The Indian growth story has become the toast of global investors and the growth train has been chugging along at a steady rate with strong leadership at the helm. Though right now the world economy is in a slump with the global crash of commodity prices, and India too is facing some turbulence, we still remain one of the bright spots in the world economy.
As a result of this growth, we have reversed the brain drain whichhad been a major problem in the not so distant past. Now it is common for one to find entrepreneurs who have returned from the West starting business ventures in India. In some cases we even have Harvard students of Western origin now starting of their entrepreneurial journey here in India, take the example of the successful start-up Zoom Cars in Bangalore.
Being members of this noble profession we are usually the first point of contact for these returnees seeking advice on setting – up their business and managing their tax compliance in India as well as the country in which they were earlier employed. In this article we will be discussing one of the aspects which we as professionals are likely to come across in case of Individuals returning from the United States of America on the frontof their personal retirement finances.
Usually individuals who have been in employment in the United States and return to India for various reasons, becoming tax resident in India (R& OR), are usually beneficiaries of a 401-K Plan or an IRA Plan (Individual Retirement Account) which was subscribed to, on account of their earlier employment in United States of America.
In the United States of America, the individual tax payer may contribute to a Retirement Benefit Plan, to avail the benefit of tax deferral, & tax shall only be payable by the individual once the pay-out benefit from the retirement plan is initiated or on premature withdrawal, where a penalty as well is levied (Premature Withdrawal – Withdrawal from the plan before the age of 59.5 Years). The retirement plans are mainly of two types:
- 401K Plan
- Individual Retirement Account (IRA) Plan
A 401K Plan is subscribed to when the individual is in employment. The employer makes an equal contribution to match the employee’s contribution subject to terms and conditions of employment.
An Individual Retirement Account Plan subscription is made when the taxpayer is generating self-employment income. In case of a taxpayer who is a member of a 401K Plan, when his/her employment services are discontinued, the 401K Plan can be rolled over into an IRA Plan.
The Retirement Plans have two types of schemes, where a subscriber may specify as to the proportion of allocation to each scheme from the total amount paid into the subscription plan. The two schemes are discussed below:
Defined Contribution Plan:
- Limit on Contribution to the plan – As per the IRS regulations
- Contributions are defined
- The subscriber has discretion to choose the assets invested under the plan, through instruction to the fund manager.
Defined Benefit Plan:
- Limit on Contribution to the plan – As per the IRS regulations
- The benefits under the plan are defined
- The subscriber to the plan has no discretion to choose the assets invested under the plan, and the plan is administered by the fund manager.
Most often when dealing with such Individuals who have returned to India and are beneficiaries of a United States of America retirement plan, the plan is in the nature of a Defined Contribution Plan, as Defined Benefit Plans have become rare in the United States of America. The issues involved while advising clients on taxation of retirement plans in India are plenty, such as when the beneficiary makes a contribution to the plan they are eligible for deduction in the USA from their taxable income whether such deduction is available even in Indian taxation jurisdiction etc.
In this article we will be discussing the issue surrounding taxation of accretions that occur in a defined contribution plan of a USA citizen or green card holder who is also a tax resident in India. While dealing with these set-of clients one will notice that the clients have accumulated substantial balances into their retirement plans/accounts. The return on such account is in the form of capital gains, dividends and interest. These earnings/accretions to the fund are tax deferred in the USA and liable to tax only on withdrawal or on maturity. However, a question arises whether these accretions which are tax deferred in USA are to be offered to tax in India as part of the global income of the Resident & Ordinarily Resident assessee. To tackle this situation let us look at it from the angle of the Income-tax Act, 1961 and the angle of double taxation treaties.
Income-tax Act, 1961
The retirement plan funds are set-up in the form of trust and administered by various financial service providers such as Fidelity, ING etc. By subscribing to the plan the individual becomes a beneficiary of the plan which is in the nature of a determinate trust.
Taxation of income of trusts is prescribed by Sec. 161 to Sec. 164 of the Income-tax Act, 1961. If a trust is a determinate trust Sec. 161 will apply which prescribes that the trustee is assessable to tax at the rates applicable to each beneficiary, by virtue of the trustee being a representative assessee. However, in case of a USA retirement plan the trustee would be located outside the Indian tax jurisdiction and the Indian revenue authorities would find it challenging to collect taxes at the trustee level. As an alternative the Indian revenue authorities would exercise their powers under Sec. 166 of the Income-tax Act, 1961 where income can be directly assessed in the hands of the beneficiary where it is not possible to assess the income in the hands of the trustee as a representative assessee.
