Court :Mumbai Income Tax Appellate Tribunal
Citation [ITA No. 4776/Mum/04] in the case of Tata Sons Ltd.
Brief :The ITAT held that the taxes paid on profits, whether on presumptive basis or on the basis of actual profits earned, represent application of income and are not allowed as deduction in computation of taxable profits. In terms of applicable provisions of the Indian Tax Laws (ITL), read with the applicable tax treaty, such taxes qualify for tax credit relief so as to avoid double taxation.
Background and facts- Under the ITL, income which has suffered overseas taxes is entitled to relief from double taxation in India by allowing tax credit in respect of the overseas taxes against the tax payable on such doubly taxed income (Tax Credit). Furthermore, a specific provision in the ITL denies deduction in respect of tax levied on profits of the business. A clarificatory amendment was made to provide that the amount eligible for double taxation avoidance relief would always be deemed to be part of tax on profits and, hence, disallowable (restriction provision).
The Taxpayer, a resident of India, is an investment company and is also engaged in the business of export of software and provision of engineering consultancy. The Taxpayer paid taxes in overseas jurisdictions on the income earned therein. The Taxpayer claimed a Tax Credit in respect of overseas taxes paid. The income earned in overseas jurisdiction was claimed exempt from payment of taxes in terms of the specific tax incentive provision under the ITL.
In addition to the Tax Credit, the Taxpayer also claimed deduction of the overseas taxes as normal business expenditure while computing its taxable profits in India. It took support of a favorable ITAT decision in its own case for earlier years against which the jurisdictional High Court (HC) had rejected an appeal.
The Tax Authority, on the other hand, was of the view that income tax paid, whether in India or overseas, was an application of income and not a charge on income which qualifies as deductible business expenditure. Furthermore, overseas taxes paid by the Taxpayer are entitled to the Tax Credit and are specifically restricted to be claimed as a deduction from taxable profits in terms of the restriction provision.
On an appeal by the Taxpayer, by placing reliance on the earlier ITAT decision and the jurisdictional HC decision, the first appellate authority ruled in favor of the Taxpayer. Aggrieved by the decision, the Tax Authority appealed before the second appellate authority.
Issue before the ITAT
Whether overseas taxes paid are deductible from the taxable profits of the Taxpayer in India.
The deductibility of overseas taxes against taxable profits is supported by an earlier decision of the ITAT and the jurisdictional HC in the Taxpayer’s own case.
The overseas taxes paid are inherently in the nature of expenses incurred for the purposes of the Taxpayer’s business.
Under the ITL, a restriction is placed on deduction of taxes entitled for the Tax Credit. The overseas taxes paid by the Taxpayer are state income taxes paid in the US and Canada which are not eligible for the Tax Credit.
Under the ITL, the meaning of ‘tax’ as used in the restriction provision does not include taxes paid overseas. Hence, overseas taxes are not hit by the restriction provision. The deduction, therefore, needs to be granted and the Taxpayer proceeded on the basis that the taxes paid overseas did not qualify for the Tax Credit.
Tax Authority’s contentions
The earlier decision of the ITAT was clearly contrary to the fundamental scheme of the ITL. Furthermore, the above decision is not admissible since it was delivered before the amendment to the restriction provision.
Payment of income tax in overseas tax jurisdictions, in addition to taxability in the home jurisdiction, is an inevitable corollary of inherent conflict between the source rule and residence rule of taxation. While the source rule, as also the residence rule, continues to be integral parts of most of the tax systems, a mechanism is generally provided in the domestic tax law to relieve taxpayers of such double taxation.
As per the Tax Credit mechanism followed the world over, there exist four mutually exclusive methods under which double taxation so arising is relieved by the country of residence. The four methods followed internationally are as follows:
Territorial method: The residence country follows pure territorial method of taxation and brings to tax only such incomes as are sourced in the residence jurisdiction itself. Thus, there exists no conflict between the source rule and the residence rule.
Exemption method: The residence country exempts the income earned in the source country from taxation, subject to fulfillment of condition of actual taxation in the source country.
Credit method: Credit is given in respect of taxes paid in the source country while computing tax liability in the residence country. However, such credit generally does not exceed the residence country tax liability in respect of the income earned in the source country.
Deduction method: Deduction is allowed in respect of tax paid in the source country in computation of taxable income. Under this method, tax is treated as a charge rather than appropriation of income and is treated as an expenditure incurred for earning income abroad.
In the Taxpayer’s case, overseas taxes have been treated as a ‘charge’ of income by claiming them as a deduction in computing taxable profits and they are also treated as an ‘application’ of income by claiming the Tax Credit in respect thereof. There cannot be any justification for making such contradictory claims and, in the process, obtaining overall tax relief of measure larger than actual taxes paid overseas.
The income tax paid under the provisions of the ITL or under the laws of the source country is an appropriation of income rather than a charge against such income. Reliance was placed on an HC decision in the case of S Inder Singh Gill [47 ITR 284] to support this proposition.
The earlier ITAT decisions (against which appeals were rejected by the jurisdictional HC) were on the issue of ‘local taxes’ and not on the aspect of deductibility of taxes leviable on profits. Such local taxes which were permitted as deduction by the past orders were not in the nature of income tax and, therefore, the ITAT’s decisions cannot be applied to the facts of the present case.
Overseas taxes in respect of which Tax Credit was available under the provisions of the ITL fall within the ambit of the restriction provision. Although the term ‘tax’ is defined to mean a tax levied under the ITL, such a definition cannot be viewed on a stand-alone basis and will have to be read in the context of the restriction provision. Reliance was placed on the Supreme Court decision in the case of K P Varghese [47 ITR 284] to contend that, while interpreting the provisions of the ITL, the context and the underlying scheme have to be taken note of. Furthermore, the jurisdictional HC, in the case of Lubrizol India Ltd. [187 ITR 25] has concluded that tax as defined is not restricted to tax as levied under the ITL but also to taxes as levied by the source country. Considering such direct precedent of the jurisdictional HC, it would not be correct to accept that overseas taxes on profit are not tax covered by the restriction provision.
The overseas taxes (state tax of the US and Canada) paid by the Taxpayer are covered by the restriction provision and deduction of the same from taxable profits is not allowed under the ITL.
Comments:- Relief from double taxation is an integral part of a taxation system to mitigate adverse impact of juridical double taxation arising due to conflict arising from different basis of residence/source rule of taxation adopted by various countries. This ruling explains various methods of avoiding double taxation and also provides exposition on the method adopted in the ITL. This ruling examines the settled principle of interpretation of the provisions of the ITL and clarifies that tax paid by a taxpayer is not a tax deductible expense but is an appropriation of income which is eligible for tax relief.