CPE STUDY CIRCLE MEETING

FOREIGN TAX CREDITMAY 2016

INTRODUCTION

Objectives of a tax treaty

• Elimination of double taxation

• Clarification of fiscal situation of tax payers

• Certainty on nature of income and quantum of tax payable irrespective of tax laws of overseas state

• Establishing the right of a country to tax an income stream

• Exchange of information to combat tax avoidance/tax evasion

• Promotion of cross border trade

Foreign Tax Credit 3May 2016

Treaty - Basic structure

Foreign Tax Credit 4May 2016

SCOPE PROVISIONS

1. Article 1 - Personal Scope2. Article 2 - Taxes covered

3. Article 30 - Entry into force4. Article 31 - Termination

ANTI-AVOIDANCE

1. Art 9 - Associated Enterprise2. Art 26 - Exch of Info

ELIMINATION OF DOUBLE TAXATION

1. Article 23 - Elimination of double taxation

2. Article 25 - Mutual Agreement

DEFINITION PROVISIONS

1. Article 3 - General definitions2. Article 4 - Residence3. Article 5 - Permanent

Establishment

SUBSTANTIVE PROVISIONS

1. Article 6 - Immovable property2. Article 7 - Business Profits3. Article 8 - Shipping, etc4. Article 10 - Dividends5. Article 11 - Interest6. Article 12 - Royalties & FTS7. Article 13 - Capital gains8. Article 15 – Income from employment9. Article 16 – Directors fees10. Article 17 - Artistes & Sportsmen11. Article 18 - Pensions12. Article 19 - Government service13. Article 20 - Students14. Article 21 - Other income15. Article 22 - Capital

MISCELLANEOUS PROVISIONS1. Article 24 - Non-discrimination

3. Article 28 - Diplomats4. Article 29 - Territorial Extension

2. Article 27 – Assistance in collection of taxes

Reasons for double taxation

Foreign Tax Credit 5May 2016

• Most countries provide for the following basis of taxation:

– Residents taxed on their world-wide income

– Non-residents taxed on income arising from sources within the country

• Certain countries tax world-wide income of their citizens, irrespective of their being residents of other states e.g. USA

• Thus, double taxation occurs in situations where the country of residence and the country of source seek to tax the same income

• Conflict in determining residential status – Tie breaker rule to be applied

Double taxation - Impact

ILLUSTRATION

Particulars State of residence State of source

Income 100,000 -

Income in source state 50,000 50,000

Total income 150,000 50,000

Tax rates Upto 100,000 – 30%100,000 – 200,000 – 40%

40% flat

Total tax 70,000 20,000

Tax system - Types

Country of residence will give credit for tax paid in the country of source

DOUBLE TAXATION - TYPES

Double Tax Relief - Approaches

Unilateral Tax Relief Bilateral agreements

Foreign Tax Credit system in the domestic law

Mutual covenants for sharing of tax revenue and elimination of double

taxation

Section 91 of ITA Section 90 of the Act – As per Double Tax Avoidance Agreement (DTAA)

Approaches to eliminate double taxation

Unilateral Tax Credit System in India

• Section 91 of Act• Preconditions

– Available to a tax resident of India– Available in respect income accruing or arising outside India– Actual tax payment in foreign country on such income – Tax liability resulting in tax payment in India (i.e. income is actually

doubly taxed)– No DTAA with the foreign country in which tax is paid

• Quantum of Relief– Proportionate relief at lower of ‘Indian tax rate’ or ‘foreign tax rate’– Not full credit

Unilateral tax credit - Scenarios

Foreign Business Income 250,000

Business losses in India (100,000)

Other income in India 50,000

Total Income 200,000

Impact of losses from other sources in India

Doubly taxed income in the above scenario – 200,000 or 250,000?

Impact of losses from sources outside India

Income from branch in Country A 300,000Loss in Country B (200,000)Income from sources in India 200,000Total Income 300,000

Whether doubly taxed income in the above scenario should be computed before or after setting off losses incurred by other overseas branches?

Redress Mechanism in DTAAs - A snapshot

• Different alternatives in DTAA aiming at avoiding double taxation (or) granting relief there against

• Residence – Residence conflict

– Article 4 ‘tie-breaker’ test ensures that person is resident of only one of the two contracting states

• Agreeing to exclusive tax jurisdiction pursuant to distributive rules in favour of one of the contracting states

– Exclusive jurisdiction to Country of Residence (COR)

Ex: Capital gains on sale of shares earned by Mauritian resident taxable only in Mauritius (Article 13(4) of the DTAA)

– Exclusive jurisdiction to Country of Source (COS)

Ex: Income of PE of Indian company in Bangladesh taxable only in Bangladesh. [Refer Article 7(1)]

Bilaterial AgreementsElimination of double taxation - Overview

• Relief in terms of Article 23 when taxation right subsists with both the states

• Elimination of double taxation is the responsibility of resident state

• Two methods envisaged by Model convention - Choice left to the treaty partners Methods

Exemption Method Credit Method

Full Exemption

Exemption with progression

Direct credit Indirect credit

Special credit

Full credit

Ordinary credit

Underlying Tax credit

Tax sparing

Relevant Text of Article 23A of OECD Model: Exemption Method

• “Where a resident of a Contracting State (A) derives income..... which, in

accordance with the provisions of this Convention, may be taxed in the

other Contracting State (B), the first-mentioned State (A) shall, ..........,

exempt such income .......... from tax.

