Section 40(a)(i) is discriminatory not applicable to DTAA-Delhi High Court

Section 40(a)(i) is discriminatory not applicable to DTAA. This was held by the Delhi High Court, in a recent judgment as under:

Case Law Details:
ITA 7/2007
Commissioner of Income Tax ….. Appellant vs. Herbalife International India Pvt. Ltd. (HII) …. Respondent
Date of Judgment: 13/05/2016
Coram: Justice S. Muralidhar and Justice Vibhu Bakhru

Important Case Laws Cited:
Union of India v. Azadi Bachao Andolan (2003) 263 ITR 706 (SC)
Hyosung Corporation v. AAR (2016) 382 ITR 371 (Del)

Question of Law:
Among six questions of Law as framed by the High Court, one of them was:

Whether the ITAT was correct in holding that the provisions of Section 40(a)(i) of the Act is discriminatory and therefore not applicable in the present case as per provisions of Article 26(3) of the Indo-US DTAA.

Brief Facts of the Case:
The Assessee was an Indian subsidiary of Herbalife International Inc. (HII‘), USA and carried on business of trading and marketing of herbal products. The assessee was incorporated as a company in India with 100% foreign equity participation, pursuant to an approval granted by the Department of Industrial Policy and Promotion, Secretariat for Industrial Assistant, Ministry of Industry, Government of India. . In terms of the approval, the assessee was to manufacture herbal products on contract basis in India and should not import these items. 

The assessee entered into an Administrative Services Agreement (ASA) with M/s. Herbalife International of America Inc. (HIAI) to provide data processing services, accounting, financial and planning services, marketing services, long term financial planning for the assessee etc. For the AY 2001-02, the assessee paid an administrative fee of Rs. 5.83 crores to HIAI in terms of the ASA.

The Assessing Officer observed that under Section 9 (1) (vii) of the Act, the income by way of fees for technical services (FTS) payable by a person who is a resident in India would be deemed to accrue or arise in India because the services have been utilized in India. Therefore, under Section 195 of the Act, the Assessee was liable to deduct tax at source (TDS) on the said amount. The assessee contended that the payment was only a cost sharing arrangement and was not in the nature of a fee being remitted overseas and therefore, it was not liable to deduct tax at source. However, the AO disagreed and disallowed this expenditure invoking Section 40(a)(i) of the Act.

Aggrieved, the assessee company filed appeal before CIT(A). However, CIT(A) held that the administrative expense was in the nature of FTS rendered and was taxable in India in the hands of HIAI and therefore, Section 40(a)(i) was applicable.

The Assessee contested the matter before the ITAT. The ITAT allowed the appeal of the Assessee and held that a sum of Rs. 5.83 crores being administrative fee paid by the Assessee to HIAI was allowable as deduction. It was held that Section 40(a)(i) of the Act could not be invoked by the AO to disallow the claim for deduction as the payment in question was not taxable at the hands of the payee, i.e., HIAI as business income. It was held that HIAI did not have a permanent establishment (PE) in India. Further in light of Article 26(3) of the DTAA, Section 40(a)(i) of the Act was discriminatory and could not be invoked to disallow the claim of the Assessee for deduction even if the sum in question was chargeable to tax in India.

Important Extract from High Court Judgment:

The questions that have been framed by this Court revolve around the interpretation of Article 26 (3) of the DTAA and Section 40 (a) (i) of the Act.

Article 26 (3) therefore states that for the purpose of determining the taxable profits of a resident of a contracting State (in the present case the Assessee who is a resident and HIAI of the other contracting State, i.e., USA). The payment of the above amounts shall be deductible under the ‗same conditions‘ that apply to such payment being made to a resident of the contracting State (India). Article 26 (3) borrows the text and language of Article 24 of the OECD Model Convention.

…..Likewise, it is not the Revenue‘s case that Article 11 (7) or 12 (8) of the DTAA is attracted…….Consequently, the Court proceeds on the basis that the exceptions mentioned in the Article 26 (3) do not apply in the facts and circumstances of the case.

…… In the context of which the expression “other disbursement” occurs in Article 26 (3), it connotes something other than ‗interest and royalties‘. If the intention was that ‗other disbursements‘ should also be in the nature of interest and royalties then the word ‘other’ should have been followed by ‗such‘ or ‘such like‘. There is no warrant, therefore, to proceed on the basis that the expression ‘other disbursements‘ should take the colour of ‘interest and royalties‘. 

The expression ‘other disbursements‘ occurring in Article 26 (3) of the DTAA is wide enough to encompass the administrative fee paid by the Assessee to HIAI which the Revenue has chosen to characterize as FTS within the meaning of Explanation 2 to Section 9 (1) (vii) of the Act.

Section 40 (a) (ia) refers only to payments of ―interest, commission or brokerage, fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor‖ etc. It does not include an amount paid towards purchases. Correspondingly, there is no requirement of TDS having to be deducted while making such payment.

…… As far as payment to a non-resident is concerned, Section 40 (a) (i) of the Act as it stood at the relevant time mandated that if no TDS is deducted at the time of making such payment, it will not be allowed as deduction while computing the taxable profits of the payer. No such consequence was envisaged in terms of Section 40 (a) (i) of the Act as it stood as far as payment to a resident was concerned. This, therefore, attracts the non-discrimination rule under Article 26 (3) of the DTAA.

Section 40 (a) (i), in providing for disallowance of a payment made to a non-resident if TDS is not deducted, is no doubt meant to be a deterrent in order to compel the resident payer to deduct TDS while making the payment. However, that does not answer the requirement of Article 26 (3) of the DTAA that the payment to both residents and non-residents should be under the ‗same conditions‘ not only as regards deduction of TDS but even as regards the allowability of such payment as deduction. It has to be seen that in those ‘same conditions‘ whether the consequences are different for the failure to deduct TDS. 

In the first place it requires to be noticed that DTAA is as a result of the negotiations between the countries as to the extent to which special concessional tax provisions can be made notwithstanding that there might be a loss of revenue…..

…… The object of Article 26 (3) DTAA was to ensure non-discrimination in the condition of deductibility of the payment in the hands of the payer where the payee is either a resident or a non-resident. That object would get defeated as a result of the discrimination brought about qua non-resident by requiring the TDS to be deducted while making payment of FTS in terms of Section 40 (a) (i) of the Act.

A plain reading of Section 90 (2) of the Act, makes it clear that the provisions of the DTAA would prevail over the Act unless the Act is more beneficial to the Assessee. Therefore, except to the extent a provision of the Act is more beneficial to the Assessee, the DTAA will override the Act. This is irrespective of whether the Act contains a provision that corresponds to the treaty provision. In Union of India v. Azadi Bachao Andolan (supra) the Supreme Court took note of the Circular No. 333 dated 2nd April 1982 issued by the CBDT on the question as to what the assessing officers would have to do when they find that the provision of a DTAA treaty is not in conformity with the Act…..

Consequently, the Court negatives the plea of the Revenue that unless there are provisions similar to Section 40 (a) (i) of the Act in the DTAA, a comparison cannot be made as to which is more beneficial provision.

Section 40(a)(i) is discriminatory not applicable to DTAA

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