As an NRI in the US, you may have several of your investments in securities in India - equity shares, mutual funds, debentures, private equity investments etc. First let us look at how these investments are taxed in India.
Equity mutual funds and listed equity shares: Long term capital gain on sale of equity shares (that is if you sell after one year of holding) is tax free in India. Therefore, there will be no tax implication. Short term capital gain is taxed at a flat rate of 15%. For an NRI, the tax is deducted at source (TDS) before you receive your sale proceeds.
Debt mutual funds and listed debentures:
Private equity investments (unlisted equity shares): Long term capital gain on sale is taxed at 10%. Short term capital gain is taxed at the taxpayer's regular tax slab. TDS will be 30%.
Tax in the US
As a resident or citizen of the US, you are required to pay tax in the US on your global income. So any income from sale of shares, mutual funds or debentures in India must be declared in your US tax return and you must pay tax in the US on that income.
Double Taxation Avoidance Agreement and Foreign tax credit
According to Article 25 of the DTAA, the US shall allow its residents or citizens to claim a tax credit in the US on income tax paid to India. Therefore, according to this Article 25, taxes paid in India on capital gains on shares and securities (in the form of TDS or otherwise) should be allowed to be claimed as tax credit in the US. However, there is more to this.
Article 25 further states that '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.'
And here is where the trouble begins. "According to the US tax code, in order to claim a tax credit of taxes paid in another country, the income must be 'foreign sourced.' According to IRC Sec 865, 'income from sale of personal property by a US resident shall be sourced in the U.S.'," explains Rahul Ranadive, a tax attorney with Florida based Global Tax and Estate Counsel LLP.
Equity mutual funds and listed equity shares: Long term capital gain on sale of equity shares (that is if you sell after one year of holding) is tax free in India. Therefore, there will be no tax implication. Short term capital gain is taxed at a flat rate of 15%. For an NRI, the tax is deducted at source (TDS) before you receive your sale proceeds.
Debt mutual funds and listed debentures:
Private equity investments (unlisted equity shares): Long term capital gain on sale is taxed at 10%. Short term capital gain is taxed at the taxpayer's regular tax slab. TDS will be 30%.
Tax in the US
As a resident or citizen of the US, you are required to pay tax in the US on your global income. So any income from sale of shares, mutual funds or debentures in India must be declared in your US tax return and you must pay tax in the US on that income.
Double Taxation Avoidance Agreement and Foreign tax credit
According to Article 25 of the DTAA, the US shall allow its residents or citizens to claim a tax credit in the US on income tax paid to India. Therefore, according to this Article 25, taxes paid in India on capital gains on shares and securities (in the form of TDS or otherwise) should be allowed to be claimed as tax credit in the US. However, there is more to this.
Article 25 further states that '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.'
And here is where the trouble begins. "According to the US tax code, in order to claim a tax credit of taxes paid in another country, the income must be 'foreign sourced.' According to IRC Sec 865, 'income from sale of personal property by a US resident shall be sourced in the U.S.'," explains Rahul Ranadive, a tax attorney with Florida based Global Tax and Estate Counsel LLP.
What this means is that irrespective of the country of investment, any sale by a US person, of personal property would be treated as US sourced and therefore, foreign tax credit would not be available.
So if you are a US person (that is US citizen, resident or green card holder) and you sell securities in another country, they will be treated as US sourced because you are a US person. So foreign tax credit will not be available on such income. What this means is that you will pay tax in India on your capital gains (wherever applicable). You will also end up paying tax in the US on this income with no benefit of tax credit.
When will this impact you?
Obviously this will impact you only if you are paying taxes in India. Since there is no long term capital gains tax on equity shares and equity mutual funds in India, you will not be impacted in those cases. However, you will feel the pinch in case of short term capital gains on equity shares and mutual funds and long or short term gains on other securities like debt mutual funds, listed debentures and private equity funds.
Tax planning
"If you can take proper pre-investment tax planning, you may be able to face this situation. The most common planning technique is using a holding company in a treaty jurisdiction like Mauritius or Cyprus and routing your investments in Indian companies through these companies," advices Ranadive.
However, this method comes with certain costs such as incorporation and maintenance of the holding company. So you would need to weigh the tax advantage against the costs. Naturally, this strategy might make sense for high networth investors. Small investors would, in most cases, just need to bear the taxes.
Do consult a tax advisor to get advice on your individual situation.
Long term capital gain on sale of debt mutual funds (that is if you sell after one year of holding) is taxed at 20% (or 10% without indexation). TDS on this gain will be 10%. Short term capital gain on debt mutual funds is taxed at the taxpayer's regular tax slab. TDS will be 30%. In case of debentures, when they are sold in the secondary market, the same rules for capital gains tax apply. When will this impact you?
Obviously this will impact you only if you are paying taxes in India. Since there is no long term capital gains tax on equity shares and equity mutual funds in India, you will not be impacted in those cases. However, you will feel the pinch in case of short term capital gains on equity shares and mutual funds and long or short term gains on other securities like debt mutual funds, listed debentures and private equity funds.
Tax planning
"If you can take proper pre-investment tax planning, you may be able to face this situation. The most common planning technique is using a holding company in a treaty jurisdiction like Mauritius or Cyprus and routing your investments in Indian companies through these companies," advices Ranadive.
However, this method comes with certain costs such as incorporation and maintenance of the holding company. So you would need to weigh the tax advantage against the costs. Naturally, this strategy might make sense for high networth investors. Small investors would, in most cases, just need to bear the taxes.
Do consult a tax advisor to get advice on your individual situation.
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