We often come across with cases where there has been double taxation on the same income both from source and resident countries. Typically from an India tax perspective, in case of ‘resident and ordinarily resident’ (ROR) having investments abroad, this scenario is quite common. In order to mitigate such double taxation implications, Section 90 of the Income Tax Act, provides for relief in case of countries with which India has Double Taxation Avoidance Agreement (treaty). Further, Section 91 of the Act provides for relief in case where there is no treaty with the other country. Treaties generally provide relief in the form of exemption or credit. Under exemption method, taxing rights would be given only to one country (generally, to source country). However, in case of credit method, income taxed in source country is also considered by the resident country to arrive at the tax base, but the taxes paid in the source country will be allowed as a deduction from its own taxes. Let us deep dive into the computation of foreign tax credit in case of US source income and some of the nuances associated with such computation.
India has a comprehensive tax treaty with the US which deals with taxability and double taxation relief for various sources of income. Article 25 of the treaty specifically deals with foreign tax credit (FTC). Since there is a tax treaty, provisions of Section 90 read with Rule 128 would be applicable. The credit would be the lower of taxes paid in the US or the taxes as computed under India Income Tax Act.
US Investment income
Considering the case of an Indian ROR who has investments in US, the income arising out of such investments may be multifaceted. Accretions include interest, dividend, capital gains etc. Some of these may be taxable at special rates in US. Computing FTC by applying average rate of tax may not be the right approach for such incomes since the special rates are generally lower than the normal slab rates. Taking an example of dividend income, US has a concept of qualified dividends which are taxable at 0% to 20% depending on the slab rates applicable to normal income of the taxpayer. Same in the case of long term capital gains as well. Many times these rates would be lower than the India tax rates as well and hence computing FTC by applying average rate of tax as per US return may result in incorrect claims. So, how to ascertain the tax rates applicable to these incomes in US tax return? One should refer to ‘Qualified dividends and capital gain tax worksheet’ in US tax returns which provides tax rates applicable to such incomes.
Another example of such income is Capital gain distributions. These distributions are basically dividends from US mutual funds. For US tax purposes, if the fund meets certain criteria, the distributions are taxed as long term capital gains. For the purpose of FTC, you may apply the special rate of tax as discussed above. However, bigger challenge with such income is determining the right head of income from India stand point. Whether to be taxed as capital gain which is in line with US tax laws or go by the nature of that income i.e., dividend and tax it under the head income from other sources? One should take a conscious call and then decide.
Retirals and pensions
Articles 19 and 20 of India-US tax treaty govern the taxability of government pensions and private pensions respectively. Apart from these, US also has other retirement benefits such as IRAs and 401(k)s. Both these are defined contribution plans which entitle the taxpayer to withdraw at certain age of retirement. Periodic accretions to these funds are not taxable in the US. Early withdrawals are permitted with certain exceptions and penalties. From India tax perspective, what happens to these periodic accretions? Taxable or not taxable? The FAQ to Black Money Act (Circular No. 15 of 2015 dated 03 Sep 2015) clarifies that such accretions should be taxable in India. So, how would you claim foreign tax credit for such accretions? Since the periodical accretions are not taxable in the US, there are no taxes paid on the same in US. However, these may be taxable in US at the time of withdrawal. There is a huge timing difference with respect to taxability and could result in double taxation. How to mitigate the double taxation in these cases?
Till 2020, there was no mechanism in place to mitigate this hardship. However, the budget 2021 proposed to prescribe the manner in which such income should be taxed from the specified retirement funds in India. The specific rules are still awaited in this regard. Hope, this will provide more clarity on the taxability and helps in mitigating the double taxation.
State/city income taxes in US
Another unique aspect of US taxation is state and city taxes. Most of the states and certain cities in US levy income tax. Whether these taxes can be considered for claiming FTC in India tax return? If there is a tax treaty between India and the foreign country, generally, the treaty defines the scope of taxes for FTC purposes. As per the definition provided under India-US DTTA, ‘taxes covered’ does not include state and city taxes. Hence, as per the tax treaty the FTC is not available for state and city taxes. So, again there is a double taxation?
We have an interesting ruling by Karnataka High Court (HC) in this regard (Wipro Ltd Vs. Deputy Commissioner Of Income Tax [382 ITR 179]). The HC ruled in favour of the assessee and held that credit for taxes paid at the state level is also available for credit u/s 91 i.e., where no tax treaty in place. Since, this is a HC ruling the applicability is limited to the state jurisdiction. Again a conscious call to be taken if credit is availed based on this ruling.
Net Investment Income Taxes (NIIT)
In US, on certain investment income, there is a special levy called NIIT in addition to normal income tax. This is applicable @ 3.8% provided the gross income exceeds certain threshold. This is basically an additional income tax on investment income and should be available for FTC. Form 8960 of US tax return gives you the details of NIIT paid by a tax payer. In the US tax return this will be added as other taxes and hence one should be cognizant of this while claiming FTC. Many times this will result in a higher tax credit on India tax return.
Hope the above gives an idea on the challenges associated with claiming FTC on US source income on India tax return and also a direction to mitigate the implications from such challenges.