Cleaning the Augean tax stable

Continuing with its new approach to subordinate rule-making, the Central Board of Direct Taxes (CBDT) has put out foreign tax credit (FTC) rules in the public domain for comments. Framing rules was part of the promise that the finance minister had made in the Budget speech in 2015.

These rules are important and are meant to relieve Indian investors from double tax payment; an Indian multinational which pays taxes overseas is entitled to claim credit of the taxes while computing its income on the world-wide basis and tax liability thereon. It is not the case that giving credit for foreign taxes was not there, but there was no rule available which often led to subjective computations.

This further led to uncertainty as well as litigation for Indian multinationals in availing credit of taxes paid abroad, resulting in double taxation. So, the FTC rules are another example of the government’s effort to clean the Augean tax stable.

That said, the rules are narrowly based and not in line with the economic reality, as many Indian companies have either already or are likely to go out in search of natural resources — gas, minerals, etc., an important ingredient for giving impetus to manufacturing.

To promote such investment, the government needs to decide whether we continue to follow the ‘credit method’ for computation of FTC or start looking at other FTC methods such as exemption method and tax sparing credit method.

Under the credit method, income is taxed in both the countries, and the country of residence, while looking at the world-wide income, allows tax credit/reduction for taxes paid overseas.

In the exemption method, the entire income earned in the foreign country is not considered by the home country for taxation, and that provides relief for the outbound investments. Many countries use the exemption method as an important international fiscal policy instrument, and it is important India also includes this in its matrix for FTC.

Tax-sparing credit method, though not so attractive from the Indian stand-point but nonetheless used in some tax treaties with countries such as Czech Republic, and Malaysia means that if income earned in the foreign country is exempted under the domestic laws, the tax payer in the home country would get credit of the tax amount, which would have been paid in foreign country had there been no such exemption in the domestic tax laws.

So increasing the ambit of the FTC rules can be one key suggestion, but it is equally important that the draft rules do clarify the nature and conditions for availability of FTC to Indian taxpayers. The draft rules contemplate a source-by-source basis for computing FTC to be granted to a taxpayer; this means individual source of income from a particular country is to be considered on a stand-alone basis for granting FTC.

This system is inherently complex and may result in administrative difficulty, and would also make eligibility of FTC less than optimal. While cumbersome for taxpayers to claim FTC, it would be equally time consuming for the tax authorities to verify or check the eligibility of FTC. On the balance, therefore, it would be better to allow the taxpayers to pool country-specific tax credits for claiming FTC.

Another challenge often faced by taxpayers in claiming FTC is in obtaining certificates from the foreign tax authority, particularly from those countries which do not have established procedures to issue withholding tax certificates and other related documents as required by the draft rules.

Many times, certificates issued by these authorities are in their local language. Draft FTC rules must provide detailed guidelines for obtaining a declaration/affidavit from the taxpayer or getting translation confirmed from the embassy of the country concerned.

Also, in many countries taxpayers need to file tax return computing the likely tax liability. However, the actual tax payment is required to be made once the tax authorities complete assessment.

There may, thus, be a time gap between filing of the tax return and completion of tax assessment. In such cases, the tax credit may be allowed pending verification/confirmation of tax amount by the foreign tax authorities.

The draft FTC rules may provide for submitting a declaration/bond from the taxpayer, that the additional taxes, if any, will be deposited if there is any reduction in the foreign taxes upon completion of assessment by foreign tax authorities.

Similarly, additional FTC may be allowed where the assessment in foreign country results in additional tax payment.

From the corporate point of view, most limiting provision in the draft FTC rules is the proposal to limit the carry forward of MAT credit in respect of FTC utilised for MAT payments to difference of FTC utilised under MAT vis-à-vis normal tax.  It may be appreciated that MAT is a mode of tax payment, provided for in the Income-tax Act. 

Once MAT is paid and MAT credit has been quantified, limiting the credit for use in the subsequent year defeats the purpose of MAT tax payment. The fact that MAT credit is wholly or partly available on account of FTC should not affect its entitlement to such MAT credit, as otherwise this would result in unjustified loss of MAT credit to the taxpayer. 

The rules also do not make any provisions for carry forward of excess foreign tax paid, neither do they address the issue of branch profits tax nor that of underlying tax credits for dividend income and tax refunds as it is allowed in other countries. The draft rules only need to provide for that.

In summary, the draft rules, though a welcome step for much awaited guidance on methodology of claiming FTC against Indian tax payable, do pose a few challenges which needs urgent attention and action.

It is imperative that the CBDT does take into account some of these suggestions, and also others which it may have received, before finalising the FTC rules. The overall FTC model should be encompassing and modernising.

Kumar is a senior adviser and Rawal is senior manager at Deloitte India