Indian Income Tax for Foreign Entities: Key Insights for Non-Resident Companies Dealing with Indian Clients

Introduction

Navigating the complexities of international taxation can be challenging, especially when it involves earning income from a foreign country. India, with its intricate tax regulations, poses a significant compliance challenge for foreign entities. Recently, our firm handled a case that serves as a stark reminder of the importance of understanding Indian tax laws. A foreign company, unaware of specific tax obligations in India, found itself in a difficult situation when the Indian Income Tax Department issued a notice demanding payment of taxes, along with interest and penalties, for services rendered to an Indian client. This article delves into the details of that case, analyses the taxability under the Income Tax Act (ITA) and Double Taxation Avoidance Agreements (DTAA), and underscores the importance of compliance with Indian tax regulations.

Case Study

The Scenario: A foreign company provided professional services to an Indian party and received payment for these services. However, there was a critical oversight: the Indian party did not deduct income tax at the source, as required under Indian law. The foreign company, not fully aware of its obligations under Indian tax laws, believed that it had fulfilled all necessary requirements by simply receiving the payment.

The Notice: To the foreign company’s surprise, the Indian Income Tax Department issued a notice directly to them, stating that taxes on the income earned from India had not been deducted at source. The notice demanded that the foreign company pay the outstanding taxes, along with accrued interest and penalties. This came as a shock to the company, which was unfamiliar with the intricacies of Indian tax regulations.

Taxability as per ITA and DTAA: Under the Income Tax Act (ITA) and applicable Double Taxation Avoidance Agreement (DTAA), the primary responsibility to deduct tax rests with the payer, the Indian party. However, the general power to levy tax on the payee, the foreign company, always remains with the Indian Income Tax authorities. If the Indian party had deducted the tax but failed to remit it to the authorities, the foreign company would have no liability, and the ITA would need to collect the tax from the Indian party. On the other hand, if the Indian party made the full payment without tax deduction, the IT Authority could directly collect the tax from the foreign company.

The Consequences: The financial implications for the foreign company were significant. Not only were they required to pay the taxes that should have been withheld by the Indian party, but they also faced hefty penalties and interest charges. Additionally, the company had to engage in lengthy and costly legal proceedings to address the notice, which could have been avoided with proper tax planning and compliance.

Lessons Learned: This case highlights several critical lessons for foreign entities engaging in business with Indian clients. The most important takeaway is the necessity of understanding and complying with Indian tax laws, even if the entity does not have a permanent establishment in India. Failure to do so can result in unexpected tax liabilities, legal complications, and damage to the company’s reputation.

Importance of Understanding Indian Taxation

Why Foreign Companies Should Be Aware: India’s tax regulations can be particularly stringent when it comes to income earned by non-residents. Even in the absence of a permanent establishment in India, foreign companies may still be subject to Indian taxes on income deemed to accrue or arise in India. This includes income from services, royalties, dividends, and more. Additionally, as per Section 115A of the ITA, a non-resident is exempt from filing an income tax return in India only if withholding taxes are deducted as per the ITA. If the withholding is done according to the DTAA, this exemption does not apply, making it mandatory for the non-resident to file a tax return in India.

Avoiding Penalties and Interest: Non-compliance with Indian tax laws can lead to severe financial penalties, including the payment of interest on outstanding taxes. In cases where the payer fails to deduct tax, the ITA holds the payee liable for the tax, unless the tax was deducted and not paid by the payer. However, the payer faces the risk of a 100% penalty and prosecution if they fail to deduct tax at source.

Conclusion: To navigate the complexities of Indian tax laws, it is crucial for foreign entities to have a thorough understanding of tax obligations, including the need for filing Income tax return, obtaining Tax Residency Certificate (TRC), the requirement to file Form 10F, and the applicable withholding tax rates under the ITA and DTAA. This can help avoid costly mistakes and ensure compliance with Indian regulations.

Please feel free to write us in case of any queries.

It is being erroneously reported that all Indian citizens must obtain income-tax clearance certificate (ITCC) before leaving the country - a position that is factually incorrect

Section 230 (1A) of the Income-tax Act, 1961(the ‘Act’) relates to obtaining of a tax clearance certificate, in certain circumstances, by persons domiciled in India. The said provision, as it stands, came on the statute through the Finance Act, 2003 w.e.f. 1.6.2003. The Finance (No.2) Act, 2024

has made only an amendment in Section 230(1A) of the Act, vide which, reference of the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 (the ‘Black Money Act’) has been inserted in the said Section. This insertion has been made to also cover the liabilities under the Black Money Act in the same manner as the liabilities under the Income-tax Act,1961 and other Acts dealing with direct taxes for the purpose of Section 230(1A) of the Income tax Act,1961.

There appears to be a mis-information about the said amendment emanating from incorrect interpretation of the amendment. It is being erroneously reported that all Indian citizens must obtain income-tax clearance certificate (ITCC) before leaving the country. This position is factually incorrect.

As per section 230 of the Act, every person is not required to obtain a tax clearance certificate. Only certain persons, in respect of whom circumstances exist which make it necessary to obtain a tax clearance certificate, are required to obtain the said certificate. This position has been in the statute since 2003 and remains unchanged even with the amendments vide Finance (No. 2) Act, 2024.

