Foreign Tax Credit June 2016
Table of content 1 Introduction 2 Types of Relief 3 Exemption Method 4 Credit Method 5 Double non-taxation 6 Excess FTC 7 Documentation 8 Cases where FTC not available 9 Case Studies 10 Draft FTC Rules 2016 B S R & Co. LLP, an LLP of Chartered Accountants, duly registered under the Limited Liability Partnership Act, 2008. All rights reserved. 2
Introduction
What is Foreign Tax Credit? Foreign tax credit ( FTC ) - Method for elimination of double taxation. Credit for the taxes paid in the source country against the taxes to be discharged in the residence country. Income tax systems that tax residents on worldwide income generally offer FTC to mitigate the potential for double taxation of income. For a tax payer to be eligible for FTC, the tax payer must have made a payment to a foreign government, and the payment must be towards an income tax, or a tax in lieu of an income tax. 4
Concept of Double Taxation Jurisdictional double taxation - One and the same person is taxed on the same income in more than one state. This may happen for one of the following reasons: Residence in one state and source in another state Triangular taxation Economic Double taxation - Two separate persons are taxed on the same income in more than one state Foreign income taxed in the hand of overseas company distributing dividend and dividend taxed in the hands of shareholder Taxation in source country in the hands of a partnership entity whereas in the residence county, partners of such partnership are taxable 5
Elimination of Double Taxation Countries often provide their residents with relief from double taxation through their domestic tax laws Chapter IX of the Income-tax Act, 1961 ( the Act ) Double Taxation Avoidance Agreements ( DTAAs ) also contain articles for the elimination of double taxation Relief via DTAAs may be more generous than the domestic tax laws Relief entrenched in the DTAA also restricts a country s ability to amend unilaterally the double tax relief provisions in its domestic law to the detriment of tax payers Residence State to provide the relief Residence as per Article 4 Allocation of Right to Tax Renunciation of right to tax by either state (Dependant services) Sharing of rights (Resident state will provide Relief) 6
Types of Relief
Types of Relief Types of Relief Under section 91 of the Act Under section 90 of the Act Applicable where DTAA does not exist Applicable where DTAA exist Unilateral Relief When the domestic tax system of a state provides relief for double taxation irrespective of whether the other state s tax system provides corresponding relief or not Bilateral Relief Two states negotiate an agreement for providing double taxation relief, such relief is provided through a DTAA 8
Unilateral Relief - Illustration Particulars Case I Case II Assumptions INR INR Income In India 150,000 150,000 Income in foreign country 100,000 100,000 Global Income 250,000 250,000 Tax rate in India 30% 30% Tax in foreign country 25% 35% Workings Income tax on global income (A) 75,000 75,000 Income tax on foreign income (B) 30,000 30,000 Foreign tax on foreign income (C) 25,000 35,000 Unilateral tax relief as per the Act - Lower (B) or (c) (D) 25,000 30,000 Tax Payable in India (A)-(D) (E) 50,000 45,000 Total tax outflow (C) + (E) 75,000 80,000 Effective global tax rate 30% 32% 9
Bilateral Relief - Methods Methods Exemption Credit Full Exemption Exemption with progression Full credit Ordinary credit Tax Sparing Underlying tax credit 10
Exemption Method
Exemption Method Under this method, the residence country exempts the income arising in the source country Income would be chargeable to tax only in the source country Generally preferred in DTAAs between a developed country and developing country, as the developed country would generally be exporting capital and technology to developing country Two variants Full exemption - The residence country fully exempts the income earned by its resident in the source country. Accordingly the capital / technology exporter would not be required to pay tax on such income which would make it attractive for the exporter to export capital/ technology to the source country (e.g. Article XVII of India Greece DTAA) Exemption with progression - The residence country exempts the source country income but the exempt income is considered for determining the tax on the non-exempt income (eg Article 23 of India Austria DTAA) Exemption method - concerns Reduces the tax share of resident state Encourages use of low-tax countries as source state May result in Double non-taxation (explained later) where source country exempts such income 12
