International Taxation: How DTAA and Foreign Tax Credit Works?

International taxation is one of the most complex areas of taxation as it not only involves national taxation laws but also international agreements between two or more countries, what we commonly call Double Taxation Avoidance Agreement (DTAA). Two of the most common concepts that arise in international taxation are DTAA and the foreign tax credit. These are critical to reducing the overall tax liability of taxpayers. Let’s decode double taxation avoidance agreement and foreign tax credit and how it affects you.

What is Double Taxation?

Double taxation means taxation of the same income twice. It can take place through two different means:

• Economic Double Taxation: Here, the same income is taxed in the hands of more than one person. For instance, income earned by a company is taxed both in the hands of the company (as profits) and in the hands of the shareholders (as dividends). 
• Jurisdictional Double Taxation: Also known as juridical double taxation, here, the same income is taxed in the hands of a single person in two different countries. For instance, Mr. A is a resident of India and has also earned income from the USA. Therefore, the US government will tax such income as income accrued in the US (Source Rule) whereas India will also levy tax as Mr. A is resident in India (Home Rule).

The concepts of DTAA and foreign tax credits play a prominent role in eliminating jurisdictional double taxation.

What is Double Taxation Avoidance Agreement (DTAA)?

Whenever a person earns income from more than two nations, then such a person may be taxed in both the source country (where the income was earned) and the home country (where the person is resident). To avoid such circumstances, the governments of different countries enter into Double Taxation Avoidance Agreements (DTAAs) to avoid double taxation of such incomes. DTAA under income tax work by allocating the right to tax certain types of income to one country while the other country gives complete or partial exemptions. 

India has DTAAs (comprehensive agreements) with over 97 countries. These double taxation avoidance agreements provide a number of benefits to taxpayers, including:

• Exemption From Tax: As stated earlier, double taxation avoidance agreement eliminates the instances of double taxation. However, in certain rare cases, DTAAs can provide for the exemption of income from tax in both countries. This can happen when a double taxation avoidance agreement specifies that a certain income will be taxable in a specific country and in such country, the income is actually exempt from tax. 
• Credit for Foreign Taxes: DTAAs also provide for the credit of foreign taxes paid on income that is taxable in India. This means that taxpayers can offset the amount of foreign tax they have paid against the amount of tax they owe in India.
• Reduced Withholding Taxes: Governments levy withholding tax to collect the taxes at the point the transaction is entered into. double taxation avoidance agreements can also reduce the amount of withholding tax that is applied to certain types of income and can even exempt the same. 

What is Foreign Tax Credit (FTC)?

A Foreign Tax Credit (FTC) is a credit that is allowed against the amount of tax payable in India on income that has already been taxed in another country. The FTC is calculated by multiplying the amount of foreign tax paid by the applicable exchange rate and then deducting the resultant amount from the amount of tax payable in India. The FTC is available under Sections 90 and 90A of the Income Tax Act, 1961 (ITA). To claim the FTC, taxpayers must have paid foreign tax on income that is also taxable in India. The FTC can be claimed through two methods:

• Exemption Method: Here, a particular income is taxable in only one of the countries while it is completely exempt in the other.
• Tax Credit Method: Here, the income is taxable in both countries. However, the tax paid in one country (usually the source country) is provided as credit in the other country (usually the home country).

If India has not entered into double taxation avoidance agreement with the source country, still the taxpayers can claim unilateral relief under Section 91 of the Income Tax Act, 1961 to prevent double taxation.

How to Claim FTC in India?

For claiming the foreign tax credit in India, you need to submit Form 67 under income tax before the end of the relevant assessment year and  the income tax return has been filed u/s 139(1) or 139(4) of the Act. Form 67 shall also be filed in case you have carried forward the backward losses in the current year due to which there is a refund of foreign tax credit. The FTC is claimed while calculating the taxable income and consequent tax liability. The amount of FTC that is allowed is deducted from the total amount of tax payable in India.

In a Nutshell

double taxation avoidance agreements and FTCs under income tax are important aspects for taxpayers who have income that is taxable in India and in foreign territories. By understanding these provisions, taxpayers can ensure that they are not taxed twice on the same income. By ignoring the provisions of double taxation avoidance agreement and claim of FTC, you might lose a significant portion of your income in paying taxes twice to different governments. While determining the foreign tax credit, a careful analysis of the provisions of DTAA and Indian taxation laws is a must to avoid any future legal hurdles. In case you need any assistance in relation to international taxation, double taxation avoidance agreement (DTAA) and FTC in India, feel free to contact the ASC Group.

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