US tax filing: Help for NRIs on how global income is taxed
Posted on February 15, 2012
It’s tax filing season in the US. As we approach the last date – 17th April 2012 – for filing tax returns for the year 2011, here’s some help for NRIs living in the US on how their income from India gets taxed.
Tax on global income in the US
If you a US resident or US citizen (whether NRI, PIO or OCI), you must pay taxes in the US on your global income. Before we proceed, let us quickly look at the definition of US resident.
A person is said to be a resident of the US if he meets either of these two tests:
1. The first test is the ‘green card test’. If at any time during the calendar year you were a lawful permanent resident of the United States according to the immigration laws, and this status has not been rescinded or administratively or judicially determined to have been abandoned, you are considered to have met the green card test.
2. The second test is the ‘substantial presence test’. To meet the substantial presence test, you must have been physically present in the United States on at least 31 days during the current year, and 183 days during the 3 year period that includes the current year and the two years immediately before. To satisfy the 183 days requirement, count all of the days you were present in the current year, and one-third of the days you were present in the first year before the current year, and one-sixth of the days you were present in the second year before the current year.
If you are a green card holder (or a US citizen), you are considered a US resident for tax purposes irrespective of where you actually live. We will study the requirements of filing US tax returns for green card holders and US citizens living in India in another article.
If you are not a green card holder, then you must satisfy the substantial presence test. In this article we will see the US tax filing requirements for those who are actually living in the US.
How are various incomes taxed?
Having seen the definition of US resident, let us look at the various incomes in India and the tax implications on your US tax returns. While we are explaining the broad contours of the law, we strongly recommend that you read the relevant sections in the income tax act of both countries, the DTAA and also consult an expert for your specific case.
If you are a resident of the US but earned a part of your salary in India, then, as per the above definition, you would have to pay tax on your India income in the US. Is the payer in India subject to deduct tax at source in India? Not really. Article 16 of the DTAA states that salaries earned by a person who resides and works in country A (country A in this case being the US), shall be taxed ‘only’ in the country of residence, that is, the US. So if you are a resident in the US and are working in the US, you will pay tax on your India salary in the US.
However, it might happen that you earned salary in India before you became a resident of the US and tax was deducted at source on that income in India. In such cases, you can claim a credit of the taxes paid in India in the US.
Rajesh Vaidya, a chartered accountant from India who is currently a member of the American Institute of Certified Public Accountants and works at Florida based Raju Maniar CPA firm makes an important point, “I would like to highlight a grey area here. In India, various components of the salary package are taxed differently. For instance, reimbursements and certain allowances are tax-free. In the US however, there is no such distinction; any payment received from your employer is taxable. Now your form 16 reports only the taxable components of your salary. Ideally, when you file your income tax return in the US, you must disclose all the tax-free components of your Indian salary and pay tax in the US on those components too.”
How to report: You must include your salary income from India in the tax return Form 1040. In case you are claiming tax credit, you must also fill up Form 1116. Remember that the US follows the calendar year for tax purposes while India follows the fiscal year. You must pro-rate your income according to the relevant years.
Note: There is an exception to Article 16 which states that in case the employment is exercised in the other country, that is, in India, tax will be deducted at source. But this exception would apply mainly to green card holders and US citizens. We will see this in the next article.
Income from contracts, freelance
If you are a consultant working in the US but receiving income from an Indian company, you would have to pay tax on that income in the US. This is irrespective of whether you receive the income in a bank account in the US or in India.
Again, we need to take a look at the DTAA to check if this income will get taxed in India. Article 15 of the DTAA says that in such cases, if a person is resident of one country and earning income from a source in another country, then that income would be taxed ‘only’ in the country of his or her residence.
So, if you work in the US and receive income from a source in India, you would owe taxes only in the US. You would have to inform your Indian payer not to deduct taxes at source from your income by submitting a Tax Residency Certificate, issued by the US IRS to the payer in India. In case you do not submit the certificate and your payer in India deducted tax at source, you can claim a credit of that on your US tax return.
How to report: “You must report your income on Schedule C of the 1040. You can claim all expenses that you incurred such as office expenses, depreciation of computer, mileage etc. In case you have to claim tax credit in the US for taxes paid or deducted in India, you must report the same on form 1116,” Vaidya explains.
If you own a property in India and have given it out on rent, the income from rent will be taxed in the US. Will you have to pay tax on this in India or US?
