A dispute over a 20 per cent withholding tax levied by Japan seems to have been resolved, with Japan agreeing to reduce the tax to 10 per cent.

Officials said the re-worked double taxation avoidance agreement is likely to become operational from the next fiscal.

"The Japanese authorities have agreed to a 50 per cent reduction in the tax rate. But the final rate will be decided later," the officials said.

The move will benefit Indian IT industry as the national tax authority of Japan has been treating offshore work by the Indian companies as "fees for technical services", and has been taxing such work at 20 per cent on gross basis.

The move will benefit companies like Infosys [Get Quote], Wipro [Get Quote], TCS [Get Quote] and HCL [Get Quote], which are tapping the Japanese market.

India's IT and IT-enabled services exports to Japan are estimated to exceed $450 million in the financial year 2004-05. In 2003-04 the exports had grown by 43.2 per cent to $385.4 million.

The issue assumes importance as the offshore services are being taxed at 20 per cent on gross billing, whereas for on-site services the tax is on profits (gross billing less costs), which works out lower.

India has lowered the rate for "fees for technical services" in the recent budget to 10 per cent. This has benefited the Japanese companies as industry experts indicate there is a substantial import of technical know-how from Japan.

According to tax experts, the Japanese interpretation of the tax treaty is not in line with international norms, as software and IT-enabled services are generally not taxed as "fees for technical service".

Further, DTAA, which is a tax avoidance agreement, cannot be used to levy a tax, the experts say. All these factors have led to an agreement on reducing the tax rates.

The Indian authorities had taken the position that offshore services should not be taxed, while part of them relating to management and co-ordination services could be included as part of on-site work and taxed accordingly.

The issue relating to interpretation of DTAA came up about three years ago when the Indian industry raised concerns that the Japanese were interpreting the agreement in their favour.

This was because the DTAA overrode the Japanese domestic law which did not tax off-shore services.

Taxing problem

Japan has been treating offshore work by the Indian companies as "fees for technical services", and taxing such work at 20 per cent on gross basis.

India feels that offshore services should not be taxed, while part of them relating to management and co-ordination services could be included as part of on-site work and taxed accordingly.

India's IT and IT-enabled services exports to Japan are estimated to exceed $450 million in 2004-05.