Estimating Tax Deduction at Source: An Unending Controversy

1. Introduction

A difference of opinion amongst the Judges of the Supreme Court of India is rare. It is even rarer in the context of tax dispute. A recent such disagreement,¹ however, has brought into focus the contours and nuances of tax law provisions which provide for deduction of tax at source. In the background of this disagreement between the Judges of the Supreme Court, this article makes an attempt to revisit the underlying foundations of such provisions to bring the dispute in context and delineate the consequences of the disagreement.

2. Backgrounder: Introduction to Tax deduction at Source

“Taxing event” is a key component of tax laws. It implies the occurrence of the event upon which befalls a tax consequence. It has been judicially established² that the trigger of a tax law is inchoate unless the taxing event prescribed thereunder fructifies. For illustration, the taxing event in a law governing tax on income is the accrual of income. As another illustration, the taxing event under the sales tax law is the conclusion of sale. These illustrations can be multiplied galore. However, the common theme amongst them is the overwhelming emphasis upon the taxing event as the cause for occurrence of the tax liability.

In practice, however, taxes are often collected even before the occurrence of the taxing event. This state of affairs is largely attributed to the “canon of convenience” qua collection of taxes. For illustration, under the income tax law the determination that income exists and assessment of income tax is due upon the end of the prescribed assessment period. However, most tax laws today follow the canon of convenience propagated by Adam Smith in his famous treatise The Wealth of Nations.

The canon of convenience comes to hold that the tax should be levied at the time and the manner that is most convenient for the taxpayer to pay it. For instance, if the tax on agricultural land is collected in instalments after the crop is harvested, it will be more convenient for farmers to pay it. In short, it is expedient to collect tax from a person at the time the person has means to pay the tax. In the context of the aforesaid income tax illustration, qua salaried persons, the ideal time to collect income tax is therefore when salary is paid to them. Similarly, for traders, canon of convenience would prescribe tax collection when the trader receives the consideration for sale.

It is largely on account of this canon that the concept of tax deduction at source has originated. The decision at source comes to address a situation where there is a certain time lag before the tax liability can be ascertained penny to penny whereas the tax paying capacity may decrease or may not exist at such point of ascertainment. Thus, it is expedient to collect the tax in advance to avoid non-collection altogether. The tax deduction at source (or TDS) concept goes by many names. With some variants, it is rechristened as tax collection at source, pay-as-you-go, etc. However, the underlying premise is the same that TDS implies deduction of a specified amount from the receivable at the time of remittance to the receiver as an estimate of the tax liability payable by the receiver.

There are two other aspects relating to TDS which make it popular amongst tax administrators. The first aspect is through the TDS mechanism the Government is able to receive the tax throughout by ensuring TDS compliance by tax deductor under the law. Thus the Government is always cash-rich because taxes are collected throughout the year instead of on a single point upon the conclusion of the taxable period or on determination of tax liability. The second rationale for its popularity is that by introducing TDS the tax administration largely shifts the responsibility of tax assessment from itself to the payer who is obligated to make the assessment, albeit on an estimated basis with only the limited function of final tax assessment remaining with the tax administration. Of course the payer is not compensated for carrying out this obligation (which in fact is of the tax administration) and thus a large part of the responsibilities of the tax administration are performed gratis by the payer in view of the TDS stipulations under the tax law.

On the other hand, given that for the receiver excess TDS implies a reduced remittance, the correct estimation of the amount to be deducted is crucial; excess deduction always being a sore point. Furthermore, entire tax deducted by the payer is deposited with the Government which means that pragmatically the only remedy for a person who suffered excess deduction is to claim a refund of tax. It is no gainsaying that even where such refund is available and is actually received, still the excess deduction results into blockage of working capital for such person. Thus, it is not irregular that even the estimation of tax liability — for enforcing the TDS obligations — generates large ranging tax controversies and disputes.

The TDS provisions are not required to be appreciated only qua the receiver. In fact the obligation to ensure that the TDS provisions are correctly applied is far onerous for the payer. To exemplify, the payer can be found to be “assessee in default” for failure to deduct the correct amount of TDS which entails various consequences.³ In addition, the income tax law provides for disallowances where the payer had failed to enforce TDS provisions appropriately.⁴ Thus, the stakes are equally high, if not higher, even for the payer vis-à-vis TDS provisions.⁵

In order to pre-empt and obviate such disputes, the tax law often envisions specific provisions to guide the payers, besides the Government handholding them through instructions and executive guidance so as to ensure that TDS is enforced at the appropriate rate. Nonetheless, one cannot rule out myriad commercial transactions and the inherent complexity of the tax laws also muddles determination of the correct amount of TDS. To address such eventualities, the tax law generally carves out a formal avenue whereby tax administration can be approached for determining the estimated tax liability and the appropriate amount of TDS. This is to ensure that bona fide taxpayers are able to obtain formal guidance of the tax administration and issues on account of TDS can be minimised.

