Foreign Tax Credit vis-à-vis Tax Paid in a Contracting State

CA Ashish Chadha has provided a lucid commentary on the issue of whether a resident is entitled to claim credit for the foreign tax paid by him against the tax payable in the contracting state. The author has analyzed the judgements of the foreign courts on the subject and explained them in the context of the Indian law and judgements of Indian courts

The Federal Court of Australia, very recently, dealt with a fascinating question: whether a taxpayer (resident of Australia) claim excessive Foreign Tax Credit (‘FTC’). The question before the Court was that though only 50% of the capital gain derived from sale of investments in the United States (‘US’) was taxable in Australia, could the taxpayer claim FTC in Australia for the tax paid in US on the entire amount of capital gain. In that context, the Australian Court examined Article 22(2) of the tax treaty between Australia and the US regarding ‘Relief from double taxation’.

Though the provisions of this Article may give an impression that they are rather simple provisions, but the fact that the matter reached the Federal Court and the three judges on the Bench could not reach to a unanimous conclusion supports the view that, in practice, the issue of FTC involves far more complex aspects.

Facts of Australian decision in the case of Burton v. Commissioner of Taxation dated 22 August 2019:

Mr. Burton was a tax resident of Australia. During the years 2011 and 2012 he derived capital gains from investments held by him in the US. He paid the taxes in the US on such capital gain income. For such taxes paid in the US, the taxpayer sought to claim FTC in Australia, which was the subject matter of controversy in this decision.

As the investments were held by the taxpayer in the US for a period of more than one year, gains on sale of such investments qualified for a concessional tax treatment in Australia, and resultantly, only 50% of the said gains were included in the taxpayer’s taxable income. The taxpayer, however, claimed tax credit for the entire amount of the US tax on the said gains. The Australian tax authorities rejected the said claim made by the taxpayer, holding that only 50% of the amount of the capital gain could be taken into account for determination of the permissible amount of FTC in Australia. Accordingly, the Australian tax authorities concluded that there was no conflict between the relevant provisions under the Australian tax law and Article 22(2) of the tax treaty between Australia and the US. The Australian tax authorities stated the said approach of considering 50% gains for determination of FTC as “apportionment approach”.

It is further worthy to note that the US also taxed such long-term capital gain income of the taxpayer in a concessional manner, i.e. at the rate of 15% on the entire amount of the capital gains, instead of the regular tax rate of 35%. Thus, the tax laws of Australia as well as the US granted concessional tax treatments for long-term capital gains, though in different manner, viz. 50% of gains being excluded from taxable income in Australia and gains being taxed at a lower rate in the US.

Article 22(2) of the tax treaty between Australia and the US:

In order to relate with the facts of the case and findings of the Federal Court, the relevant portion of the Article is reproduced hereunder:

“Subject to paragraph (4), United States tax paid under the law of the United States and in accordance with this Convention, other than United States tax imposed in accordance with paragraph (3) of Article 1 (Personal Scope) solely by reason of citizenship or by reason of an election by an individual under United States domestic law to be taxed as a resident of the United States, in respect of income derived from sources in the United States by a person who, under Australian law relating to Australian tax, is a resident of Australia shall be allowed as a credit against Australian tax payable in respect of the income. The credit shall not exceed the amount of Australian tax payable on the income of any class thereof or on income from sources outside Australia. Subject to these general principles, the credit shall be in accordance with the provisions and subject to the limitations of the law of Australia as that law may be in force from time to time.”

Findings of the Court:

The three judge Bench of the Court decided the matter in favour of the Australian tax authorities by a majority of 2:1.

One of the two judges who dismissed the appeal of the taxpayer noted that there had to be a limitation on the credit to be allowed to a taxpayer and the same could not exceed the amount of Australian tax payable on the income or any class thereof or on income from sources outside Australia. In his view, Article 22(2) of the tax treaty was not confined to a simple comparison of the tax paid in different countries on the underlying transaction. He opined that in each case, the term ‘income’,expressed by the words “in respect of”, had to bear a nexus with “US tax paid” and “Australian tax paid”. He concluded that it was necessary to consider as to how the subject income was taxed in each of the contracting State. He further stated that because the object of Article 22(2) of the tax treaty was to require Australia to grant tax credit against the tax payable in Australia, the starting point in this direction had to be the identification of income that was taxable in Australia. Since 50% of the capital gains was excluded from the taxable income, Australia did not tax the entire amount of gain and accordingly, only the remaining 50% of the gain, which was taxable in Australia, amounted to income (doubly taxed income) for the purpose of Article 22(2) of the tax treaty. Therefore, only 50% of the US tax could have been regarded as paid in respect of the income taxable in Australia.

