by H. Jayesh and Freddy Daruwala
After 14 years of protracted negotiations, evocative of the duels between Errol Flynn and Basil Rathbone in old Hollywood swashbucklers, India and the United States have finally reached agreement on avoiding double taxation. The last obstacle to the USA Double Tax Avoidance Agreement (the “Agreement”) was over taxation of fees for technical services (“FTS”) in India. The Agreement sets forth a test to determine whether these service fees are subject to taxation in India. Under the Agreement, taxes must be withheld on service fees paid to a taxpayer who does not have an address or assets in India, or is generally located outside the territorial jurisdiction of India. In the event that the Agreement conflicts with the Income Tax Act 1961 (“Act”), the Agreement controls and the taxpayer may seek the more beneficial treatment of the two.
FTS has been addressed differently in various Indian double tax avoidance treaties. For example, reference is made to Fee for Included Services (“FIS”) in the Agreement, as in the agreements between India and Singapore and India and the United Kingdom. The agreement between India and Japan the Act’s definition of FTS is employed. In the agreements between India and France and India and Germany, the Act’s definition of FTS is also employed, but is subject to a most favored nation (“MFN”) clause to modify its scope in line with other more beneficial, future Indian double tax treaties. Some agreements, such as the one between India and Mauritius, do not contain an FTS clause.
This article focuses only on FIS. Article 12(4) of the Agreement provides:
For purposes of this Article, “fees for included services” means payments of any kind to any person in consideration for the rendering of any technical or consultancy services (including through the provision of services of technical or other personnel) if such services :
(a) are ancillary and subsidiary to the application or enjoyment of the right, property or information for which a payment described in paragraph 3 is received; or
(b) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design.
Thus, FIS has two basic components: (a) fee for technical services made available; and (b) the transfer of knowledge, etc.
A fair amount of controversy has been generated over the meaning and scope of the “make available” clause. The technical explanation which accompanies the Agreement attempts to clarify the concept of make available by providing examples. In simplistic terms, if A renders services to B to repair B’s car, such services do not “make available” knowledge unless by virtue of such services B is able to repair a third party’s car. More close to home, if a U.S. law firm provides a legal opinion to an Indian client the services rendered do not “make available” technical knowledge unless the client is an Indian law firm who will then be able to render an informed opinion on a similar issue to its clients. In that case, outbound service fees remitted from India to the U.S. will be taxable in India and taxes must be withheld on any such remittance.
The phrase “make available” has also been construed by the courts. Although the case involving the Federation of Indian Chambers of Commerce and Industry (“FICCI”) (AAR 811 and 812 of 2009), does not constitute binding precedent on future cases involving different parties due advance ruling limitations, it is instructive because it provides an insight into the current judicial thinking on the meaning of “make available.” FICCI entered into a set of agreements with an Indian technology company and the University of Texas (“UT”) to provide an integrated service comprising of technology, assessment, training, programme management, and business development for a consolidated service fee. The individual components of the contract were not severable. The main questions before the Authority for Advance Rulings (“AAR”) were: (a) whether UT, as a tax exempt entity in the U.S., may claim benefits under the Agreement; (b) whether payments by FICCI to UT constituted FIS; and (c) whether taxes had to be withheld on such payments. The AAR ruled in the affirmative on the first question and in the negative on the second and third questions. It stated that while integrated services have some component of training that may fall under the FIS category, it did not amount to FIS as a whole. Thus, the service fee was not subject to taxation or the requirement to withhold taxes. It also ruled that a non-profit entity under U.S. law is entitled to claim benefits of the Agreement. Another recent decision was given by the Chennai special bench of the Income Tax Appellate tribunal in the case of Prasad Productions. The court analyzed whether the payer had a bona fide belief that the income remitted to the payee was not taxable in India. It also discussed whether funds could be paid suo-motu without withholding taxes and not following the procedure of applying to the payer’s assessing officer to determine the issue of taxability when the payer had such a bona fide belief. These two decisions have clarified the meaning of the law to a large extent.
If the recipient of a service fee is deemed to constitute a permanent establishment (“PE”) in India, the service fee will not be taxed as FIS or FTS income but will be taxed as business income of the PE. In addition, if the fees are paid to an “associate enterprise,” under the Act, the “arms length” nature of the transaction must be examined, similar to the requirements of Section 482 of the U.S. Internal Revenue Code.
Withholding taxes on payments to non residents are generally covered by Section 195 of the Act. Taxes must be withheld on all payments to a non resident which are taxable in India before remittance. A failure to withhold taxes may have serious consequences, such as penalties, interest, disallowance of a deduction for the amount paid, and prosecution. Therefore if the remittance is deemed to be taxable in India, taxes should be withheld using the following procedure:
- The payee first applies for an identifying permanent account number (“PAN”). This is to ensure that taxes are withheld at the prescribed rate. In absence of a PAN, taxes must be withheld at a minimum of 20% (or at a higher rate if applicable).
- The payer then deducts the tax and issues a withholding taxes certificate in the prescribed format (Form 16A) identifying the payee and the payer’s PAN.
- The payer then uploads the information onto the Income Tax website. The payer will receive an acknowledgement on the website. This hard copy will have to be certified by a practicing chartered accountant and transmitted to the remitting bank. Only upon receipt of this document may the remitting bank in India transmit the funds to the overseas recipient.
If there is any doubt as to the taxability of the remittance or the remitter believes that the amount of tax to be withheld should be less than the prescribed rate, then the remitter should apply to its Assessing Officer for an adjudication on the taxability of the amount or for permission to withhold less taxes, respectively. The tax authorities generally take an aggressive stance. An alternative is to upload the information regarding the remittance on the revenue website and obtain a certification by a practicing chartered accountant that the payment is not taxable in India and that the remittance may be made without withholding taxes. This certification may then be transmitted to the remitting bank, which in turn would remit the funds without withholding taxes. To avoid litigation with revenue authorities at a later date, the accountant certification option should be resorted to where the service fee is clearly not taxable.
The tax landscape in India is expected to be considerably altered when the impending Direct Taxes Code (a revised discussion paper on which was released on 15th June 2010) becomes effective. Nevertheless, the Agreement provides much needed relief and guidance to the remitter of service fees to the U.S.
Mr. H. Jayesh is the founder partner of Juris Corp and specializes in mergers and acquisitions, joint ventures, derivatives, structured finance, and restructuring. He also has significant experience in arbitration and tax-related matters. He is also a Chartered Financial Analyst and may be contacted at firstname.lastname@example.org
Mr. Freddy Daruwala is a partner in Juris Corp and specializes in cross-border taxation matter. He is also a Chartered Accountant. He may be contacted at email@example.com