Non-residents caught in tax tornado amid spike in royalty/FTS rates in India

The Finance Act 2023 has brought significant changes to the Indian income tax law (IT Act). One such amendment was made with respect to the increase in taxation rates from 10% to 20% under the IT Act for royalty and fees for technical services (FTS). The said amendment was unexpected as it did not form part of Budget 2023 proposals but was announced only a week before the enactment of the Finance Act 2023. This crucial amendment not only left the taxpayers bereft of its intent but also of a reasonable time to digest the change and make appropriate representations before the Indian tax authorities (ITA). The article discusses the amendment in depth, the possible intentions behind its introduction and its significant ramifications on taxpayers.

Prior to April 1 2023, section 115A of the IT Act provided a tax rate of 10% (plus applicable surcharge and cess) for taxation of royalty and FTS income of non-resident taxpayers. For a foreign company, the effective tax rate, therefore, worked out to 10.92%. The taxpayers were also granted exemption from filing income-tax returns (ITR) in India if the taxable income consists of royalty and/or FTS only and tax has been withheld as per rates mentioned under section 115A.

However, the taxpayers had to forego the exemption from filing ITR if they chose to avail the benefit of non-deduction or lower deduction of tax under the applicable double taxation avoidance agreement (DTAA/Tax Treaty).

Since filing ITR in India comes with host of other compliance tasks like obtaining tax registrations, creating login credentials on online portals etc., many non-resident taxpayers choose to be governed by the IT Act despite DTAA provisions being more beneficial. Further, most of the DTAAs provide for an effective tax rate of 10% for royalty/FTS. Consequently, the additional burden was only marginal (i.e., less than 1%) vis-à-vis the benefit of escaping various compliance burdens under the IT Act.

With effect from April 1 2023, an amendment was made in section 115A, increasing the tax rates on royalty/FTS income from 10% to 20%. For a foreign company, the effective tax rate would now work out to 21.84%, which will significantly increase the gap between the rates provided in the IT Act and the applicable DTAA. In many cases, the tax rates prescribed in DTAAs were higher than the earlier tax rates under the domestic law. After the recent amendment, the position has changed. The below table displays a sample list of countries, wherein the treaty rates will now become beneficial post the recent hike in domestic tax rates.

Sr. No.	Country	Treaty rate – royalty & FTS/FIS
1.	Australia	15%*
2.	Brazil	25% (Trademarks)/ 15% (Others)
3.	Canada	15%*
4.	Denmark	20%
5.	Italy	20%
6.	Mauritius	15% (Royalties)**
7.	UK	15%*
8.	USA	15%*

*Royalty relating to use of Industrial, Commercial or Scientific Equipment – 10%

**FTS- 10%

The taxation rates under section 115A of the IT Act have been subject to change multiple times in the past. However, the rates showed an upward trend only once, in the year 2013. The reasoning provided for such an increase back then was that the DTAA provided for taxation rates ranging from 10% to 25%, whereas the tax rate as per section 115A was fixed at 10%. In some cases, this resulted in taxation at a lower rate of 10% even if the DTAA allows the income to be taxed at a higher rate. Seemingly, the rationale behind introducing the amendment this time is also to allow India to levy and collect tax at maximal rates in terms of the DTAAs.

Since many non-resident taxpayers were not availing DTAA benefits, the intention can also be to push them to avail DTAA benefits, which in turn will compel them to obtain tax registrations and file tax returns in India. This may also be intended to subject such non-residents to increased levels of scrutiny by tax authorities in India.

This unexpected and steep rise in the tax rate may leave taxpayers with no option but to avail the benefit under the applicable DTAA. To avail such benefits, a taxpayer is required to provide proof of his tax residency abroad, often known as a tax residency certificate (TRC). The IT Act also requires taxpayers to additionally file form 10F, if the TRC does not contain the requisite details. The TRC is often a standard document issued by the revenue authorities which usually does not contain the details as prescribed. Therefore, the non-residents taxpayers will invariably be required to file Form 10F in most of the cases.

The hardship of non-resident taxpayers does not end here. With effect from July 16 2022, Form 10F has been mandated to be filed electronically, which is not possible without obtaining tax registration i.e., permanent account number (PAN) in India. A one-time relaxation has been provided for the taxpayers who do not have PAN and are not required to have PAN, from the electronically filing of Form 10F. These taxpayers may file Form 10F manually until September 30 2023 without PAN. However, the situation post-September 30 2023 remains uncertain. It is significant to note that the said relaxation is not applicable to those who are statutorily required to obtain PAN in India but fail to obtain it.

Thus, the amendment in section 115A will now compel the taxpayers to undertake a host of compliance (like filing Form 10-F, obtaining TRC, obtaining PAN, filing tax returns) to save themselves from paying higher taxes in India.

Further, the implications of this amendment are not only on the non-resident taxpayers, but also on the resident payers of royalty or FTS income. Such residents can be held as ‘assessee in default’ if the ITA conclude that the non-resident taxpayers were not eligible for DTAA benefits or that they have not performed the necessary compliance to be eligible for such benefits. Thus, the resident payers will now have to be more prudent while allowing the benefit of the DTAA to any non-resident at the time of withholding of tax from payments being made.

Through the amendment in section 115A of the Act, the non-residents have been caught in a corner as they must either maintain extensive documentation or pay almost a double tax rate on their royalty and FTS income. Such a move may prove counter-productive to the nation’s economic growth, by limiting Indian businesses’ ability to access the latest technology, skills and expertise available with non-residents.

The increase in the taxation rates may also add to the cost of the Indian resident payers of royalty and FTS income, wherever the agreements require grossing up of payments. Thus, the Indian resident payers of royalty and FTS income may now have to negotiate for better terms in agreements to reduce their tax burden.