When a foreign company deputes its employees to work in India for a joint venture company, is there a liability on the foreign company to deduct tax on the income of its expatriate employees working in India? Will the provisions for tax deduction at source apply to payment made abroad by a person who is located outside India? These vital questions came up for consideration before the Supreme Court recently.

Late in the 1990s, the Central Board of Direct Taxes (CBDT) realised that multinational corporations were defaulting on a large scale in the matter of TDS on their employees working in India. It did an in-depth analysis of the problem and as feared, default was on large scale.

Eli Lilly and Others

More than 100 companies were taken up for scrutiny for default under Section 192 of the Income-Tax Act, 1961. Eli Lilly and Co.(India) Pvt. Ltd was incorporated in India as the joint venture between Eli Lilly, Netherlands B.V. and Ranbaxy Laboratories Ltd.

The foreign partner had sent four expatriates to the joint venture in India. They were employed by the joint venture.

However, they continued to remain on the payrolls of the foreign company. They received home salary outside India from the foreign partner. No tax stood deducted in respect of such home salaries and other allowances paid by the foreign company. The ground taken for not deducting tax was that there was no obligation to deduct tax under Section 192(1). The home salary was not paid by the joint venture company. Unlike other sections in Chapter XVII-B, Section 192 requires tax reduction to be made on estimated income chargeable under the head salaries and at the time of payment of salary.

TDS provisions, it was argued, had no extraterritorial operation. The issue raised was whether TDS provisions which are in the nature of machinery provisions enabling collection and recovery of tax are independent of the charging provisions which determined the assessability in the hands of the employee-assessee (recipient).

Is there an obligation to deduct tax at source on payment made abroad by a foreign company even though such payments may be income chargeable as salaries and even though the expatriates had rendered services in India?

Tentative deduction

The Supreme Court examined Section 192(1) on standalone basis. The scheme of the TDS provisions applied not only to the amounts paid having the character of income like salaries, dividends, interest, etc., but also applied to gross sums, the whole of which may not be income or profits in the hands of the recipient like payments to contractors. TDS provisions are meant for tentative deduction of tax subject to regular assessment.

The general concept as to the scope of the income-tax is that, given a sufficient territorial connection or nexus between the person sought to be charged and the country seeking to tax him, income-tax may extend to that person in respect of his foreign income.

If the payment of home salary abroad by the foreign company to the expatriate has any connection or nexus with his rendition of services in India, then such payment will constitute income which is deemed to accrue or arise to the recipient in India as salary earned in India in terms of Section 9(1)(ii).

Extraterritorial operations

The Act has extraterritorial operations in respect of the subject matters and the subjects which are permissible under Article 245 of the Constitution. An Explanation was inserted to Section 9(1)(ii) by Finance Act, 1999 w.e.f. April 1, 2000, to settle the controversy in interpretation. The expression earned in India is equated to services rendered in India.

The Explanation shifted the accrual test to the earning test. Income chargeable as salary shall be deemed to accrue or arise in India if it is earned in India, that is, if the services under the agreement of employment are rendered in India, the place of receipt or actual accrual of the salary being immaterial. Section 192(1) has to be read with Section 9(1)(ii).

Survey operations in the case of Elli Lilly showed that no work was performed for the foreign company by the four expatriates to the joint venture company in India. The home salary and other allowances were paid to them by Elli Lilly for services rendered in India. The tax deductor was statutorily obliged to deduct tax under Section 191(1).

If any payment of income chargeable as salaries fell within Section 9(1)(ii), then the TDS provisions will be attracted. These expatriates did no work for the foreign companies. They were working in India and rendering services in India.

The Supreme Court decided the matter in favour of Revenue. It upheld the levy of interest under Section 201(1A); however it quashed penalty proceedings under Section 271(1)(c) on the ground that the issue involved was a nascent issue.