Thus the income arising to the client as a beneficiary of the determinate trust will be taxed in the hands of the beneficiary as per the provisions of Sec. 161 read with Sec.166 of the Income-tax Act, 1961. Therefore we will have to look at such situation from the angle of double taxation avoidance agreements and if any relief is available to the assessee therein.
Double Taxation Avoidance Agreement (DTAA)
DTAA’s are taxing conventions entered into between two countries allocating the taxing rights between the parties to the convention. For taxing income of an international character one will have to look at the provisions of the Act as well as the provisions contained in the DTAA governing the transaction.
On the basis of deductive reasoning as USA shares close cross – cultural ties with other Western nations it is common for citizens to frequently migrate between USA and other Western nations. Therefore, it is possible that the same issue of taxation of 401-K/IRA plans will be commonplace among tax assessees in these countries. On further research and reading the tax treaties between USA and countries such as Canada, UK, Germany, the same provide specific methodology for taxation of USA retirement plans of a resident in the aforementioned countries. Many a time the treaties have been recently amended realising the hardship that income-tax assesssees may face due to the risk of double taxation from the operation of tax laws in the respective jurisdictions on the retirement plans. Below is a reproduction of the USA – UK DTAA before and after the amendment:
ARTICLE 18 of the USA – UK Treaty before 2003
1. Subject to the provisions of paragraph 2 of Article 19 (Government Service), any pension in consideration of past employment and an annuity paid to an individual who is resident of a Contracting State shall be taxed only in that State.
2. Alimony paid to an individual who is a resident of one of the Contracting States by an individual who is a resident of the other Contracting State shall be exempt from tax in the other Contracting State.
3. The term "annuity" means a stated sum payable periodically at stated times, during life or during a specified or
ascertainable period of time, under an obligation to make the payments in return for adequate and full consideration in money or money's worth.
Article 18 of the USA – UK tax treaty w.e.f 06-04-2003 (Extract)
1. Where an individual who is a resident of a Contracting State is a member or beneficiary of, or participant in, a
pension scheme established in the other Contracting State, income earned by the pension scheme may be taxed as income of that individual only when, and, subject to paragraphs 1 and 2 of Article 17 (Pensions, social security, annuities, alimony, and child support) of this Convention, to the extent that, it is paid to, or for the benefit of, that individual from the pension scheme (and not transferred to another pension scheme).
2. Where an individual who is a member or beneficiary of, or participant in, a pension scheme established in a
Contracting State exercises an employment or self-employment in the other Contracting State:
(a) contributions paid by or on behalf of that individual to the pension scheme during the period that he exercises an employment or self-employment in the other State shall be deductible (or excludable) in computing his taxable
income in that other State; and
(b) any benefits accrued under the pension scheme, or contributions made to the pension scheme by or on behalf of the individual's employer, during that period shall not be treated as part of the employee's taxable income and any such contributions shall be allowed as a deduction in computing the business profits of his employer in that otherState……..
In reference to the above quoted extracts of the USA – UK tax treaty, the UK tax authorities had come out with further clarification vide HMRC DT 19876A, where the amendment to the treaty is specifically discussed and the clarification mentions how prior to the amendment income of an USA IRA is taxable as it arises.
Now when we look at the India – USA DTAA, Article – 19 & Article – 20 deal with Pension and Annuities. Article – 19 is in reference to pension from government services and Article – 20 is in reference to pensions and annuities other than those referred to in Article – 20. The articles in the India – USA tax treaty are fairly standard articles and unlike the USA – UK tax treaty (supra) do not provide beneficial treatment of tax deferral on income of retirement funds to the assessees. On reading through these articles, one can conclude that the assessee will not be eligible for any beneficial treatment for income of such retirement plans in the nature of defined contribution plans which are the subject matter of this discussion.
Therefore, a client assessable to tax under the Income-tax Act, 1961, on his global income will have to declare the income accretions to the retirement plans in the USA as taxable income in India, though they may enjoy a tax deferral in the USA. As a double whammy, once the client starts withdrawing the funds later on, s/he may again have to pay tax in the USA subject to availing the foreign tax credit on taxes paid earlier on the IRA income in India as per the tax laws in the USA.
This issue has potential to cause undue hardship for many assessees, the same will have to be addressed at the ministerial level urgently either through a treaty amendment or board circulars. Until then, as professionals we may inform our clients who are beneficiaries of USA retirement plans to the potential exposure to tax under the provisions of the Income-tax Act, 1961