Cross-border transactions have always attracted attention from both businesses and regulators due to the intricate web of domestic laws, international tax treaties, and evolving global principles. When it comes to the import of goods, one recurring question is whether tax must be deducted at source when an Indian company makes payment to a non-resident supplier. This question becomes particularly relevant in scenarios where the foreign seller is based in a treaty jurisdiction and does not have a permanent establishment in India.
The example of A Ltd, an Indian company, purchasing goods worth INR 5 crores from S Ltd, a Singapore-based supplier, provides a useful starting point to examine this issue. The instinctive answer under established principles of international taxation is that no withholding tax should apply. However, this conclusion is rooted in the conventional understanding of permanent establishment, business connection, and treaty protection. Before the concept of significant economic presence altered the landscape, this interpretation stood unchallenged.
We explore the traditional framework governing tax deduction at source on the import of goods, with particular focus on the India-Singapore treaty, the role of permanent establishment, and the rationale behind the conventional no-TDS position.
The Framework of TDS in Cross-Border Transactions
The Indian Income Tax Act, 1961, contains specific provisions that require a person making certain payments to non-residents to deduct tax at source. The logic is straightforward: since the non-resident may not have a physical presence in India, the tax authority ensures collection of tax at the point of payment. This mechanism places the onus of compliance on the payer, in this case the Indian importer, rather than on the foreign seller.
The scope of TDS obligations is directly linked to whether the payment constitutes income chargeable to tax in India. In the case of payments for goods imported into India, the critical question becomes whether such consideration gives rise to income deemed to accrue or arise in India under section 9 of the Act. Historically, the principle has been that sale of goods by a non-resident to an Indian buyer, where the seller has no presence in India, does not constitute income chargeable to tax in India. Consequently, no TDS obligations were triggered on such import payments.
Permanent Establishment as the Traditional Test
The cornerstone of international taxation has long been the concept of permanent establishment, commonly referred to as PE. Both domestic tax laws and Double Taxation Avoidance Agreements (DTAAs) rely heavily on this concept. A PE generally refers to a fixed place of business through which the business of a foreign enterprise is carried out in the source country. It may include a branch, office, factory, or even an agent in some cases.
If a foreign seller operates without any fixed place of business in India, and its transactions with Indian buyers are limited to offshore sales, then under the traditional framework, there is no business connection in India. Consequently, income from such sales does not become taxable in India. As a result, there is no need for the Indian buyer to deduct TDS while making payments.
The India-Singapore DTAA exemplifies this principle. The treaty clearly provides that profits of an enterprise of Singapore are taxable only in Singapore unless the enterprise carries on business in India through a permanent establishment situated in India. In the absence of a PE, business profits remain outside India’s taxing rights.
India-Singapore DTAA and its Importance
The Double Taxation Avoidance Agreement between India and Singapore is one of the most relied-upon treaties in cross-border commerce. Singapore has emerged as a major trading and investment hub, and Indian companies frequently source goods and services from Singaporean entities.
Under Article 7 of the treaty, business profits of a Singapore resident are taxable only in Singapore unless the enterprise has a permanent establishment in India. The treaty defines PE broadly, but the definition still requires a degree of physical presence or a dependent agent undertaking core activities in India. Mere sales of goods into India without such presence do not create a PE.
In the example of A Ltd purchasing goods from S Ltd, since S Ltd has no PE in India, Article 7 ensures that India does not have taxing rights over S Ltd’s business profits. Therefore, A Ltd is not required to withhold tax on its payment for imported goods.
This principle has been consistently upheld in judicial precedents where courts have reiterated that payments for import of goods to non-residents, in the absence of a PE, are not chargeable to tax in India. Accordingly, no TDS obligations arise under section 195 of the Income Tax Act.
Historical Treatment of Import Payments
Before the concept of significant economic presence was introduced, import payments enjoyed a clear position under Indian tax laws. Payments made to foreign companies for the purchase of goods were treated as business profits of the foreign entity, and such profits were not taxable in India without a PE. This view was supported not only by treaty provisions but also by circulars and judicial decisions.
