The Hindu Business Line : Barring the benefit of double deduction

The recent amendment seems to imply that if foreign tax credit is not allowed for any reason, foreign tax paid may be allowed in the computation of profits.

Should foreign taxes be allowed as deduction in computing profits for the purpose of Indian income-tax? This question had arisen in a number cases relating to the assessment of shipping lines.

Courts had pointed out that there is a distinction between monies spent to earn profits and monies spent out of profits, and that income-tax would arise in the latter category. Taxes are not paid for earning profits. In recent cases, however, the view in general has been that foreign income-tax or business profits tax levied by another state should be allowed as a deduction in computing the profits for Indian income-tax.

The Bombay High Court rejected a reference application, in CIT vs South East Asia Shipping Co (ITA No. 123 of 1976), holding that foreign tax does not fall within Section 40(a)(ii) and that on general principles, the assessee's net income after foreign taxes is his real income for purposes of the I-T Act. In March 1993, the Bombay High Court again rejected such a reference in CIT vs Tata Sons Ltd (ITA No. 89 of 1989).

Legal provisions

Section 40(a)(ii) of the Income-Tax Act bars deduction from total income any sum paid on account of any rate or tax levied on the profits or gains of any business or profession, assessed as a proportion of, or otherwise on the basis of, any such profits or gains.

The non-obstante clause is made applicable for this section too. No deduction will be allowed even if there is anything to the contrary in Sections 30 to 38.

Section 2 of the I-T Act defines `rate' as that which is in force in relation to an assessment or a financial year (sub-section 37 A).

If the rate is not assessed on the basis of profits, it is allowable as business expenditure. Where the rate or tax is assessed as a proportion of profits and gains, deduction is denied.

The Thai tax

A subtle distinction was made by the Bombay High Court while interpreting Section 40(a)(ii) in CIT vs KEC International Ltd (256 ITR 354). The company claimed deduction in respect of business tax paid in Thailand. There are two types of taxes in Thailand — corporate and business. There was no dispute about the disallowance of corporate tax.

However, the applicability of Section 40(a)(ii) to business tax became the bone of contention, as business tax in Thailand is not on income but turnover.

The Bombay High Court ruled in June 2000 that Section 40(a)(ii) has no application to business tax paid in Thailand.

The company was considered entitled to claim deduction in respect of business tax paid by it in Thailand. Thus, judicial opinion is divided on the question of allowing deduction for foreign taxes.

Clause 10 of the Finance Bill, 2006 has amended Section 40(a)(ii). What are the implications? The amendment ends the controversy by providing that deduction will not be allowed if the same is eligible for tax relief under Section 90 or deduction from income-tax payable under Section 91.

The deeming clause provides that such a deduction was never allowable at all under Section 40(a)(ii). However, the amendment makes it clear that taxpayers will be eligible for tax credit in respect of income-tax paid in a foreign country in accordance with Section 90 or 91. The amendment is said to be clarificatory and takes effect from April 1.

The amendment bars benefit of double deduction, once by way of deduction from the profits computed for income-tax purposes and again by way of set off of foreign tax credit. No objection can be taken to this amendment. It also seems to imply that if foreign tax credit is not allowed for any reason, the foreign tax paid may be allowed in the computation of profits. This is a possible interpretation, but is likely to be resisted by the Government.

It may be useful here to refer to the Full Bench ruling of the Supreme Court in Harshad Shantilal Mehta vs Custodian (231 ITR 871). The apex court ruled that the definition of `tax' under Section 2(43) of the Act does not include penalty or interest and, therefore, it follows that interest leviable under the Act is not covered by Section 40(ii). The section applies only to taxes as such.

(The author is a former Chief Commissioner of Income-Tax)