Is tax to be withheld on payments made by Indian company to a foreign company?

In this article we would analyse whether tax needs to be deducted on payments made to foreign companies. In this world of globalization, where cross-border transactions are the order of the day, there is often confusion and ambiguity with regards to deduction or withholding of tax on payment made to foreign companies.

Take, for example, a company situated in Bangalore, engaged in rendering IT and ITES services to their clients worldwide, which needs to pay marketing and business development fees to a company situated in Denmark. Now, the question is whether the Indian company should deduct or withhold taxes on payment made to the Denmark company.

In case where the foreign company has a PE (Permanent Establishment) in India

First, we need to check whether the foreign company has permanent establishment (PE) in India. We need to see whether the fees, royalty or technical fees which the foreign company has received from the Indian company is effectively connected to such permanent establishment (PE) or fixed place of business. If that is the case, then the income shall be computed under the head profit or gains of business or profession in accordance with the provisions of the Income Tax Act.

Also, only such expenditure and allowance which are wholly or exclusively incurred for the business of such permanent establishment or fixed place of profession in India would be allowed in determining profits of such PE, on which tax rate @ of 40% will be leviable.

Where the foreign company does not have a PE in India

Further, in this case, if the foreign company does not have a permanent establishment (PE) in India, then we need to check, article 13(2) of the Double Taxation Avoidance Agreement (DTAA) executed between India and Denmark, which states that the amount payable towards fee for technical services to the resident of the other Contracting State can be also taxed in India at a rate not exceeding 20 percent of the gross amount of the fees for technical services.

Further, as per section 115A(1)(b) of the Income Tax Act, 1961, the tax on fees for technical services on a foreign company received from an Indian company is 10%. Also, section 90(2) of the Income Tax Act, 1961, suggests that, if the Central Government has entered into a DTAA with any country outside India, for TDS purposes the most beneficial rate has to be applied in the case of an assessee to whom such DTAA is applicable. Therefore, the most beneficial rate is 10% as per section 115A; accompanied by surcharge @ 2% and education cess @ 3%, the net effective rate will be 10.506%.

Thus, tax rate @ 10.506% could be applied on the payment to be made to a foreign company, towards fees for technical services rendered in India, since it is the most beneficial rate as per section 90(2) of the Income Tax Act 1961.

Also, the foreign company would be required to obtain a PAN (tax number) in India for the TDS deduction. If the foreign company does not wish to obtain the PAN in India, then higher rate of TDS @20% needs to be deducted. Foreign company can file tax return in India to claim refund of TDS deducted, by taking deduction of expenses incurred in India for earning aforesaid technical fees. However, in case the foreign company does have a PE in India, then all the tax and regulatory provisions which apply to a company would also apply to such foreign company.

Please note that fees for the marketing and business promotion activities paid by an Indian company to a foreign company is construed as fees for technical fees under the Indian Income Tax Provisions, as held by Authority for Advance Ruing in India.

To Conclude – There is extra caution required while making payment to foreign companies, to see if TDS or withholding provisions are triggered for the particular payment. Also, each transaction should be looked at differently from the standpoint of Indian Income Tax provisions and double tax avoidance treaty entered with the concerned country.