Obligation to withhold tax can arise only when the subject payments are chargeable to tax

Facts of the case:

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The taxpayer Mitsubishi Corporation India Pvt Ltd (MC India) is an Indian company and part of a multinational conglomerate. During the financial year 2005-06 (assessment year 2006-07), it undertook certain transactions involving the purchase of goods from seven associated enterprises located in the USA, Japan, Singapore, and Thailand. The taxpayer also facilitated intermediary services connecting ultimate customers in India with the group companies.

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During the course of assessment proceedings, the Tax officer? noted the presence of a liaison office in India for MC Japan, a group entity, qualifying as a permanent establishment ('PE') and necessitating withholding tax under section 195 of the Income Tax Act, 1961 (the Act). Drawing parallels, the Tax officer inferred a similar PE status for all group companies, leading to implication ?of withholding tax under section 195 for payments to non-residents.

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Consequently, while framing the draft assessment order, the Tax officer disallowed purchase considerations paid to non-resident associated enterprises by invoking section 40(a)(i) of the Act for the absence of tax deductions. The transfer pricing adjustments were also suggested on the intermediary services provided to group entities.

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The non-discrimination clause of the India-USA treaty (Article 26) and India-Japan treaty (Article 24) mandates equal treatment concerning the deductibility of payments to non-resident and resident individuals. However, this clause excludes cases subject to transfer pricing norms under Article 9 (Associated Enterprises) of the respective treaties.

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The objections against the draft assessment order were dismissed by the dispute resolution panel. Subsequently, the taxpayer filed an appeal before the Income Tax Appellate Tribunal (‘ITAT’), which was allowed and the disallowances were deleted.

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Contention of the Revenue:

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The Revenue contended that all group entities receiving payments from the taxpayer had business connections in India. Referring to the Supreme Court ruling in the case of Transmission Corporation of AP Ltd. v. CIT2, the Revenue argued that the taxpayer was obligated to deduct taxes at source under section 40(a)(i) for sums ‘chargeable to tax’ under the Act.

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The Revenue also argued that residents of India could not invoke the non-discrimination clause under DTAA. They argued against the applicability of the non-discrimination clause under Article 24(3) of the India-Japan treaty and Article 26(3) of the India-USA treaty, citing treaty exceptions related to transfer pricing provisions under Article 9 of the respective treaties.

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Provisions of DTAA relating to non-discrimination were argued not to mandate absolute parity between residents and non-residents. Moreover, the Revenue stressed that the determination of taxable income and the existence of a PE were distinct matters.

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The Taxpayer's Argument:

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The taxpayer argued that payments to group companies based in the USA and Japan were protected by the non-discrimination clause under respective treaties.

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The taxpayer emphasised that the provisions of section 195 requiring deduction of TDS were not determinative on the issue of discrimination. Citing the Supreme Court ruling in the case of GE India Technology Cen. P. Ltd. v. CIT4, the taxpayer argued that tax deduction liability was contingent upon the determination of chargeability.

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Ruling of the High Court:

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The division bench of the Delhi High Court rendered divergent judgments in 2017, prompting referral to a Third Judge. The Third Judge observed that while section 40(a)(ia) aimed to disallow specified sums paid to residents without tax deductions, it did not include payments to resident vendors, thereby perpetuating discrimination.

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Given the more favourable provisions of non-discrimination articles under treaties, the disallowance was deemed inappropriate and rightly deleted by the ITAT. The Third Judge noted that transactions involving residents of Singapore and Thailand did not result in taxable income in India, as confirmed by ITAT observations.

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Our Take:

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The ruling of the Delhi High Court clarifies the application of non-discrimination clauses under treaties concerning disallowance under section 40(a)(i) of the Act. It brings home the point that withholding liability arises only when income is chargeable to tax in India in terms of the provisions of domestic laws and tax treaty. The principles laid down by the High Court can be relied upon in similar cases involving non-residents covered by treaties with comparable non-discrimination clauses.