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To tax or not to tax! Extra-territorial applicability of Indian withholding tax provisions
January, 02nd 2015

Multinational corporations often take advantage of economies of scale and resource by operating in multiple jurisdictions. However, this has its own set of challenges given the diverse tax regimes in various countries.

India has been looked at as one of the fastest growing economies in the world and has emerged as a key destination for foreign investors.

However, the tax environment in India is often viewed as complex with multiplicity of taxes, increasing litigation and uncertainties around taxability of transactions. Recently, there have been a lot of controversies on lack of stability, arbitrariness and retrospective changes in tax laws.

At the forefront of this legal debate, there are discussions around the applicability of the Indian Income Tax Act ('the Act') to non-residents — especially when non-residents do not have a business presence in the country. The debate is particularly on the onus of complying with withholding tax provisions on India-sourced income.

Consequential amendments post the Vodafone ruling have sought to expand the scope of withholding tax provisions to non-residents.

Contextually, the extra-territorial operation of the Act's provisions has been a matter of intense debate over the last few years. After the Vodafone ruling and consequential amendments to the Act, the issue has gained further momentum.

The Finance Act, 2012, amended the section 195 of the Act (dealing with withholding tax on payments made to non-residents) retrospectively to clarify that it extends to all persons including non-residents, irrespective of whether or not the non-resident has any presence in India. The clarificatory amendment along with its retrospective effect has caused much concern, criticism and controversy.

The Vodafone tax saga has certainly been one of the most closely watched cases wherein the Apex Court held that indirect transfers between two non-residents are not taxable under the Act. The decision has wide ramifications for large, cross-border transactions and it has gained significant attention globally from investors.

While delivering the judgement, the Apex Court touched upon the principle of "extra-territorial application" under section 195 of the Act. The Apex Court held that in the absence of nexus of the transaction with India, there can be no withholding tax liability in terms of section 195 on non-residents.

It is a generally accepted principle that laws made by any country are intended to be applicable to its own territory and are aimed at governing their domestic conditions. The law framers of a country can enforce an extra-territorial provided it has an impact on their nexus with India.

In India, Article 245 of the Constitution gives Parliament the authority to make laws which are extra-territorial in application. However, such application is based on the existence of a clear nexus with the country in question.

Section 1 of the Act provides that the Act applies to the territory of India. Generally speaking, the word "any person" referred in section 195 has to be read with section 1 of the Act that provides that the Act extends to the "whole of India".

Hence, a conjoined reading of both the sections suggests that the scope of section 195 cannot be deemed to operate extra-territorially and non-residents cannot be forced to comply with the Act in absence of a nexus with India.

The pre-condition of "territorial nexus" for applicability of withholding tax provisions has been the subject matter of interpretation before the Apex Court in the case of Commissioner of Income Tax v. Eli Lilly.

In Eli Lilly, the subject matter of the case was whether the tax deduction at source provisions under the Act is applicable to payments made abroad by the foreign company for services rendered in India.

The Court has held that the Act has extra-territorial operation in respect of the subject matters, and that the subjects which are permissible under Article 245 are enforceable within the area where the Act extends through the machinery provided under it.

In this case, the services were rendered in India, the income was taxable in India, and the foreign company was held liable to tax deduction before making the payment abroad.

The landmark decision in the case of GVK Industries Ltd wherein the Apex Court deliberated that the Indian Parliament does not have the power to legislate for any territory other than the territory of India or any part of it, is also of relevance here.

As per the decision, laws enacted by Parliament with respect to extra-territorial aspects or causes that have no impact or nexus with India would be ultra vires and would be laws made for a foreign country.

The decision affirms the legislative competence of the Parliament to enact laws that extend to extra-territorial aspects, but restricts such powers to aspects that have nexus with India.

While the Court did not deal with the validity of specific provisions of the Act, the principles laid down in this decision will nonetheless have a significant bearing on matters where the extra-territorial reach of the Act has been asserted.

Also, an analysis of similar provisions in other countries and their statutes shows that internationally too, withholding tax provisions are limited in their scope as regards applicability to non-residents.

In various countries, withholding tax in case of non-residents applies only when payments are made by residents to non-residents. For instance, according to the Japanese Tax code, withholding tax applies only if income is paid in Japan or if it is paid abroad but the payer also has an office or residence within Japan.

The principles of interpretation of other countries' statutes could serve as a guiding factor in resolving the controversies regarding application of section 195 to non-residents.

Given the onerous responsibilities associated with withholding tax compliances, viz. obtaining tax deduction account number, withholding & depositing of taxes, filing withholding tax returns, etc., it is important to adopt a cautious approach as it would cause administrative inconvenience to non-residents and may hamper business transactions with India. Non-compliance therewith also increases the tax cost — and effectively the overall cost — of doing business with/in India.

Accordingly, suitable clarifications, particularly in respect of transactions which have no nexus with India, would serve as guidance in taking informed decisions and avoiding protracted litigation in this regard.

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