Foreign tax credits available for exempt Indian income: Karnataka High Court
The Karnataka High Court (“HC” or “High Court’) recently held that Wipro is eligible to claim tax credit on foreign taxes paid in relation to exempt income under section 10A of Income Tax Act, 1961 (“ITA”), which provides tax exemptions to income arising to newly established free trade zones on export of software etc. The HC rightly held that merely because an exemption has been granted under the ITA leading to no actual payment of the tax does not mean that such income is not “liable to tax” and thereby not eligible for foreign tax credit.
Wipro Limited (“Wipro”), the taxpayer, is an Indian company engaged in the business of exporting computer software and services. It is also eligible to tax holidays for its STP (software technology parks) undertakings under Section 10A of the ITA. Wipro’s on-site development of software is carried out through its permanent establishments (“PEs”) in countries such as the USA, UK, Canada, Japan and Germany. Wipro paid foreign income taxes applicable on profits attributable to the PEs. Wipro would also receive consideration from some foreign clients after withholding of tax. In respect of these foreign taxes, it has claimed a tax credit in India.
The tax officer refused Wipro’s claim for foreign tax credits for taxes paid in the foreign countries on the ground that credit could only be claimed for taxes actually paid in both countries. Although the Commissioner of Income-tax (Appeals) held in favour of Wipro, the Income Tax Appellate Tribunal ruled that no foreign tax credit can be claimed in respect of income that is exempt from tax in India. Wipro approached the High Court against the order of the Tribunal.
The key issue addressed by the High Court was whether credit for taxes paid in a country outside India in relation to income eligible for deduction under Section 10A from total income would be available under Section 90 of the Income tax Act, 1961 (“ITA”) read with the relevant double taxation avoidance agreement (“Treaty”).
Section 4 is the principal charging provision of the ITA that imposes income tax on a person in respect of his total income. Section 5 defines the scope of “total income”. Section 2(45) which purports to define total income merely says “total income” means the total amount of income referred to in Section 5 computed in a manner laid out in the ITA.
Section 14 classifies income under five specific heads i.e. salaries, income from house property, profits and gains of business and profession, capital gains, and income from other sources. This classification is made for the purposes of providing appropriate rules of computation under each head.
Section 10A of the ITA appears under Chapter III and refers to income that does not form a part of the “total income”. Section 10A is a special provision introduced to encourage export of manufactured articles and computer software. It grants a “deduction” of the profits (relating to export of computer software etc.) from the total income.
Section 90 provides that the government may enter into an agreement with the government of a foreign country/ territory for:
The inclusion of relief in respect of income “chargeable to tax” under the ITA/ corresponding foreign law was introduced by way of an amendment through the Finance Act, 2004 effective from April 1, 2004 (“Amendment”).
Under Section 90(2) of the ITA, if a taxpayer is resident in a country with which India has a tax treaty, the taxpayer has the option of being taxed under the provisions of the tax treaty or the ITA, to the extent it is more beneficial to the taxpayer.
The judgment of the Karnataka High Court comes as a welcome relief to the IT and ITES industry where Indian taxpayers take benefits of the tax holidays under the ITA, and at the same time also interact and engage with several foreign service providers/vendors leading to a foreign tax liability.
The High Court has, in the context of foreign tax credits, taken note of the distinction between “liability to pay tax” and “actual taxes paid”, which was discussed by the Supreme Court in Azadi Bachao Andolan v. UOI, and has recently been reiterated by the P&H High Court in Serco BPO v. AAR. The judgment provides that merely because the taxpayer’s income is exempt from tax due to a limited tax holiday provided under the ITA, does not mean that foreign tax credit can be denied on that basis.
However, the judgment will have to be read along with the nature and wordings of the provisions of the relevant treaty dealing with tax credits. A number of treaties limit the applicability of tax credit only to the extent of taxes paid in the other country, so as to avoid a situation where one country is essentially subsidizing the other country’s taxes. In a few cases such as the India-USA Treaty, there are no restrictions or limitations provided. Therefore, the rule laid down by the Karnataka High Court is not an absolute rule, and has to be read in light of the relevant treaty. While under the India-USA treaty, there is no requirement for tax to have been actually paid in India, the India-Canada treaty specifically requires taxes to have been paid in India.
Another important aspect considered by the High Court was with respect to availability of tax credits for state level taxes paid in a foreign country under Section 91 of the ITA. In the US, state level taxes range from anywhere between 3 to 11% and therefore clarity on this aspect will be beneficial to dual taxpayers.
1 (2012) 341 ITR 385 (Karn.)