By Monika Wadhwa and Rupali Ashar, ET CONTRIBUTORS
Foreign Tax Credit (FTC) is a mechanism employed by countries to alleviate double taxation arising from income earned in one country and taxed both in the country in which it arises and in another where the receiver of the income is a resident. In an era of globalisation and digitalization, where businesses, people, and their investments transcend geographical boundaries, FTC becomes increasingly critical to optimize global effective tax rates.
Tax Treaties serve as a cornerstone in this process, facilitating the mutually agreed distribution of taxing rights between the source country (where income is generated) and the residence country (where the taxpayer resides). These treaties aim to prevent double taxation while ensuring fair allocation of taxing rights between countries. They also lay out rules for determining residency status and in some cases specify the applicable tax rates.
In India, regulations pertaining to FTC are governed by domestic tax laws and bilateral tax treaties. However, navigating the complexities of FTC regulations can be daunting. Various factors such as the type of income, characterisation at source, and the availability of tax credits under the relevant tax treaty need careful planning and robust documentation. Resident Indians (RIs) often face challenges related to claiming FTC, given that Tax treaties or Double Tax Avoidance Agreements (DTAA) often contain technical language and complex provisions. Some of the key challenges and tips and tricks to sail a smooth FTC journey are.
Tax Treaties serve as a cornerstone in this process, facilitating the mutually agreed distribution of taxing rights between the source country (where income is generated) and the residence country (where the taxpayer resides). These treaties aim to prevent double taxation while ensuring fair allocation of taxing rights between countries. They also lay out rules for determining residency status and in some cases specify the applicable tax rates.
●Residency Status: Determining residency as per applicable DTAA is crucial to claim FTC under that DTAA. At times, the taxpayer may qualify to be a resident of both countries as per their respective domestic tax laws, and this adds to the complexity of determining treaty residency as per the tie-breaker rule or reaching out to Competent authorities to determine ultimate residency under certain DTAAs.
Residential planning and accurate application of international principles for treaty interpretation may help to navigate this challenge
●Coverage of taxes: In certain countries (for example the US), income taxes are levied by the State as well as the Federal Government. The eligibility to claim FTC for State taxes is prone to practical issues in India, where the DTAA covers only Federal taxes. Similarly, the US levies Investment income tax as a separate tax on certain capital gains and investment income. Eligibility to claim such investment income tax credit is also prone to practical issues. Timely assessment of practical problems and the possibility of exploring alternative views in any such tricky claims could be explored.
●Timing of Taxes Paid: Differences in tax years for offering taxable income and timing of tax payments between the two countries can affect the availability and calculation of FTC. While India follows the Fiscal Year (i.e. 1 April - 31 March) as the tax year, many foreign countries follow the calendar year as their tax year. Availability of all foreign income tax payment proofs corresponding to the income of the Fiscal Year considered in Indian Income tax returns may not be possible due to different timelines for statutory payments. To effectively claim FTC, certain alternatives like advance payment of foreign taxes or taxes deducted at source and timely sourcing of tax payment proofs or certificates from tax deductors can be explored.
●Foreign Tax Credit Limitations: Tax treaties lay out limitations on the amount of FTC that can be claimed, where amounts of FTC have to be computed separately for each source of the income. Due to exemption, reliefs, special tax rates available in one of the countries, or applicability of attribution rule, often taxpayer end up paying effectively the highest tax rate on gross income globally. Advance planning and yearly review may help to mitigate this challenge.
●Country-Specific Provisions: Certain types of income may be treated differently or may not be eligible for corresponding tax credits under the residence country's tax laws. Differences in the categorisation of tax structures, timing of taxation, availability of exemptions, and deductions across countries often complicate the determination of FTC.
For example, in the US, married couples have the option to file their taxes jointly or separately whereas India follows a single tax filing mechanism resulting in the complexity of determining foreign tax credits available to an individual taxpayer in India. Preparation of the separate computation and making separate tax payments in the US owing to each individual’s tax liability could facilitate the claim of FTC in India.
Another issue that arises in the US context is that investments in certain Indian Mutual Funds fall under the Passive Foreign Investment Company rules and are taxed in the US on a notional ‘mark to market’ basis . Whereas the same income would be taxed in India only upon the sale of investments as Capital Gains. Differences in timing of taxation, different categorisation of capital gains and rates of taxes, may ultimately result in certain global tax leakages and higher tax outflow.
●Documentation and Record-keeping: Proper documentation is essential to support the FTC claim, including calculation of income and corresponding taxes, foreign income tax returns, proof of foreign taxes paid, . Most importantly timely filing of Form 67 alongwith tax payment proofs before filing of Income tax return is a crucial step to FTC claim. Maintaining accurate records facilitates responses in case of audits or inquiries from tax authorities. Incorrectly claiming FTC or failing to comply with reporting requirements may lead to undue enquiries and levy of interest.
FTC provisions play a pivotal role in addressing tax challenges arising from global business and cross-border investments. A proactive approach to tax planning empowers RIs to navigate the complexities of international taxation effectively to achieve significant financial benefits and foster efficient tax management on a global scale.
Monika Wadhwa is Partner North Americas, Legacy Growth and Rupali Ashar is Associate Partner, Legacy Growth
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