Need for FTC

The concept of FTC came to occupy an important position in international taxation because of globalization and ease of doing business in foreign countries. Ample opportunities created greater mobility of individuals and corporate entities to diversify and expand their business portfolio in countries other than of their residence. Earning income from outside India and being subject to tax in two or more jurisdictions, led to double taxation of the same amount for a resident (known as juridical double taxation). Similarly, different persons taxed in respect of the same income also leading to double taxation (known as economic double taxation), for e.g. corporate profit is taxed in the hands of the Company and dividend is taxed in the hands of the shareholder. There are different ways to eliminate the juridical double taxation and types of methods for eliminating the same are captured below:

This Article discusses the ordinary credit method for claim of FTC.

International Approach

The Organisation for Economic Co-Operation and Development (‘OECD’) and United Nation (‘UN’) Model Conventions recognize two methods for avoiding double taxation: 1. Exemption Method; and 2. Credit Method. Different variants of these methods are discussed in the Commentaries to the Models. However, they do not recommend a particular method to be applied and broadly discuss the nuances and considerations that apply to each of the methods.

Countries provide relief from double taxation unilaterally through their domestic law as well as through tax treaties. The former applies to all, the latter are specific to the residents of the treaty country. The method by which a country provides relief from double taxation depends primarily on its general tax policy and the structure of its tax systems. Also, the provisions of the double taxation avoidance agreement provide for a certain method to be followed for that particular tax treaty.

Approaches Adopted by Some Countries

• United States: United States relieves international double taxation by granting an FTC, subject to conditions. In lieu of the credit, a tax deduction may be claimed, but in most cases, the deduction is not as beneficial as the credit method. A limitation applies to the amount of foreign taxes that may be claimed as an offset against US income tax liability. In general terms, the FTC may not exceed the amount of US federal income tax that would be imposed on the taxpayer’s foreign-source income.
• United Kingdom: In the UK, unilateral relief from foreign taxation is given by the credit method, i.e. the foreign tax paid is deducted from the UK tax payable on the same source of income. Credit relief is given strictly on a source-by-source, item-by-item basis. Relief is given only for those foreign taxes, including national, provincial and municipal taxes, which correspond to UK income or corporation tax. In case taxpayer elect that no foreign tax credit be granted, overseas tax is allowed as a deduction from the business income. The method of relief chosen by taxpayers can vary between different sources of foreign income and, in relation to a particular source, the method can be varied from year to year. Further, the bilateral relief is provided based on the provisions of a tax treaty, and the maximum credit relief granted by a treaty is calculated in the same way as for unilateral relief purposes.
• China: In China, resident enterprises may generally claim double taxation relief under domestic laws and under tax treaties, however, the FTC is limited to the tax payable in respect of such foreign income in China. Taxpayers may choose to calculate the FTC separately for each source state (per country) or on an overall basis (overall credit). Once the election is made, it may not be altered for 5 years. Any unused amount of credit may be carried forward for up to 5 years.
• Singapore: In Singapore, both unilateral and bilateral foreign tax credits are only available to persons who are Singapore residents during the relevant year of assessment. The amount of allowable foreign tax credit is limited to the lower of Singapore tax or foreign tax payable on the foreign income, after permissible deductions. The calculation of the foreign tax credit is to be made strictly on a “source-by-source and country-by-country” basis.

In view of different fiscal policies and techniques across the countries, a uniform solution for the computation and allowability of FTC may not be possible. As acknowledged in both the Model Conventions (the OECD¹ and the UN Model Conventions²), there may be a lot of difficulties in the universal application of the article on ‘relief of double taxation’, therefore they recommend that the domestic legislation should provide for solutions of all the difficult areas/ issues.

Indian Approach

In India, The FTC mechanism is governed by section 90 and section 91 of the Income-tax Act, 1961 (the Act). Section 90 of the Act provides relief from double taxation in India through a tax treaty³ concluded between India and another country. Section 91 of the Act provides unilateral relief in case no tax treaty exists. Central Board of Direct Taxes [“CBDT”] vide notification No. 54/2016 introduced Rule 128 in the Income Tax Rules, 1962 [“the Rules”] with effect from 1 April 2017. This Rule lays down the foundation, broad principles and conditions for the computation and claim of the foreign tax credit.

It follows the principle of ordinary credit, whereby the resident’s worldwide income (including the foreign sourced income) is determined, and the tax liability thereon is computed. From the tax liability so computed, credit for foreign taxes paid is granted to the extent of tax payable on such income in India (maximum deduction). Therefore, if the tax payable in India is more than the taxes paid in a foreign country, then the resident would be liable to pay the differential tax in India. If the foreign tax exceeds the Indian tax payable on such income, the excess tax credit is forfeited and cannot be carried forward.

