EY Tax Alert. Executive summary

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1 5 December 2014 EY Tax Alert Karnataka HC rules discount allowed to distributors for prepaid SIM cards and recharge vouchers not liable for withholding as commission or brokerage Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarizes a recent ruling of the Karnataka High Court (HC), in a bunch of appeals of telecom companies (Taxpayers) 1, on the issue of whether discount allowed to Channel Partners (Distributors) on sale of prepaid Subscriber Identification Module (SIM) cards and recharge vouchers (referred collectively as SIM cards for brevity) is liable for withholding tax under the provisions of the Indian Tax Laws (ITL) as commission or brokerage for acting as agents of the Taxpayers. On an analysis of the terms of the agreement between the Taxpayers and the Distributors, the manner of presentation of discount in the invoices raised and the treatment accorded in the books of account by the Taxpayers, the HC concluded that the relationship between them is on a principal-to-principal basis and the discount allowed is in the nature of trade discount and not commission. Furthermore, the HC held that, although telecom companies render services to ultimate subscribers and SIM cards are only devices to access such services, the sale of SIM cards to the Distributors represents a sale of right to service. While a service can only be rendered and not sold, what is sold to the Distributors is the right to service, which is capable of being sold, and such right to service is acquired by the Distributors on a principal-to-principal basis. 1 M/s Tata Teleservices Ltd.; M/s Bharti Airtel Ltd.; M/s Vodafone Essar South Ltd. [TS-722-HC-2014(KAR)]

2 Background and facts of the case The flow of transactions relating to the distribution of prepaid SIM cards is illustrated below 2 : Sells prepaid SIM cards of MRP INR100 at INR80 Purchases SIM cards at INR80 and earns income of INR10 upon resale at INR90 Purchases SIM cards at INR90 and earns income of INR10 upon resale at MRP INR100 Taxpayers (service providers) Distributors (dealers) Sub-distributors (retailers) End users (INR80) receivable from the Distributors. The Taxpayers recognized the net sale price of INR80 as revenue in their books and did not recognize discount of INR20. The Tax Authority took the view that the agreement between the Taxpayers and the Distributors was an agency contract in terms of which the Distributors acted on behalf of the Taxpayers and that the discount of INR20 was in the nature of commission liable to withholding by the Taxpayer. The Tax Authority, therefore, treated the Taxpayers as being in default of withholding obligation and raised demands for recovery of tax and interest. This was confirmed by the First Appellate Authority and the Income Tax Appellate Tribunal. Being aggrieved, the Taxpayers appealed to the HC. HC s ruling Under the ITL, payment of income, in the nature of commission or brokerage, to a resident attracts withholding for the 10%. The term commission or brokerage is defined, inter alia, to include any payment received or receivable, directly or indirectly, by a person acting on behalf of another person for services rendered (not being professional services). The Taxpayers, engaged in the business of providing cellular telephone services, appointed Distributors to provide prepaid connections to subscribers. The Taxpayers offered discount on bulk sale of SIM cards to the Distributors, which the Distributors were free to sell to subdistributors/retailers at a price not exceeding the Maximum Retail Price (MRP). The invoice raised by the Taxpayers reflected the MRP (say, INR100), discount (say, INR20) and net sale price The HC ruled in favor of the Taxpayers and held that the relationship between the Taxpayers and the Distributors was in the nature of a principal-to-principal relationship and that the discount allowed did not constitute commission to trigger withholding obligation for the Taxpayers, for the following reasons. (i) No principal-agency relationship Existence of a principal-agency relationship is a sine qua non for triggering withholding obligation on commission. Existence of a principal-agency relationship needs to be determined having regard to the terms and recitals of the agreement, intention of the parties as may be spelt out from the terms of the documents and the surrounding circumstances and the course of dealings between the parties. Also, while construing the agreement, one has to look at the substance rather than the form of the agreement 3. 2 Figures indicated in the diagram are merely illustrative 3 Reliance placed on Bhopal Sugar Industries Ltd. v. Sales Tax Officer [(1977)(6 CTR (SC) 284]

