Karnataka High Court rules on withholding tax obligation for non-resident payments

This article summarizes a recent ruling of the Karnataka High Court (HC) [ITA No. 2808 of 2005] in the case of Samsung Electronics and others (Taxpayers). The HC held that any payment resulting in any income in the hands of a non-resident would be subject to withholding tax under the Indian Tax Law (ITL). Unless an order is obtained from the Tax Authority for withholding tax at a lower rate or for not withholding tax, a taxpayer would need to withhold tax on the income at the applicable withholding tax rates, even if the income may not be taxable in the hands of the non-resident.

 Facts of the case

• One of the Taxpayers in the litigation was engaged in the development, manufacture and export of computer software. The Taxpayer imported ‘shrink-wrapped’ computer software from outside India for use in its business. No tax was withheld in respect of such payments on the ground the same cannot be treated as royalty either under the ITL or under the applicable Tax Treaty. However, the Tax Authority held such payments to be in the nature of royalty and subject to deduction of tax at source under the ITL.

• Certain other Taxpayers in the litigation were engaged in the distribution of ‘shrink-wrapped’ computer programs. The Taxpayers used to import copies of the computer programs for subsequent sale to customers in India.

• As the Taxpayers were under a bona fide belief that the payments made to non-residents were not chargeable to tax under the ITL or under an applicable Tax Treaty, the Taxpayers had not withheld tax on the payments nor had they applied for an order from the Tax Authority for not withholding tax.

• While the first appellate authority ruled in favor of the Tax Authority, the second appellate authority held in favor of the Taxpayers. It held that the payments made were not in the nature of royalty, based on the definition of ‘royalty’ under the ITL or under the relevant Tax Treaty and, hence, were not chargeable to tax under the ITL.

• The Tax Authority filed an appeal before the HC against the ruling of the second appellate authority.

Issue before the HC

• The main issue before the HC was whether the payments made by the Taxpayers to non-residents for purchase of computer software products can be taxed as royalty and subject to withholding tax under the ITL.

Contentions of the Taxpayers

• The payments made are for the purchase of a copy of a copyrighted article and not the copyright in the computer software. The payment is not made for acquiring any intellectual property. Hence, such payments cannot be classified as royalty either under the ITL or under the Tax Treaty.

• The payments made for purchase of computer software are for purchase of goods [1] by the Taxpayers. Such payments would constitute business income in the hands of the non- residents. These payments would be taxable under the ITL, only if the income accrues or arises or is deemed to accrue or arise in India, or where a Tax Treaty is applied, only if the non-residents have a permanent establishment (PE) in India.

• For the purpose of withholding tax on payments made to non-residents, it needs to be first determined whether such payments are chargeable to tax under the ITL. Since the payments are made outside India and also otherwise not chargeable to tax under the ITL, there is no necessity to withhold tax on such payments.

Contentions of the Tax Authority

• The payments made by the Taxpayers are in the nature of licence fee and, hence, taxable as royalty under the ITL as well as under the Tax Treaty.

• Some of the Taxpayers who paid for the purchase of computer software are in the business of software development. Hence, the payments made to the non- resident suppliers are deemed to accrue or arise in India, under the ITL.

• The payments made to non-residents by the Taxpayers for the purchase of computer software for the purpose of resale are in the nature of royalty. It is not an outright sale of goods since the copyright in the computer software remains with the transferor company. Since the definition of ‘royalty’ under the ITL as well as under the applicable Tax Treaties is similar, the payments made to non-residents are taxable as royalty.

• The Taxpayers cannot contend that no income arises to the non-residents under the ITL with respect to the payments made to such non-residents for the purchase of computer software. The Taxpayers are liable to deduct tax at source on payments made to non-residents under the ITL[2].

Ruling of the HC

• The Taxpayers contentions that no income arises to the non-residents cannot be accepted in view of the decision of the Supreme Court (SC) in the case of Transmission Corporation of A.P. Ltd. v CIT [239 ITR 587], wherein the SC held that payments made to non-residents are subject to withholding tax unless the taxpayer obtains an order from the Tax Authority for determination of appropriate withholding tax rate. In the absence of such an order, the taxpayer is liable to withhold tax on the entire income paid to the non-resident.

• The SC in its decision in the case of Transmission Corporation of A.P. Ltd. had declared the legal position with respect to withholding tax on payments made to non- residents. The law declared by the SC is binding on all the High Courts in India.

• Under the provisions governing deduction of tax at source on payments made to non-residents, taxes have to be withheld on any payment made to a non-resident which is in the nature of income.

• Charging provisions under the ITL are independent of the provisions governing deduction of tax at source. The latter seek to withhold a tentative amount as taxes before the determination of the actual tax liability of a non-resident. The actual tax liability does not determine the taxes to be withheld under the ITL.

• The Tax Authority is not required to determine the income of a non-resident for the purpose of determining the taxes to be withheld under the ITL. The only method by which a taxpayer can reduce the withholding tax liability imposed under the ITL is by making a specific application to the Tax Authority for determination of tax to be deducted at source under the ITL.

• The Taxpayers, in the present case, had not made any specific application to the Tax Authority for determination of tax to be deducted at source under the ITL. Hence, the Taxpayers cannot contend that no portion of the payments made to non-residents was chargeable to tax and that there was no liability to deduct tax at source under the ITL.

• Any payment resulting in any income in the hands of a non- resident would be subject to withholding tax under the ITL.

• In case a taxpayer has failed to withhold tax on payment to a non-resident, the Tax Authority can initiate proceedings for collection of taxes and interest from the taxpayer. In such a situation, the taxpayer cannot object to the proceedings merely by contending that the payment did not result in any taxable income.

• It is always open for a non-resident to contend its tax liability in India by subsequently filing a tax return under the ITL.

Comments

The ITL casts an obligation on any person responsible for making payment of any sum that is chargeable to tax, to withhold tax on such a sum at the applicable tax rate. This provision was generally interpreted by a number of Income Tax Appellate Tribunals (second appellate authority) firstly to determine if the sum payable was taxable and only in the event that the sum was taxable, was the person making payment obliged to withhold tax. This HC decision suggests that the person making payment of any income to a non-resident cannot make such a determination and would need to withhold tax on the payment, whether taxable or not, unless he seeks a order for nil/lower withholding tax from the Tax Authority. Further, a reading of the SC decision, relied upon by the HC, also seems to suggest that the obligation to withhold tax under the ITL is limited only to income chargeable under the provisions of the ITL.

Even though the litigation before the HC was related to the appropriate classification of payment for purchase of computer software, whether royalty or business profits, and the consequential taxability, the HC has not addressed this specific issue in its ruling. It has only ruled on applicability of withholding tax provisions on a person making payment to a non-resident.

A High Court decision would generally have a binding force in the state in which the High Court has jurisdiction and is binding on all subordinate courts, appellate authorities and the Tax Authority situated within its jurisdictional territory, unless reversed by the SC. Taxpayers, especially those who are under the jurisdictional territory of the High Court, would need to review and assess their withholding tax positions in light of the ruling.

Note:

[1] Relied on SC decision in TCS v State of Andhra Pradesh [271 ITR 401] (SC).

[2] Relied on SC decision in Transmission Corporation of A.P. Ltd v CIT [239 ITR  587] (SC).