Double Taxation Avoidance Agreements can lower tax bill for NRIs
October, 17th 2007
Taxation can be a complicated issue for a non resident (NRI). He may be subject to tax in India on some income and further doubly taxed in both countries on another source of income. This situation of double taxation can be avoided by appropriate planning, taking into consideration the provisions of the relevant Double Taxation Avoidance Agreement ( or Tax Treaty) entered by India with the relevant country and availing the benefits, if any.
An individual who is no longer staying in India, (generally referred to as a Non-Resident Indian), typically has passive income (eg: dividend, interest) and/or active income (eg: business income) streams arising from India.
Jayesh Sanghvi Tax Partner, E&Y, India
Because an individual has recently migrated from India, it does not automatically make him a non resident under the Indian Income tax Act, 1961 (the Act). Classification under the Act, for tax purposes, depends on the number of days stay in India during the specified period, as explained in the subsequent paragraphs.
While the Act levies tax on Indian sourced income of an NRI - if he is a non resident, as defined under the Act, there could be circumstances where an NRI is liable to tax in India on his worldwide income.
Residential status under the Act
Under the Act, the scope of taxable income varies with the residential status of the individual. The Act prescribes two tests of residence for individual taxpayers. Each of the two tests relate to the physical presence of the individual in India in the course of the 'tax year'. An individual is said to be a resident in India in the tax year, if he is:
a) Physically present in India for 182 days or more in that tax year; OR
b) Physically present in India for 60 days in that tax year and 365 days or more in the preceding four tax years.
If either of the tests is not satisfied, he will be considered as 'non resident'. Additionally, an individual, who is defined as a resident in a given tax year is said to be 'not ordinarily resident' in any tax year if he has been a non-resident in India in 9 out of the 10 preceding tax years or has been in India for less than 730 days during the 7 preceding tax years.
Therefore, under the Act, an individual may be classified as a resident and ordinarily resident (ROR); resident but not ordinarily resident (RNOR); or a non-resident (NR).
The incidence of tax on individuals can generally be summarized as follows:
Incidence of taxation in India
Indian income (income received or deemed to be received or income accruing or arising or deemed to accrue or arise in India)
Income from business or profession which is set up in India and controlled wholly or partly from India
Income from business or profession which is set up outside India and controlled outside India
Any other foreign income
Thus, it can be seen that a Resident and ordinarily resident (ROR) is subject to tax in India on his worldwide income.
After having established the tax incidence of a NRI under the Act, it is vital to check if the NRI can take recourse under the tax treaty for elimination of double taxation.
Analyzing tax treaties
In order to avail the tax treaty benefits, a NRI should be a resident of one of the countries to the tax treaty. As a thumb rule, the term 'resident' under the tax treaty vis--vis an individual, means a person who is liable to tax in a country under its domestic law by reason of domicile, residence or any other tests laid down therein. Accordingly, the definition of a 'resident' in the domestic tax law is usually considered to be the starting point in determining the residential status of an individual under the tax treaty.
Precarious situations could arise for a NRI as he could be a resident of both countries or a non resident of both countries to the tax treaty (while rare, this is possible in case of highly mobile employees). In the latter situation, where the NRI is considered to be a non resident of the treaty countries, he will not be entitled to the tax treaty benefits and thus would be governed by the respective domestic tax laws of those countries relating to residence and taxability.
Where an NRI is a resident of both countries, in other words a dual resident, the residential status for the purposes of the tax treaty is determined by applying the 'tie breaker' test in the tax treaty. This is essential, since the country of residence relieves the burden of double taxation by giving either the credit for taxes paid in the source country or sparing the income that has suffered tax in the source country.
The 'tie-breaker' consists of a series of tests to be applied successively until residence for the purposes of the tax treaty is established. In other words, once a test is conclusive it is unnecessary to apply subsequent tests. Generally the tests appear in the following order:
a) Permanent home An NRI is considered a resident of the country in which he has a permanent home. A permanent home may be any kind of dwelling place, owned or otherwise, that is available to the NRI on a continuous basis. If he has a permanent home available to him in both countries it is necessary to look at the next test.
b) Centre of vital interest An NRI is considered a resident of the country to which his personal and economic relations are closer. The term 'personal and economic relations' would cover the full range of social, domestic, financial, political and cultural links the NRI has in a country to the treaty. If it is not possible to determine the centre of vital interests, or the permanent home test remains inconclusive, then it is necessary to look at the next test.
c) Habitual abode An NRI is considered a resident of the country in which he has a habitual abode. Habitual abode depends on the frequency or duration of stay over a sufficient period. It is said to be in the country where the NRI spends most of his time, regardless of the purpose. If the NRI has a habitual abode in both countries, then it is necessary to look at the final test.
d) Nationality An NRI is a resident of the country of which he is a national. The nationality of the NRI is to be determined as per the domestic laws of the countries to the tax treaty. Finally, if all these tests prove to be inconclusive - even the last, since an individual may have dual nationality - the competent authorities of each country will mutually decide the residence of an individual by negotiation.
Let us consider a hypothetical scenario. Mr. Kamesh, a NRI staying in Singapore and a tax resident of Singapore under its domestic tax laws, also qualifies as an ROR in India. Mr. Kamesh is in receipt of capital gains of 100 derived on sale of shares in a Singapore Company.
Let us assume that this sum of 100 is not subject to any income tax in Singapore, as the required conditions for such exemption have been met. However, if Mr. Kamesh is taxed as a ROR in India he will have to shell out approximately 20 towards income tax (tax rate of 20 per cent - considering it is a long term asset) in India. For the sake of simplicity, this illustration does not deal with currency denominations and its conversions .
Accordingly, if Mr. Kamesh wants to take advantage of the beneficial tax regime in Singapore, it would be imperative for him to factually demonstrate that he is resident of Singapore, even on application of the tie-breaker test.
In view of the above, it is important for an NRI to firstly monitor his stay in India as well as demonstrate the factors that determine his treaty residence so that he is able to maximize his tax treaty benefits.
(The author is a tax partner with Ernst & Young, India)