ble Finance Minister clarified the purpose of increase of rate of taxation in his budget speech as under:
“Another case is the distribution of profits by a subsidiary to a foreign parent company in the form of royalty. Besides, the rate of tax on royalty in the Income-tax Act is lower than the rates provided in a number of Double Tax Avoidance Agreements. This is an anomaly that must be corrected. Hence, I propose to increase the rate of tax on payments by way of royalty and fees for technical services to non-residents from 10 percent to 25 percent. However, the applicable rate will be the rate of tax stipulated in the DTAA.”
It was assumed that distribution of profits by subsidiaries to their foreign parents was being done in the form of royalty payments. However, all cases may not fall into the said category as there could be payments from resident payer to nonresident payee who are not related in any manner. All such genuine cases suffered from high rate of taxation of 25 per cent. Most of the service recipients in India are not able to bargain in a manner that nonresident payees will have to bear the tax burden.
On account of this, most of the resident payers have to bear the tax burden and are thereby forced to gross up such taxes u/s 195A of the Act. The effective tax rate in all grossing up cases is as high as 36.05 per cent.
Thus, S. 115A provides for the tax rates on which income by way of royalty or fees for technical services in case of non-residents or a foreign company is taxed. The prescribed tax rate u/s 115A is 10%
However, as per the proposed amendment in S. 115A, the concessional tax rate of 10% is sought to be raised to 25%. Again, by extrapolation, this imputes an expenditure of only 37.5% of the gross income as per the following calculations:
|Gross Royalty / FTS – `||100.00||100.00|
|Expenditure – `||75.00||37.50|
|Net Taxable Income – `||25.00||62.50|
|Tax rate (normal) – say – %||40%||40%|
|Tax amount – `||10.00||25.00|
|Tax rate on gross basis as per S. 115A||10%||25%|
Hon’ble Finance Minister restored the earlier rate of ten per cent taxation against royalty and FTS through the Finance Bill, 2015 and observed
“Today I see a lot of young entrepreneurs running business ventures or wanting to start new ones. They need latest technology. Therefore, to facilitate technology inflow to small businesses at low costs, I propose to reduce the rate of income tax on royalty and fees for technical services from 25% to 10%.”
The cost escalation in genuine cases has been appreciated as is evident from the above observations of the Hon’ble Minister. This rate aligns with some of the rates incorporated in DTAAs India entered into.
However, it is imperative to discuss the incompatibility between the provisions of S. 195A and provisions of S. 206AA in cases where a non resident payee does not have a PAN in India.
For Section 115A, of the Income Tax Act, 1961-
Tax on dividends, royalty and technical service fees in the case of foreign companies.
S. 206AA reads as under—
“(1) Notwithstanding anything contained in any other provisions of this Act, any person entitled to receive any sum or income or amount, on which tax is deductible under Chapter XVII-B (hereafter referred to as deductee) shall furnish his Permanent Account Number to the person responsible for deducting such tax (hereafter referred to as deductor), failing which tax shall be deducted at the higher of the following rates, namely:-
(i) at the rate specified in the relevant provision of this Act; or
(ii) at the rate or rates in force; or
(iii) at the rate of twenty per cent……”
S. 195A reads as under—
“In a case other than that referred to in sub-section (1A) of section 192, where under an agreement or other arrangement, the tax chargeable on any income referred to in the foregoing provisions of this Chapter is to be borne by the person by whom the income is payable, then, for the purposes of deduction of tax under those provisions such income shall be increased to such amount as would, after deduction of tax thereon at the rates in force for the financial year in which such income is payable, be equal to the net amount payable under such agreement or arrangement.”
It is evident from the text of S. 195A that it refers to foregoing provisions of Chapter XVII B and it also refers to the “rates in force” for the purpose of grossing up. S. 206AA is not a section preceding S. 195A . Accordingly, it is only “rates in force” which are applied for withholding of taxes, are to be considered even for grossing up purpose u/s 195A.
An issue would arise when provisions of S. 206AA are to be applied to a payment made to a non resident by withholding taxes at higher rate of 20 per cent, whether grossing up is to be done at the same rate of 20 per cent or as per the “rates in force” referred in S. 195A. It is clear through plain reading of definition of “rates in force” as per S. 2(37A)(iii) that rate prescribed in S. 206AA is not to be treated as “rate in force”.
In this context it is pertinent to consult the decision of the Hon’ble Bangalore ITAT in the case of Bosch Ltd v ITO (International Taxation) (2013) 141 ITD 38 wherein it was held as under:
“&In the circumstances, the recipients are bound and are under an obligation to obtain the PAN and furnish the same to the assessee. For failure to do so, the assessee is liable to withhold tax at the higher of rates prescribed u/s 206AA of the Income-tax Act, i.e., 20% and the CIT(A) has rightly held that the provision of section 206AA are applicable to the assessee….
Thus, it can be seen that the income shall be increased to such amount as would after deduction of tax thereto at the rate in force for the financial year in which such income is payable, be equal to the net amount payable under such agreement or arrangement. A literal reading of section implies that the income should be increased at the rates in force for the financial years and not the rates at which the tax is to be withheld by the assessee. The Hon’ble Apex Court in the case of GE India Technology Center (P.) Ltd. v. CIT  327 ITR 456/193 Taxman 234/7 taxmann.com 18 has held that the meaning and effect has to be given to the expression used in the section and while interpreting a section, one has to give weightage to every word used in that section. In view of the same, we are of the opinion that the grossing up of the amount is to be done at the rates in force for the financial year in which such income is payable and not at 20% as specified u/s 206AA of the Act.”
This creates an incompatible situation whereby you withhold taxes as per S. 206AA at 20 per cent where the nonresident payee does not have PAN but the grossing up has to be done as per the rates of DTAA or S. 115A whichever are beneficial, say at 10 per cent for example, for the purpose of S. 195A. It is to be noted that this approach of adopting two different rates one for withholding of taxes and one for grossing up where the payer has to bear the tax creates an inconsistent outcome of not achieving the purport of S. 195A.
In other words, the resultant amount to be paid to a non resident payee would not be equal to the net amount payable under an agreement or arrangement entered into between the payer and the payee. Simple example is illustrated for easy understanding as under:
Royalty payable : 1,00,000
Rates in force : 10 per cent
Grossed up royalty : 1,11,111
WHT @ 20 per cent : 22,222
Net amount payable : 88,888
This will end up payer not meeting the agreement of paying Rs. 1,00,000 net of taxes to the payee. Therefore, in order to effectively pay Rs. 1,00,000 net of taxes to the payee as royalty the payer should either adopt the same rate of 20 per cent or 10 per cent both for withholding as well as for grossing up purposes. Otherwise, it would not work.