The Hindu Business Line : Withholding nitty-gritties for the employer

If you run a software company making arrangements to ship your employees abroad on assignments, you probably have all the administrative modalities worked out. While you try to make an early assessment of the tax implications for your assignees, there are some open income-tax issues that you should be aware of.

The Income-Tax Act, 1961 holds you responsible for appropriate tax withholding from salaries paid to employees and this article discusses some of the typical issues faced by employers while determining tax to be withheld from salary. For instance, determining residential status of the assignees; analysing taxability of assignees in the foreign country and the benefits available under the tax treaties; and considering foreign taxes paid at the time of withholding.

Determining residential status

To start with, the taxability of individuals in India depends on their `residential status', which in turn is determined by their physical stay. During the years of overseas assignment, they will in all probability qualify as `non-residents' in India, thereby limiting the scope of the income taxable in India. However, determining their residency in the year of departure is likely to raise some doubts. The Act contains a specific provision whereby an Indian citizen may be treated as a `non-resident' if his stay in India in the year of departure `for the purpose of employment outside India', does not exceed 181 days.

Courts have, however, sought to restrict this benefit only to cases of temporary or permanent postings outside India. Else, any assignment must be treated as a tour abroad in connection with the individual's Indian employment and if his stay in the year of departure exceeds 59 days, he would be `resident' in India in the financial year, thereby subjecting his global income to tax in India. As the Act does not clearly define the term leaving India `for the purpose of employment outside India', it remains open to debate and differential interpretation.

Taxability abroad and treaty benefits

The issues only get more complicated from here. The assignees could additionally be subject to taxation in the country of deputation. However, relief is available under the Double-Taxation Avoidance Agreements (`treaties') with governments of other countries. Relief may be available in the form of an exemption for doubly-taxed salary income or as a credit for foreign taxes paid on such income. An assignee who is `non-resident' in India and `resident' in the country of employment would be eligible for the exemption under the relevant treaty in respect of salary earned abroad, whereby such income would be subject to tax only in the work country and not in India.

This exemption clause may also be extended to assignees `resident' in India, if stay in the work country is less than 183 days and other prescribed conditions are fulfilled. The assignees may in this case enjoy the exemption in the country of employment, while salary is taxed in India. A `resident' assignee who is unable to claim exemption may at the time of calculating his Indian tax liability claim a credit for the foreign taxes paid. However, computation of credit involves a plethora of practical difficulties that are currently not addressed by the domestic tax laws.

India's financial year, which runs from April to March, may differ from the calendar year concept followed by many countries. Due to this, the foreign taxes for the period January to March will be known only in the next calendar year. Hence, the credit claim will have to wait till the next Indian tax year. Besides this timing difference, there may be a need to reconcile the differences in categorization of income, differences in income reported due to fiscal year mismatch, the nature of taxes eligible to be claimed as credit etc.

It is useful to note in this context, that for the purpose of exemption under the treaty, salary from employment exercised outside India is treated as income accruing or arising outside India. If any of the assignees qualify as `non-residents', you may want to reconsider deducting taxes at source merely for the reason that salary is received in India.

In such cases, despite the Act providing for taxability of any income received in India, in such cases, the exemption under the treaty will still be available on account of income accruing outside India and there should be no withholding tax.

If for any reason, taxes have been withheld in India on such exempt income, the assignee will have to wait for a refund from the Revenue authorities. Any claim for tax credit may be disallowed by the foreign country on the grounds that taxes were not payable in India in the first instance.

Foreign taxes at the time of withholding

Many companies prefer to retain their employees on the Indian payroll even on assignments of longer duration to assure the deputed employees uninterrupted compliance and eligibility for retirement benefits. Can the employer consider the credit or exemption under the treaty in arriving at the taxes to be withheld?

An employer is liable to withhold tax on `any income that is chargeable under the head salaries'. It is now well established that the treaty provisions must override the provisions of the Act in determining the income taxable in India.

Though the rule is not specifically extended to tax withholding provisions, judicial precedents do suggest that the relief under the treaty will also apply while ascertaining salary income for the purpose of tax withholding and hence the tax to be deducted by the employer must be arrived at after taking into account any exemptions or credit granted under the treaty.

In one of its decisions, the Andhra Pradesh High Court held that "the scheme of deduction of tax at source is intended to be of benefit to the taxpayer as well, apart from regularly collecting the tax painlessly. But such a scheme cannot be abused by collecting more than the tax leviable and driving assessees to wait indefinitely for refunds."

Employers would no doubt, like to ensure that withholding tax arrangements are economical and free of administrative hassles for their employees. However, until the Government issues clarifications, they would need to work their way around these tax issues, to ensure that taxes deducted are neither excessive nor inadequate.

(The authors are senior tax professionals with Ernst & Young.)

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