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Foreign Tax Credit: A Comprehensive Overview

The Foreign Tax Credit (FTC) is an essential mechanism in international taxation, designed to mitigate the burden of double taxation where income is taxed in both the source and the resident country. This article provides a comprehensive overview of FTC, detailing its role in encouraging foreign direct investment by reducing the tax burden on taxpayers and facilitating cross-border transactions. It explores the historical development of FTC, its operational mechanisms—including exemption and credit methods—and its incorporation into tax treaties and domestic laws, such as India's Income-tax Act. The discussion also covers the procedural aspects of claiming FTC in India, underpinned by legislative provisions and recent judicial rulings, highlighting its significant impact on global economic interactions and the challenges it faces in implementation.

Introduction

In the realm of international taxation, the FTC serves as a vital mechanism for alleviating the burden of double taxation, which occurs when the same income is taxed by two or more jurisdictions. FTC helps prevent double taxation for individuals and businesses engaged in cross-border transactions. Tax treaties play an essential role in ensuring equitable distribution of income taxes between countries while eliminating double taxation for income earners.

FTC is a mechanism that allows taxpayers, both individuals and companies, to offset taxes paid in foreign countries against their domestic tax liability. The benefits of FTC are manifold. Primarily, it safeguards taxpayers from the financial strain of being taxed twice on the same income – once in the source country and again domestically. Furthermore, by reducing the overall tax burden, FTC fosters an environment conducive to foreign investment that stimulates foreign direct investment (‘FDI’), which in turn strengthens the domestic economy through job creation and economic growth. Additionally, FTC enhances cash flow by decreasing the amount of foreign income tax due, enabling the reinvestment of capital back into the business and boosting profitability. It simplifies the tax compliance process for taxpayers with foreign income by eliminating the need for separate filings or refunds in multiple jurisdictions. Thus, FTC serves as a potent tool in the global financial landscape, offering significant benefits to taxpayers and promoting economic growth.

Historical Evolution of FTC

The United States of America (‘USA’) was the first country to enact FTC after World War I in 1918[i]. This was a unilateral measure implemented to address equity arising from double taxation of foreign-source income. On the other hand, until the 1940s, the United Kingdom (‘UK’) allowed credit only for foreign taxes paid within the British Empire and limited credit to a maximum of one-half of UK tax on foreign income.

Following technical amendments, the Income-tax Act, 1961 (‘IT Act’) was enacted. This allowed taxpayers the option to carry forward unused foreign taxes for up to 5 years or to retrospectively apply them back by 2 years. Subsequently, nations commenced bilateral negotiations culminating in double taxation avoidance agreements (‘DTAAs’) aimed at mitigating the burden of double taxation on their respective residents. Consequently, a provision was introduced to alleviate the tax liability of individuals or entities by granting relief for taxes paid in a foreign jurisdiction, thereby preventing duplication of tax on the same income within the domestic territory.

Methods of Computing FTC

There are several methods[ii] of computing FTC in international taxation laws:

a. Exemption Method: This taxation method is a principle where the domestic country chooses not to tax the foreign income of its residents to avoid double taxation as this income is already taxed in the source country. There are two variations of this method: full exemption and exemption with progression. The focus in both these methods is on the income of the taxpayer as opposed to the credit method, where the focus remains on tax and not income.

Under the full exemption method, the domestic country completely disregards foreign income for tax purposes, meaning it neither includes it in tax computation nor considers it when determining tax rates. This approach is relatively rare; however, an example of the application of this method can be found in the India-Brazil DTAA, where India applies full exemption to dividend income from Brazil.

In contrast, the exemption with progression method involves the domestic country acknowledging foreign income when calculating tax rates for the taxpayer’s remaining income. While foreign income itself is not taxed, its inclusion in rate computation can result in a higher tax rate applied to other income, reflecting a progressive tax system. This method aims to maintain equity among taxpayers by considering worldwide income for rate determination, even if part of that income is exempt from domestic tax. Basically, if an Indian taxpayer has a total income of Rs. 1,00,000 out of which he earned Rs. 20,000 from a foreign country and assuming that the tax rate in India on Rs. 80,000 or below is 10% and above is 15%, then in the full exemption method, Rs. 80,000 will be taken as the total income to be taxed in India and the rate applicable would be 10%. However, in applying for the exemption with the progression method, Rs. 1,00,000 would be taken as the total income with a 15% applicable rate and the foreign tax paid will be adjusted.

b. Credit Method: The credit method is a tax relief approach where a domestic country includes the income earned in a source country as part of the taxpayer’s taxable income. However, it allows a credit for taxes paid in the source country against the taxpayer’s domestic tax liability. This method also comes in two forms: full credit and ordinary credit.

