Issues in Claiming Foreign Tax Credit in India

1. Background on BEPS

Two
methods of granting foreign tax credits are in vogue, namely, (i) Full
Credit and (ii) Ordinary Credit. Indian tax treaties generally follow
the Ordinary Credit Method. Similarly, section 91 of the Income-tax Act,
1961 (“Act”) also prescribes ordinary tax credit method. Two methods of
tax credit are explained in brief herein below:

(i) Full Credit Method

Under
this method, total tax paid in the country of source is allowed as
credit against the tax payable in the country of residence.

(ii) Ordinary Credit Method

Taxes
paid in the country of source are allowed as credit by the country of
residence only to the extent of the incremental tax liability due to
inclusion of such income. If taxes paid in country of source are higher,
the tax payer would not get the refund of such taxes. However, if the
taxes paid in the country of source are lower than the incremental tax
liability in the country of residence then the tax payer need to pay the
balance amount of taxes.

Example:
A Ltd (Indian company)
has the following income:- Income from India – Rs. 200,000/- [Tax rate –
30%] Income from foreign country – Rs. 50,000/- [Tax rate – 40%]

Total Income Taxable (India) – Rs. 2,50,000/-

Besides
the above two methods, Indian tax treaties provide two more types of
tax credit methods, namely, (i) Tax Sparing and (ii) Underlying Tax
Credit. The same are explained as follows:

(i) Tax Sparing

State of residence allows credit for deemed tax paid on income which is otherwise exempt from tax in the state of source.

(ii) Underlying Tax Credit

This
is a method which helps in eliminating economic double taxation
(example: – Dividend income). Under this method, the country of
residence grants credit not only for taxes paid which are withheld from
dividend income but also for the taxes paid on the profits out of which
such dividend has been paid. The examples of Indian tax treaties which
allow underlying tax credit are: Australia, Mauritius, Singapore, USA
and UK. Now let us discuss some practical issues that may arise in
claiming foreign tax credit in India. For the sake of simplicity and
understanding, let us examine issues of claiming foreign tax credit
faced in various situations by an Indian Resident, namely, Mr. Darshan
Dholakia (an imaginary name for understanding various illustrations).

2. Timing issues on account of different tax years

2.1 It is a known fact that different countries follow different tax years and rules for
(i) Levy
(ii) Computation and
(iii) Collection of Tax

Therefore,
it becomes a challenging task for the taxpayer to claim the credit of
foreign taxes paid in his country of residence at the time of
discharging his tax liability in a cross border transaction where the
incidence of tax is in two States i.e. Country of Source and Country of
Residence.

2.1.1 Illustrations

a. India follows Financial Year (FY) from 1st April – 31st March as the tax year;
b. USA follows Calendar Year (i.e. 1st January – 31st December) as the tax year;

2.1. 2 Income from Salaries

Let
us consider a situation where Mr. Darshan Dholakia, an Indian resident
goes to US for employment on 31st December 2014. This is his first visit
abroad in his lifetime. Therefore, for the FY 2014-15 he remains
Resident and Ordinary Resident in India. He is required to pay taxes in
India on his worldwide income for the FY 2014-15 i.e. including his
salaries in US for the period from 1st January 2015 to 31st March 2015.
In US he would be taxed on a Calendar Year basis, i.e. CY 2015. Under
the circumstances, how does he compute his tax liability in India and US
and claim credit in India in respect of taxes paid in US, especially
for the overlapping period (from 1st January 2015 to 31st March 2015)
which falls in two different tax years in two jurisdictions?

2.1.3
In the above illustration, Mr. Darshan needs to include his income from
US for the period from 1st January 2015 to 31st March 2015 in his
Indian tax return for the FY 2014-15. He can claim the credit of
proportionate taxes paid to US Govt. (by way of deduction or otherwise)
on such income by producing necessary evidences to this effect.

2.1.4
At a later date, if there is any voluntary upward / downward revision
in computation of the taxable income of Mr. Darshan in US, then he shall
revise his Income-tax return in India u/s. 139(5). His claim for credit
of US taxes shall alter accordingly.

Further, if the assessment
of his income in India has been completed, then Mr. Darshan may not be
able to file the revised return of income in India and in such cases, he
shall inform the Income-tax department in writing and the AO shall
modify his tax liability.

2.1.5 Business Income

What
if Mr. Darshan is earning business income from his proprietary concern
in US which is taxable in India as he is a Resident and Ordinary
Resident of India? In such a situation how his US income which is
ascertained on a Calendar Year basis, will be considered for tax in
India where income is assessed based on the Financial Year?

a.
Whether Mr. Darshan needs to compute profits of his US business for the
period from January 2015 to March 2015 while filing his return for the
FY 2014-15? OR

b. Can he include US profits for the CY 2015 in FY 2015 -16?

