India’s Move Towards Citizenship-Based Taxation

India’s Finance Minister, Smt Nirmala Sitharaman, tabled the first annual budget of the NDA government’s second term (Budget) on February 1, 2020. The changes proposed in the Budget were reflected in the Finance Bill 2020 which was tabled on the same date before the Indian Parliament (Finance Bill 2020). Pursuant to deliberations on the Finance Bill 2020, the Finance Act 2020 was passed by the Indian Parliament on March 23, 2020 (Finance Act 2020).

This legislation consisted of amendments to the Income Tax Act 1961 (IT Act). Alongside several changes in residency rules for individuals, a key change introduced was that an Indian citizen shall be deemed to be resident in India if he or she is not liable to be taxed in any country or jurisdiction.

This amendment is unique in the realm of Indian taxation because of its nexus with citizenship rather than residency. This article attempts to glean the rationale behind this amendment by examining the previous and extant residency regime under the IT Act. The article analyzes the likely legal interpretation and anticipate the consequences which may flow from it. A scrutiny of judicial precedents has been undertaken to flesh out this analysis. Lastly, the article looks outward at other jurisdictions with similar provisions in their legislation to understand the likely motivations behind the amendment and conjecture on what may be forthcoming for India.

Residency Rules Under IT Act

Tax Residency Rules: Pre-Finance Act 2020

Under the IT Act, there are two ways in which an individual is deemed to be a tax resident in India.

• if he or she has been physically present in India for a cumulative period of 182 days in a financial year (April–March) (Section 6(1)(a) of the IT Act); and
• if he or she has been present in India for 365 days in the previous four years and 60 days in that financial year (Section 6(1)(c) of the IT Act). For Indian citizens and persons of Indian origin (PIOs) who come to India for a “visit,” this 60-day threshold is relaxed to 182 days (explanation 1(b) to Section 6(1)(c) of the IT Act).

The IT Act also incorporates the concept of “resident but not ordinarily resident” (RNOR). A person is said to be RNOR in India in any previous year if such person meets one of the given criteria. While an India tax resident is liable to pay taxes on global income (section 5(1), IT Act), RNORs are required to pay taxes only on their India-sourced income (proviso to Section 5(1) of the IT Act). Further, there are no reporting obligations in respect of foreign assets upon an RNOR, as there are upon a resident under Section 139(1) of the IT Act. Thus, RNOR status gives some relaxation to persons who attract a residency test but have usually not been a tax resident in India in previous financial years.

Evidently, the residency rules allowed sufficient flexibility to manage one’s tax residence in India. Given residency rules in other jurisdictions, where more often than not there is a similar requirement of spending minimum 182 days to be declared a resident, it was entirely possible and even legal for an Indian citizen not to have any tax liability in any jurisdiction during a year. For instance, if an Indian citizen spent 160 days in India, 160 days in Thailand and the remaining days in Singapore, he or she would not be liable to pay tax in India, Singapore or Thailand (both Singapore and Thailand, like India, need a minimum stay minimum of 182 days for deemed residency).

This is not a desirable outcome in the global tax environment, especially considering current developments where governments are trying to plug loopholes in the erosion of tax base. The memorandum to the Budget alluded to the same:

“It is entirely possible for an individual to arrange his affairs in such a fashion that he is not liable to tax in any country or jurisdiction during a year. This arrangement is typically employed by high net worth individuals (HNWI) to avoid paying taxes to any country/ jurisdiction on income they earn. Tax laws should not encourage a situation where a person is not liable to tax in any country. The current rules governing tax residence make it possible for HNWIs and other individuals, who may be Indian citizen not to be liable for tax anywhere in the world. Such a circumstance is certainly not desirable; particularly in the light of current development in the global tax environment where avenues for double non-taxation are being systematically closed.” (Paragraph H, Memorandum to the Finance Bill, 2020—Provisions Relating to Direct Taxes), (emphasis added)

With this background, the Finance Act 2020 introduced a slew of changes.

Amendments to IT Act: Post Finance Act 2020

The first significant amendment is that a citizen of India or a PIO who is visiting India, has income from Indian sources exceeding 1.5 million rupees ($20,352), and has been in India for more than 120 days but less than 182 days in the financial year, will now be deemed as RNOR.

