The Finance Bill 2023 that the Indian parliament passed increased the withholding tax rate under the Income-tax Act, 1961 for payment of Royalties and Fees for Technical Services (FTS) paid to non-residents from 10% to 20%.
India is a net importer of technology and high-end services from foreign jurisdictions. In such cases, Indian multinational pays significant amounts of royalties for the use of technologies and also FTS to its related and non-related foreign parties.
While making such payments, considering the source rule of taxes, the tax must be withheld, which now stands at 20% with effect from 1 April 2023 (earlier 10%) under the Indian domestic tax law. The tax withheld is then charged to tax, and the foreign company must file a return in India by obtaining Permanent Account Number (PAN), barring certain compliance exemptions provided by the tax law.
Such withholding taxes becomes a source of income to the country of source, i.e., in this case, India. In most cases, taxes that are withheld in the country of the source are given as a credit in the recipient’s country of residence. The Double Tax Avoidance Agreements and the local regulations of the country of residence govern this mechanism. Often full credit is unavailable in the residence country for the taxes withheld in the source country. Accordingly, any lost tax credits would mean an increase in the tax cost of doing business for the recipient of the income or the payer if the contract is gross of taxes. Hence, any increase in such withholding taxes would pressure the payer and the payee from the risk of additional tax leakage in cross-border transactions.
So what avenues are available for corporations to optimise their taxes and avoid structural tax leakages in the value chain while being compliant on the right side of the tax law?
Here are a few solutions that could be explored.
- Opt for Tax treaty benefits:
India provides benefits to the taxpayer to choose a tax treaty or the local law, whichever is beneficial. If favourable treatment and rates exist in the tax treaty, the taxpayer must comply with the provisions of the local law to enable access to the tax treaties. Such compliances may include obtaining a Tax Residency Certificate of the country of residence, filing a Form 10F, obtaining a No-PE certificate and applying for a PAN in India, etc.
- Possibility of restructuring transactions:
The increase of withholding taxes to 20% would negatively impact non-residents receiving FTS and Royalty income in the USA and UK. In both countries, the treaty rate was 15%, and often, the rate in the Income-tax Act @ 10% was preferred over the treaty rate. This increases the tax cost directly by 5% while the payment is being made to these jurisdictions. In such cases, one may like to evaluate the possibility of business restructuring to save such tax costs. It is imperative to note that any business restructuring should meet the business purpose and substance test, and care should be taken so that the same does not give rise to tax avoidance strategies.
- Obtain a Lower Deduction Certificate:
If you believe the TDS rate applied is higher than your actual tax liability, you can apply for a Lower Deduction Certificate from the Indian tax authorities. This certificate will authorise the payer to deduct tax at a lower rate than the standard rate. Such a remedy is not usually used in the FTS or Royalty scenario, however, a lot might depend on the facts of the case.
- Reinvest income rather than making a payment:
In a group transaction scenario, one may want to restructure and re-characterise the transactions to reinvest in India rather than making a payment to the group company. Such an aspect needs testing from transfer pricing perspective of the non-resident or a foreign company. As mentioned above, any restructuring should fit the business purpose and substance criteria.
- Use Transfer Pricing to your benefit:
A transfer pricing design has the same importance that an architect has for building construction. A poorly designed transfer pricing strategy would bleed in taxes and could lead to inefficiencies in the value chain of a multinational. Transfer pricing strategies could help optimise overall tax outflows, including the withholding tax increase.
- Consult a Tax Professional:
Engage in the services of a tax/ transfer pricing professional who is well-versed in international taxation to help you navigate the complexities of the Indian tax system and find the most suitable options for reducing your tax liability.
The increase in withholding tax by double was a contrary move by the Indian Government compared to the change brought in 2015 by the same government by reducing the tax rate to 10% from 25%. While it may lead to some additional tax collections, it has the potential to act as a deterrent to the investments being made in India. An unchecked tax cost like withholding taxes might lead to an increase in the cost of the Indian corporation and might increase transfer pricing litigations of foreign companies. Corporations should consider treaty protections and re-think alternate ways of undertaking business operations with India.