Education

Withholding tax issues for corporates

G. KARTHIKEYAN | Updated on June 08, 2012

Mr G. KARTHIKEYAN

A private limited company based in the UK, specialising in staffing solutions, set up shop in India a couple of years ago as more and more UK companies started outsourcing IT, customer service and other related jobs to India.

The company helps UK and Indian concerns hire and administer staff in India wherein all expenses incurred are reimbursed by the companies and earns a 3 per cent margin on its gross billings as management fees.

Two major challenges

As a subsidiary set up in India, the company is, of course, subject to all tax deduction at source rules here. It hires computer professionals and gets reimbursed for the salary payment along with a management fee of 3 per cent which is typically a function of a staffing company. The company faces two major challenges — the first being blockage of working capital in the form of Tax deducted at Source (TDS) and the second being higher deduction of TDS by a few of its customers.

To use a simple arithmetic example, a gross monthly billing of Rs 100 lakh towards salary reimbursement would result in a management fee of Rs 3 lakh.

However, this would invite tax deduction at 2 per cent under sec 194 C of the Income Tax Act amounting to Rs 2,24,720. How? Well, tax is calculated on gross billing so Rs 100 lakh plus service tax @ 12.36 per cent would result in a gross bill of Rs 112,36,000 and hence a TDS of Rs 2,24,720.

Let us assume that the net profit of the company is 10 per cent of the management fees, which works out to Rs 30,000.

The TDS deduction on the gross is Rs 2,24,720. This is an anomaly where the tax withheld is more than the income earned by virtue of the application of tax deduction rules. Of course, at the time of assessment, the anomaly resolves itself as any excess tax deducted/paid is refunded but meanwhile substantial working capital gets locked up and the financial costs decide the viability of the business.

There are remedies in the form of a request for lower or no deduction of tax — this would require a certificate from the Income Tax department. However, obtaining such a certificate is a procedural and a time-consuming hassle, not to mention the costs involved.

The second challenge that it faces is the rate of deduction that a few of its customers insist upon. As the company is considered to be a professional consulting firm, customers insist on TDS under Sec 194-J at the rate of 10 per cent of gross billings for professional services.

Generally for contracts, TDS is applicable at 2 per cent of gross billings under Sec 194 C whereas some of the customers insist on deduction at 10 per cent under sec 194 J. As customer is king, the company does not have an option other than accepting the business with higher deduction of tax. A refusal would cause it to lose the client all together.

In the process of taxing gross billings, the concept of equity is lost. Companies which deal in low margin services such as temp staffing always face a crunch in working capital and high deduction of tax at source only serves to accentuate the problem.

Equity would be better served if tax were deducted on the 3 per cent margin, which is the income portion of the deductee. The logic is that the taxpayer needs to have taxes withheld on the profit or revenue element but withholding on gross billing defeats the purpose and further erodes an already low margin.

Another fact we must analyse is that if these employees were directly on a client company's payroll, tax would be deducted on their salaries based on slabs but what happens in temp staffing situations is that tax is deducted on the staffing company's gross billing (which includes a reimbursement for money paid to staff) and the staffing company further deducts tax on the salaries paid to the temp staff. Thus the same income gets taxed twice albeit in different hands.

checks and balances

To compare this with international situations, withholding is generally limited to only salary income in many developed countries.

In the US, in fact, independent contractors are responsible for their own taxes. Payers only issue a 1099 Miscellaneous with a copy to the IRS to inform them of the amounts paid to an independent contractor.

The contractor, of course, must account for all the 1099s received while calculating and filing his taxes. This system of checks and balances ensures that income does not escape the tax net. Also, in cases where the IRS suspects that a taxpayer is not declaring passive income such as interest and dividends, they instruct the concerned payers to withhold tax and then pay out the interest/dividend.

All this, of course, is possible thanks to the sophisticated system of checks and balances built in over a period of many years.

India too needs to look at such systems to serve the purpose of equity and justice in taxation. Low margin businesses, especially in the services sector, thrive on availability of working capital and strict costing rules.

Subjecting them to heavy taxation even for a short period of time is not just and will only serve to drive them out of the market unless these businesses have deep pockets to pump in working capital or parent companies that can support and fund the crunch.

Another option that could be considered to resolve this is the introduction of a system of abetment wherein the cost or reimbursement portion of the gross billing is excluded and tax is withheld only on the balance.

One is supposed to pay one's taxes with a smile – it would be nice indeed if cash wasn't a compulsory additional requirement! Jokes aside, taxes are never a pleasure even when the application of rules is just. The pain is worse when a literal application of rules blocks the day-to-day funding of a business. Cash, after all, is the lifeline of every business.

(The author is a Coimbatore-based chartered accountant and can be reached at karthi@gkmtax.com)

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Published on June 08, 2012
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