Understanding Treaty Tie-Breaker Rules for US-India Taxpayers

Imagine you live in the USA and earn income in India. Now, as the income is sourced from India, you are liable to pay tax there. Additionally, as you are a US tax resident under the Statutory Residence Test, you are also liable to pay tax on this income in the US. Suddenly you realize that on the same income you are paying twice. Like you, several cross-border taxpayers face this situation every year.

Each tax system works independently, and when they overlap, just like the above-mentioned situation, they both try to tax you on your global income. In this situation, Article 4(2) of the India-US tax treaty provides a tie-breaker rule to resolve this issue. Under this, when an individual qualifies as a tax resident in both countries, their residency is determined by a four-step sequential test.

Want to know what the four-step sequential test is and how the treaty tie-breaker rules work for US-India taxpayers? Read the blog and get your answers.

Why Does Dual Residency Happen?

Dual residency happens because both India and the US have their own rules for determining a person's tax residency. In India, you are considered a tax resident if, in a financial year (April 1 to March 31), you were physically present in the country for 182 days or more. In contrast, the US has its own test called the Substantial Presence Test (SPT) to determine a person's tax residency status. The country uses a weighted three-year formula that tests on a calendar year (January 1 to December 31). Considering this:

• You were physically present 31 days in the US in the current calendar year
• 1/3 of your days in the last year
• 1/6 of your days in the year before the last year

If your total number of days is 183 or more, then for the current calendar year you will be considered a US tax resident even if you left the country in the mid-year. Confused? Here is just an overview; the tax residency in India and the US is discussed briefly in the next section. Further, let's know the common situation that triggers dual tax residency:

• During the financial year you moved from India to the US
• After working in the US, you moved to India
• While qualifying as a tax resident in India, you were a green card holder
• You passed the Substantial Presence Test (SPT)
• In both countries, you spend considerable time
• Indian professionals working on US visas still maintain close financial ties in India
• Individuals with family, property, or business split across the two countries

Further, green card holders are US tax residents automatically for the complete calendar year, until they surrender their card, regardless of how many days they were physically present in the country. Both tests work simultaneously. So once you become a tax resident in both countries, the treaty tie-breaker rules come to your rescue.

This was all about why dual residency happens. Moving ahead, let's know how India defines tax residency.

How India Defines Tax Residency in a Normal Situation?

Under section 6 of the Income Tax Act 1961, your residency status is defined as per the number of days you were physically present in India during the financial year. Considering this, your tax residency is determined on the following basis:

• Basic Day-Count Test: 182 days in a financial year generally trigger tax residency.
• Alternative Test: You have spent 60 days in the current financial year and a total of 365 days over the last financial year. If you are an Indian citizen or PIO card holder who left the country for work, the 182-day rule applies to you.
• Resident but Not Ordinarily Resident (RNOR): If you are a returning NRI and qualify as an RNOR, you are not liable to pay tax on your global income in India.
• Deemed Residency: From April 2021, NRIs who earn INR 15 lakh or more from Indian sources and are not liable to pay tax in any other country will be considered as deemed Indian residents under section 6(1A).

This is how India defines tax residency of an individual in a normal situation. Moving further, let's know how the US defines tax residency in normal circumstances.

How the US Defines Tax Residency in Normal Circumstances?

You are considered a tax resident in the US if you are a US citizen, resident alien, green card holder, or meet the substantial presence test (SPT). Further, let's know about it in detail.

• Citizenship: US citizens are liable to pay tax on their global income regardless of where they live or work.
• Green Card Holders: If you have a green card, you automatically become a tax resident in the US and liable to pay tax on your worldwide income. This applies even when you are not physically present in the US.
• Substantial Presence Test (SPT): In the current year, if you were physically present in the US for 31 days and your total weighted days in the country were 183 or more in three years.

So, here is how the US defines tax residency in normal circumstances. Moving forward, let's look at how Article 4 defines resident status.