3 (ii) However, perusal of the agreements between the Taxpayer and the Distributors indicated the following features: The Distributors were appointed for marketing and distribution of cell phone connections and other related products. It was explicitly mentioned that the parties were to act on a principal-toprincipal basis. The Distributors had no authority to bind the Taxpayers. The Distributors were liable for loss or damage of the SIM cards post sale by the Taxpayers. The Taxpayers had no obligation to accept return of unsold SIM cards lying with the Distributors. The Distributors had to insure the SIM cards and the godowns at their own cost. The Distributors were prevented from making any representation to the retailers on behalf of the Taxpayers, unless so authorized. Hence, there was no principal- agency relationship between the parties. Sale of SIM cards is sale of right to service It is true that the SIM cards have no independent, intrinsic value of their own without mobile services being provided. The Taxpayers render mobile services to the ultimate subscribers upon activation of the SIM card on payment. Although service can only be rendered and cannot be sold, what is sold by the service provider (Taxpayers) to the Distributors is right to service which is capable of being sold. Pursuant to the sale of right to service, the Distributors acquire the right to demand service, which they can either use themselves or sell further to subdistributors etc. Such right to service is acquired by the Distributors on a principal-to-principal basis, and not as agents of the Taxpayers. (iii) No accrual of income to the Distributors at the stage of purchase of right to service Primary liability to pay tax is on the recipient of income. Tax withholding obligation is a secondary liability on the payer of the income. The tax withholding provision, being a machinery provision, has to be read in conformity with the charging provision and would apply only if the sum paid is chargeable to tax under the ITL. In other words, the payer has no withholding obligation if the payment does not constitute income in the hands of the recipient. If a person is not liable for payment of tax at all, at any time, the collection of tax from him, with a possible contingency of refund at a later stage, will not make the original levy valid 4. Hence, it is incorrect for the Tax Authority to suggest that withholding is mandatory and the Distributors can seek refund of tax, if they are not liable to tax. When a Distributor purchases SIM cards from the Taxpayers, no income accrues or arises to it at that stage. The purchase price constitutes expenditure in its hands. Income accrues to the Distributors only when they further sell the SIM cards to the next intermediary (sub-dealers or retailers). In the absence of income accruing at the stage of sale of SIM cards by the Taxpayers to the Distributors, there is no withholding obligation for the Taxpayers. The discount, representing the difference between the MRP and the net sale price, is shared amongst the intermediaries in the chain of distribution and represents profits from business that each one would make on the sale of SIM cards. It does not represent commission for services rendered. 4 Reliance placed on Bhavani Cotton Mills Ltd. v. State of Punjab [AIR 1967 SC 1616]

4 (iv) Other HC rulings taking contrary views are distinguishable It is true that other High Courts 5 have held that discount allowed to distributors of SIM cards by telecom companies are liable to withholding as commission, but the nature of the relationship and the arrangement between the parties in those cases were different. In those cases, the distributors were appointed as links between the service provider and the ultimate customer, with a right to the distributor to bind the service provider. Also, the distributors were appointed to provide services of documentation and compliance of other statutory requirements. Besides, in those cases, while the High Courts did acknowledge that services can only be rendered but cannot be sold, they did not go into the question of whether the right to service can be sold. (v) Relevance of accounting treatment. Whether the differential between the MRP and the sale price to the distributor is discount or commission will be evident from the accounting treatment in the books of the payer. If the sale is accounted at INR100, the commission is shown at INR20 and the net value is shown at INR80, it would be indicative of the essence of the contract between the payer and the distributor being one of service, which triggers withholding. On the other hand, if the payer accounts only for the net sale value of INR80 and the discount of INR20 is not reflected anywhere in the books, then there is no payment by the payer and no corresponding income for the distributor and, hence, withholding shall not be attracted. 5 CIT v. Idea Cellular Ltd. [325 ITR 148 (Del)]; Vodafone Essar Cellular Ltd.v. ACIT [332 ITR 255 (Ker)]; Bharti Cellular Ltd. v. ACIT [354 ITR 507 (Cal)] Comments It is, by now, well-accepted that existence of a principal-agency relationship between a payer and a payee is essential to trigger withholding obligation on commission or brokerage. The tests for ascertaining existence of a principal-agency relationship are also laid down in a catena of judicial precedents. The dispute surrounds the application of the principles to the facts and the nature of arrangement in a particular case. Prior to the present ruling, the Delhi, Kerala and Calcutta High Courts had ruled that the distribution arrangement for prepaid SIM cards attracts withholding for the telecom company on the difference between the MRP and the sale price to the distributor since the distributor merely acts as a link between the telecom company and the ultimate customer and the distributor is able to bind the two parties. In the present ruling, on factual analysis of the nature of the relationship between the parties, the HC has ruled that withholding obligation is not attracted since there is a sale of SIM cards to the Distributors, which are liable to the risk of loss or damage to such products, and the Distributors are not authorized to bind the telecom company to the ultimate customer. The HC also held that, although the SIM card, by itself, does not have any value and is integral to the provision of telecom service, nevertheless, it constitutes a right to service which can be sold.

5 The present ruling highlights the significance of factual analysis of the nature of the arrangement to determine existence of a principalagency relationship and the consequent trigger of withholding obligation. It also places emphasis on the accounting treatment accorded in the books. The ratio of the ruling, particularly the distinction drawn between service and right to service, may be of relevance in other cases where a similar dilemma arises.

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