Foreign tax credit A Practical insight - CA Vishal Palwe 13 October 2012 1
Meaning of International Double Taxation Juridical double taxation Imposition of income taxes by two or more states on the same taxpayer in respect of the same income e.g. taxation of royalty payments by source country as well as residence country Economic double taxation Imposition of income taxes on the same income in the hands of two or more tax payers e.g. transfer pricing cases OECD and UN Model seek to resolve juridical double taxation
Types of Foreign Tax Relief Unilateral tax relief Exemption method Credit method Underlying tax credit method Deduction method Tax sparing
Unilateral Tax Relief Provision in the domestic tax law for exemption of foreign source income or credit for foreign taxes paid Section 91 of the Income-tax Act deals with avoidance of double taxation in respect of income earned in countries with which India does not have a tax treaty Section 91 employs credit method for granting unilateral tax relief
Exemption Method Residents of residence country are exempt from taxes on foreign sourced income In effect, source country has exclusive rights to tax such foreign sourced income Completely eliminates double taxation Residence Income = 100,000 Taxpayer Residence Few countries adopt exemption method e.g. Hong Kong Some countries have adopted exemption method in case of specific class of income e.g. business income and dividend income from affiliates Exemption method encourages residents to invest overseas e.g. taxpayer residing in an exemption country earning interest on funds in that country has a strong incentive to move the funds to a foreign country that imposes a low or no taxes on interest income India Income = 75,000 of income Under exemption method, Residence would exempt India Income of 75,000
Exemption with Progression Method Residents of residence country are exempt from taxes on foreign sourced income; however, foreign sourced income is taken into account by residence country for arriving at the applicable slab tax rate. Residence Income = 100,000 Taxpayer For instance, tax rate applicable in Residence is 20% if income does not exceed 100,000 else 30%. Residence India sourced income would be exempt in Residence but would be considered for arriving at the applicable tax rate Tax rate applicable to taxpayer in Residence would be 30% India Income = 75,000 of income Income of 100,000 would be taxable at 30% Under exemption with progression method, Residence would consider India Income of 75,000 for determining slab tax rate but not tax India Income of 75,000
Credit Method Foreign taxes paid would be available as credit against the domestic taxes payable on the same foreign sourced income by a resident of Residence Tax Payable = 40,000 30,000 = 10,000 Taxpayer Residence adopting credit method do not pay tax refunds when the foreign taxes paid is higher than the domestic tax payable Tax rate of Residence at 40% Residence Effectively, credit of foreign taxes paid would be restricted to the amount of domestic tax payable on foreign source income Whether foreign tax credit is to be calculated on source by source basis Whether foreign tax credit is to be calculated on country by country basis Tax rate of Residence at 30% Tax on India Income = 30,000 (100,000 *30%) of income Under credit method, Resident would allow credit of foreign taxes paid against domestic tax payable on foreign sourced income
Tax Sparing Tax sparing credit is a credit granted by the Residence for foreign taxes that for some reason were not actually pad to the but that would have been paid under the country s normal tax rules may provide for tax holidays for promoting foreign investment Tax Payable = 40,000 30,000 = 10,000 Tax rate of Residence at 40% Taxpayer Residence In the absence of tax sparing, the actual beneficiary of a tax incentive provided by a to attract foreign investment may be the residence country rather than the foreign investor OECD published report Tax Sparing: A Reconsideration Tax holiday available in India Exempt Income (due to tax holiday) in India = 100,000 of income Under tax sparing method, Resident allows credit for foreign taxes that were not paid due to tax holiday
Underlying Tax Credit Foreign taxes paid on business profits of subsidiary is credited against the domestic taxes payable For instance, Indian company distributes dividends to its foreign parent company Withholding tax on dividend paid in India would be allowed as tax credit against the domestic tax payable on dividend in the Residence County of foreign parent company Corporate income-tax paid in India on profits out of which dividend has been paid would also be allowed as tax credit against the domestic tax payable on dividend in the Residence of foreign parent company
Doubly taxed income Same income taxed by two or more countries It is only that portion of the income on which tax has been imposed and has been paid by the taxpayer that is eligible for the double taxation relief Madras High Court in the case of CIT v. O..VR.SV.VR. Arunachalam Chettiar For instance, a certain amount of foreign sourced income has suffered tax in the foreign country but if the actual foreign sourced income taxed in Residence is after allowances and set off of losses then the entire foreign sourced income is not doubly taxed. Only that portion of foreign sourced income which has suffered tax in foreign country and also Residence would be considered as such doubly taxed income. Hence, relief would be available only for double taxed income.
Importance of in accordance with the provisions of this Convention States may interpret a provision of a tax treaty differently, such as a particular State may interpret Article 12 (Royalty and fees for technical services) of its tax treaties differently from the interpretation taken by other State. In such circumstances, the State which is required to grant foreign tax relief may consider that the tax has been applied by other State by wrong interpretation/ /application of the provisions of the Convention or tax treaty thus resulting in the denial of treaty benefits to the taxpayer. Thus, the State which is required to grant foreign tax relief may not allow any relief in respect of taxes paid in the other State because taxes were not due in the country at all in accordance with the provisions of the tax treaty as interpreted by the former. However, such conflicts may be resolved through mutual agreement procedures.
India UK Tax Treaty India UK tax treaty follows credit method Indian taxes paid by UK residents would be allowed as credit against UK tax on profits, income or chargeable gains India UK tax treaty also allows for underlying tax credit If UK resident owns 10% or more stock with voting rights in an Indian company, then income-tax paid by the Indian resident com mpany on profits earned out of which dividends are paid to the UK resident company would be available as credit against tax payable on dividends that are paid to the UK company India UK tax treaty provides for tax sparing credit
India US Tax Treaty Article 25(1) In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income (a) the income-tax paid to India by or on behalf of such citizen or resident ; and (b) in the case of a United States company owning at least 10 per cent of the voting stock of a company which is a resident of India and from which the United States company receives dividends, the income-tax paid to India by or on behalf of the distributing company with respect to the profits out of which the dividends are paid. For the purposes of this paragraph, the taxes referred to in paragraphs 1(b) and 2 of Article 2 (Taxes Covered) shall be considered as income taxes.
India Singapore Tax Treaty India Singapore tax treaty follows credit method Indian taxes paid by Singapore residents would be allowed as credit against Singapore tax on profits, income or chargeable gains India Singapore tax treaty also allows for underlying tax credit If Singapore resident holds 25% or more of the share capital of a company receives dividend from that Indian company, the Ind dian taxes paid by Indian company in respect of profits from which dividend is declared, would be allowed as credit against the taxes payable in Singapore on that dividend India Singapore tax treaty provides for tax sparing credit
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