Foreign Tax Credit Rules

One of the pillars of the Double Tax Avoidance Agreement
(DTAA) is Article on “Methods for Elimination of Double Taxation”. Various
methods are prescribed for elimination of double taxation. However, elimination
of double taxation through a foreign tax credit route was fraught with several
issues such as at what rate of exchange credit for taxes are to be computed,
what documents are required to prove payment of overseas taxes, what about
mismatch of taxable years in the country of source and country of residence,
what about increase or decrease in taxes due to assessment in the foreign
country and so on. In order to address all these issues and some more, last
year CBDT had issued a Notification No. S.O.2213(E) dated 27^th June
2016 providing Foreign Tax Credit Rules (FTCR), which came into effect from 1^st
April 2017.
This article besides explaining various methods for elimination of double
taxation, deals with salient features of the FTCR.

1.0    Introduction

          The objective of a DTAA (also known as
“tax treaty”) is to distribute tax revenue between the two Contracting States
(CS). Articles 6 to 22 in a typical tax treaty contain distributive rules to
this effect. The methods for elimination of double taxation have been dealt
with by Article 23 of the UN Model Tax Convention (UNMC) and the OECD MC.
Article 24 provides for provisions of Mutual Agreement Procedure which can be
invoked by the tax payer, if the CS fails to eliminate double taxation or
apply/interpret the treaty provisions not in accordance with its intent and
purpose. 

          Usually, State of Residence (SR) taxes
global income of a tax payer including income from the State of Source (SS).
Therefore, SR will give credit for taxes paid in the SS.

          Double taxation is eliminated in two
ways, namely, Exemption of Income or Credit of taxes paid. Various methods for
elimination of double taxation can be summarised as follows:

          Before we dwell into foreign tax
credit rules, let us glance through the above methods for appreciating
applicability of FTCR in an Indian scenario.

2.0    Exemption Method

2.1     Full Exemption

          In this case, the income taxed in the
SS is fully exempt in the SR.

2.2     Exemption with Progression

          Under this method, SR considers the
income taxed in the SS only for the purpose of determining the effective tax
rate.

          Let us understand the above two
methods with the help of an example.

          Tax slabs and tax incidence in the SR
are as follows:

3.0    Credit Methods

          Under the credit method, SR will tax
income of its resident on a global basis and then grant credit of taxes paid in
the SS.

          In simple words, when any income of
the person is taxed on source basis in one country and on the basis of his
residence in other country, the country of residence shall compute tax on
overall global income of such person and while doing so, it shall grant to such
a person a credit of the taxes already paid by it on the income taxable at
source in such other country.

          There are two types of credit methods,
namely, Unilateral and Bilateral.

3.1
   Unilateral Tax Credit

          Section 91 of the Income tax Act deals
with the unilateral tax credit. Sub-section (1) of the section 91 provides that
“If any person who is resident in India in any previous year proves that, in
respect of his income which accrued or arose during that previous year outside
India (and which is not deemed to accrue or arise in India), he has paid in any
country with which there is no agreement under section 90 for the relief or
avoidance of double taxation, income-tax, by deduction or otherwise,
under the law in force in that country, he shall be entitled to the deduction
from the Indian income-tax payable by him of a sum calculated on such
doubly taxed income at the Indian rate of tax or the rate of tax of the said
country, whichever is the lower, or at the Indian rate of tax if both the rates
are equal”. (Emphasis supplied)

          From the above, it is clear that the
amount of credit in India will be restricted to the lower of the proportionate
tax in India on the foreign sourced income or taxes paid in the source country.

3.1.1 Issues

          A
question arose as to whether a tax payer can avail unilateral credit in respect
of income from a country with which India has signed a limited tax treaty?
India had a limited tax treaty with Kuwait till 2008 which covered only income
from International Air Transport. (With effect from 1^st April 2008,
a new and comprehensive tax treaty with Kuwait has become operative in India).
In case of JCIT vs. Petroleum India International (26 SOT 105), the
Mumbai Tribunal granted benefit of the unilateral tax credit u/s. 91(1) when
only limited DTAA was in operation. Thus, one may conclude that unilateral tax
relief may be available to a tax payer in respect of income which is not
covered by the limited tax treaty.