Enter DTAA! Article 6 of the DTAA provides that rent from immovable property ‘maybe’ taxed in the country in which the property is situated. So NRIs who are residents of the US would first have to pay tax on rental income in India. While you would still have to declare that income while filing your tax returns in the US, you would get a credit for taxes paid in India.
The term ‘maybe’ is important here. Unlike salary and contract income that was ‘only’ taxed in the country of residence, in case of rent, both countries will have the right to tax the income. However, the country in which the property is situated has the first right. So tax will first be paid in India on rental income as per the taxpayer’s tax slab in India. Then the taxpayer must declare the rental income in the US and calculate tax on his total income based on his tax slab in the US. He can take credit in the US on taxes paid in India. What this really means is that even if your tax bracket in India is low, you will be paying tax in the US on your rental income at the tax bracket of the US. If you own property in India and fail to pay tax in India on the rental income but pay tax in the US on that income, you might get into trouble if you are assessed in India.
How to report: Vaidya explains, “You would need to fill up Schedule E of the 1040 in your US tax return. While in India, a flat 30% expenses are allowed as deduction from rental income, in the US only actual expenses maybe deducted. So you would need to deduct expenses such as repairs, maintenance etc on Schedule E. In order to claim tax credit, you would need to fill up form 1116.”
Capital gains are the gains you make on sale of assets like property, land, financial assets like shares, mutual funds etc. In India, here is how capital gains are taxed:
Land, property and other physical assets: Gains on sale after 3 years of purchase are taxed as long term capital gains at the rate of 20%. Sale within 3 years is taxed as short term capital gains and included in your total income and taxed at your overall tax slab.
Mutual funds, shares and other financial assets: Gains from equity shares and mutual funds sold after 1 year are tax free. If you sell within a year, the tax is 15% of the capital gain.
In case of debt instruments like debt mutual funds, debentures, gains on sale after 1 year are taxed as long term capital gains. The tax rate is 20% with indexation or 10% without indexation. Sale within 1 year is taxed as short term capital gains and included in your total income and taxed at your overall tax slab.
According to the US law, the time period for long term is 1 year for all assets. Long term capital gains are generally taxed at the rate of 15% while short term gains are added to your total income.
Here’s what the DTAA says in terms of capital gains: each Contracting State may tax capital gain in accordance with the provisions of its domestic law.
So if you have capital gains in India, you would first have to pay tax in India on those gains as per the rules in India. You would then have to declare the capital gains in your US tax return and calculate taxes as per US law. Credit of taxes paid in India would be available in the US.
How to report: “You would need to fill up Schedule D of 1040. Form 1116 will allow you to claim foreign tax credit paid, if any,” says Vaidya.
Interest and dividends
In India, interest income is added to your total income and taxed according to your overall tax slab.
In the US too, interest is added to your total income and taxed thereon.
What DTAA says: Interest arising in a Contracting State and paid to a resident of the other Contracting State ‘maybe’ taxed in that other State. However, such interest may also be taxed in the Contracting State in which it arises and accordingly to the law of that State, provided that where the resident of the other Contracting State is the beneficial owner of the interest the tax so charged shall not exceed 15 per cent of the gross amount of the interest.
It means that if the interest is earned by an NRI out of deposits in India, TDS will be deducted on the same in India at the lower rate of 15 per cent (as against TDS rate of 30 per cent in absence of any DTAA).
In the US, you would have to add this interest income in your total income and calculate tax thereon. You can claim credit for any taxes paid in India on this income.
Dividends in India are tax free but in the US, dividends are added to your total income and taxed.
So while you will not pay any tax in India on the dividends, you would still need to add this to your total income in the US and calculate tax thereon.
How to report: “Interest and dividends are reported on Schedule B of 1040. Foreign tax credits are reported on form 1116,” Vaidya explains.
Agricultural income in India is tax free but taxed in the US. What this means is that any agricultural income, whether revenue income or capital income such as gains from sale of agricultural land in India will have to be added to your total income in the US and tax paid thereon.
Limits on foreign tax credit
While foreign tax credit can be claimed in the US, there are certain limits. The IRS prescribes a formula in form 1116 which effectively indicates that foreign tax credit should be in the same proportion to the total US tax liability as foreign income is to total income. Consult your CPA for details on these calculations.
State income taxes?
A final word from Vaidya, “The taxes discussed above are with respect to federal income taxes. In the US, each state also levies taxes and the rules vary from state to state. Do consult your CPA for the rules in your state regarding state taxes.”