Foreign Tax Credit Rules Notified: Clarity For Indian Taxpayers Going Global
Recently, the Central Board of Direct Taxes (“CBDT”) has released a Notification1 dated June 27th 2016 which amend the Income tax Rules 1962 to provide for a separate segment on Foreign Tax Credit Rules, 2016 (“Rules”). The Rules provide clarity on the mechanism of obtaining foreign tax credit in India, of foreign taxes paid. The intended beneficiaries of the Rules are Indian residents that earn foreign sourced income.
A draft version of the Rules2 (“Draft Rules”) was released for comments from stakeholders earlier this year on April 18th 2016, and these rules have now been notified in final form. The Rules are based on the recommendation of the Tax Administrative Reforms Commission (“TARC”) headed by Dr. Parthasarthy Shome. The TARC Report, discussed from an administrative perspective, the issues faced by resident taxpayers in availing foreign tax credit, and recommended a course of action to ease this process.
The ability for a resident to obtain foreign tax credit has been provided under s. 91 of the Indian Income Tax Act, 1961 (“ITA”), which is in the nature of unilateral relief3 where a tax treaty is not in place, or typically Article 23 of the relevant tax treaty, if applicable. The need for obtaining a tax credit arises where there is an unintended double taxation due to principles of residence based and source based taxation in different jurisdictions.
The Rules aim to provide a computation mechanism, operational clarity and procedural requirements associated with availing foreign tax credit in India.
Eligibility: The newly introduced Rule 128 provides that a resident taxpayer can claim a credit for foreign taxes paid in (a) a treaty jurisdiction i.e. a country/ specified territory with which India has a double taxation avoidance agreement or an exchange of information agreement, and (b) in any other country where income tax includes excess profits tax or business profits tax charged by the central or local authority in that country.
To claim a credit, two requirements envisaged are (i) the foreign tax must have been paid, and (ii) credit may be claimed for the year in which the corresponding income is offered to tax in India
Timing mismatch: The Rules also attempt to address timing mismatch issues which arise due to the difference in the tax year systems between the source country and resident country (India) – for eg. In the US, taxes could be paid on a calendar year basis (Jan- Dec), as opposed to India where taxes are paid on a financial year basis (Apr – March). In such cases, the Rules provide that where income is taxable across two years, credit shall be proportionately distributed across those years based on when income is offered to tax in India.
While this had earlier not been addressed in the Draft Rules, which only provided for credit being obtained in the year in which the income corresponding to such tax was offered, for the amount of foreign tax paid without accounting for possible timing mismatch, the CBDT seems to have taken into account the recommendations of TARC, and suggestions by the stakeholders to address such timing differences.
Taxes covered: The Rules also specify that the credit shall be available against the amount of income tax, surcharge and cess payable under the Act but not against interest, fee or penalty in respect of the tax payable. This is in line with judicial precedents in the context of tax treaties, which have held tax relief to be available in respect of surcharge and education cess, in addition to regular income taxes on the basis that these taxes are “substantially similar” to income taxes.4 This reduces the ambiguity amongst taxpayers on the eligible taxes, and should reduce long drawn litigation on this subject.
Disputed tax: The Rules provide that no credit shall be available for any amount of foreign tax which is disputed in any manner by the taxpayer. Therefore, a tax credit is not applicable in a situation where foreign tax was paid by the taxpayer on demand during scrutiny by the foreign tax authorities, but such taxes have been disputed by the taxpayer, under appeal proceedings.
The Draft Rules had not taken into account cases where dispute has been settled, but this clarity has been brought in the final Rules. In this regard, the Rules further provide that if (i) a dispute is finally settled and (ii) the taxpayer furnishes evidence of settlement of dispute along with (iii) an evidence that the tax liability has been discharged and (iv) an undertaking that no refund in respect of such amount has been claimed within six months from the end of the month in which the dispute is finally settled, credit of such disputed tax shall be allowed.
Depending on the tax administrative efficiency of the concerned foreign jurisdiction, it may take several years for the final dispute to be resolved. This time gap may lead to an undesirable situation where taxes have been doubly paid in India and a foreign jurisdiction for a long duration for a transaction which was, in the first place not taxable.
