Delhi High Court: DTAA Non-Discrimination Clause Overrides Discriminatory S.40(a)(i); TDS Mandate Applies Only to Chargeable Income

New Delhi: In a significant ruling concerning international taxation and the interplay between domestic tax law and Double Taxation Avoidance Agreements (DTAAs), the Delhi High Court has held that the non-discrimination clauses in DTAAs can override the provisions of Section 40(a)(i) of the Income Tax Act, 1961, where the domestic provision, as applicable for a specific Assessment Year (AY), results in discriminatory treatment. The court also reiterated that the obligation to deduct Tax at Source (TDS) under Section 195 of the Act applies only to sums chargeable to tax in India.

The judgment, delivered by Justice Rajiv Shakdher upon a reference due to a difference of opinion between Justices S. Muralidhar (as he then was) and Prathiba M. Singh , resolved key questions of law for Assessment Year (AY) 2006-07.

Background of the Case

The case involved an assessee (respondent) who made payments to several foreign group companies for purchases without deducting TDS. The Assessing Officer (AO) disallowed these payments, amounting to approximately Rs. 97.90 crore, under Section 40(a)(i) of the Income Tax Act, which prohibits deduction of certain payments made outside India or to non-residents without TDS.

The assessee challenged this disallowance, arguing on two main grounds: 1. For payments to group companies in Japan and the USA, where India has DTAAs containing non-discrimination clauses (Article 24(3)/26(3)), the disallowance under Section 40(a)(i) was discriminatory because, for AY 2006-07, similar payments for purchases to resident vendors would not have been disallowed under the then-existing Section 40(a)(ia) for lack of TDS deduction. 2. For payments to group companies in Thailand and Singapore, where DTAAs lack such non-discrimination clauses, the payments were not chargeable to tax in India as the entities did not have a Permanent Establishment (PE) in India. Therefore, no TDS was required under Section 195, rendering the Section 40(a)(i) disallowance invalid.

The Dispute Resolution Panel (DRP) sustained the AO's addition, but the Income Tax Appellate Tribunal (ITAT) ruled in favour of the assessee on the disallowance issue (while remitting the transfer pricing adjustment issue, which was not part of this appeal, back to the AO/TPO). The Revenue appealed to the High Court.

Split Verdict and Reference

A division bench of the High Court heard the appeal. Justice S. Muralidhar answered the questions of law in favour of the assessee, while Justice Prathiba M. Singh took a contrary view, favouring the Revenue. The key points of difference were: (i) Whether Section 40(a)(i) could be applied despite the non-discrimination provisions of the India- Japan and India-USA DTAAs. (ii) Whether the ITAT erred in reversing the DRP's findings on the existence of PEs in India. A third judge (Justice Rajiv Shakdher ) was appointed to resolve the difference.

Arguments Presented

The Revenue argued that Section 40(a)(i) was rightly applied as the payments were chargeable to tax in India, citing business connection tests and partly upheld PE findings. They contended that the DTAA non-discrimination clauses were inapplicable due to the exception for Article 9 (Associated Enterprises), as the transactions were between group companies. They also argued that amendments in the Income Tax Act (specifically the introduction of Section 40(a)(ia) by FA 2004) had removed the discrimination issue noticed in earlier judgments like Herbal Life .

The assessee countered that the disallowance under Section 40(a)(i) related only to payments for purchases, which were separate from the service income subject to transfer pricing adjustments (where Article 9 might be relevant). They contended that for AY 2006-07, Section 40(a)(i) was indeed discriminatory regarding payments for purchases to non-residents compared to residents, thus triggering the DTAA non-discrimination clauses (Articles 24(3)/26(3)) as per Section 90(2) (which provides that DTAA provisions prevail if more beneficial). They strongly relied on the principle from the Supreme Court's decision in GE India Technology Centre P. Ltd. v. CIT , arguing that TDS under Section 195, and consequently disallowance under Section 40(a)(i), is only required if the income is chargeable to tax in India, which depends on the Act read with the relevant DTAA (specifically, whether a PE exists for business profits taxation).

