Whether unclaimed foreign tax credit be allowed as deduction under section 37(1)

Introduction

1. The government of the day has set-up a new task force for revising decades old Income-tax Act. The new Act will be drafted to remove the present ambiguities and to bring it at par with the International best practices. One such contentious and debatable issues existing in the Income-tax

Act, 1961 ('the Act') for which no definite rule book exists relates to allowability of foreign tax credit ('FTC'). In this article, an attempt has been made to discuss upon such issue.

FTC becomes available when tax payable as per the Act is less than the foreign taxes paid. The issue which crops up, is what is to be done of balance FTC after set off against the income-tax payable. One school of thought says that balance FTC shall be allowed as business deduction under section 37(1), while the other opines that FTC having the nature of application of income shall be eligible only for relief under section 90 and no treatment of balance FTC can be permitted. To discuss it in to the details, lets proceed further:

2. Provisions Involved

(1)		Section 90(1) - Provides relief if income is subject to tax both under Income-tax Act, 1961 and as per tax rates of foreign country.
		"The Central Government may enter into an agreement with the Government 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......"
(2)		Rule 128 - Provides mechanism for computation of relief.
		"An assessee, being a resident shall be allowed a credit for the amount of any foreign tax paid by him in a country or specified territory outside India, by way of deduction or otherwise, in the year in which the income corresponding to such tax has been offered to tax or assessed to tax in India, in the manner and to the extent as specified in this rule...."
(3)		Proviso to Rule 128(5)(i) - If foreign tax paid is in excess of tax payable under this Act, then such excess shall be ignored for purpose of this clause:
		"Provided that where the foreign tax paid exceeds the amount of tax payable in accordance with the provisions of the agreement for relief or avoidance of double taxation, such excess shall be ignored for the purposes of this clause"
(4)		Section 37(1) - Any expenditure incurred wholly and exclusively for the purpose of business, shall be allowed as deduction.
		"Any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head "Profits and gains of business or profession"
(5)		Section 2(43) - Defines tax and starts with expression mean, evidencing the exhaustive meaning of the term tax. Tax means only the income-tax payable in accordance with the Income-tax Act, 1961.
		"tax in relation to the assessment year commencing on the 1st day of April, 1965, and any subsequent assessment year means income-tax chargeable under the provisions of this Act...."
(6)		Section 40(a)(ii) - Specifically disallows payment of income-tax. Use the expression 'any rate or tax'. The issue is will any rate or tax include within its ambit the foreign taxes paid or whether it pertains to income-tax only. The Explanation 1 covers foreign taxes to the extent of relief provided under section 90. Can Explanation expand the scope of main provision of the section?
		Notwithstanding anything to the contrary in sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession",-
		(ii) any sum paid on account of any 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.
		Explanation 1.-For the removal of doubts, it is hereby declared that for the purposes of this sub-clause, any sum paid on account of any rate or tax levied includes and shall be deemed always to have included any sum eligible for relief of tax under section 90 or, as the case may be, deduction from the Indian income-tax payable under section 91.
		Explanation 2.-For the removal of doubts, it is hereby declared that for the purposes of this sub-clause, any sum paid on account of any rate or tax levied includes any sum eligible for relief of tax under section 90A;"

