Foreign tax credit: Need for introduction in India

There is a general euphoria about the state of the Indian economy. Outbound investments are no longer restricted but tactically encouraged. Globalisation is the buzzword today. Not only are Indian companies exploring foreign shores by setting up operations abroad, but domestic companies across a broad spectrum of industries such as pharmaceuticals, IT, oil, gas, steel, telecom, to name a few, are increasingly adopting an acquisition led cross-border growth strategy.

Each and every transaction has its associated tax costs. Thus, operations abroad do involve a cost in terms of foreign taxes. As is well known, India adopts a world-wide system of taxation. Residents of India (that include domestic companies that are incorporated in India) are taxed on their world wide income. In other words, the foreign income is also subject to tax in India.

International tax principles (including the OECD and UN Model Conventions) recognise two methods for avoiding double taxation. In general terms under the exemption method the foreign income is exempt from tax. Countries that follow the territorial tax regime such as Singapore, Hong kong, exempt the foreign income from taxation under the domestic tax laws. A few other countries that adopt the world wide system of taxation such as Netherlands or Belgium also exempt, either fully or in part, the foreign source income. However, most countries, including India, which adopt the world wide tax regime, adopt the credit method for providing double tax relief.

Under the credit method the residence country (India "� for the purpose of this article), calculates its tax based on the taxpayers' world wide income. It then permits a deduction from its own tax (Indian taxes) for the tax paid in the other country. The principle of credit, may be applied by two main methods:

1) Full credit: Here the residence country allows the deduction of the total amount of tax paid in the other country on the income on which tax is leviable in the other country.

2) Partial credit: Here the residence country allows a deduction for the tax paid in the other country but to the extent of the tax that would have been paid on such income in its own country.

India has entered into double taxation avoidance agreements (tax treaties) with majority of its trading partners. Tax treaties entered into by India have adopted the credit method for providing double tax relief. The same is also enshrined in its domestic tax laws applicable where the other country is one which has not yet entered into a treaty with India.

Let us examine both these scenarios.

Unilateral relief as prescribed under the Income-Tax Act, 1961 (I-T Act): Section 91 of the I-T Act, grants unilateral relief in respect of income which has suffered tax both in India and in a country with which no tax treaty exists.

The method of computation is as under:

1) Ascertain the amount of income, which has been subject to double taxation;

2) On such income, tax is calculated at the Indian rate of tax and the foreign rate of tax; and

3) Tax relief is granted by allowing a deduction from the tax liability of an amount equal to the tax calculated at the Indian rate of tax or the amount of tax calculated at the foreign rate of tax on the doubly taxed income, whichever is less.

Bilateral relief as prescribed under the tax treaties entered into by India: Other than providing the general principle that tax paid in respect of income taxed in the other country (country of source of income) shall be available as a credit against the Indian tax liability, the tax treaties do not prescribe specific guidelines on the approach to be adopted while computing the tax credit. Further, tax treaties generally prescribe that the computation shall be subject to the restriction and limitation of the domestic tax laws of the country granting the credit (India for the purpose of this article).

In the absence of any specific guidelines in the I-T Act, the biggest challenge faced by Indian outbound investors is difficulties in claiming tax credits in India for foreign tax costs incurred for global operations. This results in uncertainty and hampers global expansion plans and also leads to litigation.

One of the recent reported cases that comes to mind is that of the Bangalore tax tribunal in the case of Wipro v. DCIT (96 TTJ 211). The Tribunal examined the eligibility of foreign tax credit in the hands of Wipro. It concluded that though the net profits of the company were eligible for tax holiday/tax relief under the I-T Act, this did not underscore the fact, that income was included for tax both in US (the source country) and in India. The tax officer was directed to verify that Wipro had included such income in the gross total income reflected in its Indian tax return. If yes, foreign tax credit was to be granted to Wipro.

A few practical issues that Indian outbound investors have to grapple with are discussed below:

1) Aggregation v. country-by-country approach: Where a domestic company receives income from several countries, it is unclear whether an aggregate approach or country-by-country approach should be adopted for determining the foreign tax credit eligibility in India. The aggregate method permits pooling of high-tax and low-tax income.

Let us take a concrete illustration: India Pvt Ltd, a company incorporated in India and hence resident of India has a branch in Country X (Branch X) and another branch in Country Y (Branch Y). Let us assume that both these branches have earned a net income of $100 each. Thus, India Pvt Ltd has a total foreign source income of $200. The tax rate on these branches is 20% and 40%, respectively (amounting to $20 and $40, respectively). The corporate tax rate in India is 30% (we are ignoring surcharge and cess for the purpose of this illustration). In case the aggregate approach is adopted, the total foreign income would be pooled ($200). Thus the total foreign taxes of $60 would be eligible for tax credit against the tax liability in India (30% aggregating to $60). Thus, the foreign taxes would be fully offset against the Indian tax liability.

On the other hand, if a country-by-country mechanism was to be adopted, then India Pvt Ltd would get full tax credit for the taxes paid in Country X of $20. However, as the credit for foreign tax is restricted to the India tax on that income, the tax credit for the taxes paid in Country Y would be restricted to $30. Thus, the incremental tax liability will be $10.

The aggregate approach permits pooling of low-tax and high-tax income, and this generally optimizes the FTC eligibility in India.

2) Pooling of items of income: A similar issue arises as regards items of income such as dividends, interest, royalty etc. It is not clear whether the foreign tax credit eligibility should be computed by pooling all items of income or should be computed for each item separately.

3) Allocation of expenses: In the absence of guidelines in the I-T Act, it also becomes difficult for a domestic company which earns income both from India and abroad, to allocate related expenditure between the two sources of income.

4) Carry forward of unabsorbed FTC: At times, the domestic company is unable to absorb fully the FTC. For instance, a software company could be enjoying a tax holiday in India under section 10A. Thus there are nil or inadequate Indian taxes against which to claim a set-off. Foreign taxes, in such instances, become a 'sunk cost' in the absence of provisions permitted a carry forward. Carry forward of foreign tax credit would mitigate this problem.

While dividends declared by an Indian company are tax free in the hands of shareholders, including foreign shareholders, dividends received by an Indian company from its subsidiaries abroad are taxable in its hands. Underlying tax credit (credit for the taxes borne by the subsidiary on the income from which dividend is paid) is allowed only in tax treaties entered into with Singapore and Mauritius. This also compounds the problem faced by Indian outbound investors.

Several countries, such as the United States and the United Kingdom have in place detailed foreign tax credit regulations. The Vijay Mathur Committee in its report on Non-resident Taxation, submitted in 2003, had highlighted the need for introducing comprehensive foreign tax credit guidelines. It also advocated introduction of underlying tax credit provisions to ensure location-neutrality of investments.

Specific guidelines must be introduced in the I-T Act; it will give an impetus to outbound investments.

(Courtesy: Ernst & Young)