Direct Tax Alert

BACKGROUND

Section 194-H of the Income-Tax Act, 1961 (IT Act) states that any person other than an individual or Hindu Undivided Family who pays commission or brokerage to a resident, shall at the time of payment or credit of such amount, whichever is earlier, deduct tax at source (TDS) at 5%. Commission or Brokerage as per section 194H of the IT Act includes any payment received directly or indirectly, by a person “acting on behalf of another person” for services rendered. Further, the term “acting on behalf of another person” suggests the existence of a legal relationship between principal and agent as per section 182¹ of the Contract Act, 1872 (Contract Act). Thus, provisions of section 194H of the IT Act are attracted when the legal relationship of principal and agent is established.

There is no well-settled law or a single definite criterion to determine the principal-agency relationship on which TDS under section 194-H of the IT Act may apply. Various judicial authorities have given differing views based on the facts of the case, business models etc.

In this regard, recently the Supreme Court² had an occasion to examine whether the agreements between telecom operators and distributors/franchisees for the sale of prepaid SIM Cards and recharge vouchers to end customers establish the legal relationship of principal and agent and thus liable for TDS under section 194-H of the IT Act. We, at BDO in India, have summarised the ruling of the Supreme Court and provided our comments on the impact of this decision.

FACTS OF THE CASE

• Taxpayers are cellular mobile telephone service providers as per the licence granted to them under the Indian Telegraph Act, of 1885 by the Department of Telecommunications (DOT). Taxpayers offered both postpaid and prepaid connections to their customers.

• Under the prepaid business model, the customers purchase the starter kit which contains a SIM Card and a coupon for a specified value as an advance payment to avail the services, for usage of SIM cards in future. End users/Customers are required to pay for services in advance, which can be done by purchasing recharge vouchers or top-up cards from the retailers.

• Taxpayers had entered into franchise/distribution agreements with various parties that will sell the prepaid starter kits and recharge vouchers to final customers.

• Taxpayers sold these starter kits and recharge vouchers to franchisees/distributors at a discounted price. The discounts are given on the printed price of the packs. This discount, as per taxpayers is not a commission/brokerage liable for TDS under section 194-H of the IT Act.  

• As per tax authorities, the difference between the discounted price paid by the franchisee/distributor and the sale price received by the franchisee/distributor is commission or brokerage as per section 194-H of the IT Act. Further, since the relationship between taxpayers and franchisee/distributor is in the nature of principal and agent, taxpayers are liable to deduct TDS under section 194-H of the IT Act.

• The controversy reached different High Courts whereby Karnataka, Rajasthan and Bombay High Court decided the issue in favour of taxpayers whereas Delhi and Calcutta High Court decided in favour of tax authorities.

The Supreme Court made the following observations while ruling in favour of the taxpayers:

• Section 194-H

  • Payment towards commission or brokerage is said to be received only when it is actually received or paid. The payment is receivable when the amount is actually credited in the books of the payer to the account of the payee, though the actual payment may take place in future. The payment received or receivable should be to a person acting on behalf of another person. Further, the term “another person” should be interpreted to mean “person responsible for paying”. Therefore, in order for section 194-H of the IT Act to apply, the payee should be a person who has a right to receive from such person i.e. “person responsible for paying”.  

  • For Section 194-H of the IT Act to apply, there should exist a legal relationship of principal and agent, between the payer and the recipient/payee. For this purpose, reliance is placed on co-ordinate bench ruling in the case of Singapore Airlines³.     

• Principal-Agent relationship
  • Agency in terms of section 182 of the Contract Act exists when the principal employs another person, who is not his employee, to act or represent him in dealings with a third party. As the transaction by the agent is on behalf of the principal whom the agent represents, the contract is between the principal and the third party.
  • The following factors should be taken into consideration to determine whether a legal relationship between principal and agent exists:

    • Whether the agent has a legal power to alter his principal’s legal relationship with a third party and the principal’s co-relative liability to have his relations altered.

