Cross-border payments: Achieving balance between Withholding Tax and Service Tax

December 13, 2008

K R SekarKrupa Venkatesh

Withholding Tax- Scope of Section 195 Any person

Responsible for paying to a

Non-resident, not being a company or a foreign company

Any interest or any other sum chargeable under the provisions of the act (not being income chargeable under the head salaries)

Shall at the time of

Credit of

Such income to the account of payee

Or at the time of payment of cash or by cheque or by any other mode, whichever is earlier

Deduct income-tax thereon at the rates in force

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Scope of Section 195 Any person - Meaning

Section 195- refers to any person

The definition of “person” under section 2(31) includes Individual, HUF, Company, firm, AOP, local authority, and every artificial judicial

person

Payments from resident to non-residents – provisions applicable

Payments from non-residents to non-residents SC in Electronics Corporation of India Limited (183 ITR 43) AAR in P-13(228 ITR 487)

Payments from Branches of foreign company to non-resident Circular no 740 dated 17-4-1996 Special Bench decision in ABN Amro Bank (98 TTJ 295) Citi Bank vs CIT (259 ITR 377)

Does it apply in respect of payments by agents Post 1-6-1987 it applies

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Scope of Section 195 Applies to Income Scope of the meaning “Income”

Status of RBI Approval

United Breweries Limited vs ACIT (83 Taxmann 263)(Kar) Pfizer Limited vs CIT (259 ITR 391)

Status of reimbursement of expenses

Nature of reimbursement of expenses What is the contractual responsibility Difference between Administrative expenses and services If it is towards service no reimbursement argument The decision is always on facts

Calcutta High Court in Dunlop Limited AAR rulings -Decta Limited, Danfoss Industries and Timken Limited

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Scope of Section 195 Marketing fees/agency Commission

Circular no 63 dated 23rd July 1969 CIT vs Toshoku Limited (125 ITR 525)

Payment of Salaries 195 is not applicable HCL Infosystems Limited vs CIT (274 ITR 261) ( Del)

Payment of Royalty and Technical Services 9 (1) (vii) vs DTAA DTAA shall apply if it is beneficial

Responsibility of person paying SC in Transmission Corporation Case (293 ITR 587)

Rates in force DTAA rates vs Finance Act rates whichever is more beneficial

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Vodafone Case - Facts

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Mauritius Company

HEL

100% shares

Sale of shares of CGP to Vodafone

CGP

HTILVodafone

JV - 67% owned by Hutch group balance by Essar Group

Revenue’s Contention:

Vodafone liable to Withhold tax

OBSERVATIONS / JUDGEMENT OF BOMBAY HIGH COURT

Subject matter of transaction between Vodafone and HTIL is transfer of interests, tangible and intangible in Indian companies of Hutch Group in favour of Vodafone and not an innocuous acquisition of shares of CGP

Prima facie, HTIL has earned income liable for capital gains tax in India as the income was earned towards sole consideration of transfer of its business / economic interest as a Group, in favour of Vodafone

Under the share transfer agreement, FIPB approval was mandatory and Vodafone reserved the right to cancel agreement if FIPB does not grant approval

Under FIPB approval, Vodafone bound to comply with all Indian laws including Indian Income-tax Act

Although shares may be an asset, they also may be merely a mode or vehicle used to transfer some other asset(s) (as in the present case)

Vodafone becomes a successor in interest in the JV between HTIL and Essar Group and also becomes a co-licensee with the Essar Group to operate mobile telephony in India

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OBSERVATIONS / JUDGEMENT OF BOMBAY HIGH COURT

Purpose of transaction was:

To enable Vodafone to acquire controlling interest in HEL by acquiring direct and indirect equity and loan interest

To acquire the right to manage HEL by appointing its own directors on the board To enable Vodafone to successfully pierce the Indian mobile market to enlarge

global presence

Controlling interest must necessarily be preceded by extinguishment of right, title and interest in the shares of the Indian group