The second major amendment, and the focus of this article, is the insertion of sub-section (1A) in Section 6 of the IT Act (Amendment) which reads:

“(1A) Notwithstanding anything contained in clause (1), an individual, being a citizen of India, having total income, other than the income from foreign sources, exceeding fifteen lakh rupees during the previous year shall be deemed to be resident in India in that previous year, if he is not liable to tax in any other country or territory by reason of his domicile or residence or any other criteria of similar nature.” (emphasis added)

Under Clause (d) of Section 6(6) of the IT Act, “a citizen of India who is deemed to be resident in India under clause (1A),” i.e. an individual who attracts the Amendment, will be deemed to be an RNOR.

Interpretation and Contextualization of the Amendment

The Amendment deems an Indian citizen to be resident in India if such person is not liable to tax in any other country or territory by reason of his or her domicile or residence or any other criteria of similar nature. This opens up several crucial issues.

Link to Citizenship

Source Versus Residence Taxation

Traditionally India has focused on widening its tax base by taxing the source of the tax subject, rather than the residence. As is quite typical of capital importing countries and of most emerging economies, India has shown a trend of being increasingly dynamic while enforcing its source tax rules, especially in the context of electronic commerce and cross-border movement of intangibles (Bijal Ajinkya, Source versus Residence: An Indian Perspective (2010), at 79).

However, the Amendment is unique, since India has sought to augment its residence-based taxation, by focusing on citizenship or nationality. Nationality, like residence, as a connecting factor for taxation is seen as establishing a sufficient relationship between the taxpayer and the taxing state to justify taxation on worldwide income. This is because an overwhelming majority of citizens of a state are also residents of that state and hence residence jurisdiction and nationality jurisdiction overlap considerably. In fact, most double tax avoidance agreements (DTAAs) use citizenship as a tie-breaker in resolving problems of dual residency.

For developing countries, maintaining the balance between taxation of source and taxation of residence is crucial. India has shown a definite preference for strengthening its taxation of source rules, as is evidenced by the legislative history of the IT Act. The Amendment is shifting the balance and may foreshadow other developments which focus on residence and nationality-based taxation.

Impact on Information Sharing

Exchange of information across jurisdictions has been on the rise, bolstered by the number of tax information exchange agreements (TIEAs) that have been recently concluded or agreements for automatic exchange of information (AEOI) which have become effective recently, such as with Switzerland. As a signatory to the Multilateral Competent Authority Agreement to implement AEOI based on Common Reporting Standard (CRS), India is able to receive information of its tax residents’ reportable financial activities.

To enforce the Amendment, tax authorities will increasingly rely on procurement of information from other jurisdictions. Until now, overseas Indians who were under investigation by Indian tax authorities were able to argue that there was no valid locus to share tax information since they were nonresidents. This proved sufficient since a contracting state under most DTAAs is not permitted to request information of a tax nonresident.

However, the Amendment will give an iron-clad reason to the revenue department to track the financial activity of nonresidents since the applicability of the Amendment does not require residency but only citizenship.

It should be noted that jurisprudence regarding the extent of exchange of information and the threshold for exchange on an objective basis is still not satisfactorily evolved or established.

Income Threshold

As noted above, the monetary threshold to attract the Amendment is a total income of 1.5 million rupees from Indian sources “during the previous year.” This was included in the Finance Act 2020, while the Finance Bill 2020 carried no mention of any income threshold.

Inevitably, this requires calculation of India-sourced income of a person whose tax residential status is unknown—this makes it challenging to implement the Amendment. There is no clarity on whether the benefit under the applicable DTAA should be factored in while calculating the India-sourced income for the purpose of the Amendment. Again, availing of the benefit of a DTAA by a person is dependent upon tax residential status. This appears to create a vicious cycle of applicability and implication.

Further, specifying this figure carries its own set of consequences. The Memorandum to the Budget alluded to the need to curb mischief by HNWIs. However, the threshold under the Amendment is not commensurate with the income likely to be earned by HNWIs from their Indian sources. There is thus a mismatch between the stated objectives behind the Amendment and the expected consequence.

At the current income threshold, the Amendment is likely to bring under the tax net a number of individuals who may not all be the intended targets of the Amendment. If the intention was purely to widen the tax net to include HNWIs who are stateless, the legislature could have chosen to mention no income threshold at all.

“Liable to Tax”

While interpreting the Amendment, the element of liability to tax is of considerable significance.

