Detailed foreign tax credit norms the need of the hour

This is needed to bring transparency in taxation of foreign firms in India and foreign transactions of Indian firms

The concept paper on simplification of income tax has reportedly proposed major changes in international taxation norms.

Going by media reports, four new concepts/ regulations (controlled foreign corporation, thin capitalisation, advance price mechanism and specific anti avoidance regulations) would be introduced with a view to bring transparency in taxation of foreign companies in India and foreign transactions of Indian companies.

In addition, the impending next generation reform would include detailed foreign tax credit (FTC) regulations.

India being predominantly a capital importing nation, its income-tax law has had limited provisions for dealing with FTC. However, with outbound investments on a steep rise, it becomes imperative that the Indian domestic tax laws are revisited to incorporate adequate and exhaustive provisions dealing with FTC. In countries like the US, UK, Singapore, etc, extensive FTC rules are formulated to avoid litigations and provide clarity to tax payers.

The unilateral tax credit (UTC) provisions under Indian income-tax law, which operate only in a non-treaty scenario, provide only for the computational machinery of FTC on the ‘doubly taxed income’. It lacks clarity on certain basic critical issues like meaning of the terms ‘income’ or ‘doubly taxed income’, basis of claiming FTC, time limit for claiming FTC, effect of exchange rate fluctuations on FTC, standard procedures for claiming FTC, etc.

Clarifications on some of these issues are derived from interpretations provided by various court rulings.

The Madras High Court in the case of Best and Crompton Engineering Ltd had held that for computing UTC, the term ‘income’ would mean ‘commercial income’ and not income as computed under provisions of income-tax law of India/source country.

The Supreme Court in K V A L M Ramanathan Chettiar has held that while computing UTC, ‘doubly taxed income’ means only identified income subjected to income tax twice over, in India and source country. Further, the apex court rejected source-based FTC restriction stating that income tax being a tax levied on total income, income-tax assessment is one whole and not group of assessments for different heads/items of income.

Normally, tax treaty provisions contain only guiding principles, leaving practical application for computation/ operation of credit mechanism to domestic tax laws. Now, in the absence of detailed FTC provisions in India, can one apply the computational machinery prescribed under UTC provisions for computing eligible amount of FTC under treaty provisions? One may take recourse inter alia to CBDT Circular No. 333, which provides that the laws in force in the respective country would govern assessment and taxation of income in the absence of contrary provisions in tax treaty. Further, absence of underlying tax credit (i.e. credit for foreign corporate taxes paid by overseas subsidiary) mechanism under domestic tax law as also under majority of tax treaties entered into by India effectively results in double taxation of investment income received by Indian multinationals from their overseas subsidiaries.

Under the treaty scenario, Indian entities having export (and hence exempt) income from units located in EOU/STPI/SEZ, may face the issue of whether FTC should be available for taxes paid on its exempt export income outside India.

On a similar issue, the Mumbai Tribunal in the case of Digital Equipment has disallowed FTC claim stating that there has to be ‘double’ taxation of the same income before any question of elimination of double taxation is addressed.

However, by taking recourse to the Supreme Court’s decision in the case of Azadi Bachao Andolan, one could argue that treaties stipulate only ‘maximum deduction rule’, which provides that India will allow FTC to the extent of taxes ‘leviable’ in India, which due to specific exemptions are not levied.

Similarly, the Bangalore Tribunal in Wipro Ltd., without commenting on the eligibility to claim FTC, gave directions to tax authorities to grant FTC as per treaty provisions after verifying actual payment of taxes outside India.

Other critical issues emanating from outbound investments relating to FTC include FTC relief for double taxation arising due to timing difference or tax year difference, different characterisation of same income in different jurisdictions, carry over benefit of unabsorbed FTC, etc.

Considering the plethora of issues outlined above, detailed FTC provisions in Indian Income-tax law seems to be the need of the hour in view of the country’s inevitable transformation into a capital exporting nation.

The writer is a senior manager, PricewaterhouseCoopers.