Divestment in interest of enormous value in shares by HTIL would result in enduring benefit and acquisition of a capital asset in India by Vodafone, resulting in capital gains in the hands of HTIL chargeable to tax in India

On question of extra-territorial jurisdiction, Reference to ‘Effects Doctrine” in US – any state may impose liabilities, even upon persons not within its allegience, for conduct outside its borders that has consequences within its borders which the state represents

Having admitted that HTIL has transferred 67% interest in HEL qua shareholders, FIPB, statutory authorities in USA/ Hong Kong, neither Vodafone not HTIL can take a different stand before Indian tax authorities 8

Validity of show cause notice

Vodafone has not submitted primary / original agreement, subsequent documents / agreements with HTIL; constitutional validity of the income tax provisions cannot be gone into

Question on taxability can be gone into only by concerned authorities and cannot be determined on the basis of affidavits / counter affidavits in writ proceeding.

Vodafone has not been able to demonstrate that show cause notice is totally non-est in law for absolute want of jurisdiction of the authority to even investigate into the facts, by issuing a show cause notice

The case involves investigation into voluminous facts on the basis of which the question of chargeability to tax and the question of duty to deduct tax can be determined

Rights of Vodafone are fully safeguarded u/s 195(2), 195(3) and 197 of ITA

Show cause notice cannot be termed extraneous/ irrelevant / erroneous/not based on any material at all

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Refund of Tax withheld u/s 195

Possible under limited circumstances:

(a) the contract is cancelled and no remittance is made to the non-resident;

(b) the remittance is duly made to the non-resident, but the contract is cancelled

Circular No 769

Circular No 790 dated 20/04/00

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Discussion on specific issues:

A. Software Expenses

B. Data Connectivity

C. Secondment Charges

D. Management Charges

Software Expenses

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Sources of Income in Software Industry

Development of software (copyright rights)

Reproduction and licensing of software (as an industry norm, software are sold

through license agreements and the rights in software generally remain with the

developer)

Implementation services

Regular maintenance services

Updation services

Warranty Services

.

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Software Types Shrink wrapped software

Example:

1. Microsoft Vista

2. Microsoft Office

Customized software

Example:

1. Specialized billing software for a company

2. Inventory management software software

Customization services

Example:

1. Customization of ERP Software

Copyright Rights Copyright rights refers to the legal right to control the production and selling

Per the Internal Revenue Service, USA, copyright rights refer to the right to make copies for distribution to the public the right to prepare derivative programs the right to make a public performance of the program, and the right to publicly display the program

Copyright is a capital asset of intangible nature

Grant of right to use of copyright for further production and/or selling amounts to

royalty income

Outright sale of copyright amounts to capital gains

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Copyrighted Articles Copyrighted articles refer to the final products developed from the use of copyright

Per the Internal Revenue Service, USA if a person acquires a copy of a computer

program but does not acquire any of the four copyright rights, the transfer is classified

as a transfer of a copyrighted article

It further provides that a copyrighted article as a copy of a computer program from

which the work can be perceived, reproduced, or otherwise communicated, either

directly or with the aid of a machine or device

Shrink wrapped software are generally copyrighted articles

Income from sale of copyrighted articles is generally treated as business income

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Whether royalty or business income - OECD Commentary after amendments to Article 12

Arrangement between software copyright holder and a distributor intermediary

Distributor gets right to distribute copies of the program without the right to reproduce

the program

In these transactions, the rights acquired in relation to the copyright are limited to

those necessary for commercial intermediary to distribute copies of software program

In such transactions, distributor is paying only for the acquisition of the software

copies and not to exploit any right in software copyrights

Hence the rights of the distributor should be disregarded for the purpose of analyzing

the transactions

Payments for these transactions should be covered under Article 7 and not under

Article 1217

India’s position on Article 12 India has reserved the right to include in the definition of royalties payments for the use

or right to use , industrial, scientific or commercial equipment

India has reserved the right to tax royalties and FTS on source basis

India has reserved the right to define these by reference to domestic tax law

India may define the ‘source’ which may extend beyond the source as mentioned in Para