For instance, courts repeatedly observed that mere procurement of goods from a foreign supplier does not create a business connection in India. Since the entire transaction of sale takes place outside India, the income accrues outside India. As such, section 9 of the Act, which governs deemed accrual of income in India, was not attracted.
This clarity encouraged seamless import transactions and ensured that Indian businesses could import raw materials, components, and finished products without dealing with complex withholding requirements. The lack of a TDS obligation reduced compliance burdens for Indian companies and fostered smooth trade relationships with foreign suppliers.
Business Connection and the Domestic Law Perspective
While treaties emphasize the concept of permanent establishment, Indian domestic law uses the phrase business connection. Historically, the interpretation of business connection largely aligned with the concept of PE, especially after courts consistently applied similar tests. Business connection required some level of presence or activity in India, whether through offices, agents, or operations.
Thus, when a foreign supplier sold goods from outside India and had no representative or office in India, no business connection could be established. Payments for such imports did not give rise to income deemed to accrue in India. This understanding formed the bedrock of the no-TDS position in import transactions.
The Practical Comfort of the No-TDS Position
For decades, businesses in India operated with the comfort that payments for import of goods to non-residents without a PE did not attract TDS. This comfort was reinforced by multiple factors:
- Judicial rulings consistently hold that offshore sales of goods are not taxable in India.
- Circulars and clarifications from the tax authorities recognizing that import payments are not subject to withholding.
- Treaty protections ensure that business profits remain taxable only in the country of residence, unless a PE exists in India.
As a result, Indian companies could make large-value payments for imports without deducting tax, provided the foreign seller had no presence in India. The India-Singapore scenario illustrated earlier was a classic example of how the system worked.
Why the Question Still Arises
Despite this long-standing clarity, the question of TDS on import of goods continues to surface. This is partly due to the expansive wording of section 195 of the Act, which requires deduction of tax on any payment to a non-resident that is chargeable to tax in India. Businesses often grapple with the fear of consequences if the tax authorities later dispute the chargeability of income.
In addition, the introduction of the concept of significant economic presence in recent years has unsettled the earlier clarity. While SEP primarily aimed at the digital economy, its wording also refers to transactions in goods. This has created uncertainty on whether import transactions exceeding specified thresholds could fall within the expanded definition of business connection under domestic law.
Before SEP came into play, the consensus was clear: imports from non-residents without a PE were not taxable in India, and therefore no TDS was required. The SEP provisions introduced an additional layer of complexity that demands closer examination.
The traditional framework provided clarity and predictability to import transactions. The principle was simple: no permanent establishment meant no taxation in India, and consequently no TDS on payments for imports. The India-Singapore treaty and similar agreements played a central role in providing certainty and avoiding double taxation.
However, the landscape has shifted since the introduction of significant economic presence in domestic law. This new concept expands the definition of business connection beyond physical presence and introduces thresholds based on transaction value and user interaction. In the context of imports, this raises the question of whether payments exceeding the specified threshold could attract taxation in India even without a permanent establishment.
While the traditional understanding continues to provide a basis for non-deduction of tax, the evolving framework requires businesses to revisit their positions and evaluate risks under the new law.
Emergence of Significant Economic Presence and its Impact
The focus was on the traditional understanding of tax deduction at source in the context of imports. That framework revolved around the concepts of business connection, permanent establishment, and treaty protection. The principle was straightforward: payments made by an Indian company to a foreign seller for the import of goods were not taxable in India, provided the seller had no physical presence in India. Consequently, no withholding tax obligations were triggered.
This long-established clarity was altered with the introduction of the concept of significant economic presence into the Indian Income Tax Act. While the initial intent of this provision was largely to address the taxation of digital transactions, its wording is broad enough to cover all kinds of cross-border dealings, including trade in goods. This has created significant uncertainty for businesses making large-value payments to non-resident sellers, even in cases where no permanent establishment exists.
We will examine the origin, purpose, and mechanics of the significant economic presence provisions, their relationship with business connection under domestic law, and their possible impact on import transactions that exceed the prescribed thresholds.