In
situation (a) above, it is assumed that profits of the business accrue
on a day to day basis and therefore there is a need to compute US
Profits separately for the overlapping period. Even if it is assumed
that profits of the business accrue only at the year end, upon drawing
of profit and loss account, one is confronted with provisions of section
44AB which requires one to get one’s accounts audited if the turnover
or gross receipts from all businesses put together exceeds Rs. one crore
in a previous year. The Previous year is defined u/s. 3 of the Act as
the Financial Year i.e. from April to March. So applying this
interpretation Mr. Darshan has no choice but to maintain accounts of his
US business from April to March for the purpose of complying with
Indian tax regulations.

In the above scenario, many practical
difficulties could arise as to claiming of tax credit. It may so happen
that tax may be paid for the US business post 31st March 2015. If it is
so, how can Mr. Darshan claim credit as the provisions of India-US DTAA
provides for credit of “taxes paid” and not “payable”. Even assuming
taxes are paid whether Mr. Darshan needs to apportion the same based on
profits ascertained for the period from 15th January to 15th March? What
if he has incurred losses in the period from 15th April to 15th
December? There are no clear answers to these issues. Therefore, one may
consider following alternative interpretation (which covers situation
(b) above).

In the above scenario, many practical difficulties could arise as to claiming of tax credit. It may so happen that tax may be paid for the US business post 31st March 2015. If it is so, how can Mr. Darshan claim credit as the provisions of India-US DTAA provides for credit of “taxes paid” and not “payable”. Even assuming taxes are paid whether Mr. Darshan needs to apportion the same based on profits ascertained for the period from 15th January to 15th March? What if he has incurred losses in the period from 15th April to 15th December? There are no clear answers to these issues. Therefore, one may consider following alternative interpretation (which covers situation (b) above).

Profits or losses are determined only at the year-end or when accounts are made up as per statutory requirements. There is no doubt that profit or loss is embedded in every transaction, but its actual determination is done only when accounts are drawn up for a particular period as business exigencies depends on so many factors, such as season, demand and supply etc. and these factors are best captured over a period of time. This view has been supported by the Apex Court in case of Ashokbhai Chimanbhai [(1965) AIR 1343] wherein it was held as follows:

“In the gross receipts of a business day after day or from transaction to transaction lie embedded or dormant profit or loss. On such dormant profits or loss, undoubtedly, taxable profits, if any, of the business will be computed. But dormant profits cannot be equated with accrued profits charged to tax u/s. 3 and 4 of the Income-tax Act, 1922. The concept of accrual of profits of a business involves the determination by the method of accounting at the end of the accounting year or any shorter period determined by law; and unless a right to the profits comes into existence, there is no accrual of profits.”

One more principle propounded by the above ruling is “right to receive” profits, which gets crystallised only on determination of profits or losses in accordance with provisions of law. All though the above ruling is in the context of 1922 Act, principles laid down can be applied to the provisions of the Income-tax Act, 1961 as well.

Applying the above ruling Mr. Darshan may offer in India the profits/losses earned in US business for the CY 2015 along with profits/losses of FY 2015-16 as the CY 2015 falls within FY 2015-16. This has to be done on a consistent basis. Similarly, he has to club the turnover of the US Business for CY 2015 with the turnover of Indian Business for 2015-16. Here he can argue that for the purpose section 44AB the previous year for the US Business is Calendar Year and therefore, he has considered the turnover of CY 2015 for the AY 2016-17.

It is pertinent to note that the above discussion would also be applicable in case of an Indian enterprise having a branch office in USA.

3.    Tax credit in case of deductions under special provisions

Consider a situation where Mr. Darshan Dholakia, an Indian Tax Resident, has earned foreign sourced income which in India is entitled to deductions say 50% or enjoying tax holidays on account of some provisions of the Act, (for example Exemptions u/s. 10AA to a Unit in SEZs from Exports Profits). A question may arise in relation to the admissibility of foreign taxes paid outside India on the whole of such income as credit against the income-tax liability in India?