Computation: The Rules provide that the tax credit shall be the aggregate of amounts of credit computed separately for each source of income, arising from a particular country/ territory.
Further, credit in India shall be available to an amount which is the lower of the taxes paid in India or foreign taxes paid. The Rules also provide clarity on foreign exchange fluctuation. They state that the credit shall be based on conversion rate (telegraphic transfer buying rate) on the last day of the month immediately preceding the month in which taxes were paid. This should help in reducing any incremental costs due to foreign exchange fluctuation, if there is a significant gap between payment of foreign taxes and obtaining credit in India.
Certain jurisdictions such as Singapore follow a credit pooling system where tax credits are not divided into various heads. This mechanism enables businesses to effectively utilize tax credits and avoid double taxation due to characterization issues. However, the Indian system seems to follow the more traditional form of credit – segregated on the basis of income sources.5
Credit for MAT: The Rules also provide that foreign tax credit may also be available for Indian taxes paid, which are in the nature of Minimum Alternate Tax (MAT). That said, the Rules are unclear on how the computation mechanism would work in such a case, as there may be a mismatch in the source of income tax - between MAT and taxes paid in the foreign country. Clarity that foreign tax credit in case MAT is applicable, shall be available for foreign corporate taxes paid would be useful.
The Rules further provide that if foreign tax credit is availed of in respect of MAT, the taxpayer shall not be entitled to set off MAT against corporate taxes paid in future – a credit mechanism which has been provided under the MAT related provisions. A limitation has also been provided that if the foreign tax credit available is higher than the MAT credit, the lower amount shall be considered.
Documentation: Foreign tax credit shall be allowed on the taxpayer furnishing a statement of income offered for tax for the previous year in the foreign jurisdiction, and of foreign taxes deducted or paid in the foreign jurisdiction in a prescribed form (Form No. 67).
Proof of payment of taxes: The Rules further provide that the statement should specify the nature of income and the amount of tax deducted or paid by the taxpayer, as provided by (a) the tax authority of the country outside India, or (b) from the person responsible for deduction of such tax, or (c) signed by the assesse, if accompanied by an acknowledgment of the payment of such tax in the form of bank counter foil, challan or a receipt of online payment as proof depending on mode of payment, or proof of deduction if tax has been deducted.
This flexibility afforded in the Final Rules, is a departure from the Draft Rules, which provided only for validation from the foreign tax authorities – a longwinded unworkable process.
Timeline: The above requirements should be furnished on or before the due date for filing of income-tax returns.
Carry backward of losses: Lastly, the Rules specify that Form No. 67 shall also be furnished in a case where the carry backward of loss of the current year results in refund of foreign tax for which credit has been claimed in any previous year or years.
The Rules come a welcome relief to global Indian businesses earning significant income abroad. While the ITA as well as double taxation treaties provided for a credit from a substantive law perspective, practically it was a difficult and cumbersome process in the absence of well laid out procedural rules. The CBDT has been cognizant of these difficulties, and in line with the recommendation of the TARC (which was constituted to simplify tax administration), aimed to provide procedural simplicity for availing foreign tax credit through a comprehensive set of rules.
Importantly, the Rules have removed anomalies that existed in the draft form, by taking into account representations made by stakeholders, and interested parties. Welcome changes include – clarity on timing mismatches across jurisdictions, foreign exchange fluctuation, disputed foreign income and ease in documentation requirements.
That said, there are several longstanding pain points that still need to be addressed in the foreign tax credit sphere – such as ability to claim underlying tax credit for dividend distribution taxes, buyback taxes and tax sparing which are unique to the Indian tax system.
3 R. VENKATESAN, INTERNATIONAL TAX COMPENDIUM 616 (Vol. 2, 3rd ed. 2013).
4 Deputy Director of Income, Kolkata v. BOC Group Ltd., International Tax  64 taxmann.com 386 (Kolkata – Trib), The commissioner of Income Tax v. Arthusa Offshore Company, (2008) 216 CTR Uttaranchal 86 (HC.)
5 CIT v. Bombay Burmah Trading Corp. Ltd. (2003) 259 ITR 423