I. International Tax – Foreign Tax Credit
Q. 1. Currently Taxpayers are unable to carry forward unutilized (excess) Foreign Tax Credit (FTC) to future years, and set off such unutilized FTC against the tax liability in the succeeding years. This results in a permanent loss of Credit to the Tax Payers. Will the budget suitably amend the Income Tax Act to allow carry forward of unutilized FTC for set-off against tax liability of future years?
Ans: Foreign Tax Credit (FTC) is granted to provide relief from double taxation of the same income by a Foreign Country (Source Country) and by India (Residence Country). Unless you have doubly taxed income you cannot get FTC.
Besides, India limits FTC to the income tax payable in India (at the Indian Rate of Income Tax) on foreign income. This means that the maximum FTC you can claim is equal to the Indian Tax on foreign income; you cannot claim FTC on foreign taxes that are in excess of Indian Tax on foreign income. That being the legal position, there cannot be any unutilized FTC; there can be only excess foreign tax paid on the foreign income in the Foreign Country (Source Country), on which FTC is not allowed.
So, the question really is, ‘should the Government allow Taxpayers to carry forward the excess foreign tax paid, when the cap for FTC is reached in the current year?’ To explore the answer we need to begin by looking at a fundamental issue: Will carry forward of excess foreign tax paid by the Taxpayers relieve double taxation?
Suppose, in FY 2013-14, you (an Indian Resident) earned 6 Crores foreign business income in Russia (Source country), and paid Russian income-tax of 60 lakhs at 10%. Also, you suffered business loss of 10 Crores in India. Your overall loss is 4 Crores. So, tax payable by you in India will be Nil. Thus, there is no double taxation of the foreign income of 6 Crores – that income is taxed only in Russia. Hence you will not get any FTC for 60 lakhs paid in Russia. [see JCIT Vs Digital Equipment India Ltd (93 TTJ 478) (Mumbai ITAT)]
The result: you bear income tax of 60 lakh though you actually suffered loss of 4 Crores. Grossly unfair!
Say, in the next year – FY 2014-15 – you made a spectacular turnaround and earned business income of 15 Crores in India. After set-off of the loss that you carried forward from preceding year, your Taxable Income is 11 Crores. If Russian income of 6 Crores had not reduced your loss for the preceding year, you would have carried forward loss of 10 Crores, instead of just 4 Crores. Then your Taxable Income for FY 2014-15 would have been only 5 Crores, instead of 11 Crores.
Thus, Russian income of 6 Crores, which was not taxed in India in FY 2013- 14, gets taxed in the next year. So, eventually, there is double taxation of the Russian income of 6 Crores.
But can you seek relief from such double taxation by claiming, in FY 2014- 15, FTC for Russian tax of 60 Lakhs that you paid in FY 2013-14? No, you cannot.
As the law (Sec. 91 and DTAAs/Tax Treaties) stands today, you cannot make such a claim. There is therefore a pressing need for an amendment to alleviate double taxation – in future years - in these sort of cases. A provision should be inserted in the Income Tax Act 1961 to allow taxpayers to carry forward excess foreign taxes which can then be considered to grant FTC in future years.
Suppose you earned 5 Crores of foreign income in FY 2013-14; and you paid income-tax of 2 Crores at 40% tax rate in the Foreign Source Country. Also, you earned 3 Crores income in India (your residence Country). Your Taxable Income in India is 8 Crores and your income-tax in India is 2.40 Crores (assuming Effective Tax Rate of 30%), before FTC. The foreign income of 5 Crores is taxed twice.
What will be your FTC? It will be 1.50 Crores (30% of 5 Crores of foreign income), because the FTC is currently capped at the Indian Tax payable on the foreign income.
Due to the cap on FTC, you will get credit for foreign tax paid only to the extent of 1.50 crores; you will not get credit for excess payment of 50 lakhs. Besides, you cannot claim the excess foreign tax of 50 lakhs as an expense. [see DCIT vs. Tata Sons Limited 43 SOT 27]
Carry Froward to Future Years
The existing law (Sec. 91 and DTAAs/Tax Treaties) does not allow you to carry forward the excess foreign tax of 50 lakhs, for grant of FTC in future years.
Should the Government amend the law to allow you to carry forward the excess foreign tax?
The foreign income of 5 Crores has already been subjected to double taxation in FY 2013-14. Will that same foreign income be doubly taxed again in the next year? The answer is ‘No’. What is then the rationale for carrying forward the excess foreign tax, when there is no double taxation of the foreign income of current year in the succeeding year?
FTC can only be granted if the same foreign income is doubly taxed. In our Example, that all important criteria is not fulfilled in the succeeding year. So, apparently, there is no rationale for the Government, at least legally, to allow carry forward of the excess foreign tax.
But is there any economic rationale? Yes, there surely is. Many developed countries (the US, Japan, France, Canada, Australia, Netherlands, etc.) allow their residents, including business enterprises, to carry forward excess foreign tax and claim FTC in future years, in the Scenario II described above. The Government should, therefore, allow carry forward of the excess foreign tax for grant of FTC, to improve the competitiveness of the Indian Exporters in the global market.