Article 4: The Treaty Definition of "Resident"

Article 4 of the India-U.S. tax treaty defines residence for treaty purposes. Article 4(2) provides a sequential tie-breaker for individuals who are residents of both countries under their respective domestic laws.

Comparison: India vs. US Residency Test

The table below showcases the comparison of the Indian and US residency tests:

Now, moving further, let's know the four-step tie-breaker test.

The Four-Step Tie-Breaker Rule for US-India Taxpayers

As mentioned earlier, Article 4(2) consists of a four-step tie-breaker rule for US-India taxpayers to avoid double taxation. Additionally, you start at step one and move down only when you do not get an answer from it.

Step 1: Permanent Home

Where is your permanent home available? Here, "permanent" does not mean having your own home; you can also count your long-term rental home. Additionally, "available" means you can use your home any time you want.

Considering this, if you have a permanent home in only one country, that means you are a tax resident of that country. However, if you have homes in both countries (a home in India and an apartment in the USA), you need to go to step 2.

Note: If you have your own home in one country but it is rented out, then it is generally not available to you. In this situation, you will be considered the tax resident of the other country. Article 4 states that the specific constant availability of a home matters more than its ownership.

Step 2: Center of Vital Interests

This step is subjective and results in most disputes. When you have a permanent home in both countries, the test checks your personal and economic connections to determine your tax resident status.

• Economic Ties: In which country is your business located? Where do you have bank accounts, clients, investments, and income sources?

• Personal Ties: Where does your partner live? In which country do your children go to school? Your social relationships, religious affiliations, and club memberships?

For instance, if you move to India, purchase an apartment there, and work for an Indian company but have a home in the US and your family lives there. In this scenario, if the family, daily economic life, and income of that green card holder are centered in India, but the personal ties are in the US, then you should move to the third step.

Step 3: Habitual Abode

If you are not able to determine your tax residency status in the first two steps, then you need to determine where the person lives habitually. Here, day-counting comes into play. The tax treaty looks at which country you spend most of your time in.

For instance, if you live 200 days in India and 120 days in the US. Here, clearly India wins. However, if you live 160 days in India and 150 days in the US, there is only a ten-day difference. This is still inconclusive, and you need to move forward to step 4.

Step 4: Nationality

If all steps fail in determining your tax residency status, then nationality comes into play. Considering this, a US citizen with homes in both countries, split interest, and who has spent almost equal time in both India and the US, under this step will be treated as a US resident as he/she holds citizenship.

However, if the tax residency is still not clear, the tax officials of both countries, under the Mutual Agreement Procedure (MAP), jointly determine it.

*Important: The above-mentioned test works in sequence. Considering this, you cannot pick any of the steps to determine your tax residency according to your choice. If your residency issue is solved in the first step, you do not need to move forward. Generally, most tax residency issues are resolved in the first two steps.

This was all about the four-step tie-breaker test. Moving forward, let's know what tie-breaker residency actually changes.

What Tie-Breaker Residency Rules Actually Change?

The tie-breaker residency rules give complete authority to the winning country to tax the individual on their global income and allow the other country to tax the individual on the income generated from there. Additionally, it also affects which country the individual will get the Tax Residency Certificate from and how they will claim the DTAA relief. Considering this:

• Global vs. Source-Based Taxation: According to the specific income article of the treaty, the winning country gets the right to tax the individual on their worldwide income. Additionally, it provides the other country the right to tax the individual on its own source income.
• Tax Relief Mechanism: Even if you are liable to pay tax in both countries, through a foreign tax credit (FTC), under the India-US DTAA, you get tax relief. For instance,
  • You can claim a tax credit in India for your already paid taxes in the US.
  • Additionally, you can also claim a tax credit in the US using applicable foreign tax credit provisions on your already paid taxes in India.
• Documentation: To get tax relief on India-sourced income, a US tax resident needs to have proper documents on hand. This includes a Tax Residency Certificate, Form 1040, Form 1116 (FTC), FBAR (FinCEN Form 114), and Form 8938 (Specified Foreign Financial Assets).
• RNOR and Transition Rules: Even when you are considered a tax resident of India, you may still avoid paying tax on your global income through RNOR status. This status often provides tax benefits to returning NRIs by not taxing their foreign income for a certain period.