...........

• Where in accordance with any provision of the Convention income derived

by a resident of a Contracting State (A) is exempt from tax in that state

(A), such State (A) may nevertheless, in calculating the amount of tax on

the remaining income of such resident, take into account the exempted

income ...............

Full Exemption Method - Impact analysis

• Income in COS 100,000

• Income in COR 100,000

• Total Income 200,000

• Tax rate in COR 40%

• Tax Matrix - Under full exemption method

Tax Rate in COS

Tax in COS on COS income of

100,000

Tax @ 40% in COR on COR

income

Total Tax in COS and COR

Effective tax rate

20% 20,000 40,000 60,000 30%

40% 40,000 40,000 80,000 40%

50% 50,000 40,000 90,000 45%

Exemption method – Key aspects

Key aspects

• Avoids double taxation by providing income exemption in respect of income taxable in source state

• Avoids double taxation by grant of exclusivity to one of the states

• Income need not necessarily be subjected to tax in source state

• Exemption method may permit the resident state the right to include income for rate purpose

Examples

• Rare for India to operate on exemption : Selective exemption possible

[Eg. India-Brazil : dividend from Brazil Company exempt from tax]

• By and large, exemption with progression.

Exemption method - Impact analysis

Advantages

– Relatively less complex

– Effective in eliminating double taxation

– Avoids dealing with two tax authorities

– Achieves import neutrality; it treats all taxpayers in COS on the same basis

– Tax benefits / concessions granted by COS are enjoyed by the investor

Disadvantages

– Issue of expense allocation, transfer pricing, etc. assume greater relevance

– May encourage shift of investment to tax heavens / lower tax regimes

– Reduces tax revenue due to the COR

– May lead to double non taxation

– Losses in COS may also be ignored in COR

Illustration – Exemption with progression method

• Income taxed in Source country considered by Residence Country only for purpose of determining tax rate on remaining income

• Residence country tax rate - 35% if income exceeds Rs 100,000; 30% if income is below Rs 100,000

• Source country tax rate - 20%

Particulars Exemption method Exemption with progression

Income from State R 80,000 80,000

Income from State S 20,000 20,000

Total income chargeable to tax in State R 80,000 80,000

Tax in State R 24,000 28,000 (80,000*35%)

Tax in State S 4,000 4,000

Total Tax Cost 28,000 32,000

Credit Method - Relevant Text of Article 23B of OECD Model

Where a resident of a Contracting State (A) derives income ....... which, in accordance

with the provisions of this Convention, may be taxed in the other Contracting State (B),

the first mentioned State (A) shall allow:

a) as a deduction from the tax on the income of that resident, an amount equal to the

income tax paid in that other State (B);

Such deduction ............. shall not, however, exceed that part of the income

tax ................, as computed before the deduction is given, which is

attributable ............, to the income ................ which may be taxed in that other

State (B).

Credit Method (Full Credit) – Illustration

Income in COR 10,000

Income in COS 10,000

Total Income 20,000

Tax rate in COR 40%

• Tax Matrix - under full credit method.

Source state - Tax rate

Particulars

20% 40% 50%

Tax on Total Income in COR @40% 8,000 8,000 8,000

Less: Credit for taxes in COS 2,000 4,000 5,000

Differential tax in COR 6,000 4,000 3,000

• If COS rate is higher, tax credit in COR beyond corresponding Home tax liability.

Text of Treaty Article - Full Tax Credit

Article 23(2) from India-Namibia treaty captioned: ‘Elimination of Double

Taxation’.

“2.In India, double taxation shall be eliminated as follows:

Where a resident of India derives income or capital gains from Namibia,

which in accordance with the provisions of this Convention may be taxed in

Namibia, then India shall allow as a deduction from the tax on the income

of that resident an amount equal to the tax on income or capital gains paid

in Namibia, whether directly or by deduction.”

Ordinary credit – Text of treaty article

Article 25(2) of India – USA treaty captioned “Relief from Double

Taxation”:

“(a) Where a resident of India derives income which, in accordance

with the provisions of this Convention, may be taxed in the United

States, India shall allow as a deduction from the tax on the income of

that resident and amount equal to the tax paid in the United States,

whether directly or by, deduction. Such deduction shall not, however,

exceed that part of the Income tax [as computed before the deduction

is given] which is attributable to the income which may be taxed in

United States.”

• Income in COR 10,000

• Income in COS 10,000

• Total Income 20,000

• Tax rate in COR 40%

Tax Matrix: Under ordinary credit method

Source tax rate

20% 40% 50%

Tax on Total Income in COR @40% 8,000 8,000 8,000

Less : Credit for taxes in COS 2,000 4,000 4,000

Tax liability in COR 6,000 4,000 4,000

Tax liability in COS 2,000 4,000 5,000

Total tax liability 8,000 8,000 9,000

• No credit beyond corresponding home tax liability.• If COS tax rate ≤ COR tax rate, burden unaffected.• IF COS tax rate > COR tax rate, additional tax exposure.