Exemption Method Particulars Full exemption Exemption with progression Assumptions INR INR Income In State R (Residence country) 60,000 60,000 Income In State S (Source country) 40,000 40,000 Aggregate taxable income in State R 100,000 100,000 Rate of tax in State R - for income up to Rs 80,000 - for income exceeding Rs 80,000 (on entire income) 25% 35% Tax rate in State S 20% 20% Workings Tax rate in State R 60,000*25% = 15,000 60,000*35% = 21,000^ Tax payable in State S 40,000*20% = 8,000 40,000*20% = 8,000 Aggregate tax 23,000 29,000 25% 35% Tax on aggregate income 23% 29% ^The exempt income has been included for the purpose of ascertaining the applicable rate of tax (i.e. 60,000 + 40,000 = 100,000). Hence, the applicable tax rate will be 35% 13
Credit Method
Credit Method Under this method, the residence country exempts the taxes paid in the source country For the residence country, the loss of revenue is generally lower in credit method, therefore generally most DTAAs relieve double taxation only through credit method Four variants Full credit - Resident state grants credit for the taxes paid in the Source State without any restriction Ordinary credit - Tax credit is restricted to lower of the taxes to be paid in the Resident state or the actual taxes discharged in the Source state Tax sparing - Income exempt in the Source state. However such income is taxable in the Resident state for which the resident state provides for deemed tax exemption or deemed tax credit Underlying tax credit - Mechanism to eliminate a form of economic double taxation 15
Full Credit Under this method, the residence country exempts the taxes paid in the source country OECD Model Convention Article 23 of India - Namibia DTAA Particulars Case I Case II Assumptions INR INR Income In State R 80,000 80,000 Income In State S 20,000 20,000 Aggregate taxable income in State R 100,000 100,000 Tax rate in State R 35% 35% Tax rate in State S 20% 40% Workings Tax payable in State R (A) 35,000 35,000 Tax payable in State S (B) 4,000 8,000 Total tax credit (credit for full taxes paid) (C) = (B) (C) 4,000 8,000 Total tax after relief (A) (C) (D) 31,000 27,000 16
Ordinary Credit Under this method, tax credit is restricted to lower of The taxes to be paid in the Resident state; or The actual taxes discharged in the Source state Article 25 of India USA DTAA Particulars Case I Case II Assumptions INR INR Income in State R 80,000 80,000 Income in State S 20,000 20,000 Aggregate taxable income in State R 100,000 100,000 Tax rate in State R 35% 35% Tax rate in State S 20% 40% Workings Tax payable in State R (A) 35,000 35,000 Tax payable in State S (B) 4,000 8,000 Taxes in Resident state on income from Source state (20,000*35%) (C) 7,000 7,000 Total tax credit - Lower of (B) & (C) (D) 4,000 7,000 Total Tax after relief (A)-(D) (E) 31,000 28,000 17
Tax Sparing Income is taxable in the Resident state but it provides for deemed tax exemption or deemed tax credit of taxes so exempted by the Source state Domestic tax laws of countries generally do not provide for tax sparing credit Article 25 of India Singapore DTAA Generally attached to income like dividend, interest, royalties, foreign branch / permanent establishment income However, concept of tax sparing credit leads to double non-taxation (explained later) 18
Tax Sparing Tax Sparing Credit - Illustration Particulars Tax sparing Absent Tax sparing Present Assumptions Amount in INR Amount in INR Income in State R 80,000 80,000 Income in State S 20,000 20,000 Aggregate taxable income in State R 100,000 100,000 Tax rate in State R 35% 35% Tax rate in State S (exempted 30%) - normal rate - special rate Workings Tax payable in State R (A) 35,000 35,000 Tax payable in State S (B) - - Tax credit (tax charged in State S) (C) - - Tax credit (tax exempted in State S) (20,000*30%) (D) - 6,000 Total tax credit (C) + (D) (E) - 6,000 Total tax after relief (A) (E) (E) 35,000 29,000 30% 0% 30% 0% 19
Underlying Tax Credit A mechanism to eliminate a form of economic double taxation Attached to dividend income; available only to a company Credit is granted by Resident state not only for the taxes withheld on dividends but also for the corporate taxes paid on the underlying profits out of which dividends has been paid Intended to mitigate the double taxation of corporate profits, which are taxed firstly in the hands of the company and secondly in the hands of the shareholders (on the dividends paid by the company) Requirement of substantial shareholding Illustratively the following Tax treaties provide for underlying tax credit Article 24 of India - UK DTAA Article 25 of India - Singapore DTAA 20
Underlying Tax Credit Illustration Particulars Amount in INR Taxation of Indian Subsidiary Co of UK Holding Co In India Profit of Subsidiary Co in source state (India) 100,000 Taxes (30%) (30,000) Profit after tax 70,000 Dividend distributed 50,000 Dividend paid to UK Holding Co (70% holding) 35,000 Dividend Distribution Tax on above (15%) (A) (5,250) Taxation of UK Holding Co in UK Profit of UK Holding Co in UK 200,000 Dividend income 35,000 Taxable income 235,000 Tax Rate (40%) (B) 94,000 Underlying Tax Credit [35,000 * 30,000 / 70,000] (C) (15,000) Total Tax Credit (A) + (C) (D) 20,250 Total Tax after Relief 73,750 21
