Taxation of Foreign Source Income

In today’s interconnected world, many individuals earn income from multiple sources across different countries. This global income landscape raises important questions about how such income is taxed in different jurisdictions.

In India, an individual’s tax liability depends on their residential status and the source of their income. Generally, resident Indians are taxable on their worldwide income, whereas non-residents are taxed only on their income earned in India. Section 5 of the Income-tax Act, 1961 provides that a resident individual earning income from Indian or foreign sources must report income under all applicable heads, including salary, house property, profits from business and profession, capital gains, and other sources, and pay the applicable tax. Let us understand how foreign income is reported and the tax implications involved.

Rules of Taxation of Income

Countries across the world generally tax income based on two fundamental principles: the Source Rule and the Residence Rule.

• Source Rule: Under the source rule, income is taxed in the country where it is earned. This rule considers the source of the income, including whether it is earned by individuals in that country or generated from resources located there. For example, if you are an Indian resident but earn income in the UK, the UK may impose tax on that income under the source rule.
• Residence Rule: Under the residence rule, the country where the taxpayer resides taxes their income, regardless of whether it is earned domestically or in another country. For example, if you are an Indian resident and earn income in the UK, India may also tax that foreign income under the residence rule.

What is a Foreign Source of Income?

Foreign source income includes earnings such as dividends, interest, royalties, and fees for technical services received from sources outside India. For income to qualify as being earned outside India, the related activities must be carried out abroad. Services may be provided from India, but they must be utilized by a recipient conducting activities outside India.

Further, even when income is earned abroad, it should not be received directly in India. The initial receipt should take place outside India, after which the amount may be remitted to India. If the income is received directly in India, it will be taxable in India.

The taxability of foreign source income also depends on the residential status of the individual.

What Does Foreign Asset Include?

For Indian tax residents, a “foreign asset” covers a wide range of assets and holdings located outside India, including:

• Bank accounts
• Financial interests in entities
• Cash value insurance policies
• Annuity contracts
• Immovable property
• Custodial accounts
• Equity and debt interests

Residential Status and Tax Liability

Understanding residential status is the first step toward determining the tax implications of income earned abroad. In India, individuals are classified into three categories based on their residential status: Resident and Ordinarily Resident (ROR), Resident but Not Ordinarily Resident (RNOR), and Non-Resident (NR). Correctly determining this classification is important because it defines the extent of an individual’s tax obligations.

How Is Residential Status Determined?

• Resident and Ordinarily Resident (ROR): A taxpayer is considered an Indian resident if they satisfy either of the following conditions: staying in India for 182 days or more during the relevant year, or staying in India for at least 60 days during the relevant financial year and 365 days or more during the four immediately preceding years.
• Resident but Not Ordinarily Resident (RNOR): An individual is treated as an RNOR if they have not been an Indian resident for 9 out of the 10 preceding years or have not stayed in India for more than 729 days during the 7 preceding years.
• Non-Resident (NR): An individual who does not satisfy any of the above conditions is classified as a Non-Resident Indian.

Tax Treatment of Foreign Income Based on Residential Status

The taxability of foreign income in India depends on the individual’s residential status:

ROR (Resident and Ordinarily Resident):

• As an ROR, you are taxable on your worldwide income, including income earned outside India.
• Foreign income is added to your Indian income and taxed according to the applicable income tax slabs in India.
• Relief may be available for foreign taxes paid under the Double Taxation Avoidance Agreements (DTAA) entered into by India with various countries.

RNOR (Resident but Not Ordinarily Resident):

• The taxation rules for RNORs can be more complex and depend on their residential history over the previous ten years.
• Generally, foreign-source income is not taxable in India for RNORs if it is not received in India.
• However, income earned from a business or profession controlled or established in India remains taxable for RNORs.

NR (Non-Resident):

• A Non-Resident is generally taxable only on income earned or accrued in India.
• Certain exceptions may apply, including interest income, royalties, fees for technical services, and capital gains from specified assets located in India.

Note: For all three categories, it is important to consider the Double Taxation Avoidance Agreements (DTAA) entered into by India with other countries. These agreements provide relief from being taxed on the same income twice.

Taxation of Foreign Income for Residents

Residents, whether classified as ROR or RNOR, are taxed on foreign income at the rates applicable to domestic income. Taxes should be paid within the prescribed timelines to avoid complications. If foreign income is received in India, it must be taxed in the same financial year. For income not received in India, taxation applies in the financial year in which the income is realized or accrued.

Distinction Between Tax Treatment of ROR and RNOR

RORs are taxable on their worldwide income, including income earned from foreign sources. In contrast, RNORs are generally taxed only on income received or accrued in India or income from a business controlled or a profession established in India. This distinction reflects the individual’s level of connection with the Indian economy.

Taxation of Foreign Source Income for Non-Residents

Specified Income Categories for Non-Residents

Non-residents are subject to a different taxation framework. Certain types of income, including interest, royalties, fees for technical services, and capital gains, are taxable in India. Section 195 of the Income Tax Act governs the taxation of income paid to non-residents.

Withholding Tax for Non-Residents

Payments made to non-residents are subject to withholding tax by the payer. This mechanism enables the Indian government to collect tax on specified income earned by non-residents within its jurisdiction.

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When Must Taxpayers Declare Foreign Assets?

Individuals holding foreign assets, whether acquired from disclosed sources or even when their income is below the taxable threshold, are required to complete the Foreign Asset (FA) or Foreign Source Income (FSI) schedule in their ITR. Failure to disclose foreign assets or income in the ITR may attract a penalty of ₹10 lakh under the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015.

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Double Taxation Avoidance Agreements (DTAA)

You may wonder whether income earned abroad needs to be taxed twice, both in India and in the country where it was earned. The answer is ‘No’.

To address the issue of double taxation, where the same income may be taxed in both the source country and the country of residence, India has entered into several Double Taxation Avoidance Agreements (DTAA). These agreements provide relief to taxpayers by allowing them to claim credit for foreign taxes paid against the tax payable in India on the same income.

Individuals can claim foreign tax credits for income taxed both in a foreign country and in India. This relief can be claimed under Sections 90 and 91 of the Income Tax Act. These provisions allow taxpayers to claim credit for foreign taxes paid when the same income is also taxable in India.

Form 67

Form 67 of the Income Tax Act is required for taxpayers seeking to claim a foreign tax credit while filing their ITR under Section 139(1). The credit is available to taxpayers who earn income outside India and are liable to tax on that income in both countries.

Schedule FA of the Income Tax Act

Schedule Foreign Assets (FA) in the Income Tax Return (ITR) requires taxpayers to disclose details of foreign assets, including foreign shares, mutual funds of foreign companies, and employee stock options (ESOPs) from foreign companies.

In other words, all foreign assets held by you, whether held legally, as a beneficiary, or as a beneficial owner, must be disclosed while filing ITR-2 or ITR-3, as applicable.

Hindu Undivided Families (HUFs) classified as Residents and Ordinarily Residents (R&OR) are also required to disclose their foreign assets in their Income Tax Returns. This requirement promotes transparency regarding international financial interests and supports tax compliance.