Interaction of two tax systems, each belonging to a different country, at times results in double taxation of income – economic double taxation or juridical double taxation.
Economic double taxation takes place when the same income is taxed in the hands of more than one person. Juridical double taxation takes place when the same income is taxed in the hands of the same person in more than one jurisdiction. Economic double taxation is typically resolved through bilateral negotiations whereas juridical double taxation is addressed in treaties, typically, through the tax credits article.
Tax credit in India is generally governed by the provisions of a bilateral Double Taxation Avoidance Agreement (‘DTAA’ or ‘the Treaty’) concluded between India and the other contracting state. Further, where there is no DTAA, section 91 of the Indian Income-tax Act, 1961 (‘the Act’) grants unilateral relief in respect of income which has suffered tax both in India and in a country with which no DTAA exists (ie doubly taxed income)1.
We will examine below the different types of tax credit mechanisms under the DTAAs and some key issues/ concepts in relation to tax credit mechanism that merit consideration.
1. Methods for availing tax credits under the DTAAs
Broadly, a DTAA would seek to eliminate juridical double taxation through either of the following two alternative mechanisms:
1.1 Exemption method
Under the Exemption method, the State of Residence (‘State R’) does not tax the income, which according to DTAA may be taxed in the State of Source (‘State S’).
1.2 Credit method
Under the Credit method, State R includes income from State S in the taxable total income of the tax payer and calculates its tax on the basis of such taxpayer’s total income (including income from State S). It then allows a deduction from its own taxes for taxes paid in State S.
The Credit method can be applied with several variations –
Ordinary credit method,
Underlying Tax Credit method, and
Tax Sparing credit.
1.2.1 Ordinary credit method
Ordinary credit method refers to allowance of credit, from the tax payable in India, to the extent of tax attributable to the income that has been taxed in State S. The restriction may also be on grant of credit only in respect of income that is taxed in the overseas jurisdiction, ie credit would be granted qua each item of income and only if the same item of income has suffered tax in the overseas jurisdiction. This can be explained with the help of the following illustration:
A Ltd, resident of India – State R, has earned a total income of INR 100,000. Of its total income, INR 20,000 is derived from State S. State R imposes a tax of 35 percent on income of INR 100,000 or more and a tax of 30 percent on income below INR 100,000. State S imposes a tax of 40 percent. In this case, the credit would be computed as follows:
Amount (in INR)
Amount of income earned
State R tax
State S tax @ 40 percent
Less: Ordinary Tax credit
Taxes due in State R
Total tax costs
* Under the Ordinary Credit method, the maximum credit is restricted to INR 7,000 (ie 35 percent which is the tax rate in State R on the income earned in State S).
DTAAs executed by India usually follow the ‘Ordinary Credit method’ for elimination of double taxation, for the taxes paid by an Indian resident, either directly or by way of deduction, in the foreign country (State S).
1.2.2 Underlying Tax Credit (‘UTC’) method
UTC is a method to provide relief from the doubly taxed income. UTC refers to the credit that may be given, in a Contracting State (State R), for the tax paid on the underlying profits out of which the dividend is paid by a company in the Other Contracting State (State S).
DTAAs entered into by India (like DTAAs with Mauritius, Singapore) provide for UTC in situations where an Indian company is a shareholder in a foreign company.
1.2.3 Tax Sparing credit
Some of the DTAAs contain “tax sparing” clauses, whereby, tax incentives offered by the particular foreign country (State S) are deemed to have been paid as a foreign tax for the purpose of computing the foreign tax credit granted. Essentially, tax sparing consists of granting a tax credit in a Contracting State (State R) for the amount of tax that would have been payable in the Other Contracting State ie, State S had there been no reduction or exemption under the tax regime of State S.
Few DTAAs with India contain tax sparing provisions, for eg, DTAAs executed with China, Qatar, Singapore (on certain select income streams), Kenya, Philippines, Bangladesh, Korea, Malaysia and Nepal provides tax sparing benefits.
3. Key issues/ concepts in relation to tax credit mechanism
3.1 In cases where tax has been withheld in State S on gross basis, should Ordinary tax credit be claimed on net income basis?
The Ordinary credit method provides for “maximum deduction rule” ie, the deduction cannot exceed the tax liability on the foreign income in State R.
In this regard, paragraph 63 of the commentary of the OECD Model convention states that “The maximum deduction is normally computed as the tax on net income, ie on the income from State E (or S) less allowable deductions (specified or proportional) connected with such income (cf paragraph 40 above).” Further, similar analogy can also be drawn from Rajasthan High Court decision in the case of CIT vs RN Jhangi 185 ITR 586 and CIT vs Dr KL Parikh, though in the context of section 91.
Therefore, Ordinary tax credit is required to be computed on net income basis. Hence, if
State S provides for taxation of income on gross basis, the tax credit in many cases would be lower than the tax effectively paid in State S.
3.2 Can tax credit be claimed against the Minimum Alternative Tax (‘MAT’) payable in India?
Typically, the Ordinary credit method permits credit of tax on the doubly taxed income against Indian tax payable, irrespective of whether the same has been computed as per normal provisions of the Act or MAT. Further, neither the Act nor the Treaty has any specific provision to allow or to restrict the claim of tax credit against MAT.