Sections 195 and 197 of the Income Tax Act are two such illustrations whereby tax administration can opine upon the estimated tax liability for TDS purposes. Section 195 enables the recipient and, conversely, Section 197 enables the payer to approach the tax administration seeking such estimation. Under both the provisions a formal certificate is issued which is binding on both the payer and the recipient qua the amount to be deducted in relation to the estimated income.

3. Principles governing estimation of tax liability and consequent TDS

Various issues have arisen as regards the interlinkage between the TDS provisions and the substantive provisions of the tax law and the manner in which the tax liability is to be estimated so as to determine the applicable TDS. The decision of the Supreme Court in Transmission Corpn. of A.P. Ltd.⁶ is amongst the first on this subject. However, there were multiple issues with the interpretation accorded in this decision. These issues came to be resolved by the Supreme Court in its decisions in Eli Lilly⁷ and GE⁸. In these decisions it was held that the TDS provisions are “machinery” in nature which could not be considered disjointed from the substantive provisions of the tax law. It was accordingly declared in these decisions that the TDS provisions and the substantive provisions form one single integral, inseparable code and, therefore, the provisions relating to TDS applies only where a tax liability exists under the tax law.

Subsequently, however, the Supreme Court in PILCOM⁹ distinguished these decisions. It was held in this case that the decisions in Eli Lilly¹⁰ and GE¹¹ dealt with Section 195 of the Income Tax Act which mandated that there must be a “sum chargeable” to tax in order for the TDS provisions to apply, which was not necessarily true for all TDS provisions. In PILCOM¹² the Supreme Court was concerned with Section 194-E of the Income Tax Act which was interpreted to hold that there was no requirement for any income to be taxable and the TDS was nonetheless required to be effected by the payer.

The effect of the aforesaid decision was explained by the Supreme Court in its decision in Engineering Analysis¹³. The Supreme Court culled out the underlying scheme of the various TDS provisions in this case to clarify that there are distinct kinds of TDS provisions; in certain cases the TDS has to be effected without recourse to the substantive provisions of the tax law whereas in other class of TDS provisions the tax deduction can occur only if the amount is taxable to begin with. The legal position was clarified in this decision inter alia in the following terms:

36. It will be seen that Section 194-E of the Income Tax Act belongs to a set of various provisions which deal with TDS, without any reference to chargeability of tax under the Income Tax Act by the non-resident assessee concerned. This section is similar to Sections 193 and 194 of the Income Tax Act by which deductions have to be made without any reference to the chargeability of a sum received by a non-resident assessee under the Income Tax Act. On the other hand, as has been noted in GE at the heart of Section 195 of the Income Tax Act is the fact that deductions can only be made if the non-resident assessee is liable to pay tax under the provisions of the Income Tax Act in the first place.

Thus, it appears that not all of the TDS provisions are sui generis; some oblige tax deduction notwithstanding other provisions of the tax law whereas some may apply only where the substantive provisions trigger a tax liability. The Income Tax Department has also recently adopted the aforesaid distinction to explain the scheme underlying a new TDS provision.¹⁴

4. Dispute before the Supreme Court and the disagreement

With the aforesaid background we examine the recent order of the Supreme Court in National Petroleum Construction Co.¹⁵ The dispute came up before the Supreme Court from a decision of the Delhi High Court^15a which had refused to interfere with Section 197 certificate issued by the Tax Department.

The taxpayer in this case was resident in UAE and was providing both onshore and offshore supplies to India under a contract with ONGC. Its claim before the Tax Department was that it should have been issued a Section 197 certificate with “nil” TDS for payments received by it in respect of offshore supplies i.e. activities undertaken by it outside India. However, Section 197 certificate mandated 4% TDS in respect of consideration for all its supplies, including offshore supplies. Refusing to interfere with the certificate, the High Court opined that the issuance of the certificate was “an administrative decision” the grounds to review which under the High Court’s jurisdiction were limited to “perversity, patent illegality, irrationality, want of power to take the decision and procedural irregularity”, which were not found to exist by the High Court in this case.

