Ravi Arora has to make a payment of Rs 55,000 to a contractor firm which renovated his office. Can he simply issue a cheque for entire amount? Not really, as contractual payments may now require him to pay certain percentage of the sum to the taxman, before making such payment to the contractor.

The concept of tax deduction at source (TDS) has gained momentum in recent years as it secures immediate deposit of income tax in the government treasury, thereby reducing the scope for tax evasion and also ensures prompt tax collection. As the responsibility of payment of tax has been shifted from payee to payer, one needs to keep track of day-to-day payments and whether or not tax is required to be deducted prior to making such payments or indeed, even prior to passing an accounting entry in favour of the payee.

Introduction in the Finance Bill, 2007: With the government bent on widening the TDS bracket and increasing collections, contractual payments have proved to be a major contributor in this regard. Earlier, individuals and Hindu undivided families (HUFs) were not required to deduct tax on contractual payments except when the individual or HUF itself was a contractor and made payments to a sub-contractor.

However, considering the number of contracts being awarded by individuals and HUFs carrying on business or profession, a change has been proposed by Finance Bill, 2007 to section 194-C of the Income tax Act, 1961 (the Act) to include individuals and HUFs as liable to deduct tax on contractual payments.

The proposed amendments to section 194-C of the Act are explained here. The scope of contractual payments has been kept very wide to cover payment for any work, such as transport contracts, service contract, advertisements, broadcasting contracts, telecasting contracts, material contracts, etc. It may, however, be significant to determine the nature of arrangement with the service provider as this would decide whether the payment qualifies as a contractual payment or not.

Where you pay a sum to a person (who is owner of a space) for a hoarding, the payment is in the nature of advertising contract and accordingly, TDS at the rate of 1% (basic rate) may be required to be deducted. Conversely, where you take a space for rental and use the same space for putting up hoarding, the payment made to the owner of space would be in the nature of rental payment (and not contractual payment) for which tax may be required to be withheld at the rate of 15% (basic rate).

Non-compliance of TDS provisions attract penal provisions in the form of interest, monetary penalty and in certain cases, prosecution for the payers. Further, any tax not deducted on behalf of a payee becomes a personal liability of the payer along with interest and penalty and the same can even result in government having a charge on personal assets. In addition to the above consequences, non-deduction of tax results in disallowance of such expenditure in computing the taxable income, effectively resulting in increase in the tax liability of the payer.

Let us take another example. Dr Shankar had made payments of Rs 2,50,000 to a contractor for certain repair work to his clinic. He has not deducted tax at source at 2% plus surcharge and cess. In this case, the TDS liability works out to Rs 5,610 (i.e., 2.244% of Rs 2,50,000 at the currently prevailing rates). From the financial year 2007-08, the cess will increase by 1% to stand at 3%, thus bringing the TDS amount to Rs 5,650 (i.e.: 2.26%).

As the contractual payment will not be allowed as an expense, the taxable profits of Dr Sharma will increase by Rs 2,50,000 with additional tax liability of Rs 84,150 (at 33.66%) on its own account or an additional tax liability of Rs 84, 975 (at 33.99%, if one takes the additional cess announced in the budget, into consideration).

Exemption provided in the Finance Bill: TDS provisions entail a host of compliance for the payers, like obtaining TAN number from the tax department, monthly deposit of tax deducted, filling of quarterly TDS returns, issue of TDS certificates to the tax payees and so on.

In view of the numerous compliance involved, relief has been granted to small tax payers by keeping them outside the ambit of TDS on contractual payments. Small tax payers include individuals/ HUFs whose total sales or gross receipts from business do not exceed Rs 40 lakh (Rs 10 lakh for professionals) during a financial year.

Also, contractual payments made for contract meant for personal purposes are also excluded from the purview of TDS.

Thus, if you are getting your house constructed through a contractor, which you intend to use for residential purposes, you may not be required to deduct TDS on payment made to such contractor.

Gaurav Karnik & Anumeha Jain
Ernst & Young