Applicability of 20% tax withholding rate to a non-resident under tax treaty scenario?

It is a settled tax principle under the provisions of the Indian Tax Law (ITL) that a non-resident can opt to apply for the provisions of the Double Taxation Avoidance Agreement (tax treaty) or of the ITL, whichever is more beneficial. A tax treaty is an agreement between India and other countries with respect to taxation rights and related aspects. Access to the tax treaty is subject to fulfillment of certain conditions, such as having a valid Tax Residency Certificate (TRC), being the beneficial owner of income in certain situations, etc.

Section 206AA was introduced in the ITL from FY11. If the payee does not furnish the Permanent Account Number (PAN), the payer is required to withhold taxes at applicable tax rate according to the beneficial provisions or 20%, whichever is higher. Any remittance to non-residents (other than salary and certain interest income) is required to be subject to tax withholding, if it is taxable in India. Accordingly, in case of a non-resident whose income is not chargeable to tax, in view of the beneficial provisions of the tax treaty, this section will not have any implications.

Section 206AA starts with a non-obstante clause, i.e., it overrides other provisions of the ITL. Therefore, in the absence of the PAN of a non-resident, the question arises: does a higher withholding tax rate of 20% apply in a situation where lower tax rate is available under the tax treaty, considering the non-resident can opt for the beneficial provisions?

Recently, the Pune Income Tax Appellate Tribunal (Pune ITAT) had an opportunity to look into this issue in the case of leading vaccine manufacturing Company. In this regard, Pune ITAT held as follows:

  • The tax treaty provides for scope of taxation and a rate of taxation that is different from the scope/rate prescribed under the ITL. On this basis, the taxpayer withheld tax at the rate prescribed under the tax treaty (rate under the tax treaty was less than 20% and PAN was not furnished by the non-resident payee eligible to access the tax treaty)
  • The provisions of the tax treaty need to be read along with the ITL while evaluating taxability and the consequent tax withholding requirements. Thus, the withholding mechanism does not override the charging provisions under the ITL or the tax treaty.
  • The section prescribing tax withholding at the rate of 20% is procedural in nature. The withholding tax mechanism is subordinate to the charging provision under the ITL. In such circumstances, the withholding mechanism, including the provision which requires withholding at 20% tax rate, cannot override the charging provision.
  • Furthermore, the charging provision under the ITL is subject to the tax treaty. Accordingly, as the tax treaty provisions are more beneficial than the ITL provisions, the tax rate prescribed under the tax treaty will govern payments to non-residents, and not the higher rate of 20% as prescribed under the ITL, whether or not the non-resident furnishes a valid PAN.

It is also pertinent to note the ruling of the Bangalore ITAT in the case of  auto components manufacturing Company. It was held that tax was required to be deducted at 20% in case the non-resident payee does not furnish a PAN, considering income was liable to tax under the provisions of the ITL as well as the tax treaty. The Bangalore ITAT discussed in detail the nature of services in terms of whether they are taxable as “fees for technical services” or otherwise in accordance with the provisions of the relevant tax treaty. However, it did not deal with the aspect of the tax treaty provisions prevailing over section 206AA of the ITL for rate purposes as well (which was discussed by the Pune ITAT).

The above case, while upheld in favor of the assesses by the Pune ITAT, is likely to be the subject matter of litigation in future. Considering the wide applicability of the provisions on various cross-border transactions, a circular clarifying the tax department’s position will be a welcome move for the industry, especially considering that the application of the section could result in genuine hardship in some cases. For example, the application of the section (i.e., tax withholding at the rate of 20%) to a net of tax contract could result in a significant increase in transaction cost for the Indian party. This is because the 20% rate may have to be further grossed up, even if the non-resident payee is eligible to access the tax treaty provisions (with lower tax rate) but does not furnish PAN.

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