Local firms face a flat rate of 35% corporate tax (plus a 2.5% surcharge). Foreign companies operating in India, on the other hand, fall into two categories. Those which are not registered under the Indian Companies Act, are taxed at 40%. Those registered in India are considered Indian as far as the IT Act is concerned and hence face a maximum tax rate of 35% plus a 2.5% surcharge.
The I-T Act also says that foreign companies have to make "prescribed arrangements" to pay dividends. It is the term "prescribed arrangements" which figured prominently in this case.

The order was issued by a division bench of ITAT, Mumbai, comprising RV Easwar and AK Garodia in a case involving a British company, Decca Survey Overseas. The ITAT held that the department cannot levy tax at a higher tax on a foreign company, using an explanation introduced into a section of the I-T Act dealing with Double Taxation Avoidance Agreements (DTAA).

The explanation, introduced in the Finance Act 2001, says that a higher rate of tax on a foreign company is justifiable if the latter has not made "prescribed arrangement" for declaration and payment of dividends in India out of the income generated in India.
The Tribunal, in its order, focused on the word "prescribed arrangement" in the explanation given to section 90 of the I-T Act and held that the term "prescribed arrangement " has not been explained properly in the Act. In the absence of the legislature laying down the meaning of the term "prescribed arrangement", the explanation cannot be relied to impose a higher rate of tax on foreign companies.
In the absence of guidelines explaining what would amount to "prescribed arrangement", it cannot be a ground for levying tax on foreign companies at higher rate, the ITAT held. The IT department wanted to levy tax at 40% against 35% plus surcharge.

The department went in appeal before the division bench, arguing that the explanation, which relates to section 90 of the I-T Act, which allows India to enter into DTAAs, should be considered before issuing an order on the matter. The I-T department was appealing against a single judge ITAT bench and the Commissioner (Appeals) who had ruled in favour of the British company.
YP Trivedi, senior tax lawyer said, "This order in fact confirms that DTAA overrides I-T Act."

Rajesh Trivedi, partner Chaturvedi & Shah said, "With this judgement foreign companies operating in India will be paying tax at 35% instead of 40%. However, whether the judgement will be upheld by the high court is yet to be seen."
T P Ostwal, senior tax consultant told ET " The 2001 amendment was an example of the abuse of treaty override provision. The ITAT order set the anomaly right".