The Tax Deducted at Source (“TDS”) mechanism is one of the most preferred methods of revenue collection among countries across the world.[1]  This is because, the emphasis of TDS is to increase the tax base to create a culture of compliance and to lessen tax evasion[2].  Simply put, the TDS mechanism imposes upon the person making a payment, an obligation to withhold tax at the time of such payment. It is further the responsibility of the remitter to deposit such TDS with the government.  Failure to do so invites penalty under section 271C of the Income-tax Act,1961 (“Act”) and prosecution under section 276B of the Act.

TDS provisions are enshrined under Chapter XVII of the Act and are applicable to a myriad of payments like salaries, fees for technical services, professional services etc. In cases of non-deduction or short deduction of TDS, the Income Tax Department (“department”) is empowered to proceed against the remitter under section 201 of the Act and to hold such remitter as an “assessee-in-default”.  Thus, the purpose of section 201 of the Act is to ensure compliance with TDS provisions and is a step-in-aid to ensure smooth collection of taxes.

However, the recent trend of the department would evidence otherwise as increasingly the proceedings under section 201 of the Act are being used as a garb to assess income of the recipient, probably owing to a larger period of limitation available to the department. To put matters in perspective, the current limitation to complete an assessment is 12 months from the end of the assessment year i.e., 24 months from the end of the relevant financial year, while an order under section 201 of the Act must be passed within 6 years from end of the financial year in which the transaction took place.  Thus, a provision intended to ensure compliance with the TDS provision is now being wielded by tax authorities to recharacterize transactions, that too in the hands of the payer who is merely discharging its obligation to pay TDS and is not even the beneficiary of the taxable income.

Recharacterization of income is a substance over form measure meant to tackle instances of tax avoidance / evasion.  In fact, the Organization for Economic Development (“OECD”) Transfer Pricing Guidelines[3] recommends recharacterization of income in certain exceptional circumstances such as:

1. The economic substance of the transaction differs from its form, given the facts and circumstances surrounding such transaction.
2. Where substance and form of the transaction are the same however the arrangement for the transaction is questionable.[4]

Thus, under the ambit of transfer pricing, recharacterization of income is permitted, albeit under an extremely limited scope.  In fact, the judicial trend in this regard would evidence that recharacterization of income in transfer pricing disputes has been constantly rejected by the Income Tax Appellate Tribunal (“ITAT”).  For instance, the Hon’ble Bombay High Court[5], in a case where the Transfer Pricing Officer (“TPO”) attempted to recharacterize a transaction of purchase of shares as provision of interest free loan, upheld the view of the ITAT that a TPO cannot recharacterize a transaction absent any cogent material on record to suggest otherwise.

Anti-avoidance rules such as the General Anti-Avoidance Rules (“GAAR”) are more accurate examples of statutory provisions within the Act which permit the department to recharacterize a transaction. To provide reference, Chapter X-A of the Act, codifies the GAAR provisions whereby any “arrangement” meant to “obtain a tax benefit”[6] is deemed to be an “impermissible avoidance arrangement”.  In other words, if the department comes to the determination that any tax structure has been intentionally created for the purpose of tax avoidance, same can be partially or completely nullified for the limited purpose of assessing taxability.

A perusal of the above would prove that the wordings of the Act are specific so as to permit recharacterization of transactions as a means to combat tax avoidance. It needs to be appreciated that while discharging its withholding obligations, a remitter is discharging tax liability of a recipient and thus it is laughable to assume any intention of tax evasion on the part of the remitter to warrant such harsh consequences.  Thus, it would be apposite to argue that recharacterization of income in context of TDS proceedings u/s 201 of the Act is a measure of over-reach by the tax administration and is thus impermissible.

In other words, once the remitter has discharged its TDS liability, the department cannot and should not use the proceedings u/s 201 of the Act[7] to create a case of substance over form and argue that tax ought to have been deducted at a higher rate.  For instance, the ITAT Delhi had dismissed a departmental appeal[8], whereby it observed that an order u/s 201 of the Act, trying to recharacterize sale of shares as sale of assets is incorrect and once TDS has been deducted and credited to the department, the remitter cannot be held to be an assessee-in-default. In the said case the assessee (Toshiba Corporation), a company incorporated in Japan, purchased shares from certain individuals who held a minority stake in an Indian entity.  Accordingly, the assessee, at the time of payment for purchase of shares, deducted TDS at 10% which was duly deposited with the Central Government.  It was against this background that proceedings u/s 201 of the Act were initiated alleging that the transaction of purchase of shares is in fact purchase of assets which ought to be taxed as short-term capital gains instead of long-term capital gains, thus inviting a higher rate of tax.

Apart from instances of recharacterization, there have been instances where section 201 proceedings have been initiated to question the binding decisions of High Courts by initiating proceedings against a remitter who has not deducted taxes in conformity with the law enunciated by a constitutional court. In such cases, instead of initiating assessment proceedings against the recipient, we have seen attempts by the department to fasten TDS liability upon a remitter whilst arguing that the legal position relied upon is incorrect and same is a subject matter of challenge before higher forums.

What is often lost sight of is that the role of an assessing officer in an assessment proceeding differs from its role in section 201 proceedings, which is merely to enforce compliance with TDS provisions.  Given the above, the department should refrain from using section 201 proceedings to challenge the existing jurisprudence on the subject which if unacceptable can be challenged in the assessment proceedings of the recipient of income.  Not only would this be contrary to the doctrine of judicial discipline but would be yet another case of overreach by the department u/s 201 of the Act.  Such acts not only hamper the ease of doing business but also lead to uncertainty.

Conclusion

The overreach of department under section 201 of the Act is a recent trend and needs to be curtailed before it turns into a Frankenstein’s monster and the tax administration is branded as regressive and unfriendly.  What needs to be borne in mind is that TDS is merely a collection mechanism and should not and cannot be used as a tool to assess tax liability of the recipient. While the judicial trend in discouraging such wanton acts is a welcome relief, the same is generally achieved after an arduous and in most cases lengthy process of assessment and appeals. The need for urgent reforms cannot be emphasized enough and while legislative act may take some time, necessary guidelines may be issued by the Central Board of Direct Taxes to grant much needed relief to taxpayers.

[1] Bharti Cellular Limited (Now Bharti Airtel Limited) v. ACIT, [TS-5077-SC-2024-O].

[2] The System of Tax Deduction at Source (TDS): Coverage, Functioning and Suggestions for Reform, P. Shome et al,. Dec 1996.

[3] Commissioner of Income-tax v. EKL Appliances Ltd. [TS-5232-HC-2012(Delhi)-O].

[4] Organization for Economic Co-operation and Development, Transfer Pricing Guidelines, Article 9, Para 1.37.

[5] Principal Commissioner of Income-tax v. Sterling Oil Resources Ltd. (2019).

[6] Section 96, Income-tax Act, 1961.

[7] Hindustan Coca Cola Beverage (P.) Ltd. v. Commissioner of Income-tax [TS-22-SC-2007].

[8] Income Tax Officer v. M/s Toshiba Corporation [TS-536-ITAT-2024(DEL)]