With the full credit method, the domestic country permits a deduction equal to the entire amount of tax paid in the source country. On the other hand, the ordinary credit method limits credit to the portion of domestic tax that corresponds to foreign income. For example, if an Indian taxpayer earns 150 USD and pays 40 USD in US taxes, but their Indian tax liability on that income is only 30 USD, then they can only claim a credit of 30 USD. The balance of 10 USD is not refundable or adjustable against other tax liabilities in India. This method ensures that taxpayers do not pay more in combined taxes than the higher domestic or foreign tax rates on their foreign income.

c. Underlying Tax Credit: This method deals with preventing double taxation at the corporate level and the shareholder level. Under this method, the domestic country not only provides credit for tax paid in the source country on the dividend itself but also considers tax paid by the company on profits out of which the dividend is distributed. In other words, it acknowledges that income has already been taxed at the corporate level and adjusts the tax liability accordingly. While not all DTAAs provide for this method, some do prescribe minimum shareholding conditions for its application. India’s DTAAs with Australia, Mauritius, Singapore, the USA, and the UK facilitate underlying tax credits.

d. Tax Sparing Credit: This method aims to benefit foreign investors. When a foreign investor pays taxes in a source country where they have invested, and that country provides tax incentives, the domestic country allows them to claim a credit for taxes that were ‘spared’ due to those incentives. In other words, even if the source country does not directly provide a tax break, the investor can still benefit by passing on the incentive to their domestic country.  For example, India has such provisions in its DTAAs with countries like Japan, Canada, Singapore, Switzerland, etc.

Relevant Provisions for FTC in the IT Act

The provisions for FTC under the IT Act encompass both bilateral and unilateral relief methods. Bilateral relief operates under DTAAs signed between India and foreign countries. It includes exemption and credit methods. Unilateral relief, on the other hand, applies when there is no DTAA between countries, and it is provided solely by the home country.

Relief is granted under s. 90 of the IT Act if a DTAA exists between India and another country. It empowers the Central Government to enter into DTAAs with other countries and provide relief on income that has accrued or arisen in a foreign country and has been taxed in both domestic and foreign countries. S. 90A applies when an agreement is between specified associations or organizations of two countries. Offering similar relief as s. 90, relief under this section is typically provided through tax credits or exemptions based on the terms of the DTAA.

S. 91 of the IT Act, the unilateral relief provision, comes into play when there is no DTAA between India and a foreign country. It offers relief to residents and non-residents from countries without a DTAA. Relief is provided by allowing the taxpayer to claim the lower tax rates between India and the foreign country.

In Wipro Ltd. v. DCIT, Central Circle 1(3), Bangalore[iii], the High Court of Karnataka (‘HC’) delivered a significant ruling in this regard. The HC, after a detailed examination of ss. 90 and 91 of the IT Act, clarified that Wipro’s right to claim FTC was not negated by exemption under s. 10A of the IT Act, which provides tax relief for software companies. The HC emphasized that the mere fact that no actual tax payment was made due to exemption does not invalidate the taxation of foreign income, thereby making it eligible for FTC under the relevant tax treaty. The HC further highlighted that an Indian taxpayer could benefit from tax holidays[iv] under the IT Act while transacting with foreign service providers. The HC made a crucial distinction between ‘liability to pay tax’ and ‘actual tax paid’. The essence of the case lay in the fact that exemption from tax, granted due to a limited tax holiday under the IT Act, does not justify the denial of FTC.