    • The degree of control a principal has over the conduct of the activities of his agent determines whether there is a master-servant relationship or principal-agent relationship.

    • The task entrusted by a principal to the agent should result in a fiduciary relationship.

    • The agent is liable to render accounts of the business to the principal and should be entitled to remuneration from the principal for the work he performs for the principal. 

  • Reference is made to the co-ordinate bench ruling in the case of Bhopal Sugar Industries⁴ which is in relation to the contract of sale vis-à-vis contract of agency to expound the difference between principal-agent contract and principal-principal contract-

    • The essence of a contract of sale is the transfer of title of goods for the price paid or promised to be paid.

    • In the case of an agency to sell, the agent who sells the goods to third parties sells them as the property of the principal, who continues to be the owner of the goods till the sale. The transferee is the debtor and is liable to account for the price to be paid to the principal, and not to the agent for the proceeds of the sale. An agent is entitled to his fee/commission from the principal.

• Commercial relationships

  • Law permits individuals to enter into complex contracts incorporating multiple rights and obligations. A singular contract may create different legal relationships and obligations. Independent contractors on occasion act for themselves, and at other times may create legal relations between their employers and third persons. 

  • All kinds of interactions with third parties, resulting from the introduction of the third parties with one who wishes a particular undertaking to be performed, may not be a result of an agency. For instance, ‘middlemen’ are sometimes referred to as ‘agents’, when in fact they are franchisees of the manufacturer or supplier, or are distributors of the manufacturers’ goods, perhaps with a ‘sole agency’ or special dealership for his goods. Such agents can be real buyers, acting as principals on their own behalf. Therefore, the true factual position must be investigated to determine whether a relationship of agency has come into existence between a set of parties or individuals.

  • To decide whether a contracting party acts for himself as an independent contractor, one has to examine whether, in the course of work, he intends to make profits for himself, or is entitled to receive prearranged remuneration. If the party is concerned about acting for himself and making the maximum profits possible, he is usually regarded as a buyer, or an independent contractor and not an agent of the principal.

• Taxpayer’s business model

  • The franchisees/ distributors were required to pay in advance a discounted price for the welcome kit containing a SIM card, recharge voucher etc. Such discounts were given on the price printed on the pack of the prepaid service products. The franchisee/distributor paid the discounted price regardless of, and even before, the prepaid products being sold to the actual consumer. The franchisee/distributor was free to sell the prepaid products at any price below the price printed on the pack. The franchisee/distributor determined his profits/income.

  • The tax authorities had highlighted that the prepaid SIM cards were not the property of the franchisee/distribution and no right, title or interest was transferred to them. These were always to remain the property of the taxpayers. This is correct, but it is equally true that this is a mandate and requirement of the license issued to the taxpayers by the DoT.

  • The income, which is the difference between the sale price received by the franchisee/distributor and the discounted price, is paid or credited to the account of the franchisee/distributor when he sells the prepaid product to the retailer/customer/end-user. The sale price and accordingly the income of the franchisee/distributor is determined by the franchisee/distributor and the third parties. Therefore, the taxpayers do not, at any stage, either pay or credit to the account of the franchisee/distributor with the income by way of commission or brokerage on which TDS under section 194-H of the IT Act is to be deducted.

  • Tax authorities by placing reliance on the co-ordinate bench ruling of Singapore Airlines (supra) contented that even if the franchisee/distributor received payment in the form of income from the retailer/end-user/customer, it would be required to deduct TDS as payment received or receivable, “directly or indirectly”, is to be subjected to TDS. However, the expression “direct or indirect” used in section 194-H of the IT Act is meant to ensure that “the person responsible for paying” does not dodge the obligation to deduct TDS, even when the payment is indirectly made by the principal payer to the agent-payee. It is not to be extended to apply to true/genuine business transactions where the taxpayer is not the person responsible for paying or crediting income.

