Why domestic withholding tax rates on royalties and fees for technical services were increased

India introduced a tax on the payment of royalties and fees for technical services (FTS) in domestic tax law in 1976 through the levy of withholding tax of 40 percent and 20 percent.

The free flow of technology and technical knowledge and experience is essential for the growth of any economy. Various countries, depending on their stage of maturity, may choose to give a fillip to their domestic industry by importing technology and skills that may not be easily available locally.

The Indian Government introduced a tax on the payment of royalties and fees for technical services (FTS) in domestic tax law in 1976 through the levy of withholding tax of 40 percent and 20 percent. To reduce the cost of technology for Indian concerns, the withholding tax rate on non-resident payments of royalties and FTS was gradually lowered from 1986 onwards and brought down to 10 percent by 2005.

Non-resident companies also had the ability to take recourse to tax rates prescribed under the tax treaties that India had signed. Many treaties prescribed a higher rate of withholding tax for royalties and FTS in the initial years, with a subsequent reduction in rates laid out in the treaties. While India’s treaties with countries such as the US and the UK prescribed a 15 percent withholding tax rate, those with many OECD countries set it at 10 percent. These are generally the countries from which India imports technology and skills.

Therefore, the reduction of the domestic rate of withholding tax on payments of such royalties and FTS to non-residents to 10 percent – excluding surcharge (initially in 2005 and again in 2015 after a brief increase in the interim period) – essentially equated the rate under domestic law with the tax rate under many tax treaties that India had signed.

Tax Rate Doubled

The Finance Bill 2023, as passed by Parliament, has now increased the domestic law rate on such non-resident payments to 20 percent. Therefore, in order to apply a lower rate, non-residents will be required to take the benefit of applicable tax treaties. This will necessitate the filing of tax returns in India by the non-resident, reporting such income and the taxes withheld as well as making a treaty claim.

While this change may seem like a reversal at first glance, there may be a few underlying reasons for it.

Firstly, an increase in the rate of withholding tax on such payments to non-residents brings it on par with the base rate of tax prescribed in domestic law for various payments to non-residents such as dividends or share buybacks. Therefore, from the standpoint of non-residents, all these forms of returns on contributions would be similarly treated under Indian domestic law.

Secondly, with the implementation of the OECD Base Erosion and Profit Shifting (BEPS) programme, many of India’s tax treaties stand amended through the application of the Multilateral Instrument (MLI). The MLI, among other things, requires the satisfaction of a principal purpose test in order for entities to access treaty benefits. This requires entities taking the benefit of a tax treaty to establish that tax avoidance was not one of the principal purposes for which a structure was established.

Need To File Returns In India

With the increase in the rate of withholding tax under domestic law, non-residents will now be required to file tax returns in order to access treaty benefits. This will enable the tax authorities to audit these returns to ensure that treaty benefits were not incorrectly accessed or that the payments from India were merely a means to extract cash without an underlying benefit to the Indian payor.

India has, at various points in time, indicated its desire to renegotiate several of its tax treaties to ensure a more current application of tax principles to changed businesses and business models. The increase in the domestic rate of withholding tax on royalties and FTS could also be seen as a more subtle way of signalling India’s intent to bring its treaty partners to the negotiation table.

From the perspective of non-residents, the increase in domestic rates could increase their overall tax costs, especially if treaty rates are at 15 percent or higher (as in the treaties with the US and UK), since companies will now move from the lower domestic tax base rate of 10 percent to those treaty rates. In many cases, where the non-resident has excess foreign tax credits in their home country, the additional withholding tax burden that would now apply could end up being a cost. Further, where a tax gross-up has been agreed on and the Indian company needs to bear the tax cost, payments to countries where the 15 percent treaty rate or non-treaty countries where the 20 percent domestic rate applies will become more expensive.

Increased Risk Of Litigation

Additionally, the need to file a tax return to access the treaty will increase their compliance burden. Audit scrutiny of these returns to grant the treaty benefit could, in many instances, also result in litigation if treaty benefits are denied. An additional issue that many Indian companies paying such amounts face, especially in the case of FTS, is to be able to demonstrate that benefits have indeed accrued to the Indian payor. Increased scrutiny on this aspect can also be expected as a result.

The mainstay of every growing economy is technology, and while India has developed significantly on this count over the past two decades, there may still be many highly specialised areas where the country can benefit from easy access to technology. In such circumstances, perhaps keeping the domestic base rate of withholding tax at 10 percent rather than increasing the compliance burden (and in some cases tax costs) could have seen the country continue to accrue the benefits of technology and skill. That said, we could also see this move result in greater and faster development of cutting-edge technology in India.

EN Dwaraknath is Partner, Price Waterhouse & Co LLP, Views are personal, and do not represent the stand of this publication.