In the current global scenario, cross-border transactions are the norm rather than the exception, especially where software services are concerned. Many US companies are taken by surprise when they perform services in USA for an Indian customer and the Indian client withholds taxes on these service charges/fees paid to the US company. Generally US Tax treaties with most countries do not allow for such withholding/deduction, if said US company has no permanent establishment in the foreign country. However the India USA income tax treaty provides for the following under Article 12:
- A U.S. service provider provides services to an Indian customer,
- The services were “of a technical or consultancy” nature, and
- The services make available to the Indian customer “technical knowledge, experience, skill, know-how, or processes” (or the services fall within certain other categories),
then an Indian income tax of up to 15% can be imposed. The payments are characterized as “fees for included services.” This TDS is imposed under the terms of the Treaty, even if the U.S service provider had no activity or permanent establishment in India.
This creates a dilemma for the US Service Provider since per domestic US regulations the payments would be US source income for which a foreign tax credit may not be claimed. However, the India USA treaty provides for resourcing of income under Article 25. Under Article 25, the US service provider can resource the income as foreign source income and then claim the foreign tax credit on the same. This proviso holds good only for “Fees for included services”. If payments do not fall in that category, the US company would need to file a return in India to claim a refund of taxes paid. Another point to note is that in case the company decides not to file and get a refund, the same cannot be claimed as foreign tax credit on US return.
To sum up – Indian customers/clients need to deduct tax at source on payments to US service providers even though service is provided in the USA. These payments must fall under the category of fees for included services in order to be resourced as foreign income and to claim a foreign tax credit in the USA. If the US company receives payments that are no fees for included services and decides not to pursue a refund in India, the IRS will consider it a voluntary payment and a foreign tax credit will not be allowed in such circumstances.