Global Background: The Digital Economy Challenge
The roots of significant economic presence lie in the challenges posed by the digital economy. With the rise of e-commerce, digital platforms, and online services, businesses were able to generate substantial revenues in jurisdictions without any physical presence. The existing international tax framework, centered on permanent establishment, failed to capture these new models.
Recognizing this gap, the Organisation for Economic Co-operation and Development (OECD) and the G20 launched the Base Erosion and Profit Shifting (BEPS) project. A key part of this initiative was to address the tax challenges of the digital economy. One proposal was to expand the definition of nexus for taxation purposes beyond physical presence, so that significant participation in a market could create taxing rights even without traditional establishments.
India was among the first countries to adopt this idea in its domestic law. Through the Finance Act, 2018, the concept of significant economic presence was introduced into section 9 of the Income Tax Act. Its implementation was deferred initially due to ongoing global discussions, but it became effective from the financial year 2021-22.
Introduction of Explanation 2A to Section 9(1)
Explanation 2A to section 9(1) is the legislative provision that introduced significant economic presence into Indian tax law. It was inserted with the explicit purpose of broadening the scope of business connection.
The explanation provides that the significant economic presence of a non-resident in India shall constitute a business connection in India. For this purpose, significant economic presence is defined in two ways:
- Transaction in respect of any goods, services, or property carried out by a non-resident with any person in India, including provision of data or software downloads in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds INR 2 crores.
- Systematic and continuous soliciting of business activities or engaging in interaction with three lakh or more users in India.
The explanation clarifies that these provisions apply irrespective of whether the agreement for the transaction is concluded in India or outside, whether the non-resident has a residence or place of business in India, or whether services are rendered in India or outside.
This wide drafting means that even traditional goods transactions, such as imports exceeding the threshold value, technically fall within the definition of significant economic presence.
Thresholds for Significant Economic Presence
The Ministry of Finance notified the thresholds for the SEP test in 2021. The monetary threshold for transaction value was set at INR 2 crores during a financial year, while the user threshold was fixed at three lakh users.
These thresholds are relatively low when considered in the context of international trade. Imports of goods routinely involve payments well above INR 2 crores, especially for medium and large businesses. As a result, the mere fact of making a payment for imports could potentially bring a foreign seller within the definition of having a significant economic presence in India.
This raises the concern of whether such transactions, which were historically outside the ambit of Indian taxation in the absence of a permanent establishment, could now be treated as taxable under domestic law merely because of their value.
Expansion of Business Connection under Domestic Law
Before the SEP provisions, business connection under Indian domestic law largely mirrored the concept of permanent establishment. Courts interpreted business connection to require a real and intimate relationship between the activities carried on outside India and the business operations in India. The emphasis was on some element of continuity and presence.
With Explanation 2A, business connection was dramatically expanded. Now, the mere act of transacting in goods or services with an Indian counterparty beyond a monetary threshold creates a deemed business connection, even in the absence of any physical presence.
This is a significant departure from the earlier regime and demonstrates India’s intent to capture value generated from its market, irrespective of traditional nexus tests. However, it also creates tension with India’s obligations under its tax treaties, which continue to apply the permanent establishment standard.
Interaction Between SEP and Double Taxation Avoidance Agreements
The introduction of significant economic presence raises a fundamental question: can domestic law provisions override treaty protections? The short answer is no.
While Explanation 2A broadens the scope of business connection under domestic law, India’s tax treaties, including the India-Singapore DTAA, continue to rely on the concept of permanent establishment for allocation of taxing rights. Under section 90 of the Income Tax Act, treaty provisions prevail over domestic law to the extent they are more beneficial to the taxpayer.
Therefore, in cases where a non-resident is eligible to claim treaty benefits, the SEP concept cannot create taxing rights in India unless a permanent establishment exists. This means that in the case of S Ltd, a Singapore tax resident, the absence of a PE in India ensures that its business profits from sale of goods to A Ltd remain taxable only in Singapore, regardless of the value of transactions.
