Navigating International Taxes: Understanding The Foreign Tax Credit

Introduction

Foreign Tax Credit is a tax credit for foreign government’s income taxes due to foreign income tax withholdings. In short, credit for the taxes paid in a foreign country for earning the income in that country. For instance, Mr. Y, a resident of India, earned income in USA in FY 21-22. Now under Foreign Tax Credit Rule, he can claim credit for the taxes paid in USA in his ITR for the respective FY.

Concept of Double Taxation

When any income is taxed more than once, it is known as double taxation.

Need for elimination of Double Taxation

Double Taxation impacts the international business as the income earned overseas by the residents of one country are taxed twice in another country as well, therefore becomes a crucial point of discussion for making investment decision. Thus, to encourage the global trade between the countries, nations address the methods for eliminating double taxation.

For example: A Ltd., an Indian Company earned professional income in Germany and paid tax on it there. Now, under Income Tax Act, 1961, A Ltd. has to pay tax in India on such income as its business income. Thus, A Ltd. end up paying tax twice on single income i.e. both in Germany and in India.

Methods for Elimination of Double Taxation are:

*Unilateral Relief: Relief provided by the home country irrespective of any double taxation avoidance agreement with the country concerned. This relief comes into play when bilateral double taxation avoidance agreements are not sufficient to meet all the cases.

**Bilateral Relief: Under bilateral relief, Governments of countries involved in transaction will provide relief to the taxpayer on mutually agreed basis. This relief are mutually agreed upon and made available through double taxation avoidance agreements/tax information exchange agreements.

Methods of Claiming Foreign Tax Credit

• Exemption Method:

Under this method the income that is taxed in foreign country is exempted in the country of residence either partially or fully.

The two types of exemption method are explained below:

Full Exemption Method: According to this method, the tax paid on income in foreign country is exempt from taxation in resident country i.e. such foreign income is not considered for taxation purpose at all.

Progressive/Partial Exemption Method:  As per this method, though income is taxed in foreign country is exempted from tax in country of residence however the same is considered for tax calculation purpose.

Difficulty in claiming relief: This method does not provide relief for the excess tax paid in foreign country if the tax rate in foreign country is higher than the tax rate in resident country. The reason behind this blockage in road of claiming credit is due to non-consideration of both foreign income as well as tax paid in foreign country while calculating relief in resident country.

Difference between the above two methods can be understood more clearly with the example given below:-

Case: A & CO. has income from foreign sources and resident sources as well and details regarding its income and foreign tax payment and tax rates are as follows:

Solution

As shown in the above table Foreign Income is not considered for tax calculation purpose under Full Exemption Method while the same is considered under Partial Exemption Method.  Due to above reason, tax rate used in former method is 30% while in later is 35%. Therefore, we can clearly see the impact on Net relief under both the methods.

• Credit Method:

Under this method, foreign income is also considered while calculating total income in resident country to arrive at tax base but deductions are allowed upto foreign taxes paid.

• Full Credit Method: According to this method, there is no restriction on credit for taxes paid on foreign income in foreign country, i. credit is granted for the whole foreign tax paid.
• Ordinary Credit Method: The most common method adopted in many Double Taxation Avoidance Agreements (DTAAs) where credit is given against tax paid/payable in resident country. i.e. country of residence calculate tax as per its domestic law provided that such income is taxable as per respective DTAA or under its domestic law. Foreign Tax Credit is provided lower of the following :

For better understanding refer the example given below:-

Case: Mr. X is having income from foreign country and wants to claim the tax credit in his country of residence. Information regarding his income, tax paid, tax rates of resident country is as follows:

Solution: Below image shows the calculation of tax credit available under domestic laws according to different methods. The difference between two methods i.e. full credit method allowing whole foreign tax paid as credit while ordinary credit method allows tax credit according to domestic law provisions and ignoring the excess foreign tax paid in Case II.

Indian Tax Laws on Foreign Tax Credit

In India, Foreign Tax Credit is governed by Rule 128 of the Income Tax Rules introduced in June 2016 and became effective from 1^st April 2017.

Rule 128 (Income Tax Rules)

Salient Features of Rule 128 are explained below:

• Available for Indian Residents having income from foreign country and tax being paid on such income in respective foreign country provided that such income is offered for tax in India during the year in which credit is claimed.
• In few cases proportionate credit is allowed where income from foreign country is offered for tax in proportions for more than one assessment year.
• The rule defines Foreign Tax as follows:
  • Countries having DTAA/TIEAs with India, then taxes covered under such agreements.
  • For other countries, taxes paid under the applicable laws of that country.
• Tax against which Foreign Tax Credit can be utilized are tax, surcharge, cess, MAT, AMT while FTC cannot be utilized for interest, penalty, fees under the Income Tax Act and any foreign tax disputed by taxpayer.
• India follows ordinary tax credit method for providing relief against double taxation.
• Following Documents are required for availing FTC and to be submitted on or before filing return of income under section 139(1) :
  • Statement of Foreign Income and Taxes in Form 67
  • Certificate or statement declaring the nature of income and foreign taxes paid/deducted :
    • From the tax authority of foreign country; or
    • From the person responsible for the deduction of Tax; or
    • Signed by the taxpayer accompanied by proof of such tax payment or deduction

Sections Involving the Concept of FTC under the Indian Income Tax Act

Section 90/90A of Income Tax Act- Where DTAA /TIEAs exist credit of foreign taxes is allowed as per respective provisions of DTAA/TIEAs.

Section 91 of Income Tax Act- Where DTAA/ TIEAs do not exist credits of foreign taxes are allowed as unilateral relief, i.e. by the Indian Government according to ordinary credit method.

• Conclusion

In essence, FTC is a relief provided by the nations against double taxation of income during cross-border transactions. In the Indian framework, FTC is one of the important determinants for arriving on a tax base in international transactions. Indian corporates are the source of inducing foreign investments in India. For safeguarding Indian entities against double taxation of foreign income, the Indian Government allows FTC, thereby, paving the way for Indian entities to actively engage in global operations.