It is almost a standard compensation practice that employers follow for its employees working in overseas locations to have a tax equalisation policy. Because of lack of awareness, expats face an issue as to whether to offer the hypothetical tax in tax return or not. Good news is that there are ample judgements by Indian courts that clearly hold that Income Tax authorities in India CANNOT tax hypothetical tax by employer. Today, let us discuss that issue in greater detail.
What is hypothetical tax/ tax equalisation
So, the first issue is: what is hypothetical tax or the so called tax equalisation policy? It may seem complex but believe me, it is a very simple concept.
Employees working in different countries have to follow the tax rules of those countries and pay tax on the income earned by working in those countries. So, what the employer does to simplify the tax returns is create a tax equalisation policy whereby the employer pays the salary to employee NET OF TAX and ensures that the tax hit on the employee will remain the same irrespective of him working in an overseas jurisdiction which has different tax rates.
Let us understanding hypo tax by way of an example given below:
Let us assume two scenerios – in Scenerio 1, employee is deputed from USA to India, and in Scenerio 2, employee is deputed from Singapore to India. I have assumed tax rates of India, USA and Singapore to be 30%, 40% and 20% respectively.
If you see in the above example, in both the scenerios, since the tax impact is different vis a vis USA and Singapore because of the different tax rates, the employer makes a hypothetical tax adjustment in salary.
In Scenerio 1, since the USA taxes are higher as compared to India, Rs. 10 is REDUCED from India salary to make the final payout equal to what employee would have got in USA.
Similarly, in Scenerio 2, since the Singapore taxes are lower as compared to India, Rs. 10 is INCREASED in India salary to make the final payout equal to what employee would have got in Singapore.
Now, issue is, what will happen to this hypothetical adjustment.
Very clearly, the amount ADDED in Scenerio 2 is clearly income in the hands of assessee and will be taxable in India as salary income so there is no dispute on that front.
The dispute arises in Scenerio 1 where assessee will not want to offer Rs. 10 as income because he had not earned it. However, the Income Tax Department will try and want to tax this amount. Further in the post, I will show you the contesting arguments of assessee and ITD and tribunal view on this matter.
A slight note here:
The actual tax calculations in will not be as simple as I’ve done here (because intention here has been to simplify the concept and explain). In a real situation, the tax amount will have to arrived at through a quadratic mathematical equation (don’t get shocked: it is a simple math equation we learnt in school)
Existing provisions of Income Tax Act applicable to this issue
Before moving forward, let us briefly speak on the existing provisions on this issue.
Section 17(ii) of the Income Tax Act says that if employer discharges any obligation of employee (paying his share of tax will squarely fall into this category), the amount will be taxable in hands of employee.
Now the good news: Section 10(10CC) exempts any tax paid by employer on a non monetary perquisite (tax paid on behalf of employee qualifies as a non monetary perquisite) will NOT BE TAXABLE in hands of employee
Decisions on Hypo Tax
Following are the decisions of various courts and tribunals in India that I could collect and analyse. It is notable that all these decisions are favourable to the assessee and give a very clear and strong view that hypothetical tax is not taxable as part of employee’s salary.
Note: If you are a CA/tax practitioner & have come across such a situation, I sincerely hope that these judgements help you in strengthening your client’s case vis a vis the Income Tax authorities.
- Commissioner of Income-tax v. Dr. Percy Batlivala [2009] 2009 taxmann.com 1028 (Delhi)
- Commissioner of Income-tax v. Jaydev H. Raja [2012] 26 taxmann.com 357 (Bombay)
- Income-tax Officer v. Lukas Fole [2010] 35 SOT 8 (Pune) (URO)
- Commissioner of Income-tax v. Rajasekaran Balasubramaniam [2015] 60 taxmann.com 402 (Madras)
- Roy Marshall v. Assistant Commissioner of Income tax (OSD)*, Circle -26(1) [2011] 11 taxmann.com 135 (Mum.)
Contentions of Income Tax Department
- The biggest argument of ITD is that the scheme of taxation of salaries (Section 16) only allows ONLY two deductions i.e. professional tax and entertainment allowance. Hence, there is no scope of claiming any separate deduction for hypothetical tax.
- As per the ITD, the hypo tax is an “application of income” and hence taxable.
- Another argument that ITD can raise is that the assessee has taken credit of taxes paid in India in the US tax returns (this, in my view, is a frivolous argument to make!)
Contentions of the assessee
- As far assessee is concerned, the only submission is that the amount for hypo tax did not accrue to the assessee as part of terms and conditions. So, if the assessee has not derived any benefit from that amount, it is completely illogical to tax it in his salary.
- It is a case of “diversion of income as per overriding title” and not application of income, hence as per settled position of law, amount should not be taxed.
ITAT view on taxability of hypothetical tax in India
Below are the main points of ITAT decisions in all these cases:
- The amount for hypothetical tax DOES NOT arise or accrue to the assessee in the first place. Hence, it cannot be taxed in his hands. (And that is a very clear view coming out in all judgements).
- The amount is in nature of diversion of income by overriding title and cannot be construed as application of income because it did not arise in the first place.
- It is completely immaterial to check the tax deduction forms of client (e.g. Form W-2 in case of a US person) to see whether a credit has been claimed in USA or not. What matters is how much income accrues in India and whether proper tax is paid in India. What is paid outside India is not relevant for deciding on the case in question.
- The hypo tax shall be deducted from the “perquisite” element of salary and not the basic salary
As an Expat, what you should know about Indian tax law on hypothetical tax/ tax equalisation
First of all, please note that the Income Tax Act in its present form does not mention anything expressly on taxability of hypo tax in India. The view that it is not taxable is based on the interpretation of decisions by tribunal and courts in India. In case of an amendment in the Income Tax Act making this income taxable in India (which will be unfortunate), then the decisions of courts given herein above will stand nullified and you’ll have to offer it to tax in India.
If you see the timing of the judgements, respective ITATs have been giving a very clear view that hypo tax is not taxable since 2009 (& may be even earlier – I don’t claim to have read all judgements on this point). But the mischief of Income Tax Department is that it has continued to litigate this matter. The person at loss is the assessee who has to hire a CA and go in appeal and bear the costs in terms of money, time and unnecessary emotional stress.
Hence, if you are an expat not offering hypo tax in India (which is definitely the right course of action to follow), just be prepared to hire a CA and undergo litigation in case you receive a notice from IT department. However, I wish to request to Central Board of Taxes (CBDT) through this platform to clarify the tax treatment of hypo tax to the on-field Assessing Officers through a clear circular in this regard. Better, the Government should consider inserting an explanation to Section 17 clarifying on this point. This will help NRI/expats breath easy and also make India a favoured destination, given our PM’s vision of “Make in India”
Coming to the offering of Income in the tax return, it is very important to deduct this tax from the “perquisites” section of your salary in the tax return as compared to deduction from basic salary – this has been categorically pointed out in the decision of Lukas Folce above.
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