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Supreme Court Rules on Applicability of Withholding Tax Provisions


The Supreme Court ("SC") has delivered a landmark ruling wherein the SC has held that the withholding tax obligation on payment to non-residents would arise only if there was income chargeable to tax in India. Taxand India examines this important ruling.

The SC was examining a batch of appeals filed by certain companies that had made payments to overseas vendors towards purchase of off-the-shelf software. These companies had not withheld tax under section 195 of the Income-tax Act, 1961 ("Act") as they claimed that the payments were not chargeable to tax in India in the hands of the non-residents. The Revenue had contended that the payments were in the nature of royalties and hence, tax ought to have been withheld. The Karnataka High Court ("KHC") held that the payers were at fault for unilaterally determining that the payments were not chargeable to tax in India and in concluding that there was no tax deduction at source ("TDS") obligation on them. The KHC also held that the proper procedure for the payers would have been to approach the Revenue seeking a determination of their TDS liability and having failed to do so, the companies were liable to pay the necessary taxes to the Revenue. The KHC did not rule on merits as to whether the payments to the non-residents for the purchase of software were liable to tax in India.

Against the judgment of the HC, the aggrieved parties preferred appeals before the SC which reversed the decision of the KHC.

Ruling of the SC

  • The SC held that an obligation to deduct tax at source arises on sums that are chargeable to tax under the Act. The person responsible for making the remittance is required to make an application to the concerned Revenue officer requiring him to determine the appropriate amount on which tax is deductible only in a situation when the payer is certain that tax is deductible but is not sure as to the amount on which tax is to be deducted.
  • The SC held that TDS obligation under the Act is restricted to that part of the sum to be remitted which is chargeable to tax. The application to be made to the Revenue Officer, either by the payer or by the non-resident recipient, for determination of the quantum on which tax is to be deducted is only a safeguard.
  • The SC observed that the language used in section 195(1) of the Act is "sums chargeable under the provisions of the Act" as against the phrase "any amount" in other TDS provisions applicable to domestic payments. The SC therefore, held that section 195 has to be read in conformity with the charging sections of the Act. The SC accordingly rejected the Revenue's argument that TDS obligation arises on every payment to a non-resident, as this would imply that on simply making a payment to a non-resident, income would be said to accrue or arise in India.
  • The SC held that the Act has to be read as an integrated code and that the charging section and machinery sections of TDS have to be read together. The SC observed that if the Revenue's contention were to be accepted, it would amount to the payer deducting tax on a payment that is not chargeable to tax under the provisions of the Act, for which the Act also does not have a mechanism for providing refund of tax to the payer, as only the recipient non-resident is entitled for the refund
  • The SC also clarified its decision in the case of Transmission Corporation which has been misinterpreted by the Revenue. The SC observed that the said case was clearly distinguishable as the decision pertained to composite payments to non-residents, part of which was chargeable to tax and the concerned payer was aware that a part of the sums payable was chargeable to tax. The payer's contention in that case was that section 195 applied to only those sums, the whole of which were chargeable to tax and that it did not apply to composite payments. The SC rejected this contention of the taxpayer and held that section 195 would apply to composite payments as well, only a part of which was chargeable to tax.
  • After deciding on the scope of TDS under section 195, the SC noted that the main issue in all the cases was whether the payment made to the non-resident software suppliers was in the nature of "royalty" and accordingly whether it was chargeable to tax in India requiring TDS under section 195 of the Act. Since the KHC had not addressed this issue, the SC remitted the cases back to the HC to decide on whether the payments made to the non-resident for purchase of software were to be treated as royalty.

Taxand's Take

This ruling assumes significance as the SC has clarified the principles on the requirement of TDS when payments are made to non-residents. This decision comes as a welcome-relief as the KHC decision had created confusion and had the potential of disturbing cross-border trade and commerce. The SC's observations on the Transmission Corporation case are also very important as this decision is very often misinterpreted by the Revenue. However, the vexed issue of whether payment towards software is 'royalty' or not has now to be decided by the KHC.

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