“Liable to tax” is an indication of a legal liability to being taxed; this is distinct from “subject to tax” which connotes actual payment of tax. This distinction is clearly drawn out in the commentary on the Organization for Economic Cooperation and Development (OECD) Model Tax Convention on Income and on Capital Convention (OECD Model Convention):

“It seems clear that a person does not have to be actually paying tax to be ‘liable to tax’ otherwise a person who had deductible losses or allowances, which reduced his tax bill to zero would find himself unable to enjoy the benefits of the convention. It also seems clear that a person who would otherwise be subject to comprehensive taxing but who enjoys a specific exemption from tax is nevertheless liable to tax, if the exemption were repealed, or the person no longer qualified for the exemption, the person would be liable to comprehensive taxation.” (Philip Baker, Double Tax Conventions, at Paragraph 4B.05, in his commentary on Article 4 of the OECD Model Tax Convention on Income and on Capital (September 2002)). (emphasis added)

The OECD definition of “resident of a contracting state” links the concept of liability to tax with residence/domicile in a particular place. It reads:

“For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof as well as a recognised pension fund of that State. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.” (Article 4(1), OECD Model Tax Convention on Income and on Capital (2017)). (emphasis added)

Inferring from this explanation, it is clear that the intended target of the Amendment is an individual who is not resident or domiciled in a jurisdiction and is hence not liable to tax therein. Thus, it is important to understand who is liable to tax, what exactly liability to tax connotes and if there is any guidance under Indian case law.

Liability to Tax: Indian Judicial Interpretation and DTAAs

The question of liability to tax arises most pressingly in the following cases:

• tax-exempt person;
• person who is an ordinarily liable taxpayer but happens to have no tax liability in the relevant year; or
• no-taxing regime, i.e. the state does not levy a tax charge on the type of income earned by that person (Roy Rohatgi, On International Taxation: Volume I (2018), at 107).

Countries follow different approaches for the above-mentioned cases and there is no single uniform approach. In the case of India, there is a substantial number of cases in which the issue of whether the individual was “liable to tax” under the relevant tax treaty was discussed judicially.

In the decision concerning Mohsinally Alimohammed Rafik the claimant resided in Dubai. There was no personal income tax to which he might be liable. The Authority for Advance Rulings (AAR) concluded that he was entitled to the benefits of the UAE–India Convention of 1992. This was followed in the case of Dr Rajnikant Bhatt.

However, the AAR reversed its view in the case of In Re: Cyril Eugene Pereira ((1999) 239 ITR 650), by conflating the concepts of payment of tax and liability to pay tax. The AAR said:

“If a taxpayer pays tax or is liable to pay tax under the laws in force in one country alone, he cannot claim any relief from a non-existent burden of double taxation under the Double Taxation Avoidance Agreement. The Double Taxation Avoidance Agreement is meant only for the benefit of taxpayers who are liable to pay tax twice on the same income.” (emphasis added)

However, the apex court was not persuaded by this decision when deciding the case of Union of India v. Azadi Bachao Andolan (2003 (263) ITR 0706 SC). The Supreme Court examined the India–Mauritius tax treaty under which India gave up its rights to tax the gains of the disposal of shares in the Indian company, leaving the taxing right to be exercised by Mauritius where the taxpayer (a company) was resident. However, Mauritius does not levy any tax on capital gains. The issue before the court was whether the taxpayer was “liable to tax” in Mauritius, which the court answered in the affirmative. While doing so, the Court said:

“In our view, the contention of the respondents proceeds on the fallacious premise that liability to taxation is the same as payment of tax. Liability to taxation is a legal situation; payment of tax is a fiscal fact. For the purpose of application of Article 4 of the DTAC, what is relevant is the legal situation, namely, liability to taxation, and not the fiscal fact of actual payment of tax. If this were not so, the DTAC would not have used the words liable to taxation, but would have used some appropriate words like pays tax. On the language of the DTAC, it is not possible to accept the contention of the respondents that offshore companies incorporated and registered under MOBA are not liable to taxation under the Mauritius Income Tax Act; nor is it possible to accept the contention that such companies would not be resident in Mauritius within the meaning of Article 3 read with Article 4 of the DTAC.” (emphasis added)

It is also pertinent to note that the latter part of the above paragraph also ties together the concepts of “residence” and “liability to tax” as its consequence. The Supreme Court’s decision has been followed in later decisions by the AAR in the case of E*Trade Mauritius Ltd and D.B. Zwirn Mauritius Trading No. 3 Ltd.

