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[2016] 65 taxmann.com 78 (Article)/[2015] 33 CPT 395 (Article)

[2016] 65 taxmann.com 78 (Article)

An Inside Story of Foreign Tax Credit

KRISHAN MALHOTRA
Head - Taxation
Shardul Amarchand Mangaldas & Co.

Introduction

1. India's economic growth has led to India's foray into elite league of capital exporting nations,
resulting in increased cross border movement of Indian capital and people. For most of the Indians
investing or working abroad, the issue of juridical double taxation of their foreign source income is
critical.

This article provides an insight into the unilateral and bilateral methods adopted by India in its
domestic and treaty laws to offer respite to Indian taxpayers in respect of juridical double taxation
of their foreign source of income.

Foreign tax credit - Concept of

2. Technically, Indian tax residents are subject to Indian taxation of their worldwide income,
regardless of its source and, therefore, need tax relief in order to reduce or eliminate "double
taxation". India allows income taxes imposed by nations where Indian tax residents earn foreign
income to be credited against the income-taxes payable in India. A foreign tax credit is a means of
relieving international taxpayers from the burden of paying taxes twice on the same income - once
in the country of source, where the income is earned, and again in the country where the taxpayer
is resident.

There are traditionally three ways in which the country of residence may afford relief:

♦ by allowing a deduction of source country taxes ("Deduction Method")

♦ by exempting source country income from residence country taxation ("Exemption
Method"); and
♦ by crediting source country taxes against residence country taxes ("Credit Method")

The deduction system is the least generous, since the relief is limited to the foreign tax multiplied
by the taxpayer's domestic marginal tax rate. Exemption is the most generous, subjecting the
foreign source income only to foreign taxation, no matter how low the foreign rate is. A credit,

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however, offers rupee for rupee relief against residence country taxation. The following table
illustrates these three different methods. Assume that Mr. X earns INR 100 of taxable income,
which is foreign sourced and subject to foreign tax rate of 30%, and its Indian source income is
INR 100, subject to Indian tax rate of 35%.

Sr. Method Foreign Total Indian tax on Indian tax on Total tax on
No. tax both domestic and foreign income foreign
foreign income income
(Indian tax +
foreign tax)
1. Deduction INR 30 Total income minus Total Indian tax INR 54.50
Method foreign tax, multiplied minus Indian tax on
by Indian tax rate of Indian source
35%, i.e., (200-30) x income, i.e.,
35% = INR 59.50 59.50-35 = INR
24.50
2. Exemption INR 30 No Indian tax on INR 0 INR 30
Method foreign source
income.

Indian source income of

INR 100 taxed at 35% =
INR 35

3. Credit INR 30 Indian tax on worldwide Total Indian tax INR 35

Method income minus INR 30 minus Indian tax on
(i.e., foreign tax Indian source
credited), i.e., (35% x income (40-35) =
200) - 30 = INR 40 INR 5

Section 91 vis-a-vis India's Tax Treaties

3. Section 91 of the Income-tax Act, 1961 ("IT Act") provides unilateral foreign tax credit to the
Indian tax residents in respect of taxes paid on their foreign source income in countries with which
India does not have tax treaty by way of the Credit Method in the following terms:

" 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."

The unilateral foreign tax credit under section 91 of the IT Act provides an important limitation on
the credit, i.e., an Indian tax resident is only entitled to a credit at the Indian rate of tax or the rate
of tax of the relevant foreign country, whichever is lower. If India was to credit fully foreign taxes
imposed on foreign source income at a higher rate than India's tax rate, India would reduce the tax
otherwise collected on income earned in its own jurisdiction, in effect benefitting the foreign
country at its own expense. A limitation on the foreign tax credit is essential if India is to collect its

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income-tax on Indian source income. For instance, in the preceding example discussed at point 3
of the table above under the head credit method, if the foreign tax rate was 50% and India allows a
full foreign tax credit without limitation, India would collect a total Indian tax of INR 20. In that
case the foreign tax credit would effectively reduce Indian tax on Indian income by INR 15. A
limitation is thus necessary to protect the integrity of India's own tax system.

In cases where Indian tax residents pay taxes on foreign source income in countries with which
India has a double taxation avoidance agreement ("DTAA"), the foreign tax credit/ other method
of providing double taxation relief would be governed by the terms of such DTAA.

Considering that India's tax treaties are based on the OECD and UN Model Conventions, set out
below is a brief discussion of foreign tax credit under Article 23 of such model conventions. Article
23A of the OECD and UN model conventions provide for the Exemption Method and Article 23B of
OECD and UN Model Conventions provide for the Credit Method. Since India adopts the credit
method in most of the treaties, only the credit method under Article 23B of the OECD and UN
Model Convention (which is identical under both) is reproduced hereinbelow:

"1. Where a resident of a Contracting State derives income or owns capital which, in
accordance with the provisions of this Convention, may be taxed in the other Contracting
State, the first-mentioned State shall allow as a deduction from the tax on the income of that
resident an amount equal to the income tax paid in that other State; and as a deduction from
the tax on the capital of that resident, an amount equal to the capital tax paid in that other
State. Such deduction in either case shall not, however, exceed that part of the income tax or
capital tax, as computed before the deduction is given, which is attributable, as the case may
be, to the income or the capital which may be taxed in that other State.

