Foreign tax credit (FTC) exists to prevent the same income from being taxed twice. But a ruling of the Supreme Court of Italy in WIS Telecom Srl highlights a significant limitation: where the source country withholds tax contrary to the applicable DTAA, the residence country may not be required to give credit for it.
The facts
WIS Telecom, an Italian company, provided telecommunication services to customers worldwide, including LDI, a customer in Pakistan. LDI treated the payment as royalty and deducted tax under Article 12 of the Italy–Pakistan DTAA. WIS Telecom offered the income to tax in Italy and claimed FTC for the tax withheld in Pakistan.
The Italian Revenue denied the claim. In its view, the payment was not royalty under Article 12 but business profits under Article 7. As the taxpayer had no presence in Pakistan, Pakistan had no right to tax the income under the DTAA, so Italy could not give credit for tax wrongly withheld there.
The taxpayer’s arguments
WIS Telecom argued that denying FTC would tax the same income twice: once through withholding in Pakistan, and again as business income in Italy. Alternatively, if FTC was not available, it argued that the Pakistani tax should at least be allowed as a deductible business expense, being a normal cost of doing business.
What the Supreme Court held
The Court rejected both arguments. The telecommunication receipts were business income under Article 7, not royalty under Article 12. Since the taxpayer had no presence in Pakistan, a correct application of the DTAA would have resulted in no withholding tax in Pakistan at all.
Where tax has been wrongly withheld by the source country, the Court held, the taxpayer must seek a refund from that country rather than claim relief from the residence country through FTC. Italy could neither grant FTC nor allow a deduction, since under Italian domestic law such tax was not a deductible expense.
The Court further observed that the Mutual Agreement Procedure cannot be used to shift the burden of tax wrongly collected by the source state onto the residence state. In effect, the residence country cannot be expected to bear the cost of tax imposed elsewhere in breach of the treaty.
Why it matters for Indian businesses
The ruling is relevant to Indian businesses that render services across multiple countries, including treaty jurisdictions. Before assuming that tax deducted overseas will automatically be available as FTC in India, it is worth first examining whether the source country was entitled to levy that tax under the DTAA at all.
The decision also shows the growing relevance of international judicial precedents in cross-border tax matters, and offers persuasive guidance on interpreting DTAAs and determining the availability of FTC in India.
Key takeaway
Tax wrongly withheld abroad is not a cost the home country has to absorb. Check treaty entitlement before tax is deducted. Where it was deducted in breach of the DTAA, the remedy is a refund from the source country, not a foreign tax credit at home.
This article is for general information only and does not constitute professional advice.