Would remittance for every import be now subject to withholding tax?
All software imports into India held subject to withholding tax
In a shocking judgment the Karnataka High Court in the case of CIT v/s. Samsung Electronics Co. Ltd1 has held that every person making a payment for import of shrink wrap software is under an obligation to deduct tax at source. By implication it means that in all instances of payments for import of any goods, irrespective of its chargeability to tax in India, tax must be withheld and paid to the Indian government. In fact, the judgment has far reaching effects whereby any and all payments made to a non-resident may be brought within the Indian tax net and subject to Indian withholding tax. The only situation under which the payer shall be not be under an obligation to withhold or may withhold at a lower rate, is if he obtains prior approval from the assessing officer by making an application under section 195(2)2 or section 195(3)3 of the Income Tax Act, 1961 (“ITA”).
A Brief History
Numerous appeals (from the orders of the Bangalore Income Tax Appellate Tribunal (“ITAT”)) were filed by the Indian Income tax Department (“Revenue”) before the Karnataka High Court. The core issue in all appeals was regarding Indian withholding tax on payments made by resident payers to foreign suppliers of shrink wrapped software.
Several resident companies were importing shrink wrapped software packages from suppliers outside India, for use in office equipment, further distribution in India, etc. These resident companies, based on their understanding that the payments made for the purchase of software were not in the nature of royalty payments (within the meaning of section 9(1)(vi)) of the ITA) and therefore, in the absence of a permanent establishment in India were not considered as income ‘chargeable to tax’ in India, did not deduct any tax at the time of the making payments for the software.4 It may be noted that none of the assessees’ (“Tax Payer”) had made applications to the assessing officer under section 195(2) under the ITA.
The Revenue contended that payments for supply of software were akin to license fees and thus, were in the nature of royalty. The Revenue also placed reliance on the Supreme Court’s decision in the case of Transmission Corporation of A.P. Ltd. v/s. CIT5, wherein it was considered that when any payments which were not explicitly declared exempt under the provisions of the ITA, the person making the payments had to withhold tax at source and the payer could free himself from the liability to withhold tax only if he obtained the assent of the assessing officer under section 195(2) of the ITA.
On the other hand, the Tax Payers contended that withholding obligations only arose when the income was first ‘chargeable to tax in India’ as per section 4(1) of the ITA. Relying on the Supreme Court case of Tata Consultancy Services v/s. State of Andhra Pradesh6, the Tax Payer’s argued that the payments were not in the nature of royalty as they were made to acquire a copyrighted article as against the copyright itself. In numerous earlier judgments like Lucent Technologies Hindustan Ltd.and Hewlett-Packard India Pvt. Ltd. among others, the Tribunal has drawn a distinction between the sale of a copyright and the sale of a copyrighted product, a test that has till now been the yardstick for determining the nature of income. Based on the aforesaid, the Tax Payer’s claimed that a resident payer may look at the nature of income in the hands of the recipient to ascertain chargeability under the ITA and if considered to be not chargeable, there should be no requirement to withhold tax from the payments made to the foreign suppliers.
Further, the Tax Payer’s contended that the ratio laid down in the judgment of Transmission Corporation of A.P. Ltd. could not be followed as the payments in that case were prima faciechargeable to tax. Thus the Tax Payer’s contended that the ratio laid down therein must be considered only in light of the factual background and it could not be relied on to say that even when there is no chargeability to tax there was an impending obligation to withhold tax.
Decision of the High Court
The High Court held that it was indeed an obligation on the part of the resident payer making a payment, being in the nature of income in the hands of a non-resident, to withhold tax under section 195(1) of the ITA. They further observed that section 195(1) is not a charging provision and the assessing officer cannot embark on an exercise to determine the actual nature of the income or the tax liability of the non-resident assessee. In fact, the High Court remarked that the ITAT was clearly in error by examining the nature of the payments and the availability of the beneficial provisions under a tax treaty. They concluded that the resident payer’s liability to withhold tax springs into action the moment there is a payment to be made to a non-resident, if such a payment is per seincome in the hands of the recipient and such payer can be relieved from his obligation to withhold tax either wholly or partially, only upon making an application to the assessing officer under section 195(2) of the ITA and demonstrating that the entire payment does not partake or only partially partakes the character of income.
The High Court explained that in a case where payments are being made for the import of certain goods, the entire costs of the goods by itself may not constitute income in the hands of the non-resident, it is only the income component as may be determined in the manner provided under the ITA which should be subjected to the withholding provisions. However, in such a case too it must be borne in mind that, an application under section 195(2) is not an exercise for assessment of income of the non-resident nor the actual tax liability thereof and the scope of the assessing officer’s powers is restricted to only determine the percentage of the payment which bears the character of income.
In light of the above the High Court abstained from answering the much debated issue of characterization of payment for the import of software.
The ratio laid down by the High Court is bound to have vast implications and will result in bringing almost every payment made for the import of goods or services from foreign suppliers within the Indian tax net and subjecting it to a withholding tax liability. Whereas the position was more or less settled, this decision has caused ripples and created much ambiguity, which would affect not only the software industry but all sorts of cross border transactions, especially since the payer is not entitled to look into the treaty provisions and the rates thereunder. For instance, in a situation where a Mauritius company receives income from the sale of shares in an Indian company, even though such a transaction is not liable to Indian income tax, a withholding tax liability could subsist unless an application is made to the assessing officer.
Moreover, since this decision disentitles the payer from assessing the taxability of the recipient, except by virtue of making an application under section 195(2) of the ITA, the procedural formalities put a huge burden on the payer and are bound to delay transactions. Additionally, given the increasing aggressiveness of Indian tax authorities in recent times, it is unclear as to whether the assessing officer may decide in favour of the taxpayer and this is likely to increase litigation.
Another important ramification of this decision is that, the widely worded section 195 could also effect dealings between two non residents, in transactions relating to an Indian asset. This could impact several cross-border M&A transactions and add teeth to the Revenue’s stand in a case similar to Vodafone and E*Trade.
Thus, considering the fact that after intense speculation from taxpayers the issue regarding characterization of payments for import of software remains unresolved, and this decision may have added to the woes of non-residents doing business in India, the time now seems to be ripe for the Supreme Court to step in and resolve the ambiguities afflicting the taxation of software imports as well as withholding obligations for payments to be made to non-residents.
1 ITA No. 2808 to 2810 of 2005 and others.
2 Section 195(2) of the ITA provides that if any person responsible for making a payment chargeable under the ITA to any non-resident or a foreign company, considers that the whole of such sum would not be income chargeable in the case of the recipient, may make an application to the assessing officer to determine the appropriate proportion of the income so chargeable and thereafter tax is required to be deducted at source on such appropriate income.
3 Section 195(3) of the ITA provides that in accordance with the rules specified therein, any person is entitled to receive income in the form of interest or any other sum chargeable to tax, may make an application to the assessing officer for the grant of a certificate to receive such interest or other income without deduction of tax therein. Pursuant to the grant of the certificate the payer shall make a payment to the person to whom such certificate is granted without deducting tax thereon.
4 Section 195(1) of the ITA provides that any person responsible for making a payment (other than salary) to any non-resident or a foreign company, which is chargeable under the ITA is required to deduct tax at source at the rates specified
5  239 ITR 587 (SC)
6  271 ITR 401