However, in situations where no treaty applies, SEP provisions could potentially create tax liability in India. For example, if a company based in a jurisdiction with which India does not have a tax treaty sells goods worth more than INR 2 crores to Indian buyers, the domestic law provisions could deem a business connection in India. In such cases, the Indian payer may face an obligation to withhold tax.
Judicial Interpretation and SEP
Since the SEP provisions are relatively new, there is limited judicial guidance on their application, particularly to import transactions. Most litigation and discussion so far has focused on digital services and online platforms. However, the wording of Explanation 2A is unambiguous in its coverage of transactions in goods.
This creates a grey area for businesses. On one hand, the legislative intent was clearly driven by the digital economy. On the other hand, the statutory language brings imports of goods within its ambit if the transaction value exceeds the specified threshold. Until courts or the tax authorities provide specific clarification, businesses must navigate this uncertainty on a case-by-case basis.
Impact on Import Transactions
For Indian companies importing goods, the SEP provisions introduce a potential risk. Transactions that were once clearly outside the scope of Indian taxation may now be argued by the authorities to fall within the expanded business connection framework. The risk is particularly acute in cases where treaty protection is not available.
Even where a treaty applies, businesses may face practical challenges. Tax officers may insist on withholding obligations based on domestic law, leaving it to the taxpayer to prove treaty protection. This could lead to disputes, increased compliance burdens, and the need for advance rulings or clarifications.
The uncertainty also impacts foreign sellers, who may be reluctant to enter into high-value contracts with Indian buyers without clarity on their tax obligations. In some cases, this may affect pricing and contract negotiations, as foreign suppliers may demand indemnities or gross-up clauses to cover potential Indian tax exposure.
Administrative Challenges for Businesses
From a compliance perspective, the SEP provisions complicate the responsibilities of Indian importers. Under section 195 of the Income Tax Act, the obligation to deduct tax arises when making payments to non-residents if such payments are chargeable to tax in India. With the expanded scope of chargeability under SEP, businesses face the challenge of determining whether a payment is potentially taxable.
This determination involves not only assessing the transaction value but also evaluating the availability of treaty protection. For transactions involving non-treaty jurisdictions, the risk of tax exposure increases. Even in treaty situations, the need for documentation, opinions, and potential disputes with tax authorities increases the compliance burden.
Theoretical Versus Practical Application
Although the wording of Explanation 2A clearly encompasses transactions in goods, there is an argument that the provision should be interpreted in line with its underlying intent, which was to address challenges of the digital economy. Applying it to traditional import transactions may go beyond the legislative intent and create unintended consequences.
Nevertheless, until there is explicit clarification, the risk remains that tax authorities may seek to apply SEP provisions broadly. Businesses must therefore be cautious and prepared for possible litigation.
Practical Implications of Significant Economic Presence
The earlier discussions explored the legal foundation of tax deduction at source in the context of import transactions and the impact of significant economic presence as introduced into the Indian Income Tax Act. We focused on traditional principles based on permanent establishment and treaty protection, and examined the conceptual shift brought by significant economic presence and its interplay with domestic law and international treaties.
Focus shifts to the practical implications of significant economic presence on import transactions. This includes the risks faced by Indian businesses, compliance responsibilities, potential disputes, and the evolving nature of the global tax framework. To provide clarity, practical scenarios and case-based examples will be used to illustrate how the law could apply in real-world situations.
Practical Risks for Indian Importers
Indian companies engaged in international trade are now compelled to factor in the possible application of significant economic presence provisions while making payments to foreign suppliers. Although treaties provide protection in many cases, the potential for disputes cannot be underestimated.
The key risks include:
- Determination of chargeability under section 195 of the Act.
- Potential exposure in cases where suppliers are based in non-treaty jurisdictions.
- Disagreements with tax authorities over the applicability of treaty provisions.
- The possibility of litigation, delaying refunds or causing financial strain.
- Higher transaction costs due to gross-up clauses or indemnity arrangements demanded by foreign suppliers.
