TDS Compliance & DTAA Optimization: A Guide to India’s Income-tax Act, 2025 for FY 2026-27

With the enforcement of the Income-tax Act, 2025, navigating India’s new TDS landscape for FY 2026-27 is essential for companies,  foreign investors seeking to optimize withholding tax and maintain seamless cross-border compliance.

Under the provisions of the Income-tax Act, 2025, tax deducted at source (TDS) applies to payments made in India that are chargeable to tax. The obligation to deduct TDS lies with the payer, ensuring advance tax collection and improved compliance.

For financial year (FY) 2026-27, TDS rates are broadly classified into the following:

1. Domestic payments- to residents
2. Cross-border payments such as double taxation avoidance agreement (DTAA)- to non-residents/foreign companies

In this article, we provide clarity on TDS applicability for foreign entities, with a concise snapshot of domestic rates for context.

CLICK HERE: Tax Compliance Calendar India FY 2026-27 | April & May Deadlines

Domestic TDS snapshot

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TDS rates for domestic companies provide a useful baseline.

1. Lower rates, of one to two percent, apply to business transactions such as contracts and procurement.
2. Higher rates of 10 percent apply to income-type payments like professional fees and rent.
3. Certain transactions (for example, virtual digital assets) are tracked closely with mandatory TDS regardless of threshold.

Domestic TDS is designed more for tracking and reporting, whereas foreign TDS is structured as a revenue collection tool.

Legal and regulatory framework for foreign TDS

TDS on payments to non-residents is primarily governed by Section 393(2) of the Income-tax Act, 2025 (which consolidates earlier provisions such as Sections 195, 194LC, 194LD, etc. under the Income-tax Act, 1961).

Interest and investment income (foreign entities)

A key principle is TDS applies only if the income is chargeable to tax in India, subject to relief under applicable tax treaties (DTAA).

Please note: The above-mentioned TDS rates are on a gross basis (no deduction of expenses). Such expenses are classified as passive income streams, since law provides concessional flat rates in lieu of expense deductions.

India continues to offer preferential withholding rates (four to five percent) for foreign debt investments to attract offshore capital, particularly in infrastructure and bond markets.

Capital gains tax (foreign investors)

Please note: Capital gains are net-taxed, though TDS may be applied on gross in practice.

The standardized 12.5 percent LTCG rate reflects a shift toward simplifying capital gains taxation for foreign portfolio investors.

Other payments to non-residents

“Rates in force” refers to:

• Applicable rate under the Act, or
• Beneficial rate under country-specific DTAA

Please note: Some treaties restrict FTS/royalty taxation to a gross basis (e.g., 10 percent), whereas others allow a net basis if treated as business profits.

Gross vs net taxation: Withholding impact on foreign investors

For foreign companies and investors, India’s withholding tax regime is predominantly structured on a gross-basis deduction, meaning TDS is generally applied on the full payment value without accounting for underlying costs or expenses. In certain cases involving business income linked to a Permanent Establishment (PE) in India, net-basis taxation may also be available, subject to meeting prescribed conditions and obtaining appropriate approvals.

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From an investor standpoint, India’s approach is intentionally withholding-driven, designed to ensure tax collection certainty at the point of payment. While this reduces enforcement risk for the tax authorities, it often results in higher upfront tax outflows for foreign entities, even where the ultimate tax liability may be lower. Consequently, foreign investors frequently encounter excess withholding situations, requiring them to pursue refund claims, which can impact cash flow efficiency and investment returns.

A practical approach for foreign companies is to manage these withholding inefficiencies through targeted tax structuring strategies. This typically includes obtaining lower or nil withholding certificates to better align TDS with the actual tax liability, leveraging DTAAs to benefit from concessional rates, and, where commercially viable, structuring investments to enable PE-based net taxation. Collectively, these measures help reduce excess withholding and improve overall tax efficiency on India-linked income streams.- Ankur Munjal, Country Director, Dezan Shira & Associates-India.

In this context, early-stage tax structuring and documentation become critical for foreign investors to minimize leakage and improve post-tax returns from India-linked income streams.

Key takeaways and business insights

1. Concessional withholding regime: India maintains globally competitive TDS rates (four to five percent) for foreign debt investments, supporting capital inflows.
2. DTAA optimization: Foreign companies should evaluate treaty benefits to reduce withholding tax exposure.
3. Permanent Account Number (PAN) and compliance risk: Failure to furnish PAN can significantly increase TDS to 20 percent, impacting cash flows.
4. Digital economy taxation: High flat rates (30 percent) on gaming and winnings reflect tighter enforcement in emerging sectors.

ALSO READ: Virtual CFO Services in India: Benefits for Foreign Investors, SMEs

FAQs on TDS payments under the Income-tax Act, 2025 (transition from 1961 Act)

1. Which law applies for TDS during the transition to the new Income Tax Act, 2025?

The applicable law depends on the earlier date of payment or credit of income:

• If this occurs on or before 31 March 2026, the Income Tax Act, 1961, applies.
• If it occurs on or after 1 April 2026, the Income Tax Act, 2025 applies.

Example:

• Income credited in March 2026 but paid in April 2026 → TDS under the 1961 Act.
• Advance paid in March 2026 but recorded in April 2026 → TDS under the 1961 Act.

2. How should TDS be handled for ongoing contracts with periodic payments?

For recurring or monthly contracts:

• Payments or credits up to March 31, 2026 → governed by the 1961 Act.
• Payments or credits from April 1, 2026, onwards → governed by the 2025 Act.

There is no need to revise existing contracts. The deductor must apply for TDS based on the timing of payment or credit.

3. Have TDS rates or thresholds changed under the new Act?

No. TDS rates and thresholds remain largely aligned with the previous tax regime. The new law mainly reorganizes provisions (for example, under a consolidated section) without altering tax rates or policy.

4. What if TDS is deducted using old section numbers after April 1, 2026?

While rates and thresholds remain the same, quoting an incorrect (old) section number may lead to errors during TDS return processing.

In such cases, the deductor may need to file a correction statement.

5. Which law applies if payment is made before April 1, 2026?

If the payment or credit happens before 1 April 2026, TDS will be governed by the Income Tax Act, 1961, even if related processes continue afterward.

6. How is TDS treated if income is credited before April 1, 2026 but paid later?

TDS will still be governed by the 1961 Act, since the trigger event (credit or payment, whichever is earlier) occurred before the transition date.

The later payment date does not change the applicable law.

7. Do businesses need to update their systems for the new Act?

Yes. Companies should update enterprise resource planning (ERP), payroll, and compliance systems to reflect:

• New section references
• Updated terminology
• Revised reporting formats under the 2025 Act

8. How will TDS on salaries be handled during the transition?

For salary payments, TDS is deducted at the time of payment:

• Salary paid on or before March 31, 2026 → governed by the 1961 Act
• Salary paid on or after April 1, 2026 → governed by the 2025 Act

9. How will TDS credits be reflected across the transition period?

TDS credits will be recorded separately based on timing:

• TDS deducted in March 2026 → reflected under Assessment Year (AY) 2026-27 (1961 Act)
• TDS deducted in April 2026 onwards → reflected under Tax Year 2026-27 (2025 Act)

The e-filing system and reporting statements will automatically allocate these credits based on the TDS returns filed.

A well-configured ERP can automate VAT and statutory reporting, manage e-invoicing, reconcile accounts in real time, implementing automation and ERP systems in India with the right setup ensures you stay ahead and gain clear visibility into your financial operations.

Divyansh Shrivastava

Assistant Manager

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