Chapter IV
Scope of total income
Residence-based taxation versus source-based taxation
4.1 The public goods and services provided by the Government are enjoyed, in general, by all persons (both natural and non-natural) living within that country. Therefore, it is logical for all such persons to contribute towards such public goods and services. This forms the underlying basis of the principle of residence-based taxation of income.
4.2 The principle of residence-based taxation asserts that natural persons or individuals are taxable in the country or tax jurisdiction in which they establish their residence or domicile, regardless of the source of income. In the case of non-natural persons such as companies or firms, the place of incorporation or the place where control or management is exercised is deemed to be the place of residence. In the context of income-tax, the ability to pay of the residents of that country is fully measured by their global income. Therefore, the principle of residence-based taxation of income envisages the taxation of global income. Key reasons for taxing the foreign source income of residents are to achieve horizontal and vertical equity goals and to improve the tax neutrality of investment decisions (efficiency).
4.3 However, there are individuals/entities whose "residence" is in one country but their business is actually carried on in another country and their income is earned in the latter country. In such cases, the principle of residence-based taxation would be inappropriate. This would be especially so in developing countries which attract substantial foreign investments. Therefore, there is a view that the country which provides the opportunity and facilities to generate income or profits should also have the right to tax the same. This forms the underlying basis of the principle of source-based taxation of income. This principle is invariably applied to non-residents in a country and envisages the taxation of only such income which is sourced in that country.
4.4 The term "source" is generally not defined in the tax legislation. The common law has developed a number of principles which operate in the absence of statutory provisions. Whether or not the income will be seen to be sourced in a country under the common law principles is a question of fact in the circumstances of a particular case. International practice varies as to the nature and extent of the source rules. Generally, countries use geographical boundaries, types of income or a mixture of both to determine the extent to which they will seek to tax income sourced in their jurisdiction.
4.5 Conceptually, a country may adopt either pure residence-based taxation or pure source-based taxation. The pure residence based taxation is supported on the consideration that it promotes economic efficiency since the decision on the location of the investment remains unaffected by the tax rate. It is neutral to capital export. Further, it is relatively easier to pin down the income unlike in the case of source-based taxation. However, the pure residence-based taxation is not adopted for three reasons. First, pure residence based taxation reduces revenues in poor developing countries, who rely heavily on source based taxation, and leans in favour of the rich developed countries where investors reside. Secondly, residence-based taxation is much easier to evade or avoid, by channeling international investments through tax havens. Thirdly, political and economic considerations do not allow a country to give up the right to collect tax from foreigners doing business within its territory.
4.6 Pure source-based taxation is an option that has been favoured by some experts. However, the major problem with this option is that it enables foreign investors to play one country against another or others in order to obtain the lowest source based tax rate. This leads to aggressive tax competition (race to the bottom) resulting in erosion of revenue base. In addition, the problems of determining the source of income and of unraveling aggressive transfer pricing that leads to suppression of income would become much more acute in a world of pure source-based taxation.
4.7 In practice, countries have tended not to stay with the pure application of either principle. They have applied a mix of residence and source-based direct taxation, the former for nationals (including non-natural persons) residing in the country and the latter for income earned within the country by non-residents. The precise nature of mixes has depended on each taxing jurisdiction's perception of the relative importance of a number of factors, notably the volume of foreign investment that is attracted, the revenue implications, the domestic administrative capabilities, and the degree of co-operation that can be expected from competing jurisdictions. Under the Code, residence-based taxation is applied for residents and source-based taxation for non-residents. A resident in India will be liable to tax in India on his world-wide income However, a non-resident in India will be liable to tax in India only in respect of accruals and receipts in India (including deemed accruals and receipts). The total income of a person will also include the income arising to spouse, minor child and other entities in specified circumstances. However, the Second Schedule enumerates incomes that are exempt from taxation and these incomes will not form part of the total income.
Test for residency
4.8 Residency rules have an important role to play in tax treaties as they clarify the right to tax and assist in the avoidance of double taxation. All countries have residence tests for both natural persons (individuals) and legal persons (companies). The residency test for individuals is usually based on either physical presence in the country (legal form, such as citizenship) or facts and circumstances that prove residence in a country (economic substance, such as the country where the person has a fiscal presence) or a combination of the two. In many cases, this may be satisfied simply by being present in a country for a prescribed period of time. The tax residence of companies (that is, where companies are established or carry on business) is usually based on either place of incorporation (legal seat), location of management (real seat) or a combination of the two.