Court's Analysis and Decision

Justice Shakdher carefully examined the background, the differing opinions, and the arguments. He noted that the disallowance under Section 40(a)(i) was solely for payments made for purchases , and there was no finding by the AO that these were "composite transactions" with embedded taxable income.

Crucially, the court analyzed the evolution of Section 40(a). It observed that while FA 2004 introduced Section 40(a)(ia) bringing certain payments (like interest, royalty, technical fees, etc.) to residents within the disallowance net if TDS was not deducted, it did not cover payments for purchases made to residents. Thus, for AY 2006-07, failure to deduct TDS on payments for purchases to a non-resident would lead to disallowance under Section 40(a)(i), whereas no such disallowance would apply to similar payments for purchases made to a resident.

The court held that this disparity constituted unequal treatment and discrimination as envisaged under Articles 24(3) and 26(3) of the India- Japan and India-USA DTAAs. Relying on Section 90(2), the DTAA provisions, being more beneficial, would apply. The argument that Article 9 (AEs/TP) exempted the application of the non-discrimination clause was rejected, as Article 9 applied to the separate service income stream subject to TP adjustment, not the purchase payments for which the disallowance was made. The court also referenced the Herbal Life case, which dealt with similar issues and apparently had been accepted by the Revenue.

Regarding the entities from Thailand and Singapore (where DTAAs lack a non-discrimination clause), the court applied the principle from GE India Technology . It emphasized that Section 195 mandates TDS deduction only if the sum is "chargeable under the provisions of the Act". Since the Tribunal had found that MC Metal (Thailand) and Metal One (Singapore) did not have a PE in India, the payments made for purchases were not taxable as business profits under Article 7 of the respective DTAAs. Consequently, there was no obligation to deduct TDS under Section 195, and thus, the disallowance under Section 40(a)(i) was incorrect. The court dismissed the Revenue's reliance on Explanation 2 to Section 195, stating it clarified the payee's liability, not altered the fundamental requirement of chargeability for the payer's TDS obligation.

Finally, the court held that the re-framing of the second question by one of the judges after the judgment was not permissible.

Conclusion

Justice Shakdher answered all three questions of law in favour of the assessee and against the Revenue.

The judgment reinforces the primacy of DTAAs under Section 90(2) when their provisions are more beneficial to the assessee than domestic law. It specifically highlights how the non-discrimination clauses in DTAAs applied to Section 40(a)(i) for AY 2006-07 concerning payments for purchases, due to the discriminatory treatment compared to residents before the curative amendment in FA 2014 (w.e.f. 01.04.2015). The decision also reaffirms the crucial principle that TDS under Section 195 and consequent disallowance under Section 40(a)(i) can only be triggered if the payment is, in fact, chargeable to tax in India, taking into account the provisions of the Income Tax Act read with the applicable DTAA.

This ruling provides clarity on the application of Section 40(a)(i) vis-à-vis DTAAs for the period prior to the FA 2014 amendment and underscores the fundamental requirement of chargeability to tax for invoking the TDS obligation under Section 195.

Case Details: * Court: Delhi High Court * Bench: Rajiv Shakdher , J. (Third Judge Reference); Originally S. Muralidhar , J. & Prathiba M. Singh , J. * Appellant: Revenue (Income Tax Department) * Respondent: Assessee (Company) * Assessment Year: 2006-07 * Legal Provisions: Section 40(a)(i), Section 195, Section 90(2) of the Income Tax Act, 1961; Articles 7, 9, 24(3), 26(3) of India- Japan /USA DTAAs. * Key Precedents: GE India Technology Centre P. Ltd. v. CIT , Union of India v. Azadi Bachao Andolan , CIT v. Herbal Life International (P.) Ltd.