Case Study 1: Treaty-Protected Import Transaction
Consider the example of A Ltd, an Indian manufacturing company, importing raw materials worth INR 10 crores from S Ltd, a company based in Singapore. S Ltd has no office, employees, or permanent establishment in India. The transaction is a simple sale of goods delivered on a free-on-board basis.
Under traditional principles, no part of the income earned by S Ltd is taxable in India, as business profits are only taxable in the country of residence unless there is a permanent establishment in India. This is explicitly covered under the India-Singapore tax treaty.
With the introduction of significant economic presence, the transaction value exceeds INR 2 crores and therefore creates a business connection under domestic law. However, treaty protection ensures that the absence of a permanent establishment shields S Ltd from Indian taxation.
In practice, the challenge arises when Indian tax authorities insist that A Ltd deduct tax at source under section 195, arguing that the payment is chargeable under domestic law. A Ltd may then be compelled to either deduct tax, seek a lower withholding certificate, or litigate to establish that treaty provisions prevail.
Case Study 2: Import from a Non-Treaty Jurisdiction
Now consider B Ltd, an Indian trading company, importing finished goods worth INR 3 crores from Z Ltd, a supplier based in a jurisdiction with which India does not have a tax treaty. Z Ltd does not have any physical presence in India.
Since no treaty is available, the protection of permanent establishment cannot be claimed. Under domestic law, the transaction exceeds the threshold of INR 2 crores and therefore constitutes significant economic presence. As a result, the business profits of Z Ltd from this transaction are deemed to accrue in India to the extent attributable to the Indian market.
In this situation, B Ltd may be required to deduct tax at source under section 195 on the payment made to Z Ltd. This creates an additional cost for Z Ltd, which may seek a gross-up of the contract price or resist further dealings with Indian buyers.
This example demonstrates the practical difficulties that Indian businesses may face when dealing with suppliers from non-treaty countries.
Case Study 3: Multiple Small Transactions Exceeding Threshold
C Ltd, an Indian electronics distributor, purchases goods worth INR 50 lakhs in each quarter of a financial year from P Ltd, a European supplier. Over the year, the total value of imports reaches INR 2 crores.
The question arises whether the threshold should be measured per transaction or on an aggregate basis. Under the wording of Explanation 2A, it is the aggregate of payments during the previous year that matters. Thus, even though no single transaction exceeds INR 2 crores, the total exceeds the threshold and constitutes significant economic presence.
If a treaty applies, C Ltd may rely on the absence of a permanent establishment to avoid withholding tax. However, if no treaty is available, C Ltd may have to deduct tax, even though each transaction in isolation appears relatively small.
Compliance Burdens for Indian Businesses
The SEP framework creates additional compliance responsibilities for Indian businesses making payments to foreign suppliers. These include:
- Conducting due diligence to determine whether treaty protection applies.
- Maintaining robust documentation to establish the absence of a permanent establishment in India.
- Seeking certificates under section 197 for lower or nil withholding where appropriate.
- Factoring in possible disputes and building contractual safeguards with suppliers.
- Managing cash flows in case of withholding and subsequent refund procedures.
These compliance costs can be significant, especially for businesses with large volumes of imports.
Possible Approaches to Risk Mitigation
Indian businesses can adopt several strategies to mitigate the risks arising from SEP provisions:
- Advance rulings: Applying for advance rulings to obtain certainty on withholding obligations for specific transactions.
- Tax opinions: Obtaining expert opinions to support the position that no withholding is required, particularly in treaty cases.
- Contract structuring: Including indemnity or gross-up clauses in contracts to allocate tax risks between the parties.
- Diversification of suppliers: Where feasible, preferring suppliers from treaty jurisdictions to minimize withholding risks.
- Regular monitoring: Keeping track of transaction values during the year to anticipate when the SEP threshold may be breached.
Role of the Tax Authorities
The practical application of SEP provisions also depends on the approach taken by Indian tax authorities. If authorities adopt a broad interpretation, disputes may become frequent. On the other hand, a more purposive interpretation, limiting SEP primarily to digital transactions, could reduce uncertainty.
