Employers beware

Updated: Nov 13 2005, 05:30am hrs
The Income tax Act, 1961, (the Act) provides that any person responsible for paying salaries is obliged to withhold tax at source on such payments. Further, payments to independent contractors and consultants are also subject to withholding taxes, but at comparatively lower rates.

In some instances, perhaps for this very reason, persons are employed as independent contractors or consultants, as lower withholding results in a higher take home pay.

Courts have in the past delved into the nature of relationship between the two parties to determine whether such relationship could be held as one between an employer and employee.

The fundamental principle laid down by the courts in this regard is that while a 'contract of service' creates an employer-employee relationship between the parties, a pure 'contract for service' would not create such a relationship.

Nonetheless, courts have time and again disregarded the formal characterisation of such relationships (as set in a contract or otherwise) and have applied the 'substance over form' rule based on the facts and circumstances of each case.

The Authority for Advance Rulings (AAR) [in AAR No 597 of 2002 Max Mueller Bhavan] (268 ITR 31), was called upon to determine the true nature of the relationship between Max Mueller Bhavan and part time teachers engaged by it on contractual basis.

This institution is predominantly a cultural institution and also provides German language courses. The issue was whether the 'honorarium' paid to these part time teachers was in the nature of 'salaries' under the Act.

The AAR relied on various judicial decisions including those of the Supreme Court and also international commentaries to examine the distinction between an 'employee' and an 'independent contractor'. In its ruling, the AAR held that the 'honorarium' constituted payment of 'salary' and hence Max Mueller Bhavan was liable to withhold appropriate taxes at source from the amounts paid to the part time teachers.

The AAR relied on the principle that the prima facie test for determination of a master-servant relationship is the existence of the right of the master to supervise and control the work done by the servant, not only in the matter of directing what work the servant is to do but also the manner in which he shall do the work. Accordingly, in the case of a 'contract of service', the employer not only orders what is to be done but also directs how it shall be done.

On the other hand, an independent contractor undertakes to produce a given result, but generally in the actual execution of such work he is not under the order and control of the person for whom he undertakes this task.

Further, the Delhi High Court impliedly affirmed in the case of Director of Income-tax v HCL Infosystems Ltd (274 ITR 0261) that payments made by an assessee in respect of technicians whose services were placed at its disposal were in the nature of 'salaries', and not in the nature of 'fees for technical services'.

Any failure to deduct tax at the appropriate rates may lead to interest and penalties in the hands of the payer. With a renewed focus on increase in tax collections, the tax authorities are scrutinising cases which involve payments to independent contractors and consultants with increased fervour to determine the existence of an 'employer-employee' relationship.

To this end, the tax authorities are also examining various incidental factors to determine the true nature of the relationships, such as: do such persons carry a visiting card of the company, do they represent themselves as employees of the company in their dealings with outsiders, are they entitled to leave and other benefits (eg insurance, health coverage, gratuity, etc) that are generally available to employees.

It would thus be incumbent to examine the nature of the relationship in case a company has hired persons as independent contractors and consultants to determine whether the payments to these persons are 'salaries' based on judicial dicta in this regard and surrounding circumstances.

In such cases, one would be advised to deduct taxes at the rates applicable to salary payments to avoid any adverse implications.

The authors are senior tax professionals with Ernst & Young