5 of Article

India does not agree with the position on Royalty on Software as explained in various

examples. India is of the view that the same is considered as “royalty”

India does not agree with the interpretation that information concerning industrial,

commercial or scientific experience is confined only to previous experience18

Data Connectivity

Connectivity charges

Software Developer

Outside India

India

Customer

VSNL

AT & T

SingTel

STPI

International portion

India portion

Earth stationsuplink

downlink

HOTLINE

Tax Issues Is it taxable as Royalty

Right to use Equipment

Right to use process

Is it taxable as Fees for Technical Services

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Right to use Equipment There must be physical contact between the user and the equipment

Use or right to use depends on the relation which exists as a matter of fact between

the person and the property. (Tourapark Pty Ltd v FCT (12 ATR 842)

Criteria for Determination of Right to Use or Use of Equipment (OECD TAG Report)

Customer has physical control/possession over the equipment

Customer has significant interest in the equipment

Provider does not guarantee revenues

Provider does not use the property concurrent to provide services to others

Hence payment for connectivity charges cannot be termed as use of process

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Recent AAR Decisions : Dell International Services Pvt Ltd (172 Taxman 418) & ISRO Satellite Centre (AAR no. 765 of 2007)

Right to use Process Process for the purpose of royalty should be understood and interpreted with regard to

the process as understood under Patents Act .

Under Patent Law, process indicates secret processes, formulas and techniques

connected with the manufacture.

The transaction of connectivity charges is not for process but for getting the signals.

The user does not get any knowledge on process or acquainted with the process

Hence payment for connectivity charges cannot be termed as use of process

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Fees for Technical Service Technical service contemplates rendering of a “service” to the payer of a fee.

Fees for technical services could only be meant to such things as are capable of

provided by way of a service or fee.

Mere collection of fee for use of standard capacity does not amount to fee for having

been provided for technical services.

The fact Telephone Service Provider has installed sophisticated equipment in the

exchange to ensure quality connectivity does not on that core make it as a provision of

technical service.

Secondment Charges

Secondment of Personnel

Creation of a PE

Fixed Base

Service PE

Options to mitigate PE Risk

Transfer of payroll to the Indian company

Cross Charge of salary

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Supreme Court decision in the case of Morgan Stanley (292 ITR 416)

Secondment of Personnel

Cross charge of salary- Issues

Withholding tax on the cross charge

Adverse AAR Ruling in the case of AT&S India Private Limited (287 ITR 421)

Service Tax on Secondment

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Important consideration in secondment Employer-Employee relationship

Management Charges – Transfer Pricing Issues

Management Charges - Meaning

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Marketing + Sales

Support

Customer Service Support

Legal and Related Support Services

Finance, Accounting &

Service Support

Management Charges

Taxability : FTS / Make Available

Transfer Pricing Officer’s stand Contend that the payment of management charges were unjustifiable

The broad premise for adopting such a stance are:

No “tangible” evidence of benefits accruing from such services;

Inadequate proof of “tangibility” in rendering the services;

None of the comparable companies identified pay such charges

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Justification for Management Charges Management fees are consideration for expertise availed by a business operating in a

nascent market/niche segment

Charges for services rendered by the parent for improving a subsidiary’s prospects;

Payments for lending skill sets unique to the business in question

Sweden Supreme Court Decision - Dow Sverige AB vs. Swedish

tax authorities :

The Supreme Court held that a deduction is allowed for costs attributable to shared

services received and paid for by a Swedish subsidiary from its foreign parent. The

Supreme Court also noted that that all related Companies applied the same allocation

method.