Thus, the Indian judicial authorities have, by and large, recognized and upheld the difference between liability to tax and payment of tax. It follows that this interpretation is largely aligned with that of the OECD, such that India is likely to treat cases of no-taxing regimes or tax-exempt persons as being “liable to tax” in that territory.

Citizenship as a Connecting Factor: Lessons from Other Jurisdictions

It appears that India is following a partial citizenship-based taxation wherein a specific narrow set of Indian citizens will be taxed on a portion of their income. However, India is not unique in using citizenship or nationality as a basis for taxation.

The U.S. is one of the few countries in the world that requires its overseas citizens and even green card holders to pay taxes on their worldwide income through their lifetime. This is a legacy of the Civil War and Revenue Act of 1862 (enacted at the height of the Civil War, the rationale behind this law in part was to deter men who fled the country to avoid joining the Union army). However, it was the U.S.’ enactment of the Foreign Account Tax Compliance Act of 2010 (FATCA) that gave teeth to this paper tiger. FATCA requires foreign financial institutions to check whether an account holder is a U.S. citizen, permanent resident or green card holder.

The Chinese concept of domicile includes within its net those who hold a passport from the People’s Republic of China. Such China-domiciled persons are taxed on their global income. Similarly, Hungary considers its citizens to also be tax residents. This applies even if they possess another country’s nationality, as long as they have a registered address in Hungary (however, if the country where Hungary’s nonresident citizens are based is one with whom Hungary has a treaty, the individual will be permitted to avail of the treaty provisions). Eritrea too levies a tax on its citizens living abroad. However, Hungary, Eritrea and China do not have a legislation similar to FATCA which can be used to effectively and stringently enforce citizenship-based taxation, as it is in the case of the U.S. (Giorgio Beretta, Citizenship and Tax, World Tax Journal, at 236 (May 2019)).

Citizenship as a connecting factor for taxation is present to a limited extent in the taxation of expatriated citizens. For instance, Finland legislates a fictitious three-year residence period upon a citizen’s transfer of residence. Similarly, Swedes migrating from the country are still liable to tax in Sweden for five years upon migration. Italy treats its nationals as resident if those individuals have migrated to a black-listed country. Mexican citizens transferring their residence to a tax haven remain liable to tax in Mexico for three years subsequent to the transfer; in the case of Portugal and Spain, this period is five years.

Therefore, it appears that India’s actions are not unique and India is merely following on the heels of several countries. India is carving out, through the Amendment, a different path towards widening its tax base—a path which is unique in form but not in spirit. Situating the Amendment in the global context allows greater insight into the motivations behind the Amendment and into what might, perhaps, be forthcoming.

Conclusion

The Amendment tightens the leash around those who are deliberately circumventing residency rules to avoid taxation. However, there may be several unintended consequences of the Amendment. There may also be several implementational issues such as dependence on international cooperation for tax information and difficulty in computation of total income of nonresidents of India.

The wording used in the Amendment, i.e. “liable to tax,” is significant. International jurisprudence believes that if a person is not “liable to tax” under the relevant attachment criteria of his or her domestic law (such as residence or domicile), he or she is not a resident of that state, and the converse also follows. Indian jurisprudence has also concluded the same. This should throw some clarity on the interpretation of the Amendment. At the same time, Indian tax authorities are likely to contend with varying interpretations across DTAAs.

The Amendment represents a shift in thinking and a move towards taxation which is less source-based and more residence-based. India’s move towards a limited form of citizenship-based taxation is inspired by similar legal systems around the world. These have been met with varying levels of success (see Allison Christians, A Global Perspective on Citizenship-Based Taxation, 38(2) Michigan Journal of International Law, at 202 (2017)).

Drawing inspiration from these countries, the government may choose to introduce further provisions of citizenship-based taxation under the tax statute going forward. While this may widen the tax base initially, the government should bear in mind that renunciation of citizenship is a solution that overseas Indians with decreasing ties to their homeland might consider in order to escape the lengthening arms of income tax authorities.

Shabnam Shaikh is a Partner and Ipshita Bhuwania is an Associate at Khaitan & Co, India.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.