US tax residents who participate in the Indian equity market are often surprised to learn that gains from the sale of Indian securities are subject to tax in both the US and India. Unlike the US, which focuses its tax lens on the residence of the seller (not the location of the corporation being sold), India taxes nonresidents when they sell Indian securities at a gain. As a result, the gain on the sale of Indian securities sold by a US tax resident is generally subject to both Indian and US tax.
Common sense dictates that, since the US and India have a tax treaty, there must be an equitable solution to this problem. For many years, the international tax community has questioned whether the problem can be resolved equitably. Fortunately, the Internal Revenue Service (IRS) recently issued two favorable Private Letter Rulings (PLRs). These PLRs appear to be among the few public documents the IRS has issued on this topic. This Alert will examine this issue and the impact of the PLRs.
What is the Problem?
When income or gains are taxed by the US and another country, the US generally offers a Foreign Tax Credit (FTC) to offset the US tax liability for the taxes paid in the other country. However, the amount of FTC which is ultimately allowed is limited to the lesser of: (1) the foreign tax paid or accrued; or (2) the FTC limitation. The FTC limitation is derived from this formula and is applied separately with respect to different categories of foreign source income:
Thus, when a US taxpayer pays foreign tax, if the related income is not considered to be foreign sourced, then, as a practical matter, no FTC is allowed. Under the Internal Revenue Code, generally speaking, with respect to capital gains of personal property (including securities), the source of the gain is based on the residence of the seller. So, if an Indian tax resident sold shares of Apple, Inc. at a gain, there should be no US tax, since the gain would not be US-sourced. On the other hand, if a US citizen sells shares of Reliance Industries Ltd (a foreign corporation) at a gain, for example, the gain should be US-sourced, not foreign-sourced. The fact that India also taxes this gain is not relevant to the sourcing rules under the Internal Revenue Code. Therefore, per the above formula, if there is no foreign-sourced gain, there is no FTC allowed.
But What About the US – India Tax Treaty?
It is true that many of the tax treaties into which the US has entered have a “treaty resourcing provision,” which will change the character of the Reliance gain, in this example, from US-sourced to foreign-sourced. The Internal Revenue Code recognizes that some gains may be resourced by an applicable tax treaty. It allows taxpayers to make an affirmative election with their US tax return to invoke treaty resourcing (and treat the gain as foreign sourced) rather than to follow the standard statutory foreign tax credit sourcing rules as described above.
However, the US-India tax treaty has some unusual language that has created a quandary for impacted taxpayers and their advisors for many years.
The current tax treaty between the US and India came into effect in 1989. The relevant provision to this discussion is Article 25, Relief From Double Taxation, which addresses the sourcing rules for the FTC computation. Specifically, Article 25(3) reads as follows (emphasis added):
For the purposes of allowing relief from double taxation pursuant to this Article, income shall be deemed to arise as follows:
(a) income derived by a resident of a Contracting State which may be taxed in other Contracting State in accordance with this Convention (other than solely by reason of citizenship in accordance with paragraph 3 of Article 1 (General Scope)) shall be deemed to arise in that other State;
(b) income derived by a resident of a Contracting State which may not be taxed in the other Contracting State in accordance with the Convention shall be deemed to arise in the first-mentioned State.
Notwithstanding the preceding sentence, the determination of the source of income for purposes of this Article shall be subject to such source rules in the domestic laws of the Contracting States as apply for the purpose of limiting the foreign tax credit. . . .
Under Article 25(3)(a), the first bolded sentence seems like the solution to the problem—the Reliance gain is foreign sourced. However, the second bold sentence seems to immediately take this benefit away since US domestic law treats the gain as US-sourced.
Taxpayers and advisors have been split over the proper interpretation of this provision. Some commentators believe that a plain-language reading leaves the Reliance gain as US-sourced and thus potentially leads to double taxation due to the FTC limit formula. Others have commented that this result is nonsensical and is not how the US-India tax treaty was intended to be interpreted. In other words, if there were no treaty resourcing intended, there would be no need for this portion of Article 25.
Enter the Private Letter Rulings (PLRs)
Until earlier this year, there was no guidance available from the IRS on how to grapple with the consequences (intended or not) of Article 25(3) of the US-India Tax Treaty. Recently, however, the IRS issued PLR 202613004 in which a US citizen owned several partnerships that sold shares of Indian corporations and was allocated gain from those sales. India taxed the US citizen on this gain.
It seems the taxpayer originally reported the gain on these sales as US-sourced income and, consequently, paid tax in the US (thus, double taxed). The taxpayer later decided to make the treaty-based resourcing election mentioned above. However, the time prescribed by the IRS to make the election had expired. The taxpayer sought a PLR allowing him or her to make the election after the required date due to reasonable cause.
Without addressing the Article 25 uncertainty, the IRS allowed the taxpayer to make the late election and resource the gains under Article 25(3) of the treaty. [1]
The IRS also issued PLR 202611004 at approximately the same time. That ruling involved remarkably similar facts, but the selling taxpayer was a US corporation that sold shares in an Indian corporation directly. The taxpayer requested the ability to make a late election under the treaty to treat the gain as foreign-sourced, which the IRS also granted.
What Does This Mean?
The IRS issues PLRs to specific taxpayers; they are not binding on the IRS, and they cannot be cited as precedent in other tax matters. However, tax practitioners often view PLRs as insights into how the IRS views a particular issue. While it would have been helpful if the IRS had specifically addressed the seemingly contradictory Article 25(3) language, the fact that the IRS allowed a late election to invoke the treaty resourcing rule creates a presumption that the IRS believes that treaty resourcing under the US-India tax treaty is available.
Final Thoughts
Obviously, this is a highly complex and nuanced area. Ultimately, each taxpayer must make their own decision as to how they will treat Indian tax paid on the sale of securities, but this PLR is a welcome ray of sunshine in an area that had been largely gray until now. If you have questions about the foreign tax credit rules or the application of the US-India tax treaty, please contact a WG tax advisor.
[1] While the PLR does not specifically mention the US-India treaty, the provision mentioned is identical to the one found in the US-India treaty.