In such cases, it has been held by the undernoted Courts that proportionate credit must be granted:-

a. The Rajasthan High Court [1994] 209 ITR 394 (RAJ.) at the time of reversing the decision of the Tribunal in the case of Dr. K. L. Parikh vs. ITO, 1982 (14 TTJ 117), held that the Tribunal was not justified in holding that the assessee was entitled to credit for the entire amount of tax deducted at source in Iran u/s. 91(1) of the Act and not in proportion to the income included in the total income of the assessee after considering the provisions of section 80RRA of the Act and relief was granted proportionately up to 50% of FTC.

b.    A similar view was upheld by the Andhra Pradesh

High Court in the case of CIT vs.. M.A. Mois (1994) 210 ITR 284.

4.    Exchange rate implications while determining income and the tax liability thereon
4.1  Rule 115 of the Income-tax Rules, 1962 provides that “The rate of exchange for the calculation of the value in rupees of any income accruing or arising or deemed to accrue or arise to the assessee in foreign currency or received or deemed to be received by him or on his behalf in foreign currency shall be the telegraphic transfer buying rate of such currency as on the specified date.”

4.2 Clause 2 of Explanation to Rule 115(1) provides that specified date means-

5.2 In a case where Mr. Darshan Dholakia is carrying on business in more than one country and he has suffered loss from a business outside India say in UK and has profit in Hong Kong, a question may arise as to how shall the relief be granted in order to discharge his tax liability in India.

5.3 In the context of section 91 of the Act (which deals with Unilateral Tax relief where India has no tax treaty), in the case of Bombay Burmah Trading – 259 ITR 423, the Bombay High Court has held as under:

“If one analyses S. 91(1) with the Explanation, it is clear that the scheme of the said section deals with granting of relief calculated on the income country wise and not on the basis of aggregation or amalgamation of income from all foreign countries. Basically u/s. 91(1), the expression ‘such doubly taxed income’ indicates that the phrase has reference to the tax which the foreign income bears when it is again subjected to tax by its inclusion in the computation of income under the Income-tax Act. Further S. 91(1) shows that in the case of double income-tax relief to the resident, the relief is allowed at the Indian rate of tax or at the rate of tax of the other country whichever is less. Therefore, the relief u/s.91 (1) is by way of reduction of tax by deducting the tax paid abroad on such doubly taxed income from tax payable in India. Under the circumstances, the scheme is clear. The relief can be worked out only if it is implemented country wise. If incomes from foreign countries were to be aggregated, it would be impossible to compare the rate of tax of the foreign country with the rate under the Indian Income-tax Act.”

5.4 Similarly, in cases where DTAA exists between India and the country of source, the said DTAAs being bilateral in nature, one may infer that tax relief shall be computed country wise and not after aggregating the foreign sourced income.
Thus, in the given example, Mr. Darshan will be able to claim relief of taxes paid in Hong Kong u/s. 91 of the Act, whereas the loss from UK will be available for set-off in India, provided his income from UK is otherwise taxable in India. In any case for his income/ loss from UK, provisions of the India-UK DTAA shall apply.

6    Claiming credit for tax paid in a country outside India with whom DTAA exists but the type of taxes paid are not covered

6.1 In this context, we have a direct decision in the case of TATA Sons Ltd. – 43 SOT 27, wherein, the assessee had paid State Income Taxes in USA and Canada. However, the India-USA and India-Canada DTAA covers only the Federal taxes paid and the assessee had sought to claim relief u/s. 91 of the Act in respect of the State Income taxes paid outside India.

6.1 The issue before the Tribunal was whether the assessee would be eligible for claiming credit u/s. 91 in light of provisions of section 90(2) of the Act?

6.2 It was held by the Hon. Tribunal that “State Income Taxes cannot be allowed as a deduction and also cannot be taken into account for giving credit is absurd and results in a contradiction. A tax payment which is not treated as admissible expenditure on the ground that it is payment of Income-tax has to be treated as eligible for tax credit. While section 91 of Act allows credit for Federal and State taxes, the DTAA allows credit only for Federal taxes. The result is that section 91 is more beneficial to the assessee and by virtue of section 90(2) of Act, provisions of section 91 must prevail over the DTAA even though this is a case where India has entered into a DTAA. Accordingly, even an assessee covered by the scope of the DTAA will be eligible for credit of State taxes u/s. 91 of Act despite the DTAA not providing for the same.”

6.3 It may be noted that the above case refers to the payment of State Income tax in the US and Canada. Assessee first claimed these taxes as expenditure u/s. 37(1) of the Act on the ground that the respective DTAA covers only Federal (Central) Taxes. This claim of the Assessee was rejected by the Tribunal vide its order dated 24th November 2010. However, the Assessee sought further clarifications and in a fresh order dated 23rd February 2011, the Hon. Tribunal held that the Assessee was eligible to claim credit for State Income tax paid in US and Canada u/s. 91 of the Act read with section 90(2), notwithstanding existence of DTAA with both these countries.

