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Tuesday, Mar 11, 2003

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Not ordinarily resident status -- A sting in the Budget fineprint

Lakshmi Anand

WHILE the income-tax proposals in the latest Budget have generally been welcomed, an obscure item tucked away in the fineprint contains a severe sting in the tail for NRIs, expatriates in India and those who have returned to India from abroad.

This is the proposal to alter the definition of `Not Ordinarily Resident' to a) reduce the number of eligible persons to a miniscule fraction of returning residents, and b) curtail the period of tax benefit drastically. Ironically this change to a decades-old provision comes in the year when the Government is ostensibly seeking to court the Indian diaspora, and encourage the Pravasi Bharatiyas to return!

The issue

Right from 1961 when the current Income-Tax Act was enacted and even earlier under the 1922 Act, residency status has been of 3 kinds — Non-resident, Resident and Resident but Not Ordinarily Resident (RNOR for short). The last category is a transitional status lasting for some years for people who have come back to India after a period of non-residency. For those with RNOR status, only income earned in India is liable to Indian income-tax. Thus, so long as an individual is in this RNOR status, his income accruing outside India will not be taxable in India.

The origins of this category can be seen even today in British tax law where a distinction is drawn between residence and `domicile' (that is, long-term residence).

That distinction is one of the reasons the UK is an attractive destination for a lot of `high net worth individuals' from other countries. Apparently, one of the reasons this status was introduced in pre-1961 India was that there were many companies and managing agencies which employed British expatriates.

These people would come to India, work for a few years and then return to Britain, but would not be willing to come if their entire British income was subject to Indian income-tax. Suffice it to say that this provision is of great vintage and has been a fundamental part of Indian tax law since the introduction of income tax.

The precise definition of the RNOR status is given in Section 6 of the Income Tax Act 1961. Without getting into legalese, the section has been taken to mean that a person who has been non-resident for more than two years continuously would on return, be entitled to RNOR status for nine years, and thus for nine years would be taxable in India only on income accruing in India.

This has been the universally accepted interpretation not only of commentators and courts, but also of the CBDT itself as seen in its own official publications on taxation of non-residents.

Last year, in a controversial interpretation, the Gujarat High Court ruled in the Pradip Mehta case that the decades-old interpretation was wrong and gave a different meaning to the section. This year, in the Finance Bill, the Finance Minister has sought to amend the law, apparently in consequence of the Gujarat High Court view.

The effect of this amendment will be that, hereafter, persons who have resided abroad continuously for nine years, or who have been physically present in India for less than 730 days in the last seven years, will get the transitional benefit for two years.

In short, the number of persons who would qualify for RNOR status would now be drastically reduced: only those who have been non-resident continuously for 7- 9 years (depending on the precise number of days spent in India) would qualify; for the few who qualify, the period of benefit would be reduced to two years instead of nine. For those who do not qualify, their entire world income would be taxable from the year they become resident in India.

Implications of change

This change has serious adverse implications for India's burgeoning software and IT-enabled services sector. One of the critical success factors of India's software sector has been the two-way mobility of professionals between India and the US.

Many have returned to India after a stint in the US either to work for Indian affiliates of US companies or in their own start-ups. Very few of them have been `continuously non-resident' for seven-nine years.

The change Mr Jaswant Singh is bringing in will mean that any income they accrue abroad — including in their Individual Retirement Accounts/401-k savings — will now be fully liable to Indian taxation from the year of their return.

Instead of a nine-year transition — which afforded them time to try out new ventures without risking their retirement savings — they will now have no transition at all. This could be disastrous for the smooth flexibility in relocation and mobility that is so critical to the Indian software industry's success. From now on, software professionals returning from the US to India will have to think twice — they would be liable for tax of approximately 33 per cent on the income earned in their US pension accounts and on any other savings they have there!

No doubt this will be subject to double taxation relief, but for such items as Individual Retirement Accounts, which are tax-deferred in the US, double taxation relief will afford no benefit since there is no taxation at the other end. Even the few professionals who have a seven-nine year period of continuous non-residency would have to think very carefully because the transition period is just two years.

This new provision will be a major impediment to the growth of India's software and ITES sector and limit the ability of Indian professionals to take full advantage of market opportunities.

While the impact is largest in software, it applies equally to all sectors where NRIs decide to return to India, particularly `knowledge-based' sectors. For example the US-returned professors at the Indian School of Business will have to re-think their personal finances — their US-based savings will now be subject to Indian taxation!

Another impact will be on expatriates working in multinationals in India. While these expatriates would probably meet the nine-year continuous non-residence criterion when they first arrive, they will find themselves paying Indian income-tax on the whole of their world income two years from their arrival. This will either mean a reluctance to come to India or a major increase in costs for the multinational, which may have to reimburse them for Indian income-tax on their foreign income. This is clearly an anti-FDI measure.

As for additional tax revenue, this is likely to be negligible in the short run because the number of people with RNOR status is very small relative to the total number of assessees. The change will induce many not to settle in India.

Those who do still come back will resort to legal methods of avoidance such as offshore trusts, so that the only real beneficiary will be lawyers and banks in Western countries which specialise in these devices. In the long run, when considering the `supply-side effect' (that is, reduction in numbers re-settling), the revenue impact is likely to be negative.

Clearly, the amendment Mr Jaswant Singh has proposed has two major negative effects — it discourages NRIs from re-settling in India and it discourages MNCs from locating here because it may become prohibitively expensive for expatriates to work in India.

Both these effects run counter to the entire thrust of Mr Jaswant Singh's economic policy and to the Government's policy of fostering closer ties with the diaspora. Paradoxically, the nine-year RNOR benefit existed throughout the long period when India had a socialistic policy, discouraged MNCs and had severe restrictions on investments by returning Indians.

It is perplexing that in an era where foreign investment is welcome and in the very year when the country is reaching out to the Pravasi Bharatiyas, going to the extent of permitting dual citizenship, this age-old provision is being scrapped. And the change will bring in negligible, and in the long run negative, revenue.

It thus appears to be a measure which has been drafted at the bureaucratic level in response to the controversial court judgement, without any understanding of the policy implications. Mr Jaswant Singh would be well-advised to withdraw it immediately before it does serious damage, and instead restore the legal status quo ante that prevailed for so many decades prior to the Gujarat judgment.

(The author is a Financial Analyst with Accuweather Inc., Pennsylvania, US, and can be contacted at

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