To sum up, we can expect Amendment in the Income Tax Act 1961 allowing carry forward of the excess foreign tax for grant of FTC in future years. Of course, there should be a time limit for carry forward – ideally 5 years, as set by other countries. And there should also be a monetary cap: FTC for carried forward excess foreign tax should be granted in future years only to the extent of the shortfall in FTC for a particular future year. By shortfall in FTC for a particular year, we mean the excess Indian Tax, on foreign income, remaining unabsorbed after FTC for that particular future year.
Q. 2. Will the Budget usher in Overall aggregate credit system of granting FTC, in place of the current Country-by-Country credit system?
Ans: As things stand today, the mechanism of granting FTC is primarily through DTAAs. And the DTAAs provide for ordinary credit method. The FTC is, therefore, restricted to the appropriate proportion of Indian tax. If the foreign tax is greater than the Indian tax, FTC gets capped at the level of the Indian tax on foreign income.
Further, the DTAAs are with individual Countries; Country-by-Country. Under the per Country limitation, FTC cap is calculated for each country individually [see CIT vs Bombay Burmah Trading Corporation (2003) 126 Taxman 403 (Bom)].
In contrast, if we have an Overall limitation, the aggregate amount of taxes paid in all source states can be credited up to the amount due in the residence state.
Applying the limit or cap for FTC, Country-by-Country, under the current provisions, works against the interests of Taxpayers, at times, by reducing the allowable FTC. Therefore, in the Domestic Law, a provision should be inserted to allow Taxpayers to choose the Overall Credit Method. Such a provision will complement the DTAAs.
The Taxpayers can then choose either the Overall Credit Method under the Domestic Law, or the Country-by-Country Method under the DTAAs, whichever method grants them higher FTC.
Q. 3. Is any other amendment needed to rectify other matters relating to FTC?
Ans: Underlying Credit – to Foreign Investors in their Home Countries – for Dividend Distribution Tax (DDT) paid by the Indian Companies, is another matter worth looking at. The concept of DDT is not prevalent, globally. And DDT - not being in the nature of Withholding Tax - is not eligible for Foreign Tax Credit in the Home Countries of most of the Foreign Investors. This is considered as a negative factor by Foreign Investors investing in India.
To remedy the situation, the Budget should convert DDT, paid by Indian Companies, into Withholding Tax, for Foreign Investors. That will enable Foreign Investors to claim Foreign Tax Credit in their home countries, for taxes paid on dividends in India, without any loss of revenue to the Indian Government.
II. Corporate Tax – Deduction of Corporate Social Responsibility (CSR) Expenditure
Q. The New Companies Act 2013 mandates spending 2% of Average Net Profits under Corporate Social Responsibility (CSR) provisions. Will the Budget bring about certainty regarding the tax treatment of CSR expenditure, by introducing a specific provision in Income Tax Act 1961 to allow deduction of CSR expenditure?
Ans. Let us begin with couple of basic questions: Is there really a need for a specific provision in Income Tax Act 1961 to allow deduction of CSR expenditure? Do the existing provisions of Income Tax Act 1961 not allow deduction of CSR expenditure?
Contrary to what many believe, CSR expenditure is allowed as deduction under the existing provisions of Income Tax Act 1961 (the Act). For instance, Sec. 35 AC of the Act (read with Rule 11K of the Income Tax Rules 1962) allows deduction of expenditure incurred on several CSR activities listed in Schedule VII to the Companies Act 2013. Besides, deduction of expenditure incurred on other activities – not covered by Sec. 35 AC – is allowed under either Sec. 35(2AA) or Sec. 35CCA or Sec. 80G(2). All these provisions allow deduction of expenditure in computation of ‘Profits and Gains from Business or Profession’ regardless of whether or not the expenditure is incurred for the activities related to the business of a Company.
In addition, under Sec. 37(1) of the Act, Courts have allowed, in the past, voluntary CSR expenditure incurred by Companies. A case in point is the recent judgement of the Karnataka High Court in the case of CIT and
Another vs Infosys Technologies Ltd. (2014) 360 ITR 714(Kar) where the High Court held that CSR expenditure which facilitates the business of the assessee is allowable under Sec. 37(1). So there is sound basis for the view that expenditure on CSR activity undertaken in advancement of business of the assessee, is allowable under Sec. 37(1) of the Act.
Where is then the need to have a new specific provision in Income Tax Act 1961 to allow deduction of CSR expenditure?
The deduction of CSR expenditure under the existing provisions of Sec. 35 AC, Sec. 35(2AA), Sec. 35CCA, Sec. 80G(2), and Sec. 37 (1), is heavily dependent on fulfilment of the conditions stipulated under each of these provisions. Also, Sec. 80G(2) allows deduction of only 50% of some of the items of CSR expenditure.
Thus, the deduction of CSR expenditure under the existing provisions will be evaluated by the Tax Authorities on case-by-case and item-by-item basis; no general deduction will be allowed. Further, there is no one-to-one correlation between items of CSR expenditure listed in Schedule VII to the Companies Act 2013 and the items of expenditure covered by the abovementioned existing provisions of the Income Tax Act 1961. That will be a cause of dispute with Tax Authorities.