Ordinary credit – Illustration

• Resident state retains right to global taxation – grants tax relief against double taxes by grant of credit for taxes paid in COS on doubly taxed income.

• If the home tax on the foreign source income is more than the foreign tax, the taxpayer must pay the deficit as additional tax at home.

• If the foreign tax exceeds the home tax on the same income, the excess tax credit not refundable

• Credit may be qua source, country or basket of countries.

• Unless specific provision in Domestic Act

– Foreign tax is not an admissible expenditure

– Excess credit is not carried forward / backward

Credit method – General principles

Credit method – Pros and cons

Advantages

• Generally achieves exports neutrality for residents• Losses in COS available for set off in COR• Discourages the transfer of assets or income to low-tax countries or tax havens

Disadvantages

• Tax credit may be lost partially or wholly if:

ü COS tax rate is higher

ü COS taxes income @ gross level or on presumptive basis – but, actual (net) income chargeable in COR is lower

ü Exemption / relief is available in COR qua Foreign Income

ü Doubly taxed income as computed in COR is lower due to accelerated depreciation, additional allowances

ü Due to losses in other sources

§ Eliminates the tax relief and incentives given in the COS, unless the COR provides for suitable tax sparing

Underlying Tax Credit (UTC)

• Credit in respect of corporate tax paid by the overseas distributing company in addition to direct credit for tax on dividend income

• Eliminates economic double taxation as well

• Feature of bilateral agreements - no such concept in the domestic law of India

• UTC benefit may be linked to threshold holding of the recipient (Eg. India-UK treaty requires UKCO to have 10% holding).

• Single Track UTC privilege by the overseas country [Eg. USA, UK, Australia, Japan]

• Both way UTC benefit [Mauritius, Singapore]

Underlying Tax Credit (UTC)

Text of Article 25(2) - Elimination of Double taxation of India – Singapore treaty

“Where the income is a dividend paid by a company which is a resident of Singapore to a

company which is a resident of India and which owns directly or indirectly not less than 25

per cent of the share capital of the company paying the dividend, the deduction shall

take into account the Singapore tax paid in respect of the profits out of which the

dividend is paid.”

Tax sparing

Explanation to the concept of Tax sparing [Source: International tax – Glossary published by IBFD]

“Term used to denote a special form of double taxation relief in tax treaties with developing countries. Where a country grants tax incentives to encourage foreign investment (e.g. a tax holiday in respect of the profits of a company carrying on a pioneer industry) and that company is a resident of another country with which a tax treaty has been concluded, the other country may give the company “tax sparing” relief. This is achieved by the other country giving a credit against its own tax for the tax which the company would have paid if the tax had not been “spared” (i.e. given up) under the provisions of the tax holiday rules.”

• Under credit method, benefit of low tax, fiscal concession / incentive in source country accrues to COR – not to the investor

• Curative step : Tax sparing covenant• Exception to normal Rule - Credit for deemed tax• Tax sparing illustrated qua 10AA qualifying branch of a foreign

company in India

Tax Sparing – Key aspects

Income in India 100 Home Country taxation

Less : Tax in India NIL Income 100

Income remitted to HO 100 Taxation –Say @50% 50

Deemed tax paid in India (40) 10

Retained income 90

Tax sparing – Illustrative treaties

Variation of tax sparing in Indian treaties [inbound and/or outbound]

Illustrative Country names

Treaties where tax sparing is granted with reference to tax incentives designed to promote economic development.

Cyprus, China, Vietnam

Tax sparing with reference to specified sections/enactments.

Srilanka, Spain

Limited tax sparing qua certain income [say, interest income].

New Zealand for interest income

Countries where time limitation is built in: for certain years starting from the year in which resident claims tax incentive benefit

Canada, U.K

PROCEDURAL REQUIREMENTS

Draft guidelines – Claim of FTC

• Credit available in the year in which the income corresponding to such tax has been offered to tax or assessed to tax

• Scope of foreign tax • Where treaty is available – tax covered under the treaty• Non treaty jurisdictions – Explained in explanation (iv) to section 91 –

income tax includes excess profits tax or business profit tax charged by the Government

• Credit available in respect of tax, surcharge and cess payable under the Act

• No credit in respect of foreign tax which has been disputed in overseas jurisdiction

• Credit to be computed separately for each source of income• Credit available even in respect of tax payable under MAT provisions• Where FTC utilized against MAT exceeds the amount of tax credit under

normal provisions, such excess shall be ignored for the purposes of computing MAT credit u/s 115JB

Documentary evidences• Certificate from tax authority stating the nature of income and tax

deducted or paid• Where payment is by way of deduction of tax at source, copy of the

certificate• Acknowledgement for payment of tax• Declaration that foreign tax has not been disputed in the concerned

jurisdiction

Draft guidelines – Claim of FTC

Questions?

Thank you