Direct Tax Alert - Delhi Tax Tribunal gives ruling on applicability of withholding tax provision on reimbursement of salary cost in case of secondment

Background

The movement of employees across different countries has become a common practice. Often, employees from one entity within a group are assigned to another entity in Host Country. This can be for specific assignments, technical support, or expertise in specific areas of operation. In most cases, a portion of seconded employees' payroll remains in the home country to ensure the continuity of their social security benefits in their home country. The home company usually disburses the social security contributions along with a portion of the employee's salary in the home country, which is later reimbursed by the host company to which the employee has been seconded, on a cost-to-cost basis.

In the secondment model, the seconded employees work under the direction, supervision, and control of the host company. In such cases, the host company bears the entire salary and related costs, including social security contributions paid in the home country. The Host company takes responsibility for the work done by the seconded employee during the period of secondment in India and usually retains the right to terminate the secondment.

Secondment has been a contentious issue in India, where the tax authorities argue that under the secondment arrangement, the home company provides services to its host company in India through the seconded employees. They claim that the reimbursement to the home company by the Indian host company, including social security contributions and salaries paid in the home country, qualifies as 'Fee for Technical Services' (FTS) and is therefore taxable in India and requires withholding tax under section 195 of the Income-tax Act, 1961 (IT Act).

Various courts have examined similar matters, and the key principles that have emerged are that each case needs to be analysed based on the facts, and the substance over form needs to be taken into consideration in determining whether it is a ‘contract for service’ or ‘contract of service’.

In this regard, recently, the Delhi Tax Tribunal¹ had an occasion to examine the applicability of withholding tax provision on reimbursement of salary cost in case of secondment. We, at BDO in India, have summarised the ruling of the Delhi Tax Tribunal and provided our comments on the impact of this decision hereunder:

Facts of the case

Taxpayer a company incorporated in India is a subsidiary of a UK-based company and operates as a Captive service centre to provide IT Services i.e., research operations, business process outsourcing and management consultancy support services to Group entities.

Taxpayer recruited three employees of the UK company on a full-time basis to work exclusively for them in the capacity of Regional CEO, CFO and HR officer. These employees were released by the UK company and subsequently entered into separate employment contracts with the taxpayer such that during the period of employment, the taxpayer was the sole and exclusive employer of the employees, having complete control, while the hired employees seized to be employees of the UK company. Further, they had an unconditional right to terminate these employees while the UK company had no obligation to replace them.

Taxpayer have entered into a ‘salary reimbursement agreement’ with the UK company, as per which, the UK company shall pay 40% salary to the seconded employees in foreign currency and claim reimbursement thereof from the taxpayer for administrative and employees’ convenience. For this purpose, the taxpayer was supposed to inform the UK company of the amount of foreign currency payable as salary to seconded employees as determined by and supposed to be reimbursed by the taxpayer.  According to the Appointment Letters and Salary Reimbursement Agreement, the taxpayer was exclusively and solely liable to pay salaries, allowances, and requisites to the seconded employees.

However, Tax authorities disallowed the aforesaid expenditure relating to reimbursement under section 40(a)(i) of the IT Act on the ground that the reimbursements of expenses for seconded employees, is in the nature of Fees for Technical Services (FTS) and is liable to deducting tax at source (TDS) u/s 195 of the IT Act. Against this order, the taxpayer filed an appeal with Delhi Tax Tribunal challenging the applicability of section 195 of the It Act and also the claim of tax authorities for classifying the amount of reimbursement as FTS.