Being called upon to determine the correctness of the High Court’s approach, one of the Judges of the Supreme Court approved the reliance placed upon by the High Court on the “the time-frame permissible in law for deciding an application” for issuance of certificate under Section 197 and that the “scope of enquiry and investigation in proceedings for grant of certificate under Section 197 of the Income Tax Act is different from the scope of assessment proceedings” to approve the High Court’s decision. Moreover, the Judge highlighted, the issue revolved around disputed questions of facts which were pending for determination in regular assessment proceedings before other courts for other years, which were a reasonable basis not to examine the issue in Section 197 proceedings. However, the Judge clarified, National Petroleum Construction Co.¹⁶ would be entitled to refund of excess deduction with interest in the case of success in the assessment.

The other Judge of the Supreme Court disagreed with the aforesaid views. In the view of this Judge, the Tax Department was obliged to follow the mandate of Section 197 and the “rules” prescribing the procedure to effectuate its mandate. According to this Judge, the High Court was obliged to take an overall view of the circumstances and whether the Tax Department has followed the legal principles, including the “principle of consistency” owing to which the Tax Department was bound by the legal conclusions drawn during earlier assessments. According to this Judge, “the order passed by the High Court is without considering the perspective and scope of issuance of the certificate for deduction of tax at lower rate or no deduction at tax and also without following the prescribed procedure” and accordingly required a revisit.

In view of the disagreement of the views, the Judges have requested the Chief Justice of India to constitute an appropriate Bench to hear the matter. In other words, the correctness of the decision of the High Court would now be subject to another hearing before another Bench of the Supreme Court.

5. Ramifications of the disagreement

On an immediate basis, the unsaid irony in the aforesaid situation is that Section 197 certificate under challenge pertained to Financial Year 2019-2020 whereas even in 2022 there is no end in sight on the correct legal position as regards the TDS to be effected on the remittance. This aspect alone as a serious consequences because businesses cannot be expected to await such long for receiving remittances.

At a larger level, given the differences of views amongst the Judges, clearly the legal position as on date appears to be in a state of flux. One may argue that this divergence of opinion does not dilute the principles under the earlier precedents, such as GE¹⁷ and Engineering Analysis¹⁸ would continue to hold good. Issues however arise because both the Judges have relied upon the GE¹⁹ decision to expound the law and still arrive at divergent views. In such circumstances, what should be the principle guiding the Tax Department and the courts required to review the actions of the Tax Department in issuing TDS certificates. One would, therefore, hope an urgent reconciliation of views by the other Bench of the Supreme Court.

At a conceptual paradigm, another issue is as regards the very nature of TDS proceedings. Are these based on an estimated determination of tax liability or, instead, do they require a detailed dissection of the substantive provisions so as to determine the TDS quantum. The issue arises because, applying GE²⁰ and Engineering Analysis²¹ for illustration, while it is settled that substantive provisions do have a play, the opinion of the other Judge goes on to hold that legal principles such as “principle of consistency” are also relevant for determining the TDS applicability. There is no doubt that these are salutary principles in order to give effect to the provisions of the tax law. However, it needs to be debated whether the application of these principles needs to be extended while determining the TDS obligations. This is because of the consequences of the rival views. On the one hand, at the cost of repetition, the liability of TDS is based on estimation qua limited facts and the application of the substantive provisions of the tax law. Thus, a meticulous appreciation of all the variables at the estimation stage would not just be illusory but may also be counter-productive as it goes against the very nature of TDS being a process of expedited estimated assessment. On the other hand, TDS cannot be far removed from the substantive tax liability. Thus, if applying the principle of consistency the substantive tax liability itself would fail then there is no reason not to extend the application of the principle even to hold that TDS should not apply. One would hope that the decision of the other Bench would finally resolve this conundrum.

6. Conclusion

Even though TDS provisions are based on an estimation of income and the determination made at the time of effecting TDS merges with the final assessment of the tax liability (which may result in a refund of excess TDS), the aforesaid discussion and particularly the differences amongst the Supreme Court Judges in National Petroleum Construction Co.²² clearly evidences the fact that TDS issues are no less intricate than substantive tax disputes. The discussion also establishes that issues qua blocking of working capital owing to excess TDS are not merely theoretical but real, so much so that the disputes regarding the correct quantum of TDS are contested up to the Supreme Court. The decisions of the Supreme Court which opine that each TDS provision is to be appraised as to its own merits, as clarified in Engineering Analysis²³, further adds to the complexity to the appreciation of the variable governing the TDS provisions. The irony remains that it is largely private citizens, namely, the payers, who are required to confront and appreciate the finer nuances of the tax law as they are required to enforce the TDS obligations.