Foreign Tax Credit in Case of Income from United States (US)
We frequently come across examples of double taxation on the same income in both the source and resident countries. This scenario is extremely typical from an Indian tax perspective in the case of ‘resident and ordinarily resident (ROR) individuals with investments abroad. Section 90 of the Income Tax Act gives relief in the case of nations with which India has a Double Taxation Avoidance Agreement in order to reduce the effects of double taxation (treaty).
In addition, Section 91 of the Act provides for relief if the other country does not have a treaty with the United States. In most cases, treaties provide relief in the form of an exemption or a credit. Only one country would be granted taxing rights under the exemption mechanism (generally, to the source country). However, in the case of the credit approach, the resident nation considers income taxed in the source country for determining the tax base, but the taxes paid in the source country are allowed as a deduction from its own taxes. Let’s take a closer look at how to calculate the foreign tax credit in the case of US source income, as well as some of the complexities involved.
Enabling provisions
India and the United States have a comprehensive tax treaty that addresses taxability and double taxation relief for numerous kinds of income. The treaty’s article 25 expressly addresses the overseas tax credit (FTC). Because there is a tax treaty in place, the provisions of Section 90 and Rule 128 would apply. The credit would be based on the lower of taxes paid in the United States or taxes calculated under the Income Tax Act of India.
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US Investment income
In the case of an Indian ROR with investments in the United States, the revenue generated by these investments could be multifarious. Interest, dividends, and capital gains are all examples of accretions. Some of these may be subject to special taxation in the United States. Because the special rates are often lower than the normal slab rates, computing FTC by using the average rate of tax may not be the best strategy for such incomes.
In the case of dividend income, the United States has a notion of qualifying dividends, which are taxed at rates ranging from 0% to 20%, depending on the slab rates applicable to the taxpayer’s usual income.
The same is true for long-term capital gains. These rates are frequently lower than the tax rates in India, therefore estimating FTC by using the average tax rate from a US return may result in inaccurate claims.
So, how do you figure out the tax rates that apply to these earnings in your US tax return?
In US tax returns, look for the ‘Qualified dividends and capital gain tax worksheet,’ which lists the tax rates that apply to such incomes.
Another example of such income is Capital gain distributions. These distributions are basically dividends from US mutual funds. For US tax purposes, if the fund meets certain criteria, the distributions are taxed as long term capital gains. For the purpose of FTC, you may apply the special rate of tax as discussed above. However, bigger challenge with such income is determining the right head of income from India stand point. Whether to be taxed as capital gain which is in line with US tax laws or go by the nature of that income i.e., dividend and tax it under the head income from other sources? One should take a conscious call and then decide.
Retirals and pensions
The taxability of government and private pensions is governed by Articles 19 and 20 of the India-US tax treaty, respectively. Aside from this, the United States offers other retirement options such as IRAs and 401(k)s. Both of these are defined contribution plans that allow the taxpayer to take money when they reach a specific retirement age. In the United States, periodic contributions to these funds are not taxable. With specific exclusions and penalties, early withdrawals are permitted.
What happens to these periodic accretions in terms of Indian taxation? Is it taxable or not?
According to the FAQ on the Black Money Act (Circular No. 15 of 2015 dated 03 Sep 2015), such accretions should be taxable in India.So, how would you claim foreign tax credit for such accretions? Since the periodical accretions are not taxable in the US, there are no taxes paid on the same in US.
However, these may be taxable in US at the time of withdrawal. There is a huge timing difference with respect to taxability and could result in double taxation. How to mitigate the double taxation in these cases?
Till 2020, there was no mechanism in place to mitigate this hardship. However, the budget 2021 proposed to prescribe the manner in which such income should be taxed from the specified retirement funds in India. The specific rules are still awaited in this regard. Hope, this will provide more clarity on the taxability and helps in mitigating the double taxation.
State/city income taxes in the US
State and local taxes are another distinctive features of US taxation. In the United States, income tax is imposed by the majority of states and certain localities.
Is it possible to claim FTC for these taxes on an Indian tax return?
If India and the other country have a tax treaty, the treaty will usually define the extent of taxes for FTC purposes. The term “taxes covered” does not include state and local taxes, according to the India-US DTTA standard. As a result, the FTC is not available for state and local taxes under the tax treaty. So there’s double taxation once more?
We have an interesting ruling by the Karnataka High Court (HC) in this regard (Wipro Ltd Vs. Deputy Commissioner Of Income Tax [382 ITR 179]). The HC ruled in favour of the assessee and held that credit for taxes paid at the state level is also available for credit u/s 91 i.e., where no tax treaty is in place. Since this is an HC ruling the applicability is limited to the state jurisdiction. Again a conscious call is to be taken if credit is availed based on this ruling.
The deadline for filing tax returns extended to December 31.
Net Investment Income Taxes (NIIT)
In the United States, a special charge known as NIIT is imposed on some investment income in addition to regular income tax. If your gross income exceeds a specific threshold, you will be subject to a 3.8 per cent tax. This is essentially a new income tax on investment income that should be available to FTC. The NIIT paid by a taxpayer is detailed on Form 8960 of a US tax return.
This will be included like other taxes on your US tax return, so keep that in mind when claiming FTC. This will almost always result in a larger tax credit on your India tax return.
I hope the following provides some insight into the problems of claiming FTC on US source income on an Indian tax return, as well as some guidance on how to avoid the negative consequences of such challenges.