As per section 5 of the Income Tax Act 1961 (the Act) practically all of a resident assessee’s world income enters his total income. In the case of a non-resident assessee, however, his entire world income does not form part of his total income under the Act.. His total income is confined only to the income received by him in the taxable territories of India and the income accruing to him or deemed to be accruing to him in the taxable territories of India. So, what happens to the taxes paid in foreign jurisdictions by the assessee?
Section 40(a)(ii) of the Income Tax Act , 1961 bars the deduction of “any rates or taxes” payable by an assessee in arriving at the profits liable to tax.
Evolution of the Concept:
Income Tax as we know it represents the crown’s share of profits. It is a case of application of profits after they have been earned. In the case of Ashton Gas Co. which went up to the House of Lords and the judgment of Buckley, J., was affirmed in 1906 Appeal Cases, 10. Earl of Halsbury, L. C., made these observations at page 12 :
"Profit is a plain English word; that is what is charged with income-tax. But if you confound what is the necessary expenditure to earn that profit with the income-tax, which is a part of the profit itself, one can understand how you get into the confusion which has induced the learned counsel at such very considerable length to point out that this is not a charge upon the profits at all. The answer is that it is. The income-tax is a charge upon the profits; the thing which is taxed is the profit that is made, and you must ascertain what is the profit that is made before you deduct the tax - you have no right to deduct the income-tax before you ascertain what the profit is. I cannot understand how you can make the income-tax part of the expenditure."
This was the philosophy behind the insertion of Section 40(a)(ii) of the Income Tax Act,1961 and section 10(4) of the erstwhile Indian Income Tax Act, 1922.
Income liable to tax within India
The issue which then arose for consideration was, whether the income of an assessee taxable within Indian shores is net of tax paid in another country or whether it is the gross income which should be brought to tax?
There was a judicial conflict prior to the enactment of the Finance Act 2006 on whether income-tax paid in a foreign country is eligible for deduction in the computation of profits or gains from business or profession. Some assessees were claiming the income tax paid in a foreign country both as a deduction in the computation of profits and gains from business or profession and as credit against tax payable in India on their global income.
With a view to ending the judicial conflict the Finance Act 2006 inserted an explanation 1 to section 40(a)(ii) of the Income Tax Act clarifying that any sum payable outside India and eligible for relief of tax under section 90 or deduction from the income tax payable under section 91 is not allowable as a deduction under section 40 of the Income Tax Act.it further clarified that the tax payers will continue to be eligible for tax credit in respect of Income Tax paid in a foreign country in accordance with the provisions of section 90 or as the case may be section 91.
Taxes referred to in Sec. 40(a)(ii)
In Lubrizol India Ltd.’s case [Lubrizol India Ltd. v. CIT [1991] 187 ITR 25(Bom)], Hon’ble Bombay High Court took note of the wording of section 40(a)( ii) and disagreed with the assessee’ s contention that the expression ‘tax’ is restricted to ‘Income-tax’ as defined under section 2(43). While doing so, Their Lordships, inter alia, observed as follows:
"It is significant to note that the word ‘tax’ is used in conjunction with the words ‘any rate or tax’. The word ‘any’ goes both with the rate and tax. The expression is further qualified as a rate or tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains. If the word ‘tax’ is to be given the meaning assigned to it by section 2(43), the word ‘any’ used before it will be otiose and the further qualification as to the nature of levy will also become meaningless. Furthermore, the word ‘tax’ as defined in section 2(43) of the Act is subject to "unless the context otherwise requires". In view of the discussion above we hold that the word ‘any’ tax herein refers to any kind of tax levied or leviable on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains."
Purpose of Insertion of Explanation to Section 40(a)(ii)
In all fairness, the intention of the legislature while inserting the explanation at the end of Section 40(a)(ii) seems to be that all those taxes covered by a Double Taxation Avoidance Treaty [hereinafter referred to as Treaty] will receive the treatment accorded to them under the treaty and hence any benefit of reduced rate of taxes or tax credits/exemptions etc will be available as per the treaty existing between India and the contracting country. Since such tax payments are already availing credit under the treaty they will not be further eligible to be deducted from the Income of the assessee which is subject to tax in India. But this is only the tip of the iceberg. The following among many situations arise chiefly;
Ø Tax paid abroad– credit allowed under Treaty[Sec90]
Ø Tax paid abroad- not covered by Treaty because
o Tax is not covered by the Treaty or
o There is no Treaty between India & the contracting country[Sec91]
If there is no Treaty between India and the contracting country then the provisions of Section 91 are attracted and benefit is accordingly given. The problem arises when there exists a Treaty between India and the contracting country but the particular tax is not covered.
The Ahmedabad Bench of the Income Tax Appellate Tribunal in a recent judgement [[2017] 86taxmann.com253(Ahmedabad-Trib) Dr Rajiv I. Modi vs DCIT (OSD) Ahmedabad] found an innovative solution to the vexed question of relief in respect of taxes not covered by a Treaty and not eligible for deduction under Section 37 by virtue of the explanation to Section 40(a)(ii) of the Income Tax Act 1961. In the case on hand the assessee had paid tax both in India and the state of Maryland US. The tax paid in Maryland was the Maryland State Tax. The Indo US treaty gives relief in respect of only Federal Taxes paid in the US. The earlier precedents had held that such taxes are clearly not deductible u/s 37 of the Income Tax Act. The Maryland State Tax is not covered by the treaty either. The Tribunal therefore pointed out relying on an earlier judgment [Tata Sons Ltd. v. Dy. CIT [2011] 10 taxmann.com 87 (Mum.)] that the fact that a taxpayer is entitled to make a claim, in accordance with a tax treaty provisions, does not disentitle him to make the claim in accordance with the provisions of the Act.
What about Section 91?
The provisions of Section 91 are to be treated as general in application and these provisions can yield to the treaty provisions only to the extent the provisions of the treaty are beneficial to the assessee; that is not the case so far as question of tax credits in respect of State Income Taxes paid in USA are concerned. Accordingly, even though the assessee is covered by the scope of India US and India Canada Tax Treaties, so far as tax credits in respect of Taxes paid in these countries are concerned, the provisions of Section 91, being beneficial to the assessee, hold the field. As Section 91 does not discriminate between State and Federal taxes, and in effect provides for both these types of income taxes to be considered for the purpose of tax credits against Indian Income Tax liability, the assessee is, in principle, entitled to tax credits in respect of the same.
Of course, as is the scheme of tax credit envisaged in Section 91, tax credit in respect of foreign income tax is restricted to actual income tax liability in India, in respect of income on which taxes have been so paid abroad.'
Harmonious Interpretation:
The Tribunal in the above judgement made it clear that the tax treaties are intended to grant relief and not put residents of a Contracting State at a disadvantage vis-a-vis other taxpayers, Section 90 of the Income-tax Act has been amended to clarify any beneficial provision in the law will not be denied to a resident of a contracting country merely because corresponding provision in a tax treaty is less beneficial. If just because there is a tax treaty between India and another country, the benefits of the domestic law provisions are being denied to the assessee, such an interpretation would lead to absurdity and calls for an interpretation harmonious with the scheme of the Income Tax Act.
Conclusion
This decision gives hope to the a non-resident who is taxed in both jurisdictions but is denied legitimate relief under Section 40(a)(ii).
[The author is Principal Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, Bangalore]