Therefore, a view could be adopted that tax credit can be availed against MAT. However, the credit should be restricted to the MAT liability. Further, the tax credit in such scenario can be computed based on the following steps (given that the Act or the DTAAs do not specify any method):
Step I – Computation of income subject to tax both in State S and State R
Book Profit in accordance with section 115JB x Turnover/ receipts from State S
Total turnover of the company
Step II – Computation of maximum credit that can be availed
MAT * Income subject to tax both in State S and State R (as per Step I above)
Book Profits in accordance with section 115JB
3.3 Should tax credit be claimed from income-tax including surcharge and cess?
Bangalore Tribunal in the case of Infosys Technologies Ltd vs JCIT 108 TTJ 282 in connection with India-Canada tax treaty has held that,
” … it is made clear that while computing tax on the doubly taxed income, such tax should also included surcharge, as that is also part of tax levied under the provision of the Act.”
Therefore, a view could be adopted that tax credit can be claimed from income- tax (including surcharge and cess).
3.4 Can tax credit be claimed for dividend distribution tax paid under section 115O?
As per the provisions of section 115O of the Act, any amount declared, distributed or paid by way of dividend is subject to Dividend distribution tax (‘DDT’). DDT is neither a withholding tax on dividend income nor a tax on the profits of the company from which dividend is declared.
Under the DTAAs, tax credit is typically available for tax on income (ie income-tax) and/ or for tax on the profits of the company from which dividend is declared (ie UTC). Therefore, tax credit on DDT is per se not available under the DTAAs.
However, credit for DDT can be availed if State R considers DDT as income-tax or underlying tax as per its domestic law. For example, tax credit for 50 percent of the DDT paid in India can be availed, subject to fulfillment of certain conditions, as per the domestic tax laws of Korea. Such credit is also permissible under the domestic tax laws of UK as per certain specific clarifications issued by the Inland Revenue Department of UK.
3.5 How tax credit should be computed under section 91 of the Act when there is income from several overseas countries and loss in India?
The issue is explained with the help of the following illustration:
Company A is a tax resident of India. It carries on business in India, and also in Country X and Country Y, with which India does not have tax treaties. For financial year 2003-04, the amount of net income earned from all businesses, and tax paid in each of the foreign countries is as follows:
The alternative situations that may arise are:
Doubly taxed income from Country X” is Rs 100 (consequent to which a relief of Rs 20 would be available under section 91) and “doubly taxed income in Country Y” is Rs 100 (consequent to which a relief of Rs 10 would be available under section 91) thus resulting a total relief of Rs 30 under section 91.
Doubly taxed income from Country X” is Rs 100 (consequent to which a relief of Rs 20 would be available under section 91) and “doubly taxed income in Country Y” is Rs 50 (consequent to which a relief of Rs 5 would be available under section 91) thus resulting a total relief of Rs 25 under section 91.
Doubly taxed income in Country X” is Rs 50 (consequent to which a relief of Rs 10 would be available under section 91) and “doubly taxed income in Country Y” is Rs 100 (consequent to which a relief of Rs 10 would be available under section 91) thus resulting in a credit of Rs 20 under section 91.
Doubly taxed income in Country X” is Rs 75 (consequent to which a relief of Rs 15 is available under section 91) and “doubly taxed income in Country Y” is Rs 75 (consequent to which a relief of Rs 7.5 is available under section 91) thus resulting in a relief of Rs 22.5 under section 91.
It is interesting to note here that the US IRC attempts to address this eventuality by a combination of regulations, which limit the overall FTC while at the same time clearly focusing on safeguarding any erosion to the tax on US soured income.
3.6 What exchange rate should be considered for the purpose of calculation of the quantum of foreign taxes that are available for FTC?
There is no express provision in the Act on this issue nor is there any judicial precedent or a revenue clarification. The US regulations as well as the treatise by “Klaus Vogel on Double Taxations Conventions”6 suggest that the foreign taxes (as expressed in the foreign currency) have to be converted into the local currency by applying the exchange rate as prevailing on the date on which such foreign taxes are paid.
There could be several situations that may arise in this regard in the Indian context. For example, an Indian resident derives business income of USD 100 in State S (the exchange rate prevailing at this time was 1 USD = Rs 45) and a tax of USD 15 has been paid in State S (the exchange rate prevailing at this time was 1 USD = Rs 46). The business income was realized during the year itself and the exchange rate prevailing at the time of realization was 1 USD = Rs 44. Hence, an issue arises on whether the foreign taxes which are eligible for credit in India have to converted into Indian currency by applying the exchange rate of 1 USD = Rs 44 (prevailing on the date of realization of income in foreign currency) or 1 USD = Rs 45 (prevailing on the date of earning of the income in State S) or 1 USD = Rs 46 (prevailing on the date of payment of tax in State S).
Therefore, the application of this principle to the Indian context is not without doubt.
Date: December 22, 2011
“Paragraph 61 MC Comm. fails to indicate the rate of exchange to be applied when converting the amount of credit. According to the working – ‘equal’ and ‘egal’- and the purpose of the credit rule, viz. to adjust the set back in wealth suffered as a result of the payment, the only material rate of exchange can be that applicable on the day when the payment was made”.