- Foreign tax credit available to taxpayers even on a portion of exempt income.
- Exempt income (under section 10A) is chargeable to tax under section 4 and 5 of the ITA although no tax may actually be payable.
- Actual payment of the tax is not necessary for claiming foreign tax credits.
- State level foreign taxes paid are also available for credit under Indian domestic law provisions.
The Karnataka High Court ("HC" or "High Court') recently held that Wipro is eligible to claim tax credit on foreign taxes paid in relation to exempt income under section 10A of Income Tax Act, 1961 ("ITA"), which provides tax exemptions to income arising to newly established free trade zones on export of software etc. The HC rightly held that merely because an exemption has been granted under the ITA leading to no actual payment of the tax does not mean that such income is not "liable to tax" and thereby not eligible for foreign tax credit.
Wipro Limited ("Wipro"), the taxpayer, is an Indian company engaged in the business of exporting computer software and services. It is also eligible to tax holidays for its STP (software technology parks) undertakings under Section 10A of the ITA. Wipro's on-site development of software is carried out through its permanent establishments ("PEs") in countries such as the USA, UK, Canada, Japan and Germany. Wipro paid foreign income taxes applicable on profits attributable to the PEs. Wipro would also receive consideration from some foreign clients after withholding of tax. In respect of these foreign taxes, it has claimed a tax credit in India.
The tax officer refused Wipro's claim for foreign tax credits for taxes paid in the foreign countries on the ground that credit could only be claimed for taxes actually paid in both countries. Although the Commissioner of Income-tax (Appeals) held in favour of Wipro, the Income Tax Appellate Tribunal ruled that no foreign tax credit can be claimed in respect of income that is exempt from tax in India. Wipro approached the High Court against the order of the Tribunal.
The key issue addressed by the High Court was whether credit for taxes paid in a country outside India in relation to income eligible for deduction under Section 10A from total income would be available under Section 90 of the Income tax Act, 1961 ("ITA") read with the relevant double taxation avoidance agreement ("Treaty").
Section 4 is the principal charging provision of the ITA that imposes income tax on a person in respect of his total income. Section 5 defines the scope of "total income". Section 2(45) which purports to define total income merely says "total income" means the total amount of income referred to in Section 5 computed in a manner laid out in the ITA.
Section 14 classifies income under five specific heads i.e. salaries, income from house property, profits and gains of business and profession, capital gains, and income from other sources. This classification is made for the purposes of providing appropriate rules of computation under each head.
Section 10A of the ITA appears under Chapter III and refers to income that does not form a part of the "total income". Section 10A is a special provision introduced to encourage export of manufactured articles and computer software. It grants a "deduction" of the profits (relating to export of computer software etc.) from the total income.
Section 90 provides that the government may enter into an agreement with the government of a foreign country/ territory for:
granting relief in respect of income on which taxes have been paid under the ITA and foreign law.
granting relief in respect of income which is chargeable to tax under the ITA, and also under the corresponding foreign law.
avoidance of double taxation of income under the ITA and the corresponding foreign law.
The inclusion of relief in respect of income "chargeable to tax" under the ITA/ corresponding foreign law was introduced by way of an amendment through the Finance Act, 2004 effective from April 1, 2004 ("Amendment").
Under Section 90(2) of the ITA, if a taxpayer is resident in a country with which India has a tax treaty, the taxpayer has the option of being taxed under the provisions of the tax treaty or the ITA, to the extent it is more beneficial to the taxpayer.
Interpretation of Section 10-A vis-ŕ-vis Section 4 and 5 of the ITA: The High Court explained the scope of total income under section 4 of the ITA, as well as income which does not form a part of total income under the ITA – such as section 10A i.e. income of newly established undertakings in the free trade zone. Relying on the decision of the HC in Yokogawa1, it concluded that the benefit under section 10A is granted with respect to the specific STP undertaking, and not the taxpayer per se. Consequently, the term "total income" under section 10A should be interpreted as 'total income' of the STP undertaking and not that of the taxpayer.
The High Court concluded that 10A is in the nature of an 'exemption', although the term 'deduction' has been used within the section. It stated that had the intent been to grant the exemption in the form of a 'deduction', the benefit would have been conferred under Chapter VIA of the ITA, which is not the case. Consequently, HC held that but for this exemption under Section 10A, the profits and gains of Wipro are "chargeable to tax". Taking into account the fact that the exemption is available only for a period of ten years, the HC concluded that income under Section 10A is chargeable to tax under Section 4 and is includible in total income under Section 5, but no tax is payable due to the exemption provided.
