How Does The Tax Credit Mechanism Work In International Taxation?

The tax credit mechanism in international taxation helps individuals and businesses avoid double taxation on income earned in multiple countries. Countries use this system to prevent excessive tax burdens on taxpayers and promote global trade and investment.

How the Tax Credit Mechanism Works

1. Concept of Double Taxation

A taxpayer earning income in Country A (source country) but residing in Country B (residence country) might be taxed twice—once in the source country and again in the residence country.

The tax credit mechanism helps reduce or eliminate this double taxation.

2. Foreign Tax Credit (FTC) System

If a taxpayer pays tax in a foreign country, they can claim a credit against their tax liability in their home country.

This credit is limited to the amount of tax that would have been payable in the residence country.

3. Types of Tax Relief

(a) Bilateral Relief (Under DTAA - Double Taxation Avoidance Agreement)

Countries sign DTAA agreements to determine how income is taxed and how tax credits are granted.

Methods: Exemption Method (income taxed in only one country) or Credit Method (foreign tax paid is credited).

(b) Unilateral Relief (Without DTAA)

If no DTAA exists, some countries offer unilateral relief, allowing tax credit based on domestic laws.

4. Example of Tax Credit Calculation

Case: An Indian resident earns $10,000 from the USA and pays $1,500 as tax in the USA.

In India, the tax liability on this income is $2,000.

The taxpayer can claim a foreign tax credit of $1,500, reducing their Indian tax liability to $500.

Legal Actions and Protections

Claim FTC under DTAA by filing the necessary Form 67 (in India) and providing proof of foreign tax paid.

Maintain documentation (tax returns, withholding tax certificates) for claiming credits.

Ensure correct tax residency to avoid disputes related to double taxation and tax credit eligibility.

Example

A software engineer residing in India works for a US company and earns income in both countries. Since both India and the US have a DTAA, the engineer can claim foreign tax credit for taxes paid in the US, reducing their total tax liability in India.

By understanding and utilizing the tax credit mechanism, taxpayers can minimize double taxation, comply with international tax laws, and optimize their global income taxation.