2. Where, in accordance with any provision of this Convention, income derived or capital
owned by a resident of a Contracting State is exempt from tax in that State, such State may
nevertheless, in calculating the amount of tax on the remaining income or capital of such
resident, take into account the exempted income or capital."

Under Article 23B of the OECD and UN Model Convention foreign tax credit may be claimed by a
taxpayer in his country of residence ("State R"), if the following conditions are met:

♦ a resident of State R derives items of income;

♦ such items of income may be taxed in country of source ("State S");
♦ such taxation is in accordance with the provisions of the DTAA.

On the satisfaction of the above conditions, State R shall allow a deduction from its income-tax an
amount equal to the lower of the following:

♦ Income-tax paid in State S; or

♦ Income-tax computed in State R [before allowing a deduction as per Article 23B(1),
which is attributable to such items of income that may be taxed in State S ("maximum
credit")

The objective behind the limitation of maximum credit is to ensure that State R does not grant
relief for a greater amount than the tax that it would have imposed on the foreign income, if no
such relief was given.

In the case of Manpreet Singh Gambhir v. Dy. CIT [[2008] 26 SOT 208 (Delhi), State R's
obligation to grant foreign tax credit is only in respect of taxes paid in State S to the extent that

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State R itself levies tax on income arising in State S. Thus, credit is provided only in respect of
juridical doubly taxed income.

State R provides tax credit only if the taxation in State S is "in accordance with the provision of
the Convention". Thus, if, as per the DTAA, an income is taxable only in State R and not in State S,
State R is not required to allow a credit for taxes paid in State S [Sanofi Pasteur Holding SA v.
Department of Revenue, Ministry of Finance [2013] 30 taxmann.com 222/354 ITR
316 (AP).

4. Underlying tax credit and tax sparing credit

4.1 Underlying tax credit: Till now the discussion on foreign tax credit related to juridical
double taxation. However, several times tax treaties provide for elimination of economic double
taxation, i.e., the same income being taxed twice in the hands of different persons. For instance,
corporate profits are subject to corporate income-tax at the corporate level and are subject to
dividend tax at shareholders' level. The concept of underlying tax credit was proposed with a view
to mitigate such economic double taxation. Under this concept State R grants credit to taxpayer for
tax withheld on the dividends and also for the corporate tax paid on the underlying profits out of
which the dividend has been paid. The concept of tax credit generally operates in case of dividend
income. An illustration in this regard is as under:

A. Ltd., a foreign company has an income of INR 10,000. The corporate tax on this income is 30
per cent. After paying tax, the foreign company distributes the entire profit to its sole shareholder,
(i.e., X Ltd.) as dividend. The withholding tax rate on dividend is 10 per cent. X Ltd. is the parent
company of A Ltd., and holds 100 per cent shares of A Ltd. X Ltd. is taxed at 35 per cent in its
country of residence. The underlying tax credit will be computed as follows:

Particulars Amount (In INR)

Total income earned by A. Ltd. in State S 10,000
Corporate Tax paid by A. Ltd. (30% of INR 10,000) in State S 3,000
Amount distributed as dividend by A. Ltd. to X. Ltd. 7,000
WHT on dividend imposed in State S (10% of INR 7,000) 700
Income of X. Ltd. in State R 7,000
Tax on income of X. Ltd. in State R (35% of INR 7,000) 2,450
Underlying tax credit 3,000
Credit for withholding tax on dividend 700
Total credit available 3,700

Therefore, in this example, even though the tax payable by X Ltd. on its foreign source income in
State R is INR 2,450, X Ltd. can claim credit for INR 3,700 against tax payable on its foreign
source income and other income in the relevant tax year.

Typically, DTAAs entered into by India do not provide for underlying tax credit. However, provision
for underlying tax credit is available under India's DTAAs with some countries like Mauritius,
Singapore, etc., on fulfilment of certain conditions.

4.2 Tax sparing credit: On several occasions tax is not levied or is exempted by State S, if the
taxpayer carries on certain specified activities to incentivize investment, etc. (e.g., investment in
certain kinds of businesses, special economic zones, etc.). However, State R may not extend similar

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tax incentives and may tax such income exempt in State S. In such a scenario, the taxpayer cannot
avail of the benefit which was given by State S, since tax was levied by State R. As a result, State R
is benefitted, as it would be entitled to levy tax on such untaxed income of its taxpayer earned in
State S. To address this anomaly tax sparing credit provides that State R will grant the taxpayer a
credit for the taxes, which would have been levied by State S, had the tax exemption not been
granted by State S.