4.9 Under the Code, the residential status of an individual in a financial year will continue to be determined on the basis of his stay in India during the financial year and the earlier years. He would be a resident in India if,—
(a) he is in India for 182 days or more during the financial year ; or
(b) he is in India for 365 days or more during the four years immediately preceding the financial year and for 60 days or more in the financial year.
4.10 The residency of an individual will be determined only on the basis of the test specified in sub-para (a) of para 4.9 in the case of,—
(a) an Indian citizen who leaves India during the financial year for the purpose of employment outside India with an employer ;
(b) an Indian citizen who leaves India as a member of a crew of an Indian ship ; and
(c) an Indian citizen or a person of Indian origin, who comes to India on a visit during the financial year.
4.11 An individual will be treated as a person of Indian origin if either he or either of his parents or any of his grand parents was born in undivided India.
4.12 An Indian company will always be treated as resident in India. However, a foreign company can either be resident or non-resident in India. It will be treated as resident in India if, at any time in the financial year, the control and management of its affairs is situated wholly or partly in India (it need not be wholly situated in India, as at present).
4.13 A Hindu undivided family (HUF), partnership firm, an association of persons or any other person will be resident in India if the control and management of their affairs are wholly or partly situated within India at any time in the relevant financial year.
4.14 A person will be a non-resident in India if he is not a resident in India.
4.15 Under the Code, the concept of "resident but not ordinarily resident" for an individual and a Hindu undivided family will be replaced by providing exemption to the income of an individual sourced outside India and not derived from a business controlled or a profession set up in India. This exemption will be available to the individual in the financial year in which such individual becomes a resident and in the immediately succeeding financial year, if such individual was a non-resident for nine years immediately preceding the financial year in which he becomes a resident.
Concept of financial year
4.16 Under the 1961 Act, the income earned in a year is taxed in the next year. The year in which income is earned is termed as "previous year" and the following year in which it is charged to tax is termed as "assessment year". For example if a person earns any income during the year beginning on 1st April 2006 and ending on 31 March 2007, then 2006-07 will be the previous year and the income shall be assessed to tax in assessment year 2007-08. The use of the two expressions has caused confusion in both compliance and administration. In order to simplify the provisions, the separate concepts of "previous year" and "assessment year" will be replaced by a unified concept of "financial year". The existing concept of assessment year will be done away with. Under the Code, all rights and obligations of the taxpayer and the tax administration will be with reference to the "financial year". This change will not change the existing system of deduction of tax at source and payment of advance tax in the year of earning of income and payment of self-assessment tax in the following year before filing of tax return. This proposal will simplify the existing provisions.
Meaning of "person", "assessee", etc.
4.17 The 1961 Act provides for an inclusive definition of the word "person". It includes an individual, HUF, company, firm, association of persons, body of individuals, local authority and artificial juridical person. Taxable entities like co-operative society, any other society, non-profit organisation and private discretionary trust are assessed as association of persons. Similarly, the institution of Government, though otherwise exempt from tax in respect of its own income, is required to fulfil certain obligations in terms of withholding of tax and filing of information. In the Code, Government, trust, co-operative society, any other society and any non-profit organization will be included in the definition of "person". The persons specified in the Third Schedule will not be liable to income-tax either wholly or partly, as specified therein.
4.18 Under the 1961 Act, assessee is a person by whom any tax or any other sum of money is payable or a person in respect of whom any proceeding under the 1961 Act has been taken (including representative assessee) or any person who is deemed to be an assessee or deemed to be an assessee in default. The definition is important since an assessee has certain rights and obligations under the 1961 Act. In the Code it is proposed to include the following "other persons" within the definition of "assessee" :—
(a) any person to whom any amount of refund is payable under the Code ; and
(b) any person who voluntarily files a return of tax bases irrespective of the fact that he is otherwise not under an obligation to do so.
This change will enable taxpayers to obtain refund of tax deducted at source. It will also help taxpayers currently below the threshold level to report their income and maintain a track record of filing returns in anticipation of earning higher—and hence taxable—incomes in the future.
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