The taxation framework in India has consistently aimed to secure the tax base, particularly in cross-border transactions involving payments to non-residents. Among the many mechanisms employed to achieve this objective, the requirement for tax deduction at source on sums chargeable to tax has emerged as a key compliance safeguard. In the context of transactions involving immovable property purchased from non-residents, Section 195 of the Income-tax Act, 1961 plays a pivotal role in ensuring that the revenue authorities have an opportunity to collect taxes before the consideration is remitted abroad.
The legal issues surrounding this provision came into sharp focus in the case of Nitesh Estates Ltd. v. Assistant Director of Income-tax (International Taxation) [2023] 30 ITR (Trib.)-OL 134 (Bangalore Tribunal). The Tribunal examined whether a purchaser could avoid liability under Section 195 on grounds of lack of knowledge of the seller’s residential status and the fact that the seller had disclosed the income in his return with no ultimate tax payable. This case also brought into discussion the provision to Section 201(1) and the related procedural requirement of Form 26A, exposing certain drafting ambiguities and practical difficulties.
Statutory Framework for TDS in Non-Resident Transactions
Section 195 provides that any person responsible for paying to a non-resident any interest or any other sum chargeable under the provisions of the Act shall deduct income-tax at the rates in force at the time of payment. The obligation is not contingent upon the ultimate tax liability of the recipient after set-off of losses or exemptions. Instead, the determining factor is whether the payment itself is of a nature that is chargeable to tax in India.
This provision has a preventive objective. Once a payment is made to a non-resident without deduction of tax, the Indian tax authorities may have no jurisdiction over the funds once they are transferred outside the country. As such, the deduction at source acts as a first line of defence in securing revenue.
Facts and Contentions in Nitesh Estates Case
The dispute arose when Nitesh Estates Ltd. purchased an immovable property from Mahesh Bhupathi, an internationally known tennis player. The purchaser did not deduct tax at source on the payment made for the property. The primary defences advanced by the purchaser were twofold. First, they claimed that they were unaware of the seller’s non-resident status at the time of the transaction. Second, they argued that the seller had already declared the capital gains from the sale in his return of income and, based on his computation, no tax was payable.
The department maintained that the obligation under Section 195 is triggered when the sum paid is chargeable to tax, regardless of whether the recipient eventually has a positive taxable income. The assessing authorities took the position that the provisions are designed to ensure that such payments do not escape the tax net merely because the payer lacked knowledge or the recipient claimed set-offs.
Tribunal’s Ruling and Reasoning
The Tribunal rejected the purchaser’s contentions and upheld the department’s view. It emphasised that ignorance of the residential status of the payee is not a valid defence. The responsibility to ascertain the applicability of Section 195 lies squarely with the payer. Furthermore, the Tribunal reiterated that the obligation to deduct arises when the sum in question is chargeable to tax, and it is immaterial whether the recipient ultimately has a tax liability after adjusting other sources of income or losses.
In doing so, the Tribunal highlighted the legislative intent of Section 195, which is to prevent situations where the entire sale consideration is transferred outside India without the tax authorities having the opportunity to recover applicable taxes. The ruling aligned with earlier judicial pronouncements, such as in GE India Technology Centre Pvt. Ltd. v. CIT, where the Supreme Court held that the focus is on the chargeability of the payment under the Act rather than the final tax computation.
Proviso to Section 201(1) – Origin and Purpose
Section 201(1) deems a person to be an assessee in default if they fail to deduct tax or, having deducted, fail to remit it to the government. Recognising that there may be circumstances where the recipient has already discharged the tax liability, a relaxation was introduced with effect from 1 July 2012. Initially applicable only to payments to residents, this provision was extended from 1 September 2019 to cover payments to non-residents under Section 195.
The proviso allows a payer to avoid being treated as an assessee in default if they can demonstrate that the recipient has:
- furnished a return of income under Section 139
- included the sum received in computing income in that return
- paid the tax due on such declared income
To avail of this relief, the payer must obtain and furnish a certificate in the prescribed form from an accountant, confirming compliance with these conditions.
Text of the Proviso
The proviso specifies that a person who fails to deduct the whole or any part of the tax on a sum paid or credited to a resident shall not be treated as an assessee in default if the above conditions are satisfied. The language was later adapted to cover non-resident transactions, reflecting the principle that if the recipient has fulfilled their tax obligations, penalising the payer serves little purpose.
