How does a DTAA work?
We've heard this so many times - "India and XYZ country have a DTAA. So I don't need to pay tax on this income right?"
Before we start, let's clear one thing up - A Double Taxation Avoidance Agreement (DTAA) is NOT a magic wand that makes your tax liability go away.
Now that we have this out of the way, let's tackle the beast that is the Double Taxation Avoidance Agreement.
We're going to use the India-US DTAA as an example here. DTAAs tend to have similar treatment overall (but obviously, if you ask a CA, we see a million differences between DTAAs with different countries).
Let's look at this in a caselet format where we deal with different sources of income.
Case 1: Professional Income
Captain Planet receives INR 45,00,000 each year from his US client. Captain Planet resides in India and is an Indian citizen. Captain Planet approached Galactic Advisors with the following statement:
"I receive money from the US and since there is a DTAA between India and USA, I will pay no tax in India, right?"
*cue facepalm* Unfortunately, that's not how a DTAA works. There is no double taxation at all in this case. India has the sole right to tax this income since services are provided from India. USA has no right to tax this income (assuming you are not a US citizen/ Green Card Holder)
There has to be some form of double taxation for the DTAA to be applicable.
Galactic Tip: If you're a freelancer, check out our comprehensive guide on tax for freelancers.
Case 2: Capital Gains on RSUs
Hermione is an Indian citizen working with Google India. As part of her compensation, she receives Alphabet RSUs every year. She understands that the value of RSUs is taxable as perquisites in India (since that shows up in her Form 16).
Hermione is smart. She knows there is no Capital Gains tax in the US for Non-American residents. She decides to sell her RSUs and remit the money to India. She approaches Galactic Advisors with the following statement:
"I know I pay no tax in the US on this sale of restricted stock. What happens in India though?"
This is again not a case of double taxation. India has the sole right to tax this income since Hermione is an Indian resident. See how tax works on foreign stocks here
Galactic Tip: We're also working on a comprehensive article on how RSUs/ ESPPs are taxed in India and reporting requirements under Schedule FA. Subscribe to our newsletter to ensure you don't miss it!
Case 3: Capital Gains on US shares
Mr. Investor is an Indian citizen who invests in US stocks. He doesn't believe in dividend stocks and invests only in growth stocks like Amazon, Alphabet or Tesla.
With the prices skyrocketing last year, Mr. Investor decides to book his profits. Mr. Investor was told by a friend that India and USA have a Tax Treaty (DTAA) so he doesn't have to pay tax in India.
This is in fact the same as Case 2 above. India has the sole right to tax this income since Mr. Investor is an Indian resident. See how tax works on foreign stocks here
Case 4: Interest income
Lily is an Indian citizen who returned to India 3 years ago after spending 10 years in the US. She has a US savings bank account on which she receives interest every year. Lily knows she has to pay tax on global income in India. Her bank requests her to share a W8-BEN each year and deducts withholding tax of 15% of her interest.
Lily makes the following assertion "Since I am paying tax in the US. I assume I have to pay no tax in India on this income. Is this correct?"
Lily is making the mistake most people seem to make when they try to understand how a DTAA works.
Let's take a few hypothetical numbers to understand Lily's case further:
First, let's analyze why the bank withheld tax at 15% in the US. This is because of the India-US DTAA. Without getting into the technical mumbo-jumbo of it, the India-US DTAA states that interest earned in the other country (USA) will be taxed at 15% in that country (USA).
Now, the DTAA also states that said interest income can also be taxed in India (by virtue of residence in India).
Lily says "This is ridiculous. Fine. Show the INR 8,50,000 in my ITR."
This is also a common error. Clients always want to show the net amount received as income as that is the amount they actually received.
Unfortunately, that is incorrect. Income is always included on a gross basis. You get foreign tax credit for the taxes deducted.
Lily hates her US bank account now "Fine. Show the INR 10,00,000. But please claim the Foreign Tax Credit so I pay no tax"
Let's quickly look at how Foreign Tax Credit (FTC) would be calculated. Note that for the sake of simplicity, we have assumed that Lily is in the 30% slab and tax rate in India is a flat 30% (we have skipped surcharge and cess for now for the sake of this example).
So Lily ends up having to still pay tax in India. Add to this the fact that she did not pay Advance tax and had to suffer interest under 234B and 234C as well.
Galactic Tip: This is a theoretical example. Claiming of Foreign Tax Credit (FTC) can be a problem in itself. Read on FTC here.
You can also read on the interest liability on non payment of advance tax here.
Case 5: Dividend income
Ted Singh invests in US stocks and receives small amounts of dividend every year. There is a withholding tax of 25% on dividends in the US.
This is exactly the same case as Case 4 above. FTC will be available. Using similar numbers below for the sake of our example.