Proposal For Taxation Of Interest Income On NRE And FCNR Accounts

By Lakshmi Rao

As the Union Budget approaches, it is proposed that a rethink is needed on how interest income earned on Non-Resident External (NRE) and Foreign Currency Non-Resident (FCNR) deposits should be taxed.

Under current provisions of the Income-tax Act, interest earned on NRE and FCNR deposits is exempt from tax in India. However, in several major jurisdictions such as the United States, the United Kingdom, and Australia, residents are taxed on their worldwide income. As a result, interest income earned in India by Non-Resident Indians (NRIs) living in such countries is ultimately taxed abroad, leading to a potential loss of tax revenue for India.

It is proposed that a limited and administratively efficient framework be introduced under which a modest tax could be deducted at source on such interest income, while explicitly ensuring that no additional compliance or return filing obligations are imposed on NRIs where this interest is their only income chargeable to tax in India. The objective is to augment domestic revenue, align with international tax principles, and preserve the attractiveness of NRE and FCNR deposits by maintaining simplicity and certainty.

Executive Summary

It is proposed that a policy change be considered regarding the taxation of interest income earned on NRE and FCNR deposits. While such interest is currently exempt under Section 10 of the Income-tax Act 1961, many NRIs residing in countries that tax global income ultimately pay tax on this income to foreign governments.

The framework suggests levying a flat tax of 10 percent, deducted at source, on interest earned on NRE and FCNR deposits, while exempting such income from the requirement to file a return of income where it constitutes the sole income chargeable to tax in India. This approach would allow India to retain tax revenue currently accruing to foreign jurisdictions, without imposing any additional compliance burden on NRIs.

Background

NRIs are permitted to maintain three categories of bank accounts in India: Non-Resident Ordinary (NRO), Non-Resident External (NRE), and Foreign Currency Non-Resident (FCNR) accounts. Under the prevailing provisions of the Income-tax Act 1961, interest earned on NRE and FCNR deposits is exempt from tax in India.

Several countries, including the United States, the United Kingdom, and Australia, tax their residents on their global income. Consequently, interest income arising in India and credited to NRE and FCNR accounts becomes taxable in the country of residence of the NRI, even though it remains exempt in India.

Illustrative Case: United States

The United States taxes its residents on worldwide income at both the federal level and, in most cases, the state level. For example, a US citizen and NRI residing in California holding NRE fixed deposits with an Indian bank earning approximately 6 percent per annum would not pay tax in India due to the exemption. However, the same interest income must be reported and taxed in the United States. Federal effective tax rates generally range from approximately 10 percent to 25 percent, while state income tax rates in states that levy such taxes generally range from 2 percent to 6 percent.

As a result, the tax exemption available in India does not translate into a net tax benefit for such NRIs, and the corresponding tax revenue accrues to foreign tax authorities.

Income taxes paid to a foreign government are generally eligible for foreign tax credit in the United States. Any tax paid in India would ordinarily reduce the tax payable in the country of residence, without increasing the overall tax burden on the taxpayer.

Policy Rationale

It is proposed that under the existing framework, India is foregoing tax revenue on income generated within the domestic banking system, while foreign jurisdictions benefit from taxing such income. A limited and final tax deduction at source on NRE and FCNR interest income would enable India to capture a portion of this revenue in a manner that is simple, predictable, and consistent with international tax norms.

Proposed Framework

It is proposed that the following framework be considered for introduction through the Finance Bill:

1.    Tax Deduction at Source
A flat tax of 10 percent deducted at source on interest income credited to NRE and FCNR deposits.

2.    Optional Higher Withholding
Eligible depositors could voluntarily opt for a higher rate of tax deduction, such as 15 percent or 20 percent, depending on their applicable marginal tax rates in the country of residence. This option could be exercised annually, with a default rate of 10 percent or continuation of the rate selected in the preceding year.

3.    Finality of Tax and No Return Filing
Where interest on NRE and FCNR deposits constitutes the sole income chargeable to tax in India, the tax deducted at source should be treated as final tax. Such depositors would be expressly excluded from the obligation to furnish a return of income.

The measure is intended to avoid introducing additional documentation or procedural requirements. Any increase in compliance burden could lead to large-scale closure