Presentation on Withholding Taxes

Vikram Singh Sankhala

Tax

Financial Charge

Imposed on an Individual or a Legal Entity

By a State

Purpose

To fund Government expenditure

Categorization

Direct Taxes

Indirect Taxes

Direct Tax

Where the person from whom the Tax is collected is the same as the person who bears the ultimate economic burden of the Tax.

Here the incidence of Tax is on the person from whom it is collected

Example Taxes on Income ,Wealth and property

Indirect Tax

Where the person from whom the Tax is collected is different from the person who bears the ultimate economic burden of the Tax

Example Sales Tax, Service Tax, Excise and VAT These taxes are usually on the value of the

transaction and are passed on to the end user though they may be collected at any point in the chain.

Income Tax

One of the important kinds of Direct Taxes

It is levied on the income of an individual or specified entities

An income normally arises as a result of a transaction

However the term income has no significance without the entity to whom it belongs

Income Tax ( Continued)

Therefore it is charged to tax levying the charge on the entity who owns this income

Income Tax ( Continued)

Therefore are therefore two critical factors for income Tax

The nature of the Transaction that gives rise to the income

And the nature of the entity that owns the income and is charged to Tax on it

Income Tax ( Mode of Collection)

A transaction has an entity which pays the money and an entity which receives the money

Normally the entity which receives the money is the owner of the income and the collection of Tax therefore normally takes place from the receiving entity

Income Tax ( Mode of Collection)

There is another mode of collection where tax is collected from the paying party or the source entity

Though this tax is collected from the paying party, it is on behalf of the party to whom the income belongs

This is because the tax is on the income

Income Tax ( Mode of Credit)

The receiving entity, who owns the income, is deemed to have paid this tax

The paying party issues a Certificate that the tax on the income has been paid on behalf of the party to whom the payment is made.

The receiving party, in turn claims credit for this tax paid on its behalf

International transactions

Normally in most transactions the paying and receiving entities belong to the same Tax jurisdiction

However in transactions involving cross border sale or provision of services, the two entities are in separate Tax jurisdictions

International transactions

Since income arises from the paying party, its tax jurisdiction is called the jurisdiction of source

However the income belongs to an entity that is not within this tax jurisdiction

International transactions

The jurisdiction of the entity to which the income belongs, is called the country of residence.

This is because it is based on the entity in whose hands the tax can be charged

International transactions

Since the income originates from the country of source , the source country would like to bring it to tax in its hands

Since the entity who owns such income is the resident of another tax jurisdiction, the country of residence would like the income taxed in its jurisdiction

International transactions

Since the income is the same, if it is taxed both in the country where it originates and the country in which it is received, it would amount to economic Double Taxation

This would discourage cross border trade

Hence most countries have provisions to deal with this issue

International transactions

We would need to start with the country where the income originates

Since the entity to which the income belongs, is outside the tax jurisdiction of the source country, it has only one means of levying and collecting this tax

That is Tax collection at source, from the entity in its jurisdiction that makes the cross border remittance

International transactions

To mitigate the issue of double taxation most countries have entered into bilateral treaties with other countries called Double Taxation Avoidance Treaties

These treaties derive their sanctity from a multilateral convention called the Vienna convention on the law of treaties of 1969

The convention has been ratified by 105 countries

International transactions

The treaties categorize the transaction giving rise to the income under various heads.

Each head is dealt with by a separate article of the treaty

The right to tax is either assigned or apportioned between the country of source and the country of residence based on various considerations within each such article

International transactions

The treaties are usually recognized by the domestic tax laws of the countries entering into them

Besides this, most jurisdictions would also have provisions to deal with such transactions as a part of their domestic Law.

Usually the assessee has the privilege to take the benefit of whatever is beneficial to him – the provisions of the treaty or those of the Domestic Law

International transactions Country of Source)

The country of source collects its share of the tax from the paying entity which is in its Tax jurisdiction

The collection is at Flat rates and on a gross basis

International transactions Country of Resident)

Since the tax is collected on behalf of the entity, whose tax liability is in the country of residence , there are methods by which this entity gets credit for the tax paid in another tax jurisdiction, in its own jurisdiction

This is done by the issue of Certificates of Tax deduction at source from the entity deducting the tax and depositing it in its own jurisdiction

This is called the method of Tax Credit

International transactions (Country of Source)

Another method, though not widely adopted , is where the receiving entity does not offer for tax, such portion of its income, that has been already brought to tax in the country of source.