3.1.2 Some other issues u/s. 91 addressed by the
Judiciary  are tabulated herein below:

3.2    Bilateral Tax Credit Methods

          There are four bilateral tax credit
methods, namely, (i) Full Credit Method, (ii) Ordinary Credit Method, (iii)
Underlying Tax Credit Method and (iv) Tax Sparing. Let us understand each of
them with illustrations.

3.2.1 Full Credit Method

          Under this method, total tax paid by
the person on his income in the country of source is allowed as a credit
against his total tax liability in the country of residence. The credit is
irrespective of his tax liability in the country of residence. Thus, a person
may be able to get proportionately more credit than the incidence of tax on his
foreign sourced income in the country of residence. This is known as full
credit method. India does not allow full credit of foreign tax to its residents
except under India-Namibia DTAA, which grants full credit in India of taxes paid
in Namibia.

3.2.2 Ordinary Credit Method

          The credit available under this method
shall be lower of the proportionate tax payable on the foreign sourced income
in the country of residence or the actual tax paid in country of source. As a
result, in this case, if the tax on the foreign sourced income is higher in the
country of residence than in the country of source, the taxpayer shall be
liable to pay the balance amount. However, if it is the other way round, i.e.
if tax paid in the source country is higher than the residence country, then
excess shall not be refunded. As stated earlier, tax treaties are distribution
of taxing rights and sharing of revenue between two contracting states and
therefore, any excess tax paid in one country is usually not refunded by the
other country. However, some countries do provide for carry forward of such
excess credit. As far as India is concerned, such excess amount is ignored.

          Majority of Indian tax treaties follow
Ordinary Tax Credit Method, which is not detrimental to the interest of the
country of residence of the tax payer and at the same time, it eliminates
double taxation of income.

          Let
us understand both these methods with the help of a Case Study. Facts of the
case are same as described in paragraph 2.2 herein above with the only change
of assumption of 20% rate of tax in the SS. SR is assumed to be India and SS as
Canada.

3.2.3 Underlying Tax Credit Method (UTC)

          Under this method, SR gives credit for
taxes paid on profits out of which dividend is declared by the company located
in the SS. This method attempts to eliminate/reduce economic double taxation as
dividend income is taxed twice, once by way of profits in the hands of the
company and secondly by way of dividends in the hands of the shareholders.

          A few Indian tax treaties which
contain UTC provisions are treaties with Australia, China, Ireland, Japan,
Malaysia, Mauritius, Mexico, Singapore, Spain, the UK, and the USA.

          However, it is interesting to note
that most of UTC provisions in Indian tax treaties are with respect to the
residents of treaty partner country and not Indian residents. Only treaties
with Mauritius and Singapore give benefit of UTC to Indian residents.
India-Singapore DTAA provides for minimum shareholding of 25 per cent in order
to avail UTC benefit. India-Mauritius DTAA provides for minimum shareholding of
10 per cent in order to avail UTC benefit.

          An UTC clause of India-Mauritius DTAA
reads as follows:

          “In the case of a dividend paid by
a company which is a resident of Mauritius to a company which is a resident of
India and which owns at least 10 per cent of the shares of the company paying
the dividend, the credit shall take into account [in addition to any Mauritius
tax for which credit may be allowed under the provisions of sub-paragraph (a)
of this paragraph] the Mauritius tax payable by the company in respect of the
profits out of which such dividend is paid.”

          Illustration of the Underlying Tax
Credit

–   Indian company holds 100% shareholding of a
Singapore Company

–   Profits before tax of the Singapore Company
is Rs. 1,00,000/-

–   Tax rates in Singapore:

     Business Income @ 20%

     Withholding Tax on Dividends 5%

–   Tax rate on foreign dividends in India 30%

–   Assume that 100 per cent of profits are
distributed as dividends

3.2.4 Tax Sparing

          Under this method, credit is given by
the state of residence in respect of deemed tax paid in the state of source.
Many a times, developing countries give many tax based incentives to attract
capital and technology from the developed nations. (For e.g. section 10
exemptions in India). However, income which may be exempt in India if taxed in
the other country, then the tax spared by the Indian government would go to the
other government rather than the company/entity concerned. Therefore, the
concept of tax sparing has come into being. Usually, provisions concerning tax
sparing cover specific sections of the domestic tax laws.

