Since, each nation have differenent rules of taxing persons, the same income may get taxed more than once (often referred to as residence-source conflict). Hence, resident country has to grant credit for the taxes paid in the other country.
Also, it is difficult to lay down uniform mechanism for allowability of Foreign tax credit because of the differences in determination of taxes especially deductions, allowances etc. There are different mechanism of providing foreign tax credit. Double taxation may arise because of Juridical or economic double taxation. These mechanisms of providing credit are –
a. Bilateral credit mechanism – This comes from section 90 of the Income tax Act, 1961 (‘Act’). Relevant extracts are reproduced below –
90 (1) The Central Government may enter into an agreement with the Govern- ment of any country outside India or specified territory outside India —
(a) for the granting of relief in respect of—
(i) income on which have been paid both income-tax under this Act and income-tax in that country or specified territory, as the case may be, or (ii) income-tax chargeable under this Act and under the corresponding law in force in that country or specified territory, as the case may be, to promote mutual economic relations, trade and investment…………………………………….
Hence, when Double taxation avoidance agreement (‘DTAA’) is in place between two countries, then method of relief is provided in the DTAA. The DTAA provides for the manner, mode and quantum of tax relief to be allowed in relation to the doubly taxed income in the hands of the taxpayer. Further, depending on the wordings of the Article on ‘Methods of allowing relief from double taxation’, the methods of granting bilateral relief mechanism may vary. The methods can be exemption method, credit method, tax sparing method or underlying tax credit method.
b. Unilateral credit mechanism – This comes from section 91 of the Income tax Act, 1961 (‘Act’). Relevant extracts are reproduced below –
91. (1) If any person who is resident in India in any previous year proves that, in respect of his income which accrued or arose during that previous year outside India (and which is not deemed to accrue or arise in India), he has paid in any country with which there is no agreement under section 90 for the relief or avoidance of double taxation, income-tax, by deduction or otherwise, under the law in force in that country, he shall be entitled to the deduction from the Indian income-tax payable by him of a sum calculated on such doubly taxed income at the Indian rate of tax or the rate of tax of the said country, whichever is the lower, or at the Indian rate of tax if both the rates are equal.
It provides for the grant of FTC to a resident taxpayer in respect of foreign taxes paid on his income earned from a country with which India does not have DTAA.
(I will discuss each method of granting FTC in detail in coming parts)