In the absence of official clarifications, businesses must prepare for the possibility of aggressive enforcement, particularly in high-value transactions or in cases involving non-treaty jurisdictions.
Interaction with Other Provisions of the Act
SEP is not the only mechanism through which India seeks to tax cross-border transactions. Provisions such as equalisation levy, royalty and fees for technical services rules, and transfer pricing also play a role in determining taxability.
For example, where a payment could be classified as royalty or fees for technical services, it may attract withholding even without considering SEP. The overlap of these provisions with SEP adds further complexity to compliance.
The International Dimension
The introduction of SEP provisions in India must also be viewed in the context of evolving international tax rules. The OECD’s Pillar One initiative seeks to create a multilateral framework for allocating taxing rights in the digital economy. Once implemented, Pillar One may supersede domestic SEP provisions, creating a more consistent international standard.
Until such global consensus is reached, unilateral measures like SEP will continue to create complexity. Businesses operating internationally must therefore align their tax strategies with both domestic rules and potential future changes in the global framework.
Potential for Litigation
Given the ambiguities surrounding SEP, litigation is inevitable. Key issues likely to be contested include:
- Whether SEP provisions apply to traditional goods transactions.
- Whether treaties override SEP in all circumstances.
- How attribution of profits to SEP should be determined.
- The role of intent versus statutory language in interpreting SEP.
Judicial interpretation will play a crucial role in shaping the future of SEP in India. Until then, businesses face a period of uncertainty where compliance strategies must be carefully designed.
Future Outlook for Import Transactions
The significance of SEP provisions for import transactions lies not only in their immediate impact but also in the signal they send about India’s approach to international taxation. By expanding the concept of business connection to include economic presence without physical presence, India has asserted its right to tax market-driven profits.
Whether this approach is sustainable in the long run will depend on the evolution of global tax rules and India’s willingness to align its domestic law with international consensus. For now, Indian businesses engaged in imports must operate in an environment of uncertainty, balancing compliance with commercial needs.
Conclusion
The issue of tax deduction at source on import of goods, particularly in light of the significant economic presence provisions, represents a complex intersection of domestic law, international tax treaties, and evolving global tax standards. Traditionally, payments to non-resident suppliers for the import of goods were considered outside the scope of Indian taxation in the absence of a permanent establishment. This approach was supported by treaty provisions that restricted taxing rights to the supplier’s country of residence.
The introduction of significant economic presence has fundamentally altered the domestic legal framework. By expanding the definition of business connection, Indian law now brings high-value cross-border transactions within the scope of deemed accrual in India, even without physical presence. While this expansion reflects India’s attempt to safeguard its taxing rights in the digital and globalized economy, it has simultaneously created uncertainty for traditional transactions such as the import of goods.
In practice, treaty protection continues to play a decisive role. Where a treaty exists, the permanent establishment test prevails, providing relief to taxpayers and reducing withholding obligations. However, in cases involving non-treaty jurisdictions, the application of SEP may compel Indian businesses to deduct tax at source, thereby increasing compliance burdens and transaction costs.
The lack of detailed guidance and judicial interpretation further complicates matters. Indian businesses must therefore approach such transactions with caution, adopting robust compliance frameworks, seeking advance rulings, and maintaining comprehensive documentation. At the same time, suppliers may demand contractual safeguards against tax-related risks, affecting the commercial dynamics of cross-border trade.
Looking ahead, the role of SEP will likely evolve in response to global initiatives such as the OECD’s Pillar One framework, which seeks a unified approach to taxing digital and market-driven profits. Until such consensus is achieved, unilateral measures like SEP will remain relevant, and Indian businesses will need to strike a balance between compliance, cost efficiency, and international competitiveness.
Ultimately, the conversation on TDS and imports under the SEP regime is not merely a technical tax question. It reflects the broader challenge of reconciling national fiscal interests with international trade principles in an increasingly interconnected economy. Businesses, advisors, and policymakers alike must therefore prepare for a dynamic and evolving landscape, where clarity will emerge only through continued dialogue, legislative refinement, and judicial guidance.