In a recent decision by the Karnataka High Court (HC) on taxability of software sale and related tax withholding obligation towards payments to non-resident, the HC ruled that it is obligatory to withhold tax on such payments. Disposing a batch of appeals filed by the Revenue, the Court held that in absence of a ‘nil’ withholding order, the payer is obliged to withhold tax, even if the payment is later held to be not taxable on finality of assessment by the Revenue.
The decision at a juncture when several multinationals are litigating on taxability of cross-border merger nternational acquisition transactions and extra-territorial application of tax withholding provisions.
HC decision - recap
Resident taxpayers imported ‘shrink-wrapped' computer software for use in its business and took a view that there is no requirement to withhold tax on such payments under a bonafide belief that it is not taxable as 'royalty' or as 'business income', in absence of permanent establishment of the non-resident software supplier in India. The Tribunal overruled orders of the lower Revenue authorities holding that withholding proceedings was not sustainable, as the consideration received by the software supplier was not in the nature of 'royalty'.
The HC has now held that tax withholding is only a tentative deduction and the rights of the recipient are not adversely affected. Such withholding obligation cannot be dispensed with, in absence of a 'nil' withholding order issued by the tax administration. The HC relied on the Apex Court's landmark decision in Transmission Corporation's case holding that the proposition enunciated by Supreme court's decision squarely covers the case.
Wide ramifications and practical difficulties
The question dealt with by the Karnataka HC has three important elements attached to it
a) Characterisation of income of the non-resident (royalty or business); b) Payer's obligation for withholding tax and; c) extra-territorial operation of withholding provisions. While the Court did not rule on the first question, the decision has come as a rude shock on the other two aspects.
The ratio of the decision suggests that there is an obligation to seek a withholding order for each singular payment to non-resident, notwithstanding the nature of payment and chargeability to tax, whether wholly or in part. The High Court in coming to the conclusion does not seem to have considered the recent procedure prescribed by the CBDT for remittance to non-resident on the basis of a Chartered Accountant's certificate and complying with related e-filings.
The e-filing would in turn serve the purpose of the tax administration in tracking down withholding tax defaulters. The new procedure was enshrined in July 2009 guidance in pursuance to a statute amendment in 2009 Finance Act and intended to streamline the procedure. In this context, the decision appears to bear a misplaced ratio insofar as applicability of new procedure is concerned, since the requirement of a withholding certificate is dispensed with if the payer has obtained an accountant's certificate before remittance.
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Such inconsistency may indeed lead to implications for the remitter who otherwise has acted on a 'bona fide belief' in complying with the new procedure for remittance. Clearly, this must not be an intended outcome and it would augur well for the litigants ( Revenue & Administration ) to plead for re-examination by the courts decision!
As for the aspect on extra-territoriality of withholding obligation, the decision could potentially give a long rope to the revenue in scrutinizing cross-border transactions between two non-residents, who prima facie may not be liable to tax. All that is required is for the Tax administration to take a view that a source of income (untested from a chargeability stand point) is liable to withholding tax. This would defeat the new administrative guidance.
Constitutional validity
The HC decision could re-invigorate the debate on extra-territorial operation of Indian tax withholding requirements. I think that the HC's reliance on Electronics Corporation case is perhaps misplaced.
Though, the issue of extra-territoriality was considered by the apex court in Electronic Corporations case, the Court however did not rule on the question and merely referred the matter to constitutional bench of the court. The issue on territoriality however could not see a resolution, as the appeal was later withdrawn.
Now, the pertinent question is the binding nature of the HC decision. Unlike apex court's order which becomes law of the land in binding on all courts (Article 141 of the Constitution), HC decisions are binding in the jurisdictional state and carry at best a persuasive value for Courts in non-jurisdictional states. The tax administration would however be tempted to apply ratio of the recent decision across the country.
In conclusion, the principles underlying the debate on characterisation of software income has not been disturbed. I am hoping that the said principle is not disturbed unless of course the apex court takes a contrary view. However, the decision is certain to add to cumbersome litigation on the question of tax withholding obligation, especially where non-compliance is for bona fide reasons. If the Revenue continues to insist on withholding tax compliance, it is bound to cause hardship and cash flow challenges.
(The author is a Partner with BMR Advisors and views are entirely personal)