 In this context, the CBDT, vide its Instruction No. 1/2004, dated 05.02.2004, has specified that the tax clearance certificate under Section 230(1A) of the Act, may be required to be obtained by persons domiciled in India only in the following circumstances:

1. where the person is involved in serious financial irregularities and his presence is necessary in investigation of cases under the Income-tax Act or the Wealth-tax Act and it is likely that a tax demand will be raised against him, or
2. where the person has direct tax arrears exceeding Rs. 10 lakhs outstanding against him which have not been stayed by any authority.

 Further, a person can be asked to obtain a tax clearance certificate only after recording the reasons for the same and after taking approval from the Principal Chief Commissioner of Income-tax or Chief Commissioner of Income-tax.

In view thereof, it is reiterated that the ITCC under Section 230(1A) of the Act, is needed by residents domiciled in India, only in rare cases, such as (a) where a person is involved in serious financial irregularities or (b) where a tax demand of more than Rs. 10 lakh is pending which is not stayed by any authority.

Being an NRI comes with its own set of perks, but it also brings a unique set of challenges—especially when it comes to your residential status in India. Whether you’re visiting family or conducting business, spending time in India could potentially change your residential status and have significant tax implications.

Why is it important for NRIs to be aware of their residential status?

Most NRIs assume that as long as they’re living outside India, they’re free from the clutches of Indian tax laws. But here’s the catch: your residential status can change based on the number of days you spend in India during a financial year. Cross the threshold unknowingly, and you might find yourself classified as a resident for tax purposes. This means you could suddenly be on the hook for taxes on your global income—something no one wants to deal with unexpectedly.

Moreover, the maximum average tax rate for individuals in India is around 35%, which is significantly higher than in many advanced countries where tax rates are much lower. We’ve seen numerous cases where NRIs, unprepared for this disparity, end up paying huge amounts in taxes, resulting in a severe financial hit. It’s essential to keep in mind that determining your residential status isn’t just about your current stay but also your stay history. If you’ve stayed in India for at least 2 years during any of the past 10 years, you could be classified as a resident even if you only stay for more than 2 months in the current year.

Taxability based on residential status

Your residential status isn’t just a label—it dictates how much tax you’ll owe in India. The Income Tax Act categorizes individuals into three groups: Residents, Non-Residents (NRI), and Not Ordinarily Residents (NOR). Here’s a quick breakdown:

• Residents: You’re taxed on your entire global income, no matter where you earn it.
• Non-Residents: Only income that’s earned or received in India is taxable.
• Not Ordinarily Residents (NOR): You get some relief here. In addition to Indian income foreign salary, income from business or profession controlled or setup from India are only taxed. Whereas all other incomes are not taxed in India.

 Residential status as per FEMA and Income Tax: Not the same thing!

One of the biggest areas of confusion for NRIs is the difference in how FEMA (Foreign Exchange Management Act) and the Income Tax Act define residential status. Here’s where it gets tricky:

• FEMA: Your intention matters. If you’re in India for more than 182 days in a financial year and intend to stay, you’re a resident.
• Income Tax Act: It’s all about the numbers. Spend more than 181 or 59 days in India during a financial year and based on your last 10 years stay history, you could be classified as a resident—regardless of your intentions.

This discrepancy can land you in a complicated situation where you’re considered a resident under one law and a non-resident under another, leading to a whole new set of compliance challenges.

If you’re caught off guard by a sudden change in status, you could face a hefty tax bill—and ignorance won’t be an acceptable excuse.

Income tax implications of being a resident

Think you’re safe from Indian taxes because you’re earning abroad? Think again. Once you’re classified as a resident, the taxman wants a cut of your global earnings. That includes income from foreign assets like property, stocks, bank accounts, and more.

Failing to declare these can lead to serious trouble. Under the Black Money (Undisclosed Foreign Income and Assets) Act, 2015, if tax residents don’t disclose foreign income and assets in their Indian tax returns, they could face penalties of up to Rs.10 lakhs—and even imprisonment. And with the increasing exchange of financial information between countries under global agreements like the Common Reporting Standard (CRS), the Indian tax authorities are more likely than ever to discover undisclosed foreign income and assets. The days of flying under the radar are over, and the consequences of non-disclosure can be severe.

Let me share an example: Suppose you’re receiving rental income from a property in the UK. As a resident taxpayer, you’re required to declare this income in your Indian tax return. Forget to do this, and you’re looking at not just a tax liability, but severe penalties and interest charges. It’s a costly mistake that’s all too easy to make.

Conclusion: Avoid the Pitfalls—Be Informed!

If you’re an NRI, staying informed about your residential status is not just good practice—it’s essential. Misunderstandings can lead to costly tax liabilities and legal challenges that can be easily avoided with a little knowledge and attention to detail.

Remember, when it comes to the taxes, ignorance isn’t bliss—it’s expensive. Make sure you understand your residential status, comply with Indian tax laws, and avoid falling into the trap of unexpected tax burdens. If in doubt, seek professional advice to keep your financial house in order.

For any assistance with NRI taxation, please feel free to reach out to us at prasad@balakrishnaandco.com.