Gaurav Taneja and Mayur Shah, senior tax professionals with Ernst & Young, tell you why it is important to time your residential status.

While NRIs generally go abroad to pursue better career prospects – most of them not even intending to return to India, they do leave their footprints in India in the form of ancestral (or self-acquired) property, bank deposits, shares in companies and other investments.  The Income-tax Act, 1961 (‘Act’) seeks to tax India-sourced income in the hands of all kinds of assessees, irrespective of their residential status – determined based on their physical presence in India.  Accordingly, even while they are away, they would continue to be liable to tax in India and the consequent compliance requirements such as obtaining Permanent Account Number, filing the annual return of income with the tax authorities, etc would follow.  Additionally, while they are away from India, they may qualify to be a resident of that country, and thus be liable to tax on the same income not only in India, but also in that country.  In these circumstances, depending upon his residential status, such an individual may be eligible to take advantage of the Double Taxation A ance Agreement (‘Tax Treaty’) entered by India with the relevant country, if any.

An attempt has been made to analyse the provisions relating to an NRI’s residential status under the Act as well as the general principles applicable for determining the residential status of the NRI under the Tax Treaty.

As per the Act, the predominant condition for qualifying as a ‘Resident’ is the test of physical presence in India during the relevant tax year.  Accordingly, once an individual breaches the threshold number of days’ presence in India (currently being either at least 182 days during the tax year or at least 60 days during the tax year where he was in India for 365 days in the immediately preceding 4 tax years), he qualifies to be an ‘Ordinarily Resident’ under the Act (liable to tax in India for their global income).  This situation typically arises when the individual leaves India for the first time or in the 2^nd or 3^rd year of his return.

Individuals not breaching the threshold limit would qualify as a ‘Non-Resident’ (liable to tax only on income received or sourced in India).  Further, an exception has been carved out in case of persons whose stay in India exceeds the threshold number of days, wherein if their physical presence in India in the earlier years was not substantial, they qualify to become ‘Not Ordinarily Resident’ instead of ‘Resident’, and would be liable to tax in India in the like manner as a ‘Non-Resident’.

Besides, the domestic fiscal laws of other countries also have tests for determining residency in that country, which are generally based on nationality or physical presence during the relevant fiscal year.  For an individual to avail the benefit under any Tax Treaty, it is essential to examine whether he qualifies as a Resident in a particular country – as usually, the Treaties seek to allocate the taxing rights with respect to specific types of income as well as method of allowing credit of taxes paid between the country of residence and the country of source.

Generally, the residency clause in most Treaties provides for determination of residential status as per the respective domestic laws.  Therefore, in case the NRI qualifies to be a tax resident of only one of the two Treaty-countries, then he would qualify to be a resident of that country for the purposes of the Tax Treaty as well.  However, a tricky situation would arise in case the NRI qualifies to be resident of both the countries or even more rarely, a non-resident in both the countries (possible in case of highly mobile personnel).  In the latter case, as the NRI does not qualify to be a resident of either of the Treaty-countries under the respective domestic laws, such person may not be able to avail the benefit of the Tax Treaty and thus would be governed by the domestic tax laws of those countries relating to residence and taxability.

Coming to the situation of dual residency, most Treaties provide for a set of rules (referred to as ‘tie-breaker rules’) to ‘break the tie’ and decide the country of residence for the purpose of interpreting the Tax Treaty.  A typical set of tie-breaker rules, to be applied sequentially, are listed below:

 (i) Location of permanent home 

The NRI would tie-break to the country where a permanent home (whether owned or rented) is available to him.  However, the permanent home must have a sense of continuous availability to the person or continuous use by the person.

(ii) The centre of vital interests 

In case the NRI has a permanent home available to him in both the Treaty-countries, then the tie would have to be broken by having resort to his centre of vital interests.  The vital interests of an NRI can be said to lie in the country where he has a place of business and/ or maintains a family.  If the NRI satisfies this criterion in both (or neither of) the countries, then the country of residence is the one in which the personal and economic interests are greater.  In order to determine the centre of vital interests, the individual’s family and social relations, his occupations, his political, cultural or other activities, his place of business, the place from which he administers his property, etc are also to be taken into account.  In a nutshell, a person’s centre of vital interests lies in the country in which he has greater personal and economic relations.

(iii) Habitual abode 

If an NRI is said to have a permanent home in neither of the Treaty-countries or where his centre of vital interests cannot be determined, then the tie would be broken in the country where he has a habitual abode.  The habitual abode of the NRI can be said to be in the country towards which he is inclined for the purpose of his business or leisure, which would be demonstrated by the length of the stay in that country.

(iv) Nationality 

If the abovementioned criteria do not break the tie to resolve the NRI’s residency under the Tax Treaty, the same would be determined based on his nationality.  The nationality of the NRI (usually India – unless he has taken up citizenship of a different country) is to be determined as per the domestic laws of the relevant countries.

Even after applying these tie-breaker rules, a situation may arise where the issue regarding the NRI’s residential status under the Tax Treaty cannot be resolved.  In such cases, the Treaty-countries can invoke the Mutual Agreement Proceedings to decide his residential status.

Another vexed issue which is a direct consequence of the residential status is the availability of foreign tax credits while paying tax in the country of residence.  Typically, the country of residence gets the right to tax all income – wherever earned, and subject to the relevant Tax Treaty, the NRI would also be eligible to claim a set-off for the taxes paid in the source-country(s) while computing the tax liability in the country of residence.

Accordingly, where the residency under the Tax Treaty can be established to one of the Treaty-countries, the NRI’s final tax liability would be lower in the country of residence on account of the credit being available of the taxes paid in the source country(s).  However, in a case where the NRI does not qualify to be a Resident in any of the countries, then it is very likely that he would have to discharge taxes on the income earned in the respective countries.

In view of the above, it is very important for NRIs to plan their presence in India during the relevant tax year, so that they are able to not only plan their residential status under the Act, but also obtain optimum advantage under the Tax Treaty.

The authors are senior tax professionals with Ernst & Young.