The Indian domestic tax laws contain certain provisions which provide differential tax treatment in transactions involving residents and non-residents. Some of the provisions have the effect of causing discrimination in transactions involving non-residents. While the domestic tax law does not contain any provisions which seek to prevent such discrimination, the tax treaty comes to the rescue of the taxpayers in such situations. In most of the tax treaties entered by India, there exists a non-discrimination article which seeks to prohibit discrimination based on nationality or residency in the tax framework in certain situations. One of the situations dealt with in the article seeks to prevent disallowance of expenses paid to non-residents, if such expenses are allowable in cases where payment is made to residents.
This article seeks to analyze the applicability of the non-discrimination article on disallowance of expenses on payment made to non-residents without withholding the applicable taxes.
Decoding the legal position
Section 40(a)(i) of the Income Tax Act, 1961 (‘IT Act’) disallows any sum, chargeable to tax under the IT Act, paid by a taxpayer to a non-resident without deduction of tax at source (‘TDS’), in calculating the income of the assessee. Further, sub-clause (ia) disallows only 30% of any sum paid by a taxpayer to a resident without deduction of the applicable TDS, in calculating the income of the taxpayer.
The non-discrimination article in majority of the tax treaties provides that interest, royalties, and other disbursements paid by a resident of India to a resident of the other country (e.g., USA) shall, for the purposes of determining the taxable profits of the Indian entity, be deductible under the same conditions as if they had been paid to a resident of India. The said rule is not applicable in case the discrimination is on account of Article 9 (Associated Enterprise) wherein disallowance can be made if the transaction is between Associated Enterprises (‘AEs’) and the pricing is not at arm’s length.
Litigation trends
In the past, there has been litigation in India on the applicability of non-discrimination article on disallowance of expenses paid to non-residents under Section 40(a)(i) of the IT Act. The provisions of Section 40(a) have undergone significant amendments since its introduction. Till 2004, only the expenses paid to non-residents could be disallowed under Section 40(a)(i) and there was no provision for disallowing expenses upon non-deduction of tax in case of payments to resident. Section 40(a)(ia) was introduced into the IT Act vide the Finance Act 2004. However, at that point of time, the provision was made applicable for disallowing certain specific expenses incurred towards residents which included interest, commission, fees for professional or technical services. Subsequently, the provision was again amended vide the Finance Act, 2014 and by virtue of the amendment all payments made to residents without deduction of applicable TDS were covered within the ambit of Section 40(a)(ia). However, the quantum of disallowance was restricted to 30% of the payment in case of payment to residents.
In the case of Herbalife International[1], the relevant period in question pertained to AY 2001-02 i.e., before the insertion of sub-clause (ia) to Section 40(a). The taxpayer had made payment for fee for technical services to non-resident AE without deduction of TDS. In said facts, the Hon’ble Delhi High Court held that the expenses paid to USA resident could not be disallowed due to application of the non-discrimination article in the tax treaty. In view of the Court, by requiring the taxpayer to deduct TDS upon payment to non-resident, an additional condition was imposed for claiming the expense. This condition was not present when payment was made to residents. The Court also observed that the fact that the payment was made to AE would not change the conclusion. This is because the disallowance in Section 40(a)(i) was not dependent on whether the payee is AE or not. Also, as an undisputed fact, the disallowance was not on account of application of transfer pricing principles.
Recently, in the case of Mitsubishi Corporation[2], the High Court of Delhi decided the matter in favour of the taxpayer by concluding that purchases made by a resident taxpayer from non-resident having PE in India could not be disallowed due to application of non-discrimination article in the tax treaty. The Court observed that in the case of similar purchases made from residents, no disallowance could be made for AY 2006-07 for default of deduction of tax at source. Thus, the Court held that disallowing expenses for default of tax deduction where similar purchases were made from non-residents having PE in India triggered non-discrimination which was not permitted as per the tax treaty. For arriving at the conclusion, the Court followed the ruling in the case of Herbalife (supra). Similar view has been expressed in the case of Honda Cars India Ltd.[3] by ITAT Delhi Bench.
Section 40(a)(i) in its present form violative of non-discrimination Article in tax treaty?
Post amendment made by the Finance Act, 2014, while parity has been achieved in the scope of payments which can be disallowed in case of payments to resident and non-resident, there still exists disparity in the quantum of payments which can be disallowed. Although sub-clause (i) disallows the entirety of a sum paid to a non-resident without deduction of TDS, sub-clause (ia) disallows only 30% of a sum paid to a resident without deduction of TDS.
In view of the above disparity, it can be argued that the non-discrimination article in tax treaties should be triggered to prevent excess disallowance of 70% in case of payment to non-residents. This is because the conditions imposed for allowability of expenses paid to non-residents are discriminatory as compared to allowability of similar payment made to residents.
The Taxman may argue that the difference in quantum of disallowance is not discriminatory as the non-discrimination article only requires that the condition for disallowance of expense in case of non-residents should not be discriminatory. It does not refer to the quantum of expense which can be disallowed. Accordingly, by covering the same scope of payments within the purview of clause (i) and (ia) of Section 40(a), the provision is no more discriminatory. The Revenue may also argue that the scope of non-discrimination article is restricted to differential treatment of expenses incurred towards residents and non-residents. Normally, if a payer complies with tax deduction obligation, the provisions of IT Act do not discriminate claim of deduction in relation to expenses incurred towards resident and non-residents. Thus, principally, there is no discrimination if requisite taxes are deducted at source. The disallowance under Section 40(a)(i) or Section 40(a)(ia) is a consequence of default of deduction of tax at source. Thus, the differential treatment is a consequence of default of compliance of tax deduction. Seen from this perspective, the Taxman could argue that the scope of non-discrimination article does not extend to circumstances where differential treatment is extended because of default in compliance with the provisions of domestic law.
In Authors’ view, since the consequence of non-compliance is intended to interfere with the claim of deduction of expense, the non-discrimination provisions should apply if a differential treatment is offered for payments made to residents and non-residents. Given the fact that only 30% of payment is disallowed upon payment to residents, the said condition should equally apply even in case payment is made to non-resident due to application of the non-discrimination article in the tax treaty. Accordingly, excess disallowance of 70% on payment made to non-residents can be argued to be discriminatory.
Conclusion
The application of the non-discrimination article in relation to Section 40(a)(i) of the IT Act, as it exists today, is yet to be tested before Courts. This issue is likely to yield another round of litigation in the future. While it will be interesting to see the tussle between the Taxpayer and the Taxman, in authors’ view, the strength of taxpayer’s arguments may outweigh the Taxman’s arguments. In cases where dispute is already pending under Section 40(a)(i), the Taxpayer will be keen to add another leg of argument to strengthen their position and reduce the risk of disallowance to 30% of the total disallowance.
[The authors are Principal Associate and Senior Associate, respectively, in Direct Tax Team of Lakshmikumaran & Sridharan Attorneys, New Delhi]
[1] CIT v. Herbalife International India (P.) Ltd [2016] 69 taxmann.com 205 (Delhi)
[2] Mitsubishi Corporation India Pvt. Ltd. [TS-106-HC-2024 (DEL)].
[3] Honda Cars India Ltd. v. Deputy Commissioner of Income-tax, (LTU) New Delhi, [2016] 72 taxmann.com 253 (Delhi - Trib.).