Extension to Non-Residents and Section 195 Payments
The 2019 amendment extending the benefit to payments covered by Section 195 was significant. It acknowledged that similar situations occur in cross-border transactions where the payer may have failed to deduct tax, but the recipient has nonetheless complied with their tax obligations. This change sought to create parity in treatment between resident and non-resident payees in such circumstances.
However, despite this progressive intent, the operational requirements and the interaction with Form 26A have raised interpretational issues. These become particularly evident when the recipient’s computation results in no net tax liability due to set-offs from other sources of income or carried-forward losses.
Role of Form 26A in Claiming Relief
Form 26A serves as the vehicle through which a payer claims relief under the proviso to Section 201(1). Certified by an accountant, it requires the declaration of the amount of taxable income under the head in which the payment has been accounted for. In the case of immovable property, the relevant head is capital gains.
A noteworthy aspect is that the form does not require verification of whether the total income in the return is positive. This means that a payee could have taxable capital gains from the transaction but, after adjusting other losses, end up with no overall taxable income. While the law aims to ensure that the specific sum paid has been brought to tax, the language of clause (iii) of the proviso suggests a requirement for tax payment on the total income declared, creating an apparent mismatch.
Practical Challenges in Applying the Proviso
From a compliance perspective, the requirement for the payer to obtain proof of the recipient’s return filing and tax payment is particularly onerous in cross-border transactions. In the case of non-residents, the payer may have no practical means of securing a copy of the return or the necessary details to complete Form 26A.
This becomes even more impractical when one considers that the tax department already possesses the information regarding whether a return has been filed and whether tax has been paid on the relevant income. Yet, the statutory framework places the burden on the payer to collect and submit this information, failing which the relief is unavailable.
Why the Nitesh Estates Ruling is Significant
The decision in Nitesh Estates reinforces the fundamental principle that the obligation to deduct tax at source under Section 195 is triggered by the chargeability of the payment. It makes clear that the absence of net taxable income on the part of the payee does not absolve the payer of this responsibility. This has substantial implications for purchasers of immovable property from non-residents, as non-compliance can result in being treated as an assessee in default, with attendant interest and penalty consequences.
The case also brings attention to the operational limitations of the provision to Section 201(1) and the reliance on Form 26A as the mechanism for relief. It highlights the need for legislative or procedural clarification to address the scenario where the specific income from the transaction is taxable but offset by other losses.
Detailed Examination of Clause (iii) of the Proviso
Clause (iii) requires that the payee must have paid the tax due on the income declared in their return. On its face, this seems straightforward. However, when read in conjunction with clauses (i) and (ii), the provision raises interpretational questions. Clauses (i) and (ii) focus on whether the sum received has been included in the computation of income. Clause (iii) adds the requirement that tax must have been paid on the income declared in the return.
In practice, income declared in the return includes all sources, not just the source relevant to the payment made by the payer. This means that if the payee has declared capital gains from the transaction but has other losses—such as from business or other capital assets—that offset the gains, the net taxable income could be zero, resulting in no tax payment. This creates a situation where the payer, despite the payee having disclosed the transaction in full, may be unable to meet the conditions for relief under the proviso.
Legislative Gap and Its Implications
The wording of clause (iii) does not appear to fully align with the legislative intent behind the relaxation. The purpose was to ensure that if the sum in question has been accounted for and subjected to tax in India, the payer should not be penalised for not deducting tax at source. However, the current drafting ties the relief to the payment of tax on the total income declared, which could exclude cases where the specific sum was taxable but overall tax liability was eliminated by other deductions or losses.
This misalignment results in an unintended consequence. In cases where the transaction results in taxable income under a specific head, but the overall income is non-taxable, the payer remains exposed to being treated as an assessee in default. This runs contrary to the principle of avoiding unnecessary duplication of tax recovery when the income has already been subjected to Indian taxation in the hands of the payee.
Role of Form 26A and Its Limitations
Form 26A is the procedural instrument for availing relief under the proviso. It requires certification by an accountant that the sum has been taken into account in the computation of income and that the tax due on such income has been paid. Importantly, the form requires disclosure of the taxable income under the specific head of income where the payment is accounted for.
For immovable property transactions, this head is capital gains. The form does not require verification of whether the overall income is positive, which suggests that the legislative requirement of tax payment on total income is not fully reflected in the form. This inconsistency adds another layer of complexity for payers seeking relief.