Rule 128 provides that credit is to be computed separately for each source of income arising from a particular country or specified territory outside India. The aggregate of such credit would be considered as foreign tax credit eligible for deduction as mentioned above.

It also specifies that foreign taxes paid in foreign currency needs to be converted into Indian rupees (INR value) at telegraphic transfer (TT) buying rate⁴ on the last day of the month immediately preceding the month in which such tax has been paid or deducted.

Besides the above, there is not much guidance in Rule 128 and therefore, there are various issues still open to debate and some of the key issues are discussed below.

Gross Basis v. Net Basis of Taxation

Rule 128 provides that where income on which foreign tax has been paid or deducted, is offered to tax in more than one year, credit of foreign tax shall be allowed across those years in the same proportion in which the income is offered/ assessed to tax. However, it does not specify “how” such income needs to be determined. Determination of income as an issue is also stressed upon in the OECD commentary⁵ on Article 23B⁶ (as also mentioned in the UN Model commentary⁷). It states that normally, the basis for the calculation of income tax is the total net income, i.e., gross income less allowable deductions. Therefore, it is the gross income derived from the State of source less any allowable deductions (specified or proportional) connected with such income which is to be considered.

In case of net income basis, one may note that there are various items of disallowances and allowances incorporated in the tax computation, post which the total income is computed. Thus, another question that arises is whether the net profits need to be considered or net income after considering such items of disallowances/ allowances need to be considered. This is further complicated by “how” the apportionment of expense and disallowance/ allowance be done in order to arrive at the net income. While this depends and differs on case-to-case basis, one may consider directly attributable expenses and apportion other expenses on a prudent and reasonable basis to arrive at net income (including adjustments for disallowances/ allowances).

At this juncture, it may be noted that in certain cases, foreign taxes are deducted in a foreign country at gross basis. One can say that there is a disparity in the determination of taxable income, since, in the Source country such income is taxed on a gross basis whereas in India such income could be taxed on net basis, which is more likely the case. In this regard, it may be noted that one of the fundamentals of gross basis of taxation is that the income is normally taxed at a lower rate compared to the rate applicable for the net basis of taxation and this is done for the reason that the concerned Source jurisdiction may not want to delve into the complexities and challenges of determining the net basis of taxation (for e.g., nature and quantum of expenses, allowability of the expenses, losses, etc.). Thus, in this sense, the expenses are deemed to be allowed in the Source country (by way of a lower rate applied on the gross amount). This of course may not match with the actual expenses desired to be claimed by the taxpayer in India and it could also result in lower FTC vis-à-vis the actual foreign taxes paid.

Judicial Precedents on Net Income & Expense Allocation

From a judicial standpoint, while the matter is still evolving and there are not many case laws, one may refer to the decision of the Hon’ble Ahmedabad Tribunal in the case of Elitecore Technologies Private Limited v. DCIT⁸ wherein it was observed that the expression used is ‘income’, which essentially implied ‘income’ embedded in the gross receipt, and not the ‘gross receipt’ itself. Further, on the specific facts of the case, it noted that the assessee did not have to incur any expenses towards earning the foreign income (more so passive in nature) and therefore, no expenses should be deducted while arriving at net income. Further, for another part of foreign income where the assessee had actually presented allocation of expense, the Hon’ble Tribunal accepted the said basis to be reasonable in absence of any infirmities being pointed by the Revenue. In addition and very importantly, the Hon’ble Tribunal rejected AO’s action of allocating a share of total expense on the ratio of turnover. It further emphasized that one needs to look at different methods such as averaging on the basis of overall revenues and profits of the assessee, or on the basis of some other ratio analysis, only when the income element cannot be worked out on some other reasonable basis. Also, it observed that the allocation of proportional deductions can be justified in some situations, such as when business operations are somewhat evenly or even in a significant manner, spread over the residence and source jurisdiction.

In the case of Infosys Technologies Ltd. v. JCIT,⁹ while the matter was regarding the validity of revisionary proceedings and not FTC computation per se, the Hon’ble Bangalore Tribunal had occasion to look at the facts and based on the same, opined that if the view adopted by assessing officer is one of the possible views for FTC computation, revision cannot be resorted to on the ground that the Commissioner do not accept such view or that necessary enquiry has not been made in this regard.

