Decoding Uncertainties in Treatment of Foreign Taxes Ineligible for Relief

[By Anshika Agarwal]

The author is a student at the Vivekananda Institute of Professional Studies, GGSIPU, New Delhi.

Introduction

In keeping up with the global trends, India has always been consolidating its financial position in international markets. With a stable tax framework and an attractive Foreign Direct Investment regime, India has enhanced its ease of doing business, thereby, attracting cross-border transactions and investors. Today, India stands as a potential hub of global investments and has attracted a high inflow of Foreign Direct Investments in recent years.

With more and more investors venturing into India, the smooth flow of transactional activities has become a matter of concern. This trend has led to the problem of double taxation. Double taxation refers to a situation where the income of the company is subjected to dual taxation based on its place of residence and source of income. To resolve this impediment, Indian taxation laws provide for the provision of credits to its residents. The said credit can be granted to an Indian resident assessee irrespective of whether there exists a DTAA between his resident country and the specified country.

This credit can be granted in respect of countries where there exists a Double Tax Avoidance Agreement (hereinafter, “the DTAA”) between India and the specified country or territory, and also in cases where no such agreement is negotiated by the Indian government. The credit also known as Foreign Tax Credit (hereinafter, “the FTC”) becomes available when a foreign tax is paid in respect of an income already taxable in India. The said credit is used for setting off the tax payable under the Income Tax Act, 1961 (hereinafter, “the Act”).

The process remains smooth and follows an ordinary credit method. However, complexities crop up when the tax payable under the Act is less than the foreign tax paid. In such a scenario, the allowability of the unclaimed and unutilized foreign tax as a business expenditure becomes a vexed question. The article aims to decode the uncertainties in the treatment of such a tax in the light of some recent rulings pronounced by different Courts/ Tribunals.

Applicable legal provisions

To analyze the above question, it becomes pertinent to look into the applicable legal provisions.

As propounded by Rule 128, Income Tax Rules, 1962 (hereinafter, “the Rules”), a credit termed as FTC will be allowed to a resident assessee in respect of any amount paid by him as foreign tax in earning the income which is also taxable under the Act. For this purpose, the foreign tax would mean a tax covered under the DTAA as entered into by India with any other country, and in cases where no such agreement exists, the tax payable under the law in force of that country.

This allowance shall be made in the form of a deduction or relief in the year in which such tax is paid. The relief to be granted would be the lower of the two amounts: the tax payable under the Act and the foreign tax paid. Where the latter exceeds the former, the former amount becomes eligible for credit under Section 90/ 91 of the Act while the balance amount becomes ineligible for the said relief. The treatment of these unclaimed and unutilized relief forms becomes the underlying crux of disputes.

With this, Section 37 comes into the picture as well. Section 37 provides that, when an expenditure is incurred wholly and exclusively for the purposes of business or profession then such expenditure can be allowed as a deduction under the head “Profits and Gains of Business or Profession” (hereinafter “PGBP”). Further, such expenditure should neither be of personal nature nor should it be of capital character. An expenditure that qualifies the said conditions would be allowed under this Section.

On the other hand, Section 40 a(ii) of the Act disallows the deduction of the amount paid as tax on the income earned under PGBP. Further, the Explanation to the said Section inserted vide Finance Act 2006, includes the amount of foreign tax eligible for relief under Section 90/ 91 as the case may be, under the expression “tax” used in the Section.

Issue

The issue that now captivates our attention is the uncertainty in the manner of treatment of the unclaimed foreign tax, as to whether such a tax that remains ineligible under Section 90/ 91 can be allowed as business expenditure under Section 37(1) of the Act? Whether the scope of the term “tax” used in Section 40 a(ii) extends to disallow this unclaimed amount of “foreign tax”?

Judicial Approach Employed 

The impugned issue has time and again, been addressed by various courts and Tribunals. Divergent approaches have been employed to settle it. The recent trends as observed in these rulings are as follows:

Reliance Infrastructure Ltd. V CIT-Mumbai

The Bombay High Court, in the present case, while deciding upon the above issue, ruled in the favor of the taxpayers. The judgment clarified the scope of Section 40 (a)(ii), explicating the extent of the word “tax” used here. It was observed that the preceding words “in this Act” used in Section 2(43) narrow down the ambit of “tax” to tax payable under the Act, thereby precluding the foreign tax paid. This, in turn, streamlines the scope of Section 40(a)(ii), thereby, limiting it to the tax payable under the Income Tax Act, 1961.

In regards to the foreign tax paid, Explanation 1 to the said Section specifically includes the amount eligible for double tax relief under the purview of Section 40(a)(ii). The legislative intent underlying the Explanation was to nullify the dual claims of benefit of credit and of deduction as expenditure, arising on the amount eligible under Section 90/ 91.

Hence, in the light of the said Explanation, the Court held that the part of foreign tax that remains unclaimed would not be hit by the provisions of Section 40 (a)(ii). Thus, such an amount, being expenditure incurred to arrive at the global income which is already taxable in India, would become allowable under Section 37.

Virmati Software & Telecommunication Ltd. v. DCIT

The impugned issue yet again popped up in the present case. The Ahmedabad Tribunal, while deliberating upon it, relied on the decision made in the case of Reliance Infrastructure Ltd, thereby, ruling in the favor of the taxpayers. It was observed that the unclaimed portion of the tax paid abroad was in the course of the business of the assessee and the corresponding business receipts were already taxable under the Act. Hence, the same will be allowed as an expenditure while computing the income of the assessee under the Act

Bank of India v. ACIT

The Mumbai Tribunal, in the present case, while contemplating on the impugned issue of allowability, also upheld the stance taken by the Bombay High Court in the Reliance case. It was observed that where the issue concerns huge national revenues, there the Court cannot adopt a superficial and perfunctory approach. Thus, the whole amount of the foreign taxes paid cannot be allowed as business expenditure. However, the amount for which the assessee has received no credit, that amount would be allowed as an expenditure while computing the business income.

Analysis

With a recent surge in cross-border investments, it becomes pertinent for India to have a settled principle of law to ensure smooth transactional activities. Seldom, we have found Courts and Tribunals employing different approaches to settle this disputed question of law, yet the ambiguity prevails. There have been instances wherein rulings have been made in the favor of the Department, thereby disallowing taxes paid abroad as expenditure for calculating business income. The rationale followed by Courts for such an approach is that the foreign tax paid is not a charge against the income but an application of income. Further, the Courts have opined that the Explanation to Section 40 (a)(ii) does not extend the scope of the said Section, rather it explains it, thereby disabling “any rate of taxes” from being treated as an expenditure.

However, the recent trend observed in the rulings suggests a more pragmatic picture. With the Mumbai Bench’s 2021 ruling and Ahemdabad Bench’s 2020 ruling, the course to be adopted while carrying out such transactions, has become clearer The interpretation that the said Explanation expands the scope of Section 40 (a)(ii) to include the extent of foreign tax subjected to double tax, runs in harmony with the definition of “tax” under Section 2(43). Further, the said interpretation adheres to the legislative intent underlying the Amendment, thereby, providing a reasonable and benign route to the taxpayers.

The latter approach would consolidate India’s financial standing in the global market. The whole concept of enhancing India’s global investments and transactions will be facilitated if taxpayers are allowed to claim the benefit of such a deduction. The said move would act in consonance with taxpayers’ interests, thereby promoting them to venture into the global market.

Notwithstanding, the stances taken by the Court, the issue remains contentious. A clarification or an explanation from the end of the Government might settle it for good. Until then, it would also be an interesting affair to observe the trend that the Courts or Tribunals follow in dealing with the said issue.

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