7    Claim for refund of tax in a case where more tax is paid in a foreign country compared to the tax payable in India on the same income

7.1 The answer to the above issue can be better explained with the help of an example.

A Ltd. (Domestic Company) – Foreign taxes paid:- INR 150/– Income-tax payable:- INR 100/– Credit allowed:- INR 100/-

–    Excess credit:- INR 50/- (150-100)

7.2 A question may arise as to whether the tax payer is eligible for a refund (if available) or he would be allowed to claim the excess tax paid as credit which may be carried forward and may be set off against the liability of the subsequent year?

No refund is allowed in respect of excess foreign taxes paid to any tax payer in India for the obvious reason that such tax is paid to the foreign government. In absence of any rules or provision allowing carry forward of unavailed/excess tax credit, the same cannot be carry forward to the next year. However, some countries do allow carry forward of excess tax credits. Canada, Japan, Singapore, UK and USA do allow carry forward of excess foreign tax credit for the period ranging from three years to an indefinite time period.

8    How shall tax relief be computed and granted in the case of a person being

i.    A Company whose tax liability is determined under the Minimum Alternate Tax (MAT) provisions?

ii.    A person other than a company whose tax liability is determined under the Alternate Minimum Tax (AMT) provisions?
Under the provisions of the Act, a company is subjected to tax either as per normal provisions of the Act or MAT whichever is higher. Similarly tax payers other than the company, are taxed as per normal provisions of the Act or AMT whichever is higher.

8.2 Therefore a question arises whether a tax payer who is subjected to tax in India either under MAT or AMT would be eligible to claim credit of foreign taxes paid on the same income?

8.3  Bombay High Court in the case of Bombay

Burmah Trading Corporation Limited (2003) 259 ITR 423 held that “basically u/s. 91(1), the expression ‘such doubly taxed income’ indicates that the phrase has reference to the tax which foreign income bears when it is again subjected to tax by its inclusion in the computation of income under the Indian Income-tax Act, 1961”.

8.4 In the light of the above decision, it would appear that wherever MAT or AMT is applicable to foreign income, it would amount to double taxation and the tax payer would be eligible to claim applicable tax credits in respect of foreign taxes paid abroad on the same income.

9    Can the taxes (based on turnover) paid to foreign government be allowed as deduction computing the total income of the assessee?

In this matter, there is a direct decision of the Bombay High Court in the case of K.E.C International Ltd (2000) 256 ITR 354 wherein the tax payer paid turnover tax in Thailand. Income-tax ideally should mean a tax which is levied on income, something which is directly linked to income of the tax payers and not indirect taxes such as Service tax, VAT or Sales Tax or Turnover Tax etc. Since the tax paid was indirect in nature and not Income-tax, it was held to be allowable as a business deduction. The Court held that in such a case, provisions of section 40(a)(ii) of the Act cannot be invoked for disallowance.

10    What if there is additional tax required to be paid on assessment in Foreign Countries? Will the same automatically increase income in India?

If the tax payer challenges various additions to his returned income in the foreign country at some higher forum, then there will not be any tax implications in India. However, if the tax payer does not challenge the additions made in the foreign country, then he is under obligation to revise his return of income in India. If the return is time barred, then necessary recourse provided under the Act will be applicable.

11    Difference in Characterisation of Income

It may be possible that business profits are offered for tax as fees for technical services (FTS) in India (say Country of Source) whereas, the Country of Residence (say, Singapore) thinks that the tax is wrongly paid as FTS and in absence of PE there was no tax liability in India. In such a scenario, Singapore may deny the tax credit and the tax payer may have to resort to Mutual Agreement Procedure.

12    Conclusion

Section 91 of the Act provides for unilateral tax relief. India has signed more than 80 comprehensive Double Tax Avoidance Agreements which also provide for tax credits. By and large Indian tax treaties provide for Ordinary Tax Credits. Prominent issues in claiming foreign tax credits are timing difference, evidences of payment and the rate of exchange for conversion of income and taxes in Indian currency.

Tax payers must remember that any income received from a foreign jurisdiction has to be computed under the Indian tax laws, by applying provisions of the Act. Rules of computation may differ in two different jurisdictions. Therefore, the credit of foreign taxes paid is always restricted to the additional tax liability in India on account of inclusion of foreign income.

The Finance Act, 2015 has amended section 295 and inserted clause (ha) to empower the CBDT to make Rules for the procedure for the granting of relief or deductions of foreign taxes against the income-tax payable in India. Many issues may get resolved once these Rules are notified by the CBDT.