FTC in India’s DTAAs

India has one of the largest networks of tax treaties for the avoidance of double taxation and prevention of tax evasion, with DTAAs in over 94 countries. The application of FTC in India’s DTAAs varies depending on the specific agreement with each country. However, the general principle remains the same: to prevent the same income from being taxed in more than one jurisdiction. It is pertinent to note at this point that the interplay of DTAA and FTC only held eliminating juridical double taxation[v] and not economic double taxation[vi].

This is achieved through two main methods: the exemption method or the credit method. The exemption method involves the resident country not taxing income that may be taxed in the source country. On the other hand, the credit method involves the resident country calculating its tax on total income, including income from the source country, and then allowing a deduction from its own tax for the tax paid in the source country. For instance, a. 24(2) of the India-UK DTAA allows for FTC in India. This credit is based on the proportion of income earned from the foreign country compared to the total income of the taxpayer in the resident country. So, if an individual or company has income from both India and the UK, the credit against Indian tax payable will be limited by a proportional relationship, ensuring a fair calculation based on the source of income.

In the case of  JCIT, Special Range-15, Mumbai v. Digital Equipment India Ltd.[vii], the Income Tax Appellate Tribunal (‘ITAT’) scrutinized a. 25(2)(a) of the India-USA DTAA. The interpretation of a. 25(2)(a) of the DTAA, regarding the deduction of income tax paid in the USA from Indian income tax liability was held to be unambiguous. It was clarified that the deduction cannot exceed the Indian income tax liability in respect of the same income. The ITAT noted that while certain incomes are taxed on a gross basis in the source country, leading to potential losses after deducting allowable expenses, this did not constitute double taxation. It was noted that the DTAA expressly stated that FTC cannot surpass the Indian income tax liability and hence, the order of the Commissioner of Income Tax (Appeals) directing a refund based on an unsustainable interpretation, was set aside.

Procedure to Claim FTC in India

In 2016, the Central Board of Direct Taxes (‘CBDT’) notified[viii] r. 128 in the Income-tax Rules, 1962 (‘IT Rules’) on FTC, which came into force from 01.04.2017. This rule, based on the report of the Tax Administrative Reforms Commission (‘TARC’), provides a comprehensive code within itself for claiming FTC in India as it outlines the conditions, procedures, operational parameters, and documentation required to claim FTC within the jurisdiction of India.

Credit Allowance: R. 128 allows a domestic taxpayer to claim credit for any foreign tax paid by them in a country or specified territory outside India. This credit is applicable in the year in which income corresponding to such tax has been offered to tax or assessed to tax in India. If income on which foreign tax has been paid or deducted is offered to tax in more than one year, the credit of foreign tax shall be allowed across those years in the same proportion in which income is offered to tax or assessed to tax in India.

Definition of Foreign Tax: The foreign tax referred to in this rule means tax covered under a DTAA in terms of s. 90 or s. 90A of the IT Act with a country or specified territory outside India. In respect of any other country or specified territory outside India, it refers to tax payable under the law in force in that country or specified territory in the nature of income tax referred to in explanation (iv) to s. 91 of the IT Act.

Credit Availability: The credit under r. 128 of the IT Rules shall be available against the amount of tax, surcharge, and cess payable under the IT Act but not in respect of any sum payable by way of interest, fee, or penalty.

Disputed Tax: No credit under this rule is to be granted for any amount of foreign tax or part thereof which is disputed in any manner by the taxpayer. However, credit of such disputed tax shall be allowed for the year in which such income is offered to tax in India if the taxpayer furnishes evidence of settlement of dispute and evidence to the effect that liability for payment of such foreign tax has been discharged by him within 6 months from the end of the month in which the dispute is finally settled.

Credit Computation: The credit of foreign tax shall be the aggregate of amounts of credit computed separately for each source of income arising from a particular country or specified territory outside India. The credit shall be the lower of the tax payable under the IT Act on such income and the foreign tax paid on such income. Further, FTC shall be determined by the conversion of the currency of payment of foreign tax at the telegraphic transfer buying rate[ix] on the last day of the month immediately preceding the month in which such tax has been paid or deducted.

S. 115JB or 115JC: In a case where any tax is payable under the provisions of s. 115JB or s. 115JC of the IT Act, FTC shall be allowed against such tax in the same manner as is allowable against any tax payable under the provisions of the IT Act, other than the provisions of the said sections.