Coming to Sec. 37 (1) of the Act, CSR Rules exclude from the scope of CSR expenditure, “activities undertaken in pursuance of the normal course of business of the company”. This exclusion will be relied upon by the Tax Authorities to deny deduction under Sec. 37 (1), overlooking the fact that notwithstanding the exclusion, the CSR expenditure is incurred ultimately in furtherance of a Company’s business.
What do we conclude? Though existing provisions allow deduction of CSR expenditure, there could still be costly disputes between the Corporate Taxpayers and the Tax Authorities.
The Taxpayers, however, while drawing up a comprehensive program of CSR, slated to continue for several years, would want to avoid disputes. They would like to ensure a consistent treatment for all items of CSR expenditure. So they are keenly awaiting a specific provision in the Income Tax Act 1961, for deduction of CSR expenditure.
One final point: The Government could additionally consider exempting the three percent cess levied for ‘education’ and ‘secondary & higher education’, in cases of Companies who directly spend funds on permitted CSR projects relating to ‘education’.
III. Transfer Pricing – Safe Harbour Rules
Q. Will the scope of Safe Harbour Rules (SHR) (notified on 18 September 2013) be extended to cover major sectors such as Automobiles (currently only Auto Ancilliary covered), Engineering, Pharmaceutical (currently only R&D in Pharma covered), Diamond & Jewellery and Metallurgical Sectors, to reduce widespread litigation on determination of Arm’s Length Price of International Transactions between Associated Enterprises?
Ans. Transfer Pricing Safe Harbour Rules in their current form have failed to rein in litigation. The Operating Profit Margins currently prescribed under the Safe Harbour Rules are unrealistic, those margins are too high. Few Taxpayers are willing to pay tax based on such exorbitant Operating Profit Margins.
So the first and foremost thing the Government can do is ‘prescribe reasonable and pragmatic Operating Profit Margins under the Safe Harbour Rules, for various Sectors that are covered’.
Besides, there is surely an imminent need to address the problem of huge Transfer Pricing Adjustments in cases of Taxpayers operating in the Sectors mentioned above in the Question. Hence the benefit of Safe Harbour Rules should be extended to the above-mentioned Sectors.
There is another aspect: Domestic Transfer Pricing. Taxpayers undertaking Specified Domestic Transactions - covered by Domestic Transfer Pricing – must also be given the option of Safe Harbour. Even under Domestic Transfer Pricing there is scope of protracted litigation. So, Safe Harbour Rules should not remain limited to International Transactions; they should be extended to Specified Domestic Transactions as well.
Looking at the demands from Industry and Taxpayers, one can expect such extensions of Safe Harbour Rules. It makes as much sense for the Government, as for the Taxpayers, to collect taxes as soon as possible with certainty, instead of losing out in the long term, due to adverse results of litigation.
IV. Domestic Transfer Pricing – Removal of Anomalies
Q. What changes do you expect in the area of Domestic Transfer Pricing?
A. Following Transactions do not merit coverage under Domestic Transfer Pricing, and may be specifically excluded:
1. Transactions in which a Taxpayer, eligible for deduction under Chapter VI-A or Sec. 10AA, brings in higher amount of foreign exchange into India, or remits lower amount of foreign exchange out of India.
2. Transactions between Related Parties where there is no tax arbitrage: when the Taxpayer (Payer) and the Sec. 40A (2)(b) Related Party (Payee) both are taxable at the same effective tax-rate.
3. Transactions between two Eligible Units, or Eligible Assessees, who are eligible for deduction of profit at the same rate.
B. Mitigation of Double Taxation
When expenditure is disallowed in hands of the Assessee (Payer), income should simultaneously be reduced in hands of the Related Party (Payee). Or else, there will be double taxation. Currently, there is no provision for corresponding reduction of income in case of the Sec. 40A (2)(b) Payee. To avoid double taxation of same income – in the hands of Payer as well as in the hands of the Payee – specific provision should be inserted to provide for corresponding reduction of income in case of the Payee, whenever expenditure is disallowed in hands of the Payer.
C. Resolution of disputes
When the Transfer Pricing Regulations have been extended to Specified Domestic Transactions, the scheme of Advance Pricing Agreement as well as Safe Harbour Rules should also be extended to Specified Domestic Transactions.
We may expect suitable amendments, because this is just the third year of Domestic Transfer Pricing and it is better to correct things sooner than later.
V. Reduction of MAT Rate for Tax Holiday Units
Q. Do you expect the MAT Rate to be reduced in the Budget?
Ans. The Rate of Minimum Alternative Tax (MAT) has increased over the years from 7.5% to 18.5%. It is a significant increase. Levy of MAT at such a high rate has negated the benefits of tax-holiday to Units eligible for deductions under Sec. 10AA, 80-IA, 80-IB, 80-IC, 80-ID and 80-IE. So, the MAT Rate for those Units needs to be reduced to 10%.
One can expect such reduction in the Budget, to give a fillip to the industry. However, we cannot expect a general overall reduction in the MAT Rate for Non Tax-Holiday Taxpayers.
By: Nilesh Patel