  • Section 194-H of the IT Act, by using the word “indirectly”, does not regulate or curtail the manner in which the taxpayer can conduct the business and enter into commercial relationships. Neither does the word “indirectly” create an obligation where the main provision does not apply. The tax legislation recognises diverse relationships and modes in which commerce and trade are conducted, albeit the obligation to tax at source arises only if the conditions as mentioned in Section 194-H of the IT Act are met and not otherwise. This principle does not negate the compliance required by law.

• Practical difficulties in deducting TDS      

  • The taxpayers are not privy to the transaction between franchisees/distributors and third parties. Therefore, it is impossible for taxpayers to deduct TDS under section 194-H of the IT Act on the difference between the total sum/consideration received by the franchisees/distributors from third parties and the amount paid by the distributors/franchisees to taxpayers.

  • Tax authorities’ argument that taxpayers should periodically ask for the data regarding SIM cards sold by franchisee/distributor is far-fetched, imposing an unfair obligation and inconveniencing the taxpayers, beyond the statutory mandate. Further, it will be impossible to deduct, as well as make payment of the tax deducted, within the timelines prescribed by law, since the timelines trigger when the amount is credited to the account of the payee by the payer or when payment is received by the payee, whichever is earlier. The payee receives payment when the third party makes the payment which cannot be payment received from the taxpayers as principal. The franchisees/distributors are not the trustees who are to account for this payment to the taxpayers as principal. The payment received is the gross income or profit earned by the franchisees/distributors as a result of their effort and work, and not as remuneration paid by the taxpayers.

  • Tax authorities referred to the co-ordinate bench ruling in the case of Singapore Airlines (supra) and contended that taxpayers would be liable to deduct TDS even if they were not making payment or crediting the income to the account of the franchisee/distributor. However, when the obligation and the time and manner in which the tax is mandated to be deducted at source is fixed by the statute, the same cannot be shifted/altered/modified or postponed on a concession in the court by the tax authorities. The concession may be granted, when permissible, by way of a Circular issued in accordance with Section 119⁵ of the IT Act.

• Legal position of a distributor

  • The distributor is an independent contractor who buys goods on his account and sells them in his territory. Unlike an agent, he does not act as a communicator or creator of a relationship between the principal and a third party. The distributor has rights of distribution and is akin to a franchisee. Notwithstanding the strict restrictions placed on the franchisees- which may require the franchisee to sell only the franchised goods, operate in a specific location, maintain premises which are required to comply with certain requirements and even sell according to specified prices- the relationship may in a given case be that of an independent contractor. The facts of each case and the authority given by the ‘principal’ to the franchisees matter and are determinative.

  • An independent contractor is free from control on the part of his employer and is only subject to the terms of his contract. An independent contractor is not required to render accounts of the business, as it belongs to him and not his employer.

• Other observations

  • The liability of the third party to pay tax when not deducted remains unaffected. Failure to deduct tax at source has serious quasi-penal consequences for a taxpayer. Hence, TDS provisions should be programmatically and realistically construed, and not by adopting a catch-as-catch-can approach.

  • In case of legal or contractual doubt in a given case, the taxpayer can rely on the doctrine of presumption against doubtful penalisation. Whether or not the said doctrine should be applied will depend on the facts and circumstances of the case, including the past practice followed by the taxpayer and accepted by the tax authorities.

• In view of the above, taxpayers are not under any legal obligation to deduct TDS on the income/profit component in the payments received by the franchisees/distributors from the third parties/customers, or while selling/transferring the pre-paid coupons or starter kits to the distributors.

BDO IN INDIA COMMENTS

This is a welcome ruling for taxpayers as it brings much-needed clarity on the legal relationship between telecom companies and franchisees/distributors with whom telecom companies have entered into an agreement for the sale of their SIM Cards. The Supreme Court has explained in detail the relevant factors one needs to consider while determining principal-to-principal, principal-to-agent or independent contractors relationship. The ruling is also expected to put at rest similar controversies with principal-to-principal arrangements in industries like pharmaceuticals, consumer goods etc. Since the Supreme Court rulings constitute the law of the land, they will be binding on all, therefore taxpayers may take a cue from the same in their pending litigations.