In effect, the form focuses on the head-specific taxability, while the statutory provision appears to require tax payment on total income. This divergence can result in situations where the form is duly completed and submitted but the relief is denied on technical grounds.
Tribunal’s Observations in Nitesh Estates
The Tribunal in Nitesh Estates clarified that the obligation to deduct tax under Section 195 is independent of the net taxable income of the payee. The decision stated that it is immaterial whether the vendor has a positive income in the relevant assessment year; if the payment is chargeable to tax, the payer must deduct tax.
This reinforces the position that the chargeability of the payment, rather than the payee’s final tax liability, determines the payer’s TDS obligation. However, it also highlights the limited scope of the provision to Section 201(1) in providing relief when the payee’s net tax liability is nil due to set-offs.
Absence of Clarificatory Guidance from CBDT
Despite the potential for differing interpretations, there has been no specific circular or clarification from CBDT addressing how clause (iii) should be applied in cases where the relevant sum is taxable but the overall income is non-taxable. This absence of guidance leaves payers in a position of uncertainty, particularly in cross-border transactions where securing the necessary documentation from non-residents is already challenging.
A clarificatory circular could confirm whether the legislative intent is to require tax payment on the total income or only on the sum relevant to the transaction in question. Such guidance would be consistent with the principle that the TDS mechanism is a mode of tax collection and not a penal measure for non-deduction when no tax is ultimately payable on the specific sum.
Practical Difficulties in Non-Resident Contexts
In transactions with non-residents, obtaining the necessary confirmation that the payee has filed a return and paid tax on the relevant income can be extremely difficult. Non-residents may be unwilling to share sensitive tax information, or may have appointed representatives who are slow to respond to such requests.
Additionally, the timeframes involved in property transactions often mean that the payer must decide whether to deduct tax well before the payee’s tax compliance status is known. The statutory expectation that the payer secure a copy of the return or equivalent proof from a non-resident is impractical in many cases, particularly when the payer has no ongoing relationship with the seller.
Burden on the Payer and Systemic Considerations
The legislative scheme places the compliance burden on the payer, despite the fact that the tax department already has access to information about return filings and tax payments. From a systemic efficiency perspective, it would be more logical for the department to verify such information rather than require the payer to obtain it.
This burden is further compounded in cases where the payer has acted in good faith and the payee has in fact discharged their tax obligations. Without relief under the proviso, the payer can face demands for tax, interest, and penalties, resulting in double hardship for both parties.
Suggested Legislative Clarification
One approach to address the identified gap would be to amend clause (iii) to refer to tax payment on the sum included in the computation of total income in the return, rather than on the total income itself. This would ensure that relief is available in cases where the specific transaction is taxable and has been duly disclosed, even if overall tax liability is reduced by losses.
Such an amendment would align the statutory provision with the structure of Form 26A and with the underlying principle of preventing revenue loss while avoiding penalising payers unnecessarily. It would also provide certainty to taxpayers and reduce litigation.
Comparative Perspective and International Practice
In many jurisdictions, withholding tax relief mechanisms focus on the specific transaction or payment rather than the overall taxable income of the recipient. This targeted approach recognises that withholding tax is intended as a collection tool and that relief should be available when the transaction-specific tax has been duly accounted for.
Applying a similar principle in the Indian context would bring the law into harmony with international best practices and reduce compliance burdens in cross-border transactions. It would also address the unique challenges posed by property purchases from non-residents, which often involve large sums and require careful adherence to tax laws.
Continuing Relevance of the Tribunal’s Decision
The Nitesh Estates decision continues to be relevant as it underscores the strict interpretation of TDS obligations under Section 195. The case serves as a reminder that the obligation to deduct is determined at the time of payment, based on the chargeability of the sum, and not on the payee’s ultimate tax liability.
For payers, this means that even with the provision to Section 201(1) in place, careful due diligence is essential when dealing with non-resident transactions. The current drafting of clause (iii) and the practical limitations of Form 26A mean that the relief mechanism may not always be available, particularly in cases involving set-offs and overall losses.
Importance of Accurate Recognition of Borrowing Costs
Recognizing borrowing costs accurately is essential for presenting a true and fair view of the financial position of an entity. Under Ind AS 23, the primary objective is to ensure that costs directly attributable to the acquisition, construction, or production of qualifying assets are capitalized.