          However, sometimes, a general
reference is made to apply tax sparing provisions in respect of incentives
offered by a country for the promotion of economic development. [E.g.
India-Japan DTAA]  

          To illustrate, section 10(15)(iv)(fa)
of the Act provides that interest payable by a scheduled bank to a non-resident
depositor on a deposit placed in foreign currency is exempt from tax in India.
If an NRI depositor from Japan earns interest income from India, which is
exempt under this section but taxable in Japan, then the Japanese Government
will give a credit of tax which he would have otherwise paid in India, but for
this exemption.

Illustration

4.0    Foreign Tax Credit
Rules

          India by and large, follows ordinary
credit method and therefore, a lot of issues were arising for claiming credit.
There was no guidance as to at what rate taxes paid in the foreign country has
to be converted for claiming credit in India, what documents to be submitted,
what about timing mismatch and so on. In order to address these and other
issues, CBDT notified FTCR on 27^th June 2016 and were made
applicable w.e.f. 1^st April 2017. Let us study these provisions in
detail.

          Income Tax Rule 128 deals with the
provisions of FTC which are summarised as follows:

Note1:Proviso
to sub rule 4 provides that foreign tax credit shall be allowed for the year in
which such income is offered to tax or assessed to tax in India if the assessee
within six months from the end of the month in which the dispute is finally
settled, furnishes evidence of settlement of dispute and an evidence to the
effect that the liability for payment of such foreign tax has been discharged
by him and furnishes an undertaking that no refund in respect of such amount
has directly or indirectly been claimed or shall be claimed.

Note 2:Proviso to sub rule 5 (i) provides that
where the foreign tax paid exceeds the amount of tax payable in accordance with
the provisions of the agreement for relief or avoidance of double taxation,
such excess shall be ignored for the purposes of this clause.

Illustration:

          An Indian company is taxed @ 20% on
royalty income in a foreign country X as per its domestic tax laws. However,
the DTAA between India and country X provides for the tax rate of 10% on such
royalty income, then notwithstanding, actual payment of 20%, the FTC in India
will be restricted to 10% only.

Note 3:Illustration
on conversion of FTC in Indian currency

          Mr. Patel, a resident in India has
received professional fees of USD 10,000/- on 1^st February 2017 from
his UK client. His UK client deducted tax @ 20% (i.e. GBP 2000) under the UK
tax laws and paid the same to the UK government on 7^th February
2017. India-UK DTAA provides the rate on FTS as 10%.

          He also earned capital gains on sale
of shares on London Stock exchange on 15^th March 2017 amounting to
GBP 5000/- on which he paid tax of GBP 500 in UK on 31^st March 2017.

          Consider
following rate of exchange of UK Pound vis-a-vis Indian Rupee:

          Rule 115 of the Act provides for the
mechanism to apply the exchange rate for conversion of foreign income to Indian
rupees.

          In the above case, applying provisions
of Rule 115 and sub-rule 5 of Rule 128, foreign income and FTC in India would
be computed as follows:

          FTC for Fees For Technical Services

          Income 10,000 @ Rs. 81/- = Rs.
8,10,000/-

          [Exchange rate as on the last date of
the previous year i.e. as on 31^st March 2017 as per Rule 115(2)(c)
of the Act]

          Indian income tax @ 30% = Rs. 2,43,000/-

          FTC on 1000 @ Rs. 84/- = Rs. 84,000/-

          [Exchange rate as on the last date of
the previous month i.e. as on 31^st January 2017 as per Rule 128(5)]

[Notes:

(i)       FTC restricted to the tax rate prescribed
in the India-UK DTAA and not the actual payment of GBP 2000;

(ii)      FTC is given at the exchange rate prevalent
on the last date of the preceding month in which the tax has been paid]

          FTC for Capital Gains

          Capital gains of 5000 @ Rs. 82/-    = Rs. 4,10,000/-

          [Exchange rate as on the last date of
the previous month i.e. as on 28^th February 2017 as per Rule 115(f)]

          Indian Income tax @ 20%              (assumed)                                =
Rs. 88,000/-

          FTC on 500 @ Rs. 82/-                                                     =
Rs. 41,000/-

          [Exchange rate as on the last date of
the previous month i.e. as on 28^th February 2017 as per Rule 128(5)]

5.0    Summation