Narendra Gokhale is a globe-trotter and earns in more than one country. And he gets taxed in all these countries as well as at home (India). Any person who is taxed in more than one country on a source of income may set off taxes paid in one country against the taxes payable in the other and can claim a Foreign Tax Credit (FTC).
A Double Taxation Avoidance Agreement or tax treaty between two countries aims at mitigating the incidence of double taxation. It is done by assigning the exclusive right of taxation to either country for different categories of income. However, when such exclusivity is not possible and both the countries insist on exercising their rights, double taxation results. Tax treaties typically contain a clause to resolve this through the FTC mechanism. India has a wide network of tax treaties with almost all its major trading partners.
Here’s how it works. When an individual qualifies as a tax resident of India as per the tax treaty between India and another country, say the US, the taxes paid in the US may be claimed as credit against taxes payable in India on the doubly taxed income.
An FTC claim is allowed for incomes that are deemed to arise in the other country as per the provisions of the relevant tax treaty. So, a tax resident of the UK who works in India may be subject to taxation in India on the employment income under the Indian law. Further, if the treaty also grants India the right to tax such income, then the UK would have to allow a credit claim for taxes paid in India when computing the tax payable in the UK.
The tax credit allowed in India is limited by the amount of tax to be paid in India on the doubly taxed income. For instance, Malik Shah, a resident of India, has an income of $20,000 from the US. If India imposes a 35% tax on such income and Shah has paid a 40% tax in the US, the maximum credit in India on such income will be restricted to $7,000 (35% of $20,000).
Credit can be claimed only when the income is taxed in the country of residence and in the year in which such income is offered for taxation. It logically follows that the credit should be computed with respect to the tax ultimately paid in the other country, arrived at after considering all allowances and exemptions in the latter country. Taxes disputed or expected to be refunded or abated must not form part of the credit claim to avoid any tax litigation.
Most tax treaties clearly define the kind of taxes that can be claimed as credit and include federal income tax and surcharges. Generally, any interest or penal amount that has been paid for a default or omission in tax payment will not be allowed in an FTC claim.
No guidelines are available under the Indian law on procedural aspects such as evidence to be furnished with respect to an FTC claim. The taxpayer should ideally insert a note in his tax return form. For prudence, the following should be kept handy if called for at the time of assessment:
• Proof of payment of foreign taxes (a tax challan, withholding tax certificate, return of income, assessment order as evidence of payment of tax in the foreign country)
• Proof that the foreign taxes on which credit has been claimed have not been overpaid.
Recently, the fringe benefit tax (FBT) law was amended to allow employers to recover from employees the FBT paid on allotment of stock options and similar instruments. It also provides that the tax recovered from employees would be deemed as income tax paid under the Indian law. While this provision may be intended to facilitate an FTC claim by employees in a foreign country, some aspects need attention.
For one, the Indian double taxation avoidance treaties do not contain specific clauses for claiming credit for FBT unlike treaties signed by Australia and New Zealand. For instance, stock option income may be taxed at the value on vesting in one country and on the exercise value in another tax jurisdiction. In the absence of a clear mechanism, this could create uncertainty on the amount of FTC available. Further, none of the statutory forms in India, including the return of income, carry a section for declaring the amount paid by employee towards FBT.
In this background, it is of vital interest that Indian laws are amended, the procedural aspects in India?fs tax treaties explained and common issues addressed.
Rajesh S is a senior tax professional with Ernst & Young