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Tax liability on retention money after receipt
July, 31st 2006

A large number of foreign companies are involved in the execution of various types of projects in India. 
Whereas payment terms differ from contract to contract, one common feature generally found in all contracts is that a certain portion of the contract amount (say 10 per cent or so) is retained by the principal as retention money, which is to be finally paid after completion of the contract or in certain cases upon satisfactory performance of the work, or after lapse of warranty period. 
Thus, this retention money may be paid to the foreign company several years after the completion of the contract. 
The issue for consideration is whether the retention money is to be treated as a foreign company's income on completion of the contract, or the same is to be treated as income only when the monies are actually received by the company. 
The aforesaid issue has recently been considered by the Madras High Court in two cases reported in 283 ITR 295 and 283 ITR 297. The issue raised was whether the monies retained by the contractee is to be treated as income only when the money is actually received by the contractor, even though the contractor is following mercantile system of accounting? 
The income-tax department brought the retention money to tax on completion of contract on the ground that the company was maintaining the mercantile system of accounting. 
On the other hand, the counsel for the contractor submitted that the money retained would be realised only when the customer was satisfied about the completion of the work entrusted to it. The company, therefore, was justified in treating the said amount as a contingent amount and would offer the same for tax on actual receipt basis. 
The high court observed that the retention money accrue to the assessee only after satisfactory completion of the contract. On the date of the bills, no enforceable liability had accrued or arisen. When the assessee had no right to receive the same by virtue of the contract between the parties, and the assessee also had no right to enforce payment, it could not be said that the right to receive payments of the remaining 10 per cent of the value of job done accrue as soon as it was completed. 
The high court also took note of the Supreme Court judgment in the case of CIT vs Shoorji Vallabhdas 46 ITR 144 in which it was held that income-tax is a levy on income. No doubt the income-tax Act took into account two points of time at which the liability to tax was attracted, viz., the accrual of the income or its receipt; but the substance of the matter was the income. 
If income did not result at all, there could not be a tax, even though in book-keeping an entry was made about a hypothetical income, which did not materialise. Based on the above reasons, the high court held that the retention money could be brought to tax only when actually received. 
The aforesaid reasoning is likely to open a new line of arguments for foreign companies to claim that retention money when received by them can be taxed only if the companies still have their permanent establishment (PE) in India. 
In cases where the retention money is received after the recipient foreign company ceases to have any PE in India, it is quite possible to successfully argue that the receipt of retention money will not be liable to tax in India.

H P Agrawal

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