Sometimes U.S. companies perform services in the U.S. for customers located in India and are surprised when the Indian customer withholds Indian taxes from the payment for those services. Most U.S. income tax treaties would not allow foreign taxes to be imposed on services performed in the U.S., where the U.S service-provider has no activity or permanent establishment in the foreign country. However, the India-U.S. Income Tax Treaty (the “Treaty”) is not a typical U.S. income tax treaty. It is based on the UN Model Tax Treaty, whereas most U.S. tax treaties are based on the OECD Model Tax Treaty.
Article 12 of the India-U.S. Income Tax Treaty - Fees For Included Services
Under Article 12, paragraphs 2 and 4 of the Treaty, if:
- A U.S. service-provider provides services to an Indian customer,
- The services were “of a technical or consultancy” nature, and
- The services make available to the Indian customer “technical knowledge, experience, skill, know-how, or processes” (or the services fall within certain other categories),
then an Indian income tax of up to 15% can be imposed. These types of payments are referred to in the Treaty as “fees for included services.” This Indian tax can be imposed under the terms of the Treaty, even if the U.S service-provider has no activity or permanent establishment in India. Article 7, paragraph 7 of the Treaty.
U.S. Foreign Tax Credits Generally Limited To U.S. Tax On Foreign-Source Income
If the U.S. service-provider performs the services in the U.S., then under U.S. domestic law the income would be considered U.S.-source income. Code §861(a)(3) and Treas. Reg. §1.861-4. Generally, foreign tax credits are limited to the U.S. tax on foreign-source income. Code §904. If the U.S. service-provider has no foreign-source income, then the foreign tax credit limitation (zero times the U.S. tax rate) would be zero, and the Indian income taxes paid could not be claimed as foreign tax credits.
Resourcing Of The Income Under The Treaty
If the income can be taxed by India under Article 12 of the Treaty, then under Article 25, paragraph 3(a), the U.S. service-provider can “resource” the services income to be foreign source income for foreign tax credit purposes. The amount that can be resourced as foreign-source income is limited to an amount just enough to allow a foreign tax credit for the 15% of Indian taxes paid. This avoids double taxation. A separate Form 1116, Foreign Tax Credit (Individual, Estate, or Trust), or Form 1118, Foreign Tax Credit—Corporations, must be completed by the U.S. service-provider, and the box “Certain income re-sourced by treaty” should be checked. No separate treaty disclosure is needed on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b). Treas. Reg. §301.6114-1(c)(1)(v).
No Foreign Tax Credit If A “Voluntary Payment”
If the Indian customer withholds Indian tax on the payments to the U.S. service-provider, but if those payments do not fall within the definition of “fees for included services” as defined in the Treaty, the U.S. service-provider should be able to file a tax return in India and obtain a refund of the Indian taxes withheld.
If the U.S. service-provider could claim a refund of the Indian taxes but decided not to, the Indian income taxes paid would be considered a “voluntary payment” and could not be claimed by the U.S. service-provider as a foreign tax credit in the U.S. In other words, no foreign tax credit can be claimed with respect to amounts paid that are not owed under a “reasonable interpretation * * * of foreign law (including applicable tax treaties).” Treas. Reg. §1.901-2(e)(5). It is therefore important for the U.S. service-provider to confirm that the services provided fall within the Treaty definition of “fees for included services” before claiming the Indian taxes as foreign tax credits. If the services do not fall within the definition of fees for included services, the U.S. service-provider should seek a refund of the Indian taxes withheld.