Amendments of 2004: The HC noted that prior to the Amendment, tax relief was granted in respect of income on which tax has been paid under the tax legislation of the foreign country as well as in India. Therefore, payment of tax in both countries was a sine qua non for this provision (s.90(1)(a)(i)) to apply. As per the Amendment, tax relief was extended even to income tax chargeable under the ITA irrespective of payment of such taxes (s.90(1)(a)(ii)). This provision was introduced as a policy measure by the Government to promote mutual economic relations, trade and investment.
In respect of the retrospective/ clarificatory nature of the Amendment, the High Court was of the view that it was unnecessary to go into this question. This was because section 90(2) states that to the extent that provisions of the Treaty are more beneficial to the taxpayer, they shall apply. Since the India – US Treaty came into effect on December 20, 1990, which was prior to the Amendment, it was not necessary to go into whether the Amendment was retrospective or not.
The HC had the following comments on tax relief under Section 90:
By avoidance of double taxation: Section 90(1)(b) speaks about agreements for avoidance of double taxation, and by virtue of these agreements tax is paid only in one country and benefit of double taxation relief by way of avoidance is granted to the taxpayer in both countries.
Credit for taxes already paid: Under Section 90(1)(a)(i), if the taxpayer has paid tax in India as well as the foreign country, relief could be given by giving credit of tax paid in the foreign country to the Indian taxpayer.
Credit for income chargeable to tax: Section 90(1)(a)(ii) applies to a case where the income of the taxpayer is "chargeable" to tax under the ITA / foreign jurisdiction law. It was further noted that although the income may be "chargeable" to tax, it is open for legislators to grant exemptions from payment of such tax for any specific period.
Foreign tax credits under the India- US Treaty: In respect of the India-US Treaty, the HC has concluded that Article 25 is in conformity with Section 90(a)(ii) of the ITA as the provision does not speak of taxes being paid by the Indian resident under the ITA as a condition precedent to claiming tax credit. Therefore, under Article 25, Wipro is entitled to such tax credit in respect of that income, which is taxed in the USA.
Foreign tax credit under the India - Canada Treaty: In contradistinction, under the provisions of Article 23 of the India-Canada Treaty, if income has been subjected to tax both in India and Canada then, the tax paid in Canada shall be allowed as a credit against the Indian tax paid in respect of such income. However, if the entire income assessed by the assessee under Section 10-A is exempted in India, then, the treaty does not provide any benefit on Wipro.
Credit on state level taxes: In so far as non-federal taxes are concerned, the High Court has interpreted the provisions of section 91 to mean that if the taxpayer has paid income tax in a foreign country at state level, the income tax paid at state level, is also eligible for credit being given to the taxpayer in India. This is because Section 91 covers tax credits in cases where no agreement has been entered by India.
The judgment of the Karnataka High Court comes as a welcome relief to the IT and ITES industry where Indian taxpayers take benefits of the tax holidays under the ITA, and at the same time also interact and engage with several foreign service providers/vendors leading to a foreign tax liability.
The High Court has, in the context of foreign tax credits, taken note of the distinction between "liability to pay tax" and "actual taxes paid", which was discussed by the Supreme Court in Azadi Bachao Andolan v. UOI, and has recently been reiterated by the P&H High Court in Serco BPO v. AAR. The judgment provides that merely because the taxpayer's income is exempt from tax due to a limited tax holiday provided under the ITA, does not mean that foreign tax credit can be denied on that basis.
However, the judgment will have to be read along with the nature and wordings of the provisions of the relevant treaty dealing with tax credits. A number of treaties limit the applicability of tax credit only to the extent of taxes paid in the other country, so as to avoid a situation where one country is essentially subsidizing the other country's taxes. In a few cases such as the India-USA Treaty, there are no restrictions or limitations provided. Therefore, the rule laid down by the Karnataka High Court is not an absolute rule, and has to be read in light of the relevant treaty. While under the India-USA treaty, there is no requirement for tax to have been actually paid in India, the India-Canada treaty specifically requires taxes to have been paid in India.
Another important aspect considered by the High Court was with respect to availability of tax credits for state level taxes paid in a foreign country under Section 91 of the ITA. In the US, state level taxes range from anywhere between 3 to 11% and therefore clarity on this aspect will be beneficial to dual taxpayers.
1 (2012) 341 ITR 385 (Karn.)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.