This helps in matching costs with the benefits generated by the asset in future periods. Inaccurate recognition can lead to overstated or understated profits, misleading stakeholders and affecting decision-making processes.
Capitalization Thresholds and Policy Choices
One of the key practical aspects is determining the capitalization threshold. While Ind AS 23 mandates capitalization of directly attributable borrowing costs, entities have to establish internal thresholds for materiality. For example, minor borrowing costs that are insignificant in value may be expensed directly instead of capitalized, provided this aligns with the entity’s accounting policy. Clear documentation of such thresholds is crucial to maintain consistency and transparency.
Identification of Qualifying Assets
Not all assets qualify for capitalization of borrowing costs. Qualifying assets are those that take a substantial period of time to get ready for their intended use or sale. Common examples include large-scale infrastructure projects, manufacturing plants, and real estate developments. In practice, determining what constitutes a substantial period requires judgment, considering factors such as industry norms, project complexity, and expected timelines.
Allocating Borrowing Costs Between Projects
When an entity undertakes multiple projects simultaneously, borrowing costs need to be allocated appropriately. If funds are borrowed specifically for a particular project, the costs can be directly assigned to that project. However, in the case of general borrowings, an average capitalization rate must be applied to the expenditure on qualifying assets. The allocation must be based on consistent and logical methods, supported by detailed records to withstand scrutiny during audits.
Suspension of Capitalization
Ind AS 23 requires suspension of capitalization during extended periods when active development is interrupted. In practice, determining what constitutes an extended period can be challenging. Factors such as unavoidable delays due to legal issues, environmental clearance, or natural disasters are considered. Entities should maintain comprehensive documentation to justify the suspension period and ensure it is applied consistently across projects.
Resumption of Capitalization
Once the active development of a qualifying asset resumes, capitalization must recommence. The transition between suspension and resumption needs clear documentation to demonstrate compliance with the standard. Entities must ensure that interest costs incurred during suspension periods are expensed and not inadvertently capitalized.
Foreign Currency Borrowings and Exchange Differences
For projects funded through foreign currency borrowings, exchange differences on such borrowings can impact the amount capitalized. Ind AS 23 allows certain exchange differences arising from foreign currency borrowings to be considered as adjustments to borrowing costs. This requires entities to segregate exchange differences related to interest from those related to principal repayments, ensuring only eligible amounts are capitalized.
Treatment of Ancillary Costs
Borrowing costs often include ancillary costs such as fees, commissions, and transaction costs incurred in arranging borrowings. These costs should be amortized over the term of the borrowing using the effective interest rate method. For qualifying assets, the proportion of these costs attributable to the construction period can be capitalized, requiring detailed calculations and supporting evidence.
Coordination with Project Management Teams
Accounting for borrowing costs is not an isolated finance function. Coordination with project management teams is essential to obtain accurate and timely updates on project status, expenditure patterns, and development timelines. This collaboration ensures that capitalization begins and ends at the correct stages, aligning with actual progress rather than accounting estimates alone.
Internal Controls and Documentation
Robust internal controls are necessary to ensure compliance with Ind AS 23. This includes maintaining detailed schedules of borrowings, capitalization rates, expenditure timelines, and project milestones. Documentation should also include management’s judgments, estimates, and approvals related to capitalization and suspension decisions. These records are critical during statutory audits and regulatory reviews.
Disclosures in Financial Statements
Ind AS 23 requires detailed disclosures to enhance transparency for stakeholders. Entities must disclose the amount of borrowing costs capitalized during the period, the capitalization rate used, and the nature of qualifying assets. These disclosures enable users of financial statements to assess the impact of borrowing costs on the financial performance and position of the entity.
Common Mistakes in Practice
Several common errors can occur in applying Ind AS 23, including premature commencement of capitalization, failure to suspend capitalization during project delays, misclassification of general borrowing costs as specific borrowing costs, and incorrect calculation of capitalization rates. Regular training of accounting personnel and periodic reviews can help mitigate these errors.
Role of Auditors in Reviewing Borrowing Costs
Auditors play a vital role in verifying compliance with Ind AS 23. This involves examining loan agreements, recalculating capitalization rates, reviewing project timelines, and ensuring that disclosures are complete and accurate. Auditors also assess whether judgments and estimates made by management are reasonable and consistent with the standard’s requirements.
