Facts and background of the case:
- The assessee, an Indian company and a subsidiary of Herbalife of International America Inc.(“HII”), a company incorporated in USA, was engaged in the business of manufacturing herbal products used in weight management, for improving nutrition and enhancing personal care.
- The assessee entered into an Administrative Services Agreement (“ASA”) with Herbalife International of America Inc. (HIAI) in terms of which HIAI was to provide data processing services, accounting, financial and planning services, marketing services, long term financial planning services etc., to the assessee.
- For the aforesaid services, the assessee, during the assessment year 2001-02, paid administrative fee to HIAI without withholding tax at source.
- The Assessing Officer (“AO”) disallowed the aforesaid fee claimed deduction by the assessee, invoking provisions of section 40(a)(i) of the Income-tax Act('the Act') on the ground that payments for the aforesaid services were in the nature of Fee for Technical Services (“FTS”) under section 9(1)(vii) of the Act and were subject to tax deduction at source (TDS) at the applicable rate.
- The Commissioner of Income Tax (Appeals) [“CIT(A)”] upheld the action of the AO.
Ruling of the Delhi Tribunal
- Aggrieved by the order of the CIT(A), the assessee filed an appeal before the Delhi Bench of the Income Tax Appellate Tribunal('Tribunal'). The Tribunal held that section 40(a)(i) of the Act was wrongly invoked by the AO to disallow the deduction of expense claimed by the assessee since the aforesaid payment constituted business income and in absence of Permanent Establishment (PE) of HIAI in India, the same was not taxable in India in terms of Article 5 read with Article 7 of the India-US Tax Treaty.
- It was further held that in any case disallowance under section 40(a)(i) of the Act was not called for having regard to the provisions of Article 26(3) of the India-US Tax Treaty, relating to non-discrimination, which, inter alia, provides that interest, royalties, and other disbursements paid by a resident of India to a resident of USA shall, for the purposes of determining taxable profits US resident, be deductible under the 'same conditions' as if they had been paid to an Indian resident.
- The Tribunal observed that provisions of section 40(a)(i) of the Act, prior to insertion of sub clause(ia) in section 40(a) of the Act by the Finance (No.2) Act, 2004, were discriminatory in nature inasmuch as disallowance of expenditure on failure to withhold tax at source from FTS was required only in respect of payment to non- resident/US resident but not in respect of failure to withhold tax from similar payments made to residents.
- Aggrieved by the order of the ITAT, the Revenue filed an appeal before the Delhi High Court.
Ruling of the Delhi High Court
- In the present case, the payments in question were made in the previous year relevant to assessment year 2001- 02. As per the provisions of section 40(a)(i) of the Act as applicable during such assessment year any payment made to a non-resident, in respect whereof tax was deductible at source but was not so deducted, was not allowable as expense. The provision for disallowance on account of expenses for non-deduction of tax from payments made to a resident was inserted by way of section 40(a)(ia) of the Act, only with effect from April 1, 2005. Prior to April 1, 2005, the condition under which expenses were deductible where tax had not been deducted at source or not were not the same in respect of payments to residents and non-residents.
- Non-deduction of tax at source when the payment is made to a non-resident has an adverse consequence for the payer. Since it is mandatory in terms of section 40(a)(i) of the Act for the payer to deduct TDS from the payment to the non-resident, the latter receives the payment net of TDS. The object of Article 26(3) of the Tax Treaty was to ensure non-discrimination in the condition of deductibility of the payment in the hands of the payer where the payee is a resident of the Contracting State. The said object would stand defeated if there is discrimination qua non-resident by requiring tax to be deducted while paying FTS in terms of section 40(a)(ia) of the Act but not so in respect of payment to resident.
- While tax deduction from payments to non-residents may be justified, that does not meet the test of Article 26(3) of the Treaty as regards condition for deductibility of the payment itself. The conditions for deductibility under the provisions of the Act are different in respect of payments made to residents and non-residents. Therefore, non-discrimination provisions under Article26(3) of the Tax Treaty is applicable in the instant case.
- The plea of the Revenue that unless there are provisions similar to section40(a)(i) of the Act in the Tax Treaty, a comparison cannot be made to determine which is a more beneficial provision is erroneous. The provisions of the Tax Treaty will prevail unless any specific provision in the Act is more beneficial to the assessee.
The Court thus concluded that no tax was required to be withheld at source on payments made by the assessee to HIAI under the ASA and that the disallowance made under section 40(a)(i) of the Act was rightly deleted by the Tribunal.
- Many Tax Treaties entered into by India contain the non-discrimination Article. However, only some of the Treaties contain the clause facilitating deduction neutrality. Illustratively, India's Tax Treaties with Finland, France, Germany, Hungary, Japan, the Netherlands and the US contain this clause.
- The aforesaid decision of the Delhi High Court is of considerable significance, being the first from a High Court wherein the Court has elucidated various facets of availing the benefit of the deduction neutrality clause of the non-discrimination Article and upheld that different tax withholding treatment for the foreign enterprise per se is enough to invoke the non-discrimination clause under the India US Tax Treaty.
- Interestingly, Finance Act, 2014, restricted disallowance of payments made to residents, without deduction of tax, to 30 percent of the payment. A corresponding amendment in respect of payments to non-residents has not been made. Accordingly, in appropriate cases, non-discrimination argument may be raised by assessees to avail of deduction parity, if provided for in the Treaty.