Tax Hotline: Expense disallowance discriminatory when not applicable to payment to residents

• Expense disallowance (on the basis of failure to withhold taxes) prescribed under domestic law with respect to payments made to non-residents for purchase of goods is not in consonance with the non-discrimination obligation under the India Japan DTAA;
• Such disallowance may still be made for payments such as royalties and fees for technical services as they give rise to an obligation to withhold tax even on residents;

INTRODUCTION

The Delhi Income Tax Appellate Tribunal (“Tribunal”) recently held that provisions relating to expense disallowance on the basis of failure to comply with withholding tax obligations cannot be applicable in case of payments made to Japanese residents. The Tribunal held that such disallowance discriminates between payments made to Japanese residents and payments made to Indian residents. Consequently, the Tribunal held that such disallowance is not in consonance with India’s non-discrimination obligation under the India Japan Double Tax Avoidance Agreement (“Japan treaty”).

While negotiating cross-border transactions, quite often the parties involved are not in agreement with respect to taxability of the transaction and applicability of withholding tax obligations. From the payee’s perspective, they tend to be conservative for two reasons – (i) potential demand being raised by the tax authorities in relation to the tax amount to be withheld and interest and penalties thereon; and (ii) potential disallowance for expenses claimed. In light of India’s non-discrimination obligation under the Japan Treaty, the Delhi tribunal’s ruling discusses the validity of provisions dealing with disallowance provisions read with the payee’s withholding obligation.

FACTS

Mitsubishi Corporation India Private Limited (“Mitsubishi India”), an Indian company, is a wholly owned subsidiary of Mitsubishi Corporation (“Mitsubishi Japan”), a Japanese company. Various payments were made by Mitsubishi India to non-resident Associated Enterprises (“AEs”), some of some of which did not have a permanent establishment in India. The Assessing Officer (“AO”) disallowed expenses in respect of all the above-mentioned payments on the ground that Mitsubishi India failed to withhold applicable taxes on such payments.

ISSUE

The key issue involved in this case is whether domestic law provisions on expense disallowance (on the ground of failure to withhold taxes on such expense) are in consonance with India’s non-discrimination obligation under the Japan Treaty. In several tax treaties entered into by India (including the Japan Treaty), non-discrimination clauses provide that nationals of the treaty country shall not be subjected to any taxation or connected requirements which are more onerous than those imposed those imposed on Indian nationals. Further, such clauses also provide that expense deduction for payments made by a resident enterprise in India to a resident of treaty country shall be allowed under the same conditions applicable to payments made to residents of India. The non-discrimination obligation relating to expense deduction is not applicable when Article 9(1) of the Japan Treaty applies. Article 9(1) provides that, in case of transactions between related parties (where one party is an Indian resident and other party is a Japanese resident), if the transaction is not carried out at arms’ length, appropriate (transfer pricing) adjustments can be made.

Therefore, while computing taxable business profits of an Indian resident enterprise, expense deduction for payments made to a Japanese resident are required to be allowed under the same conditions applicable to payments made to an Indian resident, except in the circumstance mentioned above.

The revenue’s argument was that Article 9 was applicable as payment was made by Mitsubishi India to a related party in Japan and consequently, the non-discrimination obligation relating to expense deduction does not apply.

RULING

In relation to payments to non-resident AEs which did not have a PE in India, the Tribunal held that such payments were not liable to withholding as such payments (which are in consideration of sale of goods to an Indian entity) were not chargeable to tax in India. Therefore, no disallowance can be made on the basis that taxes were not withheld.

With respect to payments made to Japanese AEs, the Tribunal held that expense disallowance (on the basis of failure to withhold taxes) prescribed under domestic law with respect to payments made to non-residents (particularly Japanese residents) for purchase of goods is not in consonance with the non-discrimination obligation under the Japan Treaty. Tribunal also held that the applicability of the non-discrimination obligation was not excluded merely by virtue of the fact that the payment was between related parties. The Tribunal reasoned that the exclusion on the basis of Article 9 was relevant only where a transfer pricing adjustment is sought to be made.

ANALYSIS

Non-discrimination clauses, limiting the application of domestic tax law provisions in the host country to residents of the partner country are found in several tax treaties worldwide. The non-discrimination obligation generally deals with discrimination on the basis of nationality or on the basis of differential treatment to a PE in India. Therefore, courts have often held that discrimination on the basis of tax residence (as against nationality) does not amount to non-discrimination. However, specifically with respect to expense disallowance, the non-discrimination obligation deals with discrimination on the basis of tax residence.

In India, withholding tax obligations are applicable in case of any entity (including both resident and non-resident entities) making payment to a non-resident if such payment is chargeable to tax in India. However, payments made to residents such as consideration for transfer of capital assets (giving rise to taxable capital gains), payment for sale of goods, payment for services other than technical services, etc are generally not subject to tax withholding obligations. Therefore, this ruling could be relevant in case of expense deduction for the abovementioned payments made to residents of countries whose tax treaty with India has a similar non-discrimination clause. To clarify, this ruling only addresses expense disallowance and does not deal with other consequences of non-compliance with withholding tax obligations, particularly, liability for tax amount, interest at 12% per annum and penalties, which could extend up to 100%. Further, this ruling may not apply where payments made to residents are subject to withholding tax obligations such as royalties and fees for technical services.

Thus, the ruling could have an impact in circumstances where two parties to a transaction do not agree on taxability of the transaction and withholding obligations arising as a consequence. This becomes highly relevant in case of transactions involving disputed issues such as taxation of permanent establishment in India involving sale of goods or services that are not technical services (especially, on the basis of virtual presence or presence of a server or right to access to technical equipment without any right to possess or control the equipment), entitlement to treaty relief where the payee is a fiscally transparent entity like a partnership, trust, LLC, etc..