Facts of the Case: Learned CIT, during the revision proceedings under Section 263 of the Act, issued a notice proposing a revision of the order passed under section 143(3) of the Act. Learned CIT was of the opinion that the credit as available under The India - Canada tax treaty and India – Thailand tax treaty was granted without properly applying the provision of the said tax treaties and this failure on the part of the assessing officer (AO) has rendered the order erroneous and prejudicial to the interest of the revenue. Thus, it directed the AO to compute the relief as per the provisions of the said tax treaties.

Assessee’s Arguments: Among many other contentions, the assessee contended that Learned CIT did not demonstrate in what manner the claim of credit of taxes paid in Canada and Thailand made by the assessee and allowed by the AO was wrong. The assessee further contended that India does not have any rules in the domestic legislation governing relief from double taxation.¹⁰ In the absence of specific rules and in situations where more than one solution is possible, the adoption of one of the many alternatives should not mean, that the order passed by the AO is erroneous. The assessee also pointed out that for the years under consideration, there were six computations on the record made by different AOs and authorities at different points of time. These different alternatives, all of which appear apparently correct, suggest that more than one solution is possible and therefore, the order cannot be treated as erroneous.

Tribunal’s Judgement: The Hon’ble Tribunal inter-alia observed that “in this case, originally FTC was not given. When the assessee perused the matter and submitted the details, the same was given while giving effect to the appellate order. The dispute relating to non-giving of credit for tax paid in Canada and Thailand was not raised before Commissioner (Appeals) but was pursued by the assessee before AO under section 154 of the Act. After having satisfied himself, the AO gave the credit. Once again, this credit was sought to be withdrawn by AO invoking section 154 of the Act. Once again on the reply filed by the assessee no action under section 154 was taken by AO. This means that the AO has satisfied himself that the tax credit was properly claimed and allowed. The Commissioner in revision proceedings has not given any finding that the credit is erroneously given... An order can be revised only when the order is demonstrated to be erroneous. The AO has adopted one of the possible modes of granting credit in respect of income arising in Canada and Thailand”. In conclusion, the revisionary proceedings were quashed.

To appreciate what is that possible view, which assessee adopted and the assessing officer accepted, the computation of FTC as enumerated in the above case is tabulated below:

From the above calculation, one can see that the proportionate income from Canada/ Thailand considered for arriving at the tax liability is the profits (before depreciation and tax) apportioned based on the gross billings from Canada/ Thailand to total turnover. Further, the total tax liability is apportioned on the basis of such net income from Canada/ Thailand to total income. In this case, the deduction of expenses or items of disallowances/ allowances, etc., was not considered. Thus, the above decisions rendered in view of the specific facts of its case could be considered as guidance only. The determination of income must be based on strong rationale, tax principles and commercial expediency that reflects the business realities of the situation which would then aid the claim of FTC.

Conversion of Foreign Income into INR Value

There could be foreign exchange rate fluctuation between the day an Indian resident derives foreign income and the day such income is realized and further, the day on which foreign taxes are paid/ deducted. A question, therefore, arises as to which exchange rate be considered for converting the foreign into INR value.

Generally, it is seen that when resident entities receive foreign income in their bank account, it is already converted and credited by the Bank at a certain rate. For the purpose of books of account, the resident entities are required to apply the applicable accounting norms and guidelines to recognise this foreign income at a certain converted value.

However, for the purpose of FTC, Rule 128 is silent on the conversion of foreign income to INR value. In this regard, it may be noted that Rule 115 of the Rules provides that rate of exchange for calculating INR value of any income, accruing or arising or deemed to accrue/ arise or received or deemed to be received by the assessee, in foreign currency, shall be TT buying rate as on the “specified date”.

The specified date depends on the category of income and the cross application of another Rule, namely, Rule 26 of the Rules. This Rule provides that rate of exchange for the deduction of taxes on income payable in foreign currency shall be the TT buying rate as on the date on which tax is required to be deducted under the provisions of Chapter XVIIB (Indian taxes and not foreign taxes). Where Rule 26 applies, the specified date for the purpose of Rule 115 shall also be the date on which tax was required to be deducted (in other words, the same rate and date applies for Rule 115 and Rule 26 in tax deduction cases). This brings parity between the amount of INR value to be considered by the deductor and the amount of INR value to be considered by the recipient of income. However, it is to be noted that Rule 26 will apply to cases where such income is payable to an assessee outside India. Therefore, this Rule may not apply to residents receiving income in foreign currency in India. Accordingly, resident receiving income in foreign currency in India may apply the rates specified in Rule 115 itself.