For several developing countries tax sparing credits become essential to ensure that incentives
offered by them to foreign investors yield results. As the Commentary to the UN Model Convention
notes, "one of the principal defects of the foreign tax credit method, in the eyes of the developing
countries, is that the benefit of low taxes in developing countries or of special tax concessions
granted by them may in large part inure to the benefit of the treasury of the capital-exporting
country rather than to the foreign investor for whom the benefits were designed. Thus, revenue
is shifted from the developing country to the capital-exporting country. The effectiveness of the
tax incentive measures introduced by most developing countries thus depends on the inter-
relationship between the tax systems of the developing countries and those of the capital-
exporting countries from which the investment originates. It is of primary importance to
developing countries to ensure that the tax incentive measures shall not be made ineffective by
taxation in the capital-exporting countries using the foreign tax credit system. This undesirable
result is to some extent avoided in bilateral treaties through a "tax sparing" credit, by which a
developed country grants a credit not only for the tax paid but for the tax spared by incentive
legislation in the developing country."

Provisions for tax sparing credit are seen in India's DTAA with UK, Australia, Canada, etc.

Key Issues relating to foreign tax credit in India

5. Section 91 of the IT Act and Article 23 of the OECD and UN Model Conventions, as such do not
provide detailed rules as regards the mechanism for computing relief. At present Indian domestic
tax law does not contain detailed rules for granting relief from double taxation. Accordingly, the
Finance Act, 2015 has amended section 295 of the IT Act to empower the Central Board of Direct
Taxes ('CBDT') to make rules pertaining to procedure granting relief in case of double taxation as
follows:

"In section 295 of the Income-tax Act, in sub-section (2), after clause (h), the following clause
shall be inserted with effect from the 1st day of June, 2015, namely:—
(ha) the procedure for granting of relief or deduction, as the case may be, of any
income-tax paid in any country or specified territory outside India, under section 90 or
section 90A or section 91, against the income-tax payable under this Act;"

Such amendment has taken effect from 1st June, 2015. The CBDT is still in process of drafting rules
for grant of foreign tax credit. Pending such rules, set out below are some issues which have arisen
in relation to foreign tax credit in India.

5.1 Computation of credit in case foreign source income arises in several countries:
The calculation of tax credit in cases where a tax resident has income from more than one foreign
country was not clear. A key issue which arose in this regard was whether to group all foreign
income and taxes together, regardless of foreign tax rates, while computing the limitation of India's
tax rate or whether to calculate separately the credit and limitation for each foreign jurisdiction.
These methods are often called the "overall limitation" and "per country limitation", respectively.
The IT Act does not provide any guidance in this respect.

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In the case of CIT v. Bombay Burmah Trading Corpn. Ltd. [2003] 259 ITR 423/126
Taxman 403 (Bom.), the tax department pooled all the eligible income and the credit by
adopting the lesser of the two taxes with reference to the pooled amount. However, the Bombay
High Court held that the computation of foreign tax credit will be done only on country-wise basis.
The relevant extracts of the observation made by this Court is as under:

"The relief under section 91(1) is by way of reduction of tax by deducting the tax paid abroad
on such doubly taxes 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 the
argument of the Department is to be accepted then, it would be impossible to compare the
rate of tax of the foreign country with the rate under the Indian Income-tax Act"

Hence, the relief has to be calculated on the basis of per country limitation method and not on the
basis of overall limitation method.

5.2 Whether credit is available against MAT liability?: In ACIT v. L&T Ltd. [IT Appeal
No. 4499 (Mum.) of 2008, dated 22-7-2009], it was held that credit for foreign taxes would
be available even if taxpayer was liable to pay MAT.

5.3 In which year will foreign tax credit be made available?: In CIT v. Petroleum
India International [2013] 351 ITR 295/213 Taxman 41/29 taxmann.com 250 (Bom.),
the credit in India for foreign taxes would be allowable in the year in which the foreign income is
assessable in India, irrespective of the year in which the income has been assessed or tax has been
paid in the foreign country.

5.4 Inclusion of surcharge for granting tax credit: Another area where the courts have
adjudicated is whether or not surcharge should be included in the tax which is to be commutated
for the purposes of determining credit? The Bangalore Income Tax Tribunal in the case of Infosys
Technologies Ltd. v. Jt. CIT [2007] 108 TTJ 282, while interpreting Article 23 of the India-Canada
Tax Treaty, held that 'tax' should include surcharge and, hence, a credit in India (State R) for
Canadian tax would be available only after first computing the Indian tax inclusive of surcharge.

5.5 Classification of income under identical head in State R and State S: In Som Datt
Builders (P.) Ltd v. ITO [1989] 29 ITD 495 (Kol.), it was held that for the availability of tax
credit, it is not necessary that both State R and State S should tax the income under an identical
head. However, the prerequisites for claiming tax credit is that the income should relate to the
same person in both the States.

Conclusion

6. The Indian law on foreign tax credit is still evolving. Several nuances of implementing foreign
tax credit in India need to be worked out. Indeed, Finance Act, 2015 has pre-empted the growing
significance of foreign tax credit law in India, given the increased mobilization of Indian capital
and people. In view of such background, the rules issued by the CBDT on the procedure relating to
foreign tax credit are now eagerly awaited.

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