The other judge, who also dismissed the appeal of the taxpayer, noted that the arrangement of words in Article 22(2) of the tax treaty between Australia and the US indicated that for the purpose of foreign tax credit in Australia, the provision would apply to the amount of income that is taxable in the US as well as Australia. He took note of the fact that the term that is used in the tax treaty to indicate a connection between the relevant amount of income and each of the US tax and the Australian tax is “in respect of”. On that basis, he opined that for the purposes of Article 22(2) of the tax treaty, ‘the income’ in the present case referred to only 50% of the capital gains that were taxable in Australia.

Accordingly, by way of a 2:1 decision, the Federal Court of Australia held that only 50% of the US tax paid by the taxpayer on the above-mentioned capital gain could be considered for determining the amount of foreign tax credit in Australia.

Indian legislature and judicial developments on similar issue:

The provisions of the Income-tax Act, 1961 (‘the Act’) with regard to availability of foreign tax credit are covered under Section 90 of the Act. The extent provisions of Section 90(1)(a)(ii) of the Act provide that the Central Government may enter into an agreement with the Government of any country outside India for granting relief in respect of income-tax chargeable under the Act and under the corresponding law in force in that country. The said provision was introduced in the Act vide Finance Act, 2003 with effect from 1 April 2004. Prior to this amendment, the provisions of Section 90 inter alia provided that the Central Government may enter into an agreement with the Government of any country outside India for the granting of relief in respect of income on which have been paid both income-tax under the Act and income-tax in that country, or for the avoidance of double taxation of income under that Act and under the corresponding law in force in that country. The amendment vide Finance Act, 2003 was made in order to promote mutual economic relations, trade and investment.

In this context, it is pertinent to refer to the judgment of Karnataka High Court in the case of Wipro Ltd. v. Deputy Commissioner of Income-tax [2016] 382 ITR 179. In this case, assessee claimed the credit of taxed paid outside India in relation to income eligible for deduction under Section 10A of the Act. The Assessing Officer (‘AO’) denied the claim of the assessee holding that credit claimed under Section 90 of the Act is only applicable for grant of relief in respect of income on which taxes have been paid both under the Act and the Income-tax Act in the foreign country. The Court in this case, has extensively dealt with the pre and post amendment provisions of Section 90(1) of the Act and has concluded that merely because an exemption has been granted in respect of the taxability of a particular source of income, it cannot be formulated that the entity is not liable to tax. The Court further took note of the fact that the exemption granted under the Act has the effect of suspending the collection of income-tax for a period of 10 years and does not make the said income not leviable to income-tax. It was, therefore, concluded by the Court that the case of the assessee would fall under the provisions of Section 90(1)(a)(ii) of the Act. The Special Leave Petition filed by the Income-tax Department against the order of the High Court has been granted by the Apex Court, leaving the decision of the High Court to be adjudicated upon by the Supreme Court.

Further, the Income Tax Appellate Tribunal, Delhi Bench in the case of Polyplex Corporation Ltd. v. Assistant Commissioner of Income-tax [2019] 103 taxmann.com 71 allowed the credit of 10% tax to the Indian company on dividend received from its Thailand subsidiary, despite the fact that the company was not liable to pay any tax in Thailand by virtue of exemption granted as per the Investment Promotion Act of Thailand. In this case, the assessee claimed that it was entitled to claim sparing of foreign tax payable in Thailand on which exemption was available to assessee as per Investment Promotion Act and that under Article 23(3) of the DTAA between India and Thailand, assessee was eligible for tax rebate of 10% on said income. The Tribunal, in this case, after perusing the commentaries to Model Conventions noted that the concept of tax sparing credit will be applicable to the assessee in the present case only if the dividend received was taxable in the hands of assessee as per Thai Tax laws and exemption is available to assessee either as per Revenue Code of Thailand or as per Investment Promotion Act. The Tribunal further noted that exemption was available to assessee of dividend received from its subsidiary in Thailand as per Investment Promotion Act and the same would have been otherwise taxable as per Thailand Revenue Code at the rate of 10%. Tribunal, thus, concluded that assessee would be entitled to credit of taxes deemed to have been payable in Thailand under Article 23(3).

In conclusion:

Considering the above judicial pronouncements, the fact that the cases involving issues of foreign tax credit have reached the Court of law in appeal, and moreover have attracted differing views amongst the members of the Court in the Australian Federal Court, is an affirmation of the view that though a plain reading of the foreign tax credit provisions in the tax treaties may appear straight forward, in practice they involve much more convoluted issues. In order to analyse the claim of foreign tax credit by a taxpayer, it is imperative to understand the provisions regarding foreign tax credit in the income-tax Act of that country and the corresponding provisions in the tax treaty. Surely, the above are not the last judgments on this issue, and the uncovering and elucidation of the provisions by the Apex Court of law in India in the case of Wipro Ltd. (supra)might provide some lucidity on the subject from Indian tax law perspective.