Impact of Changes in Interest Rates
Fluctuations in interest rates can significantly affect borrowing costs, especially for projects financed through variable-rate loans. Entities must update capitalization rates accordingly and assess the impact on total capitalized amounts. This requires close monitoring of financial markets and timely communication between treasury and accounting functions.
Borrowing Costs in Group Entities
In consolidated financial statements, borrowing costs may arise from both parent and subsidiary entities. The challenge lies in determining whether intercompany borrowings qualify for capitalization and how to treat them in consolidation. Intercompany arrangements should be reviewed to ensure that the interest is genuine and not eliminated during consolidation before capitalization.
Impact of Government Grants and Subsidies
In some cases, projects may receive government grants or subsidies that reduce the effective borrowing costs. Entities must assess whether such benefits should be netted against borrowing costs or recognized separately. The treatment should be consistent with other accounting standards, such as Ind AS 20 on government grants.
Borrowing Costs in Joint Ventures
When projects are undertaken through joint ventures, the recognition and allocation of borrowing costs depend on the contractual arrangement between the parties. If the joint venture entity borrows funds directly, capitalization follows the standard approach. However, if the venturers finance the project individually, allocation of costs must be based on agreed-upon terms and documented in the joint venture agreement.
Sector-Specific Considerations
Different industries face unique challenges in applying Ind AS 23. For instance, real estate developers must deal with multiple qualifying assets in various stages of completion, while infrastructure companies often have long gestation periods requiring meticulous tracking of capitalization. Manufacturing entities may need to differentiate between regular maintenance and the construction of new production facilities.
Leveraging Technology for Compliance
Modern accounting software can automate much of the borrowing cost calculation process, including tracking expenditure timelines, applying capitalization rates, and generating disclosure-ready reports. Implementing such systems reduces manual errors, enhances efficiency, and ensures that capitalization aligns with actual project progress.
Training and Capacity Building
Continuous training for finance teams is essential to keep pace with evolving interpretations of Ind AS 23. Workshops, seminars, and internal knowledge-sharing sessions help accountants stay updated on best practices, regulatory guidance, and emerging trends in borrowing cost capitalization.
Alignment with International Standards
Ind AS 23 is substantially aligned with IAS 23 under IFRS. Multinational companies operating in India benefit from this alignment as it allows for consistency in financial reporting across jurisdictions. However, entities must remain alert to any local regulatory modifications or guidance issued by Indian authorities.
Addressing Regulatory Inspections
Regulatory bodies may scrutinize borrowing cost capitalization, particularly for large infrastructure and real estate projects. Entities should be prepared with well-documented evidence to justify their accounting treatments. Proactive communication with regulators can help resolve potential issues before they escalate.
Integrating Borrowing Costs into Performance Analysis
While borrowing costs are a financial reporting requirement, they also provide insights into project efficiency and financing strategies. Analyzing trends in capitalized borrowing costs across projects can help management identify cost overruns, financing inefficiencies, or delays in project execution.
Conclusion
Borrowing costs represent a significant component of financial decision-making and accounting treatment for many entities, particularly those engaged in capital-intensive projects. Understanding the recognition, measurement, and capitalization rules under Ind AS 23 is essential for ensuring accurate financial reporting and compliance with applicable standards. The standard provides a structured approach by distinguishing between qualifying and non-qualifying assets, defining the scope of capitalization, and setting clear timelines for commencement, suspension, and cessation of capitalization.
By capitalizing eligible borrowing costs, entities can reflect the true cost of asset acquisition or construction in their financial statements, thereby providing a more realistic view of asset value. This approach ensures that expenses are matched with the periods benefiting from the asset, enhancing the reliability of reported profits. At the same time, recognizing non-capitalizable borrowing costs as expenses in the period incurred preserves transparency and prevents overstatement of asset values.
In practice, applying Ind AS 23 demands careful attention to the nature of the asset, the source of financing, and the timing of activities necessary to prepare the asset for use. Accurate allocation of borrowing costs in the case of general borrowings, as well as consistent treatment of exchange differences and other related expenses, is critical for maintaining compliance.
Ultimately, adherence to the principles of Ind AS 23 not only strengthens the credibility of financial statements but also supports informed decision-making by stakeholders. A robust understanding of borrowing costs allows management to plan financing strategies more effectively, optimize tax positions where permissible, and maintain stakeholder confidence in the entity’s financial health. As businesses continue to operate in complex and evolving financial environments, the precise application of borrowing cost rules remains a cornerstone of sound accounting practice.