The Income-tax Act, 1961, seeks to tax India-sourced income in the hands of all kinds of assessees, irrespective of their residential status which is determined based on their physical presence in India.
Even in cases when they are away, they continue to be liable to tax in India and the consequent compliance requirements such as obtaining a Permanent Account Number and filing the annual return of income with the tax authorities.
Additionally, while they are away from India, they may qualify to be a resident of another country, and thus be liable to tax on the same income, not only in India, but also in the second country.
In these circumstances, depending on the residential status of the taxpayer, he or she may be eligible to take advantage of a Double Taxation Avoidance Agreement (DTAA) entered into by India and the second country.
There are two categories of taxable entities: residents and non-residents.
Residents are further classified into two sub-categories: resident and ordinarily resident and resident but not ordinarily resident.
The law prescribes two alternative technical tests of residence for individual taxpayers.
Each of the two tests relates to the physical presence of the taxpayer in India throughout the course of the previous year which refers to the 12 months from 1 April to 31 March.
The domestic fiscal laws of other countries also have tests for determining residency in that country, which are generally based on nationality or physical presence during the relevant fiscal year.
For an individual to obtain the benefit under any tax treaty, it is necessary to examine whether he or she meets the requirements to be a resident in a particular country.
Usually, tax treaties seek to allocate the taxing rights with respect to specific types of income as well as determining the method of allowing credit of taxes paid between the country of residence and the country in which the income was earned.
The residency clause in most treaties provides for determination of residential status based on the respective domestic laws.
Therefore, if a non-resident Indian (NRI) qualifies to be a tax resident of only one of the two treaty countries, he or she would qualify to be a resident of that country for the purposes of the tax treaty as well.
However, a tricky situation would arise in the event of the NRI qualifying for residency in both countries or, even more rarely, non-residency in both countries (possible in the case of highly mobile personnel).
In the latter case, the NRI does not qualify to be a resident of either of the treaty-countries under the respective domestic laws.
The implication for such a person may be an inability to take advantage of the benefits of the tax treaty.
He or she would therefore be governed by the domestic laws of those countries relating to residency and taxability.
In the event of dual residency, most tax treaties provide a set of rules referred to as “tie-breaker rules”.
The aim of these rules is to determine the country of residence for the purpose of interpreting the tax treaty.
A typical set of tie-breaker rules, commonly applied sequentially, are the location of permanent home, the centre of vital interests, the individual’s habitual abode and the nationality of the potential taxpayer.
Even after applying these tie-breaker rules, a situation may arise where the NRI’s residential status under the tax treaty cannot be resolved. In such cases, the treaty-countries can invoke Mutual Agreement Proceedings to decide a taxpayer’s residential status.
Another important issue, which is a direct consequence of the individual’s residential status, is the availability of foreign tax credits while paying tax in the country of residence.
Typically, the country of residence gets the right to tax all income, wherever earned, and subject to the relevant tax treaty.
The NRI would be eligible to claim a set-off for taxes paid in the source country or countries when calculating his or her tax liability in the country of residence.
Accordingly, where residency under the tax treaty can be established in one of the two treaty-countries, the NRI’s final tax liability may be lower in the country of residence on accounnot of the credit for taxes paid in the source country or countries.
Sumes Dewan is a partner at KR Chawla & Co Advocates & Legal Consultants. The firm is headquartered in New Delhi and has offices in Chennai and Bangalore as well as a representative office in Singapore.
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