Unfortunately, in the case of ACIT v. Snia Fibre SPA,¹¹ the above phrase “income is payable to an assessee outside India” was not highlighted/ discussed and the Hon’ble Delhi Tribunal upheld the assessee’s argument that Rule 26 should apply in its case since taxes have been deducted. Further, it is not clear whether such taxes deducted were Indian taxes under the provisions of Chapter XVIIB or foreign taxes deducted by the payer in a foreign country. Thus, these aspects may be evaluated before deciding on the application of Rule 26. One may note that a co-ordinate bench of the Hon’ble Delhi Tribunal in the case of Sedco Forex International Drilling Inc. v. DCIT¹² upheld the claim of the assessee (non-resident company) in applying Rule 26 wherein taxes were deducted by ONGC (Indian entity).

Further, it is important to note that there is an exception carved out in Rule 115 in view of which the said Rule will not apply to cases where income is received in, or brought into India in terms of exchange control regulations by the assessee or on his behalf before the specified date and such income is chargeable under the head “house property“, “business or profession“ and “other sources except for dividends and interest on securities”. In such cases, the rate at which the bank has credited the income (foreign exchange) could be considered as INR value for the purpose of taxation.

Reference in this regard can be made to the Hon’ble Supreme Court in the case of CIT v. Chowgule & Co. Ltd.,¹³ wherein it was observed that “if the foreign currency received by an assessee has been converted into rupees before the specified date, the question of application of Rule 115 does not arise.” Other decisions upholding this view include Snia Fibre (supra), Sedco Forex (supra) and DCIT v. Cathay Pacific Airways Ltd.¹⁴

Therefore, barring the exceptions, Rule 115 may be considered for deriving the INR value of the foreign income. Further, it is a better approach to be conservative and consider a higher INR value (for taxing the income) in case the INR value realised by the Company is actually more than the converted value as per Rule 115. The corresponding Indian tax payable would also be higher and therefore, a higher threshold available to compare the actual foreign taxes paid.

Computation of Proportionate Tax

The OECD commentary specifies that FTC may be computed by any of the below two ways:

1. Formula 1: FTC = (Total Tax / Total Income) * Income for which credit is to be given
2. Formula 2: FTC = Income for which credit is to be given * Tax rate for total income

There could be other ways as well such as a normal tax rate applied on foreign income or turnover based computation instead of total income. Normally taxpayers adopt the first approach above in arriving at proportionate Indian taxes and this may be considered a reasonable basis for FTC computation. However, which way works best would depend on the facts and circumstances of each case.

Other Critical Aspects

Higher Foreign Taxes Paid in Source Country

Withholding taxes paid by the Indian resident in a foreign country is normally based on tax treaty provisions to the extent that the same is beneficial. However, there may be cases where withholding taxes are deducted/ paid as per the rate specified in the domestic law of the foreign country which may be higher than the tax treaty rate. A question thus arises whether such excess tax paid being the difference between domestic law rate and tax treaty rate can be claimed as FTC? In this regard, one may note that Rule 128 inter-alia provides for the meaning of foreign tax as under:

“(a) in respect of a country or specified territory outside India with which India has entered into an agreement for the relief or avoidance of double taxation of income in terms of section 90 or section 90A, the tax covered under the said agreement.”

Thus the Rule provides for granting of FTC in accordance with the tax treaty.

In the case of Bhavin A Shah,¹⁵ the Hon’ble Ahmedabad Tribunal laid down several aspects which AO need to examine before granting FTC viz. (i) the residential status of the assessee under the treaty, (ii) whether amounts shown as dividends are actually in the nature of dividends, (iii) whether US tax withholding is in accordance with the provisions of Article 10 of the treaty and (iv) whether FTC claimed is lower of such tax withholding or Indian tax liability on such income whichever is less and in any case it cannot exceed the rate specified under Article 10.

Given the above decision and the fact that the matter is not settled at the Apex Court level yet, payment of foreign taxes beyond the tax treaty rate is bound to generate a lot of conflicts. While one needs to look at the interpretational side of the issue in analysing the treaty provisions along with domestic law provisions and the reasoning for payment of higher taxes, the FTC on a general basis, may not be allowed to the extent it exceeds the tax treaty rate.

Having said so, one can explore claiming a deduction of such excess FTC under section 37 of the Act (foreign taxes treated as ineligible credit). The Hon’ble Mumbai Tribunal in the case of Tata Sons Ltd. v. DCIT¹⁶ observed that: “There cannot obviously be a tax payment which is neither treated as admissible expenditure, because it is treated as an Income-tax, nor is it taken into account for tax credits, because it is not to be treated as Income-tax”.