Double non-taxation
Double non-taxation Double non-taxation is a situation where on account of benefits available under DTAA, a tax payer is not liable to tax in both the Resident state as well as Source state Capital Gains taxability under the India Mauritius tax treaty is a classic example of the same Mauritius India Sale of shares of Indian Co Company X (Mauritius resident) Shares held Capital Gains exempt in Mauritius as per Mauritius tax laws Mr X Indian Co Capital Gains exempt in India for a Mauritius resident as per DTAA between India and Mauritius 23
Double non-taxation As visible from the diagram, the above arrangement discharges Company X from tax liability from both the Resident state (Mauritius) as well as Source state (India) Some companies take undue advantage of the above arrangement by merely incorporating subsidiaries in low-tax jurisdictions and by shifting the profits through legal planning into these subsidiaries 24
Excess FTC
Excess FTC The amount of FTC that can be claimed in India is the lower of: The amount of foreign income tax paid; or The amount of income tax chargeable on that foreign source income in India A taxpayer will not be able to claim full FTC in India if the amount of income tax paid in the foreign country is higher than the amount of income tax payable in India on that foreign source income The DTAA s entered by Government of India do not permit carry forward of excess FTC. 26
Excess FTC Following countries allow carry forward of excess foreign tax paid: Country FTC carry forward (No of years) Carry-back (No of years) Reference Canada 10 3 Section 126(2)(a) of the Canada Income Tax Act Japan 3 3 Code No 12007 of National Tax Agency Singapore No limit - Section 50 of the Singapore Income Tax Act UK No limit 3 Sections 72 to 74 of the Taxation (International and Other Provisions) Act 2010 USA 10 1 IRC Section 904 (c) 27
Documentation
Documentation required for FTC Overseas Tax withholding certificates evidencing payment of taxes in foreign jurisdiction External third party confirmation Overseas Tax Returns, if any Certificate from Foreign Tax authorities, where possible 29
Cases where FTC is not available
Cases where FTC not available Not furnishing of Permanent Account Number ( PAN ) In case a foreign resident does not furnish a PAN; any payment made to him shall be subject to withholding tax at the higher of the following rates: at the rate specified in the relevant provision of the Act; or at the rate or rates in force; or at the rate of twenty percent If a foreign resident for the reasons mentioned above is subject to withholding tax at a higher rate than tax rate provided under the DTAA, availing FTC will be difficult on the additional amount withheld on account of non furnishing of PAN; which is penal in nature 31
Cases where FTC not available Foreign Account Tax Compliance Act ( FATCA ) - US If an Indian resident earning interest income from USA (source country) does not comply with FATCA reporting requirements, than he may be liable to an additional withholding tax of 30% on the interest income so earned However, availing FTC will be difficult on the taxes withheld on this account as it is not covered under the definition of Taxes covered under the DTAA and are merely penal in nature 32
Case Studies
Case Study 1 Facts Company A pays Federal and State taxes in the USA Taxes covered as per Article 2 of India USA DTAA in the USA include federal income taxes imposed by the Internal Revenue Code Deduction of foreign taxes disallowed under Section 40(a)(ii) of the Act as any any taxes paid covered any sum paid on account of any rate or tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains shall not be deducted from Business income Credit for only Federal income taxes paid is allowed as per India USA DTAA Question Would Company A be eligible to claim credit of the State taxes under Section 91 in light of Section 90(2) of the Act? 34
Case Study 1 Held In the case of Tata Sons Limited v DCIT (43 SOT 27), it has been held that the view that State taxes cannot be allowed as a deduction and also cannot be taken into account for giving credit is incongruous 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 the Act allows credit for Federal and State taxes, the DTAA allows credit only for Federal taxes. The result is that the Section 91 is more beneficial to the assessee and by virtue of Section 90(2) of the 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 under Section 91 of the Act despite the DTAA not providing for the same 35