So this is what the tie-breaker residency rule actually changes for US-India taxpayers. Moving ahead, let's better understand it with common scenarios.

Common Scenarios

The dual residency situation is generally faced by H-1B/L-1 visa holders, US citizens or green card holders who move to India, and NRIs who return to the country mid-year. Confused? Here are some common scenarios where these individuals face dual residency and treaty tie-breaker rules come to their rescue.

These are some of the common scenarios where US-India taxpayers face a dual residency situation. Moving further, let's know how to claim a treaty position.

How to Claim a Treaty Position?

As an Indian resident, to claim treaty residency in the US, you need to fill out Form 8833. Additionally, you need to provide a tax residency certificate (Form 6166 via filing Form 8802) and Form 10 to reduce your Indian withholding. Further, in the US, the foreign tax credit is claimed by filing Form 1116, and in India, via Form 67.

• Under section 6 of the Income Tax Act, 1961, US citizenship, green card status, or the substantial presence test determine your tax residency status in India and the US.
• Sequence-wise, apply the four steps of treaty tie-breaker rules, and provide supporting documents at every point. This includes lease/ownership records, location of the family, sources of income, and time spent.
• If you are claiming tax treaty benefits in India, you need to fill out Form 8802 with the IRS and request a tax residency certificate via Form 6166.
• Now, to reduce the withholding rates on your India-sourced income, royalties, or interest, submit Form 10F and TRC to Indian tax officials.
• Additionally, disclose your tax position in the US on Form 8833 and attach it to your Form 1040. Also, when filing your tax return in the US, mention the specific article and any saving clause that apply to your situation.
• To claim a foreign tax credit in India, you need to fill out Form 67, and in the US you need to fill out Form 1116.
• You also need to fulfill the FBAR/ FATCA obligations if your Indian assets are above the specific threshold.

This is how you can claim the treaty position. Moving ahead, let's know the mistakes to avoid when claiming treaty tie-breaker rules.

Mistakes to Avoid When Claiming Treaty Tie-Breaker Rules

Here are some key mistakes to avoid when claiming treaty tie-breaker rules:

• Use the treaty tie-breaker rules sequence-wise. For instance, taking the fourth step, nationality, to know your tax residency is wrong.
• Not considering the saving clause. US citizens and green card holders often think that the Indian treaty residency exempts them from paying taxes in the US.
• Treating your inherited or parental home as "available" without considering whether it is actually available for you or not.
• Tie-breaker rules are fact-intensive, and to prove your view, you need to have proper documents by your side. This includes an ownership/lease agreement, a record of the days you were present in the country, and where your family and income are located.
• Forgetting FBAR/ FATCA reporting. These are separate from your dual-tax obligations in both countries and apply based on your tax status in the US and foreign account threshold.
• When claiming treaty position in the US, not filing Form 8833 triggers IRS penalties.
• Assuming residency position remains the same. It is not permanent, and as facts change, it also impacts your residency in the country.

These are some common mistakes you should avoid when claiming treaty tie-breaker rules.

Final Thoughts

Lastly, it is vital to understand the treaty tie-breaker rules for US-India taxpayers, as dual residency is one of the important factors of international taxation. Whether you are returning to India, moving to the US, or keeping financial ties in both countries, these rules help you avoid double taxation. The decision is based on a four-step process: permanent home, center of interest, country you generally live in, and your nationality. Depending on where you live, work, and maintain your social and economic connections, it is important to determine your residency status every year. To do so, maintain records of the number of days you stay in a country during a financial year and annually review your tax position.

Further, with proper tax planning, accurately determining your residency, filing the required tax forms on time, and correctly applying the India-US DTAA, you can avoid the dual residency issue. If you are not so sure about your tax residency in the country or are looking for assistance, connect with Savetaxs. We have a team of experienced cross-border tax advisors who help you determine your tax residency and ensure you remain compliant with tax laws.