Delhi Tax Tribunal Ruling

While upholding the claim of the taxpayer and disregarding the applicability of section 195 of the IT Act, the Delhi Tax Tribunal made the following observations:

• Employees had an employee-employer relationship with the taxpayer only and thus, have no rights to act on behalf of the UK company or bind the UK company which gave the conclusion that the taxpayer was the legal and economic employer.
• Salary is paid partly by the taxpayer and remaining through the UK company on request of the taxpayer only for ease in administration purposes, which is reimbursed by the taxpayer on a cost-to-cost basis. This salary was chargeable to tax as salary in the hands of employees and not as FTS since there was no agreement/document to prove that the UK company provided any Technical Service. Accordingly, TDS under section 192 of the IT Act is withheld by the taxpayer before making payment to employees.
• Emphasis can be placed on CBDT Circular 720 dated 30 August 1995 (PB-703), to observe that payment shall be liable for TDS, only under one section which is done under section 192 of the IT Act in the instant case.
• Accordingly, the salary reimbursement to the UK parent company need not be subjected to withholding tax under section 195 of the IT Act as tax is already deducted under section 192 of the IT Act on salary paid to the employees where the taxpayer is found to be the legal and economic employer.
• Further, the Delhi High Court judgement in the case of Centrica India² and Supreme Court judgement in the case of Northern Operating Systems Pvt Ltd³ can be distinguished on facts of the case as below:
  • In Centrica’s case, it was a newly formed entity and did not have the requisite technically trained human resources. Secondees were not only providing services to Centrica India in the initial period but also ensured that going forward, the skill set of other employees of Centrica India was built and these services could be continued by them without assistance from secondees. Centrica India had admitted that the reason for secondment was to provide support during the initial years till the necessary skillset was acquired by the resident employees. Therefore, it was held that the secondees had transferred their technical ability and had made available their technical know-how for future consumption. The seconded employees were not specifically taken into employment by Centrica India and continued to remain on the payroll of the overseas entities who used to pay and disburse the salaries. The right of the seconded employees to seek their salaries and other emoluments was against the overseas entities. Also, the seconded employees were not released by the overseas entity during the period of secondment and had a lien on their employment with the overseas entity. Centrica India has no right to terminate the employment of expatriate employees with Centrica. In this case, the Delhi High Court also observed that the money paid by Centrica India to the overseas entity accrues to the overseas entity, which may or may not employ it for payment to the secondees, based on its contractual relationship with them.
  • In Northern Operating System’s case, the seconded employees were not released by the foreign company during the period of secondment. The foreign company issued a ‘Letter of Undertaking’ to seconded employees and salary and other allowances were decided by the foreign company and the seconded employees continued to remain on the payroll of the overseas entities who used to pay and disburse the salaries. The right of the seconded employees to seek their salaries and other emoluments was against the foreign company. In case Northern Operating System rejects the employees selected for secondment, the foreign company will give a replacement for such employees. It needs to be noted that the judgment rendered in the Northern Operating System case was in the context of service tax. The only question for determination was whether the supply of manpower was covered under the taxable service and was to be treated as a service provided by a Foreign Company to an Indian Company. However, in the present case, the legal requirement requires a finding on whether to treat a service as 'FTS'.
• Further, reliance can be placed on the Karnataka High Court ruling in Flipkart Internet Private Limited⁴ to hold that the Supreme Court ruling in Northern Operating Systems was rendered in the context of service tax and hence, not applicable to IT Act to determine if the payment is for FTS.

BDO in India Comments

The issue with respect to whether tax needs to be deducted under section 195 of the IT Act on reimbursement of salary cost under the secondment arrangement has been a matter of debate before the Courts/Tax Tribunals.

In industrial practice, it is a settled position that the mere reimbursement made by the Indian entity to an overseas entity towards the reimbursement of salary of seconded employees cannot be regarded as FTS and there is no withholding obligation under section 195 of IT Act on the Indian entity. It is irrelevant whether any profit element is included in the income or not.

The Delhi Tax Tribunal in the present case has also held that the reimbursement made by an Indian company, for salary and other costs of the seconded employees working in India, to foreign entities does not constitute FTS but it is a mere reimbursement of salary by an Indian entity to a foreign entity. Hence, the taxpayer was not required to deduct TDS under section 195 of the IT Act.

The terms and conditions of the secondment agreement between the Home Company and the Indian Host Company need to be carefully drafted and required to be factually substantiated in order to take a position on the non-applicability of TDS provision on salary cost charge of seconded employees.

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