Case Study 2 Facts Company A has operations in India, Country A and Country B Income details of the branches in Country A and Country B are as follows Branch Income/ (Loss) (INR) Country A 1,000 Country B (300) Total (post set-off) 700 Question For the purposes of relief under Section 91(1), whether income of Rs 1,000 or Rs 700 to be considered? 36
Case Study 2 Held In the case of CIT v Bombay Burmah Trading Corporation (259 ITR 423), Bombay High Court held that Section 91 read with explanation of rate of tax of the said country, it is evident that the section deals with granting relief calculated on income country-wise and not on the basis of amalgamation or aggregation of income of all foreign countries Expression 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 under the Act Thus, relief has to be considered country-wise 37
Case Study 3 Facts Assessee (Resident of India) earns income from provision of export services outside India Tax deducted at source on the above income Deduction of 50% was claimed by assessee under section 10A [Entities established in Special economic zone ( SEZ )] of the Act while offering the above income to tax in India Question For the purposes of relief under Section 91(1) of the Act, whether FTC can be claimed on entire taxes deducted in foreign country? 38
Case Study 3 Held In the case of Dr K.L.Parikh v ITO, 1982 (14 TTJ 117), the assessee claimed that relief from Double taxation must be allowed in respect of entire amount of taxes deducted at source. The assesse has earned income from Iran on which taxes were deducted. While offering the foreign sourced income to tax in India, Assessee had claimed deduction (upto 50 percent) under section 80RRA of the Act. The Commissioner of Income-tax (Appeals) [ CIT(A) ] rejected the assessee s claim and allowed relief upto 50 percent of taxes deducted The Tribunal rejected CIT(A) claim and declared the decision in favour of the assesse 39
Case Study 3 However, Rajasthan High Court 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 under section 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 upto 50 percent of FTC Based on above, same principle will apply to entities established in SEZ and hence they cannot claim tax credit on foreign taxes paid abroad in respect of incomes which are exempt from tax in India 40
Draft FTC Rules
Draft FTC Rules The Central Board of Direct Tax ( CBDT ) had proposed the following draft rules for grant of FTC: The resident taxpayer shall be allowed FTC of any tax paid in a country or specified territory outside India, by way of deduction or otherwise, in the year in which the income corresponding to such tax has been offered to tax or assessed to tax in India. The FTC shall be available against the amount of tax, surcharge and cess payable under the Act but not in respect of any sum payable by way of interest, fee or penalty. FTC shall not be available in respect of any amount of foreign tax which is disputed by the taxpayer. The FTC shall be aggregate of the amount of credit computed separately for each source of income arising from a particular country or specified territory and given effect to the following manner: The FTC shall be the lower of the tax payable under the Act on such income and foreign tax paid on such income. The FTC shall be determined by conversion of the currency of payment of foreign tax at telegraphic transfer buying rate on the date on which such tax has been paid or deducted. 42
Draft FTC Rules In the case where any tax is payable under the provisions of Minimum Alternate Tax ( MAT ) under the Act, the credit of foreign tax shall be allowed against such tax in the same manner as is allowable against any tax payable under normal provisions of the Act. Where the amount of FTC available against the tax payable under the provisions of the MAT, exceeds the amount of tax credit available against the normal provisions, then while computing the amount of MAT credit with respect of taxes paid under MAT provisions, as the case may be, such excess shall be ignored. The FTC shall not allowed unless the following documents are furnished by the taxpayer: Certificate from the tax authority of a country or specified territory outside India specifying the nature of income and amount of tax deducted therefrom or paid by the taxpayer. However, in a case where the foreign tax is deducted at source, the taxpayer from may furnish a certificate of tax deducted from person responsible for deduction of such tax; Acknowledgement of online tax payment or bank counter foil or slip or challan for tax payment where the payment of foreign tax has been made by the taxpayer; and A declaration that amount of foreign tax in respect of which credit is being claimed is not under nay dispute 43
Thank You CA Sridhar Swaminathan