Foreign Tax Credit

Tax Credit refers to granting credit of taxes deducted at source while computing the tax paid by the recipient of income.

The Income Tax Act provides relief mechanism for foreign tax credit for the treaty countries and non –treaty countries separately.

Provisions of section 90(2) provides for foreign tax credit in relation to the assessee to whom such agreement applies.(Bilateral Relief)

Provisions of section 91 provides for foreign tax credit for the resident in India in respect of his income arouse outside India and on which he has paid tax in any country with which no agreement entered under section 90 of the Act.(Unilateral Relief).

The bilateral relief seeks to provide relief by way of (i) Exemption Method; (ii) Credit Method. Exemption method:

The country of residence has a right to tax its residence and treaties seek to mitigate double taxation in the source taxation. Country of residence can also give up their right to tax the income of its resident earned in foreign country by exempting such foreign sourced income.

It provides for exemption either by way of full exemption or exemption with progression.

Under full exemption method the resident country exclude the income already charged to tax in the source country while computing total income liable to tax.

Under exemption with progression method, the country of residence take into account the exempted income sourced outside India while calculating the rate of tax applicable on the remaining income.

Ex:- Income earned in India Rs. 80,000/- and income earned outside India Rs. 20,000/-. Tax deducted on income earned outside India is Rs. 4000/-. Tax rate in India say 35%.

Tax in India on Global Income = (Rs. 1, 00,000 – Rs. 20,000)*35% Rs. 28,000/-. Tax Relief = Rs. 35,000 (Rs. 1, 00,000 * .35) - Rs.28,000/- = Rs. 7,000/-Credit Method:

Country of residence includes global income in the taxable total income and computes the tax and allows credit of taxes paid in source country from such tax liability.

 

Tax credit is either full tax credit or ordinary tax credit.

Two more methods tax credits are “Underlying Tax Credit” and “Tax Sparing”.

Full tax credit method provides that the country of residence allows tax paid on income earned outside India be reduced from the total tax liability in that country. This is not very commonly used method of granting tax credit.

Ordinary tax credit method provides for deduction of taxes paid in the country of source to the extent of tax paid by the taxpayer in the country of residence in respect of doubly taxed income.

Ex:- Indian income Rs. 80,000/- Foreign Income Rs. 20,000/-. Tax paid on foreign income is Rs. 8,000. Indian tax rate is 35%. (Ordinary tax method)

Tax Liability:

Details	Amount in Rs.	Tax Rate	Tax Amount
Global Income ( Indian and Foreign Income)-	1,00,000/-	35%	Rs. 35,000/‑
Less: Tax on Foreign Income paid out side India subject to maximum of 35% on such income	20,000/-	40%	Rs. 7,000/‑ ( least of Rs. 8,000/‑ or Rs. 7,000/-)
Tax liability in India	80,000/-	35%	Rs. 28,000/-

Though tax paid outside India is Rs. 8,000/- maximum credit is limited to the extent of liability @ applicable under domestic law (i.e Rs. 7,000/-) only.

Underlying Tax Credit: India does not provide for Underlying Tax Credit. US, UK and some other countries provide for this credit. Under this method the country of residence provides for credit of taxes paid on dividend income and for corporate taxes paid on underlying profits out of which dividend has been paid.

Ex:- A, Indian company 100% subsidiary of US Holding Co. A Ltd has earned Rs. 1, 00,000/- profit in India. Rate of taxes in India: Corporate tax @ 30% and Dividend distribution tax @ 15%. US Holding company profit is Rs. 2, 00,000/- and rate of tax @ 40%.

Underlying tax credit is computed as follows:

Particulars	Amount in INR	Amount in INR
Profit of subsidiary in India		1,00,000/‑
Less: Tax @30%	1,00,000*30/100	30,000/‑
Prof it after tax		70,000/‑
Dividend distributed		70,000/‑
Dividend distribution tax	70,000* 15/100(ignoring provisions of section 115-O)	10,500/‑
Profit of holding company(US)		2,00,000/‑
Profit of Indian Subsidiary		1,00,000/‑
Total Income		3,00,000/‑
Tax @40% on total income	3,00,000*40/100	1,20,000/‑
Underlying Tax credit Corporate Dividend tax- Share in Corporate tax paid on underlying profits-	10,500 (A) 1,00,000*30/100 (B)	10,500/‑ 30,000/‑
Total Tax Credit	(A+B)	40,500/‑
Tax Payable after credit	1,20,000-40,500	79,500/-

Tax sparing: The Source State generally grants incentives to foreign investors for the purpose of attracting foreign investments which get neutralized if the State of Residence taxes them fully on the basis of no taxation in State of Source.

Tax Sparing is the allowing of relief by State of Residence of those foreign taxes which have been spared under the incentive program of the State of Source.

Under this concept, the country of residence grants credit for the taxes which would have been levied by the country of source had the tax exemption been not granted by it.

Example:

Particulars	No Tax Sparing	Tax Sparing
Income in the country of Residence	Rs. 1,00,000/-	Rs. 1,00,000/‑
Income in the country of source (exempt)	Rs. 1,00,000/-	Rs. 1,00,000/‑
Total Income for tax in country of residence	Rs. 2,00,000/-	Rs. 2,00,000/‑
Tax Rate in the country of Residence	40%	40%
Tax Rate in the country of source	30%	30%
Tax payable in country of residence (A)	Rs. 80,000/-	Rs. 80,000/‑
Tax Payable in country of source (B)
Tax credit ( Tax exempted on income- country of source) (C)		Rs. 30,000/‑
Total Relief (B+C)		Rs. 30,000/‑
Tax payable after credit (A-B)	Rs. 80,000/-	Rs. 50,000/-

Unilateral Credit: It is applicable where there is no DTAA with foreign country in which tax is paid or liability incurred. Relief is provided to the extent of lower of Indian Tax Rate or Foreign Tax Rate, whichever is least (Ordinary Tax Method).

General documents required to claim foreign tax credit:

• Overseas Tax Withholding Certificates;
• Tax Payment Challans;
• Overseas Tax Returns.

This article is contributed by Partners of SBS and Company LLP - Chartered Accountant Company. You can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it.