One could also refer to the decision in the case of Bank of India v. ACIT¹⁷ wherein it was held that the assessee will be eligible for deduction of taxes paid abroad on its income in respective tax jurisdiction in respect of which the assessee had not been granted any tax credit.

Source of Income Is Eligible for Tax Holiday / Deduction (Section 10A / Exemptions)

No tax would be payable on the foreign income earned in cases where exemption, deduction, etc. applies, however, in these cases, the taxpayer may have paid foreign taxes in the source country. A question thus arises whether FTC would be available in these cases where taxpayers do not have India tax payable. Reference in this regard can be made to the following judicial decisions which on the principle basis have upheld that FTC would be eligible even in cases where there is no Indian tax payable, provided it is in accordance with the provisions of the tax treaty and the relevant exemption/ deduction provision under the Act:

• Blue Star Infotech Ltd. v. ACIT:¹⁸ Revenue authorities denied FTC on the income on which the assessee was charged tax in Japan was not chargeable to tax in India being exempt under the provisions of section 10A. The Hon’ble Mumbai Tribunal allowed the FTC by observing that “after amendment by Finance Act, 2000 with effect from 1-4-2001 deduction under section 10A being from the total income leads to the conclusion that there was charge of tax in India also on the income that has been subjected to tax in Japan. The tax liability of the assessee is equal to the tax payable in India at normal rates. Accordingly assessee qualified for tax relief under para (2a) of article 23 of Double Tax Avoidance Convention between India and Japan as applicable to the assessment years under consideration.”
• Tata Consultancy Services Ltd. v. Addl. CIT:¹⁹ The Hon’ble Mumbai Tribunal observed that “whether where respective tax treaty provide for benefit of foreign tax paid even in respect of income on which assessee has not paid tax in India, still, it would be eligible for tax credit”.
• Wipro Ltd. v. DCIT:²⁰ The Hon’ble Karnataka High Court held that “income which is exempt under section 10A is actually chargeable to Income-tax Act under section 4; exemption only suspends collection of income tax for a period of 10 years and, thus, such a case falls under section 90(1)(a)(ii) and assessee would be entitled to take credit of Income-tax paid in foreign country in respect of such income.” This decision is followed by several courts holding the matter in favour of the taxpayers.

Concluding Remarks

Though FTC is an effective tool to mitigate double taxation, yet the concept of FTC with respect to computation is not refined. There is limited jurisprudence and limited guidance under sections 90/ 91 of the Act and Rule 128 of the Rules, which makes it highly vulnerable to litigation. Different entities might take a different stand. There is no concrete approach or methodology. To avoid future litigation and possible outflow of cash as a consequence of such litigation, an appropriate method of calculating FTC should be employed and that must be supported by robust documentation. Also, one must bear in mind that the above aspects could interplay with other issues such as interpretational aspects, dealing with loss situations, etc.

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Footnotes & Citations

1. Organisation for Economic Co-operation and Development (OECD) Model Tax Convention on Income and on Capital (2017)
2. United Nations Model Double Taxation Convention between developed and developing countries (2021)
3. Double Taxation Avoidance Agreement
4. “telegraphic transfer buying rate”, in relation to a foreign currency, means the rate or rates of exchange adopted by the State Bank of India for buying such currency having regard to the guidelines specified from time to time by the Reserve Bank of India for buying such currency, where such currency is made available to that bank through a telegraphic transfer.
5. Commentary on OECD Model Tax Convention on Income and on Capital (2017)
6. Article 23B deals with foreign tax credit methods
7. Commentary on UN Model Double Taxation Convention between developed and developing countries (2021)
8. ITA No.623/Ahd/2015
9. 2006 103 ITD 399 Bang, (2006) 105 TTJ Bang 802
10. At the relevant time, India had not introduced specific rules. However, at present, Rule 128 governs FTC claims.
11. [1996] 55 TTJ 554 (DELHI)
12. [2000] 72 ITD 415 (DELHI)
13. [1996] 84 Taxman 623 (SC)
14. [2003] 84 ITD 205 (CAL.)
15. [TS-130-ITAT-2017(Ahd)]
16. [2011] 10 taxmann.com 87 (Mum.)
17. [2021] 125 taxmann.com 155 (Mumbai - Trib.)[04-03-2021]
18. [2015] 57 taxmann.com 386 (Mumbai - Trib.)
19. [2020] 121 taxmann.com 190 (Mumbai - Trib.)
20. [2015] 62 taxmann.com 26 (Karnataka)

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Author may be reached at: ca.ankithajain@gmail.com and eboard@icai.in