3. Judicial Precedents on this aspect

(1)		Mastek Ltd. v Dy. CIT [2013] 36 taxmann.com 384/[2014] 146 ITD 642 (Ahd. - Trib.), "As far as applicability of section 40(a)(ii) is concerned, the nature of expenditure clearly does not fall in the said category as taxes have not been paid under the Indian Income-tax Act, but have been paid to carry out its business outside India."
(2)		CIT v. South East Asia Shipping Co. [IT Appeal No.123 of 1976] - Mumbai Tribunal, "payment of foreign income-tax formed part of the expenditure like other usual business expenses incurred in the course of business and as such, the assessee was entitled to claim deduction of the same u/s. 37 of the Act for being incurred wholly and exclusively for the purpose of business."
(3)		Reliance Infrastructure Ltd. v. CIT [2016] 76 taxmann.com 257 (Bom.), However, to the extent tax is paid abroad, the Explanation to section 40(a)(ii) provides/clarifies that whenever an assessee is otherwise entitled to the benefit of double income-tax relief under sections 90 or 91, then the tax paid abroad would be governed by section 40(a)(ii). The occasion to insert the Explanation to section 40(a)(ii) arose as assessee was claiming to be entitled to obtain necessary credit to the extent of the tax paid abroad under sections 90 or 91 and also claim the benefit of tax paid abroad as expenditure on account of not being covered by section 40(a)(ii). This is evident from the Explanatory notes to the Finance Act, 2006 as recorded in Circular No.14 of 2006 dated 28-12-2006 issued by the CBDT. The above circular, inter alia, records the fact that some of the assessees who are eligible for credit against the tax payable in India on the global income to the extent the tax has been paid outside India under sections 90 or 91, were also claiming deduction of the tax paid abroad as it was not tax under the Act. In view of the above, Explanation inserted in 2006 to section 40(a)(ii), would require in the context thereof that the definition of the word 'tax' under the Act to mean also the tax which is eligible to the benefit of sections 90 and 91. However, this departure from the meaning of the word 'tax' as defined in the Act is only restricted to the above and gives no license to widen the meaning of the word 'tax' as defined in the Act to include all taxes on income / profits paid abroad.
(4)		Dy. CIT v. Elitecore Technologies (P.) Ltd. [2017] 80 taxmann.com 6/165 ITD 153 (Ahm-ITAT), "If Explanation to section 40(a)(ii) talks about foreign tax, then the term 'any rate or tax' includes within its ambit foreign tax paid. The Explanation does not extend the scope but rather explains the scope of said section. If something is covered by the Explanation, it cannot be said that it is not covered by the main provision...... In view of the above, it is held that no deduction under section 37(1) can be allowed in respect of any income-tax withheld abroad as the same will be hit by the disabling provisions under section 40(a)(ii) of the Act. The relief granted by the Commissioner (Appeals) in respect of tax withheld abroad in respect of which no foreign tax credit is admissible under section 37(1) must, therefore, stand vacated."

4. Key Takeaways

(1)		Section 37(1) provides for deduction of those expenses which are incurred wholly and exclusively for the purpose of business or profession. Section 40 starts with stating that notwithstanding anything to the contrary contained in sections 30 to 38, following amount shall not be allowed as deduction. It implies that foreign taxes being incurred for business shall be allowed unless specifically disallowed under any limb of section 40. Section 40(a)(ii) deals with disallowance of 'any rate or taxes' and Explanation 1 further expands the scope to include foreign taxes eligible for relief under section 90.
		Thus, the entire analogy suggests that if foreign taxes are not eligible for section 90, then such foreign taxes be allowed as deduction under section 37(1). Also, the intent of the Circular No. 14 of 2006 dated 28-12-2006was to restrict double disallowance both under section 90 and section 37(1). Even in the circular it is not mentioned that remaining balance of FTC after allowance under section 90 be disallowed under section 37(1). What circular prohibits is double disallowance. This view stands fortified by the judgement of Reliance Infrastructure (supra). This line of argument is based on presumption that foreign taxes are a charge against income.
(2)		There are a host of judicial precedents wherein it has been held that income-tax is an appropriation of income of the assessee and is not a charge on income. In this context, reliance can be placed on the decision of Kerala Lines (Mad) and KEC International (Mum). It may be said that foreign taxes paid by the assessee are only an application of income and is not an expenditure incurred wholly and exclusively for the purpose of business. Therefore, not allowable as deduction under section 37(1).

For instance, net income earned from overseas is Rs 20 after allowance of deduction of Rs 80. Taxes paid overseas are Rs 10(10% of gross Rs100). Taxes to be paid in India on such income will be 30% of Rs 20, that is, Rs 6. Now the Act provides for relief on such foreign income upto income-tax payable. The logic behind restricting the deduction of foreign taxes upto amount of income-tax is that the revenue considers that since foreign taxes are also application of income the same shall be restricted, because allowing the balance under section 37(1) will partake the nature of charge against income. Thus, foreign taxes at the same time cannot be partly treated as application of income for claiming income-tax credit (to the extent of Rs 6) and the partly (Rs 4) as a charge on income by claiming the same as deduction being expenditure incurred to earn the income. If this view is followed, then foreign tax credit cannot be claimed as deduction under section 37(1) of the Act.

Keeping in view of the high pitched assessments being usually done by the department, the view 2 that foreign taxes are application of income and, thus, be only allowable as relief under section 90 of the Act.