Some concepts pertinent to us

The Indian Income Tax Act

Model Tax Conventions

Permanent Establishment

Business Income

Royalty and Fees for Technical Services

Treaty Shopping

Limitation of Benefits

The Indian Income Tax Act

The Indian Income Tax taxes residents on a global basis and it taxes non residents on that portion of their income that accrues or arises in India.

The term ‘accrues or arises in India’ has not been explicitly defined under the Indian Income Tax Act.

Section 9 lays down certain conditions for the various heads of Income of non residents , which if satisfied , such income is deemed to accrue or arise in India.

The Indian Income Tax Act( Cont.)

When the income of a non resident accrues or arises in India, it becomes the obligation of the payer, to deduct taxes at the rates in force.

The taxes are deducted under Section 195 of the Indian Income Tax Act.

The rates in force can be found in the first schedule to the relevant Finance Act.

Model Tax Conventions

Section 90 of the Indian Income Tax Act , also provides sanctity to DTAAs entered into, by India , as being an alternative basis for determining the tax liability of the Income of non residents.

It is a generally recognized principle , that the assessee has the liberty to use the provisions of the DTAA or those of the Indian Income tax Act for determining the tax liability.

He is at liberty to apply the provisions that are beneficial to him

Model Tax Conventions

India has DTAAs with – countries

While the provisions of the DTAA vary from country to country, they are broadly modeled on a standard draft.

There are three model Draft conventions currently in practice.

The are the US Model, the UN Model and the OECD Model

Model Tax Conventions

The DTAAs signed by India are modeled using the OECD Draft Convention.

The Draft model has different articles The articles broadly deal with the jurisdiction of the

DTAA, i.e. to whom it can be applicable, the concept of a Tax resident, the concept of a permanent establishment, the classification of the Incomes and with their assignment.

Many DTAAs undergo amendment from time to time.

Permanent Establishment

If income is earned from the country of source, through a fixed base available in the country of source, such income is assigned under, both the DTAA and the Indian Income tax Act, to the country of source.

Such fixed base is called a Permanent establishment.

However, what arrangements can be called a fixed base, is a subject in itself.

Business Income

Business Income in the absence of a Permanent Establishment, is assigned for the purpose of taxability ,entirely to the country of residence

However, if a Permanent establishment is present , then the basis is changed and it is assigned for the purpose of taxation, entirely to the country of source.

Classificatory Rules

The various articles of the DTAAs also deal with rules of classification of the Income into various heads

Such classification is material for us, because it would determine the allocating for the purpose of Taxation and therefore the Tax rate.

Royalty and Fees for Technical Services

One classification that is important for us is the difference between whether an Income of the non resident would be classified as Business Income or come under the ‘Royalty and Fees for Technical Services’.

Normally in the absence of a permanent establishment, Business Income attracts a NIL rate of Tax while the rate on ‘Royalty and Fees for Technical Services’, varies depending on various conditions.

Software

Worldwide there is a dispute as to whether software comes within the ambit of ‘Royalty and Fees for Technical Services’, or is in the nature of Business income.

The dispute usually arises because software consists of a code, and the income is on account of that code.

The has many similarities with the concept of copyright.

Income on account of copyright is one among the various ways in which Royalty is denoted.

Software

In India too, the dispute as to whether Payment for Software is in the nature of a Business Income or in the nature of Royalty has not been conclusively settled.

Treaty Shopping

Since the assessee has the liberty of applying the articles under the DTAA and there are certain treaties where the provisions are more favorable for certain categories of Income, one method of reducing withholding taxes, would be route such payments through jurisdictions where the treaties provide a favorable treatment.

Treaty Shopping

These are done using conduits in such jurisdiction

While this is a method of tax planning that does not explicitly violate the law, it is often felt that this would be against the spirit of the agreement

Limitation of Benefits

The use of conduits is often called a method of treaty abuse

To check this , some treaties also incorporate provisions to prevent the abuse of the treaty

Restrictions are placed on the transactions to which the treaty would apply

This is usually done by the insertion of a clause called the ‘ Limitations of Benefits Clause’

An example would be the DTAA between India and Singapore with specific reference to Income arising from Capital Market Transactions.

And Finally

People who complain about taxes can be divided into two classes: men and women

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