Excess Credit: Where the amount of foreign credit available against the tax payable under the provisions of s. 115JB or s. 115JC exceeds the amount of tax credit available against normal provisions, then while computing the amount of credit under s. 115JAA or s. 115JD in respect of taxes paid under s. 115JB or s. 115JC, as the case may be, such excess shall be ignored.

Documentation: FTC is allowed to taxpayers on furnishing a statement of income from a country or specified territory outside India, offered to tax for the previous year and of foreign tax deducted or paid on such income in Form- 67, and verified in the manner specified therein. A certificate or statement specifying the nature of income and the amount of tax deducted therefrom or paid by the taxpayer is also required.

Form Submission: The statement in Form No. 67 and certificate or statement is to be furnished on or before the end of the assessment year relevant to the previous year in which the income referred to in r. 128(1) has been offered to tax in India and the return for such assessment year has been furnished within the time specified under s. 139(1) or s. 139(4) of the IT Act.

In Akshay Rangroji Umale v. DCIT, Circle-12[x], the ITAT ruled in favour of a taxpayer, entitling him to claim FTC even on the belated filing of Form-67, certificate, and statement as required under r. 128(9) of the IT Rules. It was held that the prime object of prescribing the filing of the requisite form, certificate and statement on the record is to verify and vouch for the genuineness and correctness of the FTC claimed and that belated compliance would be indifferent to eligibility, genuineness and correctness, hence, cannot be subjected to rejection or denial. Thus, it was concluded that belated filing of the said documents any time before it is actually processed or before the final assessment is actually made is sufficient compliance of r. 128(9) of the IT Rules.

Loss Carry Backward: Form No. 67 shall also be furnished in a case where the carry backwards of loss of the current year results in a refund of foreign tax for which credit has been claimed in any earlier previous year or years.

Conclusion

FTC stands as a cornerstone of international taxation, providing a robust mechanism to mitigate the impact of double taxation on income earned abroad. As globalization continues to shape global trade and investment, FTC plays a crucial role in facilitating cross-border transactions. Beyond its role in preventing double taxation, FTC serves as a catalyst for economic growth, fostering international cooperation, and enhancing India’s position in the global economy.

However, like any policy, the application of FTC in India is not without its imperfections. While it offers relief to taxpayers, there are areas for refinement and improvement. Notably, some countries provide taxpayers with the option to either claim credit for foreign taxes paid or deduct them as expenses. It is important to recognize that FTC applies solely to eligible income and cannot be extended to cover interest or penalties on such income. Thus, while FTC represents a significant advancement in international taxation, continued evaluation and fine-tuning are essential to ensure its efficacy and fairness in the evolving global landscape.





End Notes

[i] Chapter 1: Origins of the Foreign Tax Credit, in International Tax Policy for the 21st Century, https://www.nftc.org/archive/tax//fip/NFTC1a%20Volume1_part2Chap1-5.pdf 

[ii] Availment of Foreign Tax Credit and Issues Involved, 65 taxmann.com 266 (Article)

[iii] [2015] 62 taxmann.com 26 (Karnataka), [dated: 25.03.2015]

[iv] A tax holiday under the IT Act is a period during which eligible businesses or sectors are granted a temporary exemption from certain taxes, such as income taxes, to stimulate investment and economic growth.

[v] Same income is taxed in the hands of a single person in two different countries.

[vi] The same income is taxed in the hands of more than one person.

[vii] [2005] 94 ITD 340 (Mumbai), [dated: 10.03.2004]

[viii] Notification No. S.O.2213(E), dated 27.06.2016

[ix] Explanation (ii) to Rule 26, Income-tax Rules, 1962:

(ii) telegraphic transfer buying rate", in relation to a foreign currency, means the rate or rates of exchange adopted by the State Bank of India constituted under the State Bank of India Act, 1955 (23 of 1955), for buying such currency, having regard to the guidelines specified from time to time by the Reserve Bank of India for buying such currency, where such currency is made available to that bank through a telegraphic transfer.

[x] [2024] 159 taxmann.com 210 (Pune - Trib.), [dated: 01.02.2024]




Authored by Siddharth Jha, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.






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