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Service Tax

Import of Services – Evolution of the concept

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Date Significance

16th Aug 02 Insertion of Clause (iv) in Rule 2(1)(d) to include the recipient of service in the definition of ‘person liable to pay’ service tax

1st Jan 05 Issue of Notification 36/2004 dated 31st Dec. 2004, effective 1st January 2005

16th June 05 Explanation to Section 65(105) inserted

18th April 06 Taxation of Services (Provided from outside India and received in India) Rules, 2006; Explanation to Section

Effective date – the raging controversy 16th August 2002 virtually ruled out

Current controversy is on account of decisions in

Hindustan Zinc Ltd. Vs.

Foster Wheeler 2007-TIOL-785-CESTAT-AHM Referred to Larger Bench

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Taxation of Services (Provided from Outside India and Received in India) Rules, 2006 Commonly known as Import of Services Rules

With effect from 19.04.2006

Services placed in three categories for determining ‘import’

Recipient of service liable to pay tax

The amount has to be paid in cash; no adjustment against CENVAT credit can

be done

Service tax paid as a recipient is available as credit for future liability

Largely inspired by the UK Place of Supply Rules

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Classification of Import of Services

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Taxable services are divided into three categories for determining import

Category I Category II Category III

Based on location of Immovable Property

Based on Performance Based on location of recipient

Rule 3 (i) Rule 3 (ii) Rule 3 (iii)

Common condition: Receipt of consideration in foreign exchange

Some typical examples

Management Re-charges

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Parent company

Subsidiary

Outside India

India

Management re-charges

One of the most common form of re-charges

Generally flows from a management services agreement

Cost allocated usually on some rational basis, most common of which are head

count, time spent, turnover, etc. on cost-plus basis

Services are generally in the nature of advice on day-to-day operations of Indian

subsidiary

Service Tax Implications

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More often than not services categorized as ‘management consultant’ services

Placed in Category III service

Onus to discharge tax on recipient of service

Tax paid available as credit for set off or refund, as the case may be

Secondment of Personnel

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Parent company

Subsidiary

Outside India

India

Secondment of personnel

Common arrangement with expatriate employees

Assignees continue to be on the rolls of the parent company for continuation of

social security benefits

Service Tax Implications

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Would create a client-service provider relationship between the Indian subsidiary

and parent company

Leviable to service tax under the category ‘manpower supply’

Payable on entire salary

Creation of an employee-employer relationship may be the answer

Dual employment

Parent company

Subsidiary

Outside India

India

Cost allocation

Service provider enters into a global agreement for providing data connectivity to

group entities all over the world

Charges for connectivity paid centrally

Cost allocated to Indian subsidiary on the basis of usage/headcount, etc.

Service provider Global agreement

services

Data Connectivity Charges

Service Tax Implications

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Services provided by a person who has been granted a licence under the Indian

Telegraph Act, 1885

If last mile service provider is Indian service provider, he is liable to charge service

tax

If the service provider is not in India, then possible to take a position that the

reverse charge will not apply as he is not a person licenced under the Indian

Telegraph Act

Same position can be adopted when parent company allocates connectivity

charges based on usage

Service Tax Implications

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Raging controversy over levy of service tax on software downloads

Customs Duty Vs. Service Tax

Valuation issues where paper licenses are imported and software is

downloaded

Whether ‘goods’ or service?

Decision in TCS and recent Madras HC decision in Infosys Technologies

Sustainability of the levy itself

Industry practice

Levy of both service tax and VAT

Service tax on VAT component or vice-versa?

Maintenance of Sotware - Service Tax Implications

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Recently introduced IT services covers maintenance services

Overlap with maintenance & repair services

Effective date

1st July 2003 or 7th October 2005 or 16th June 2008?

Effective date

Decision of Tribunal in Nokia case

Whether argument under consulting engineer is still available?

Remote maintenance

If software resides in India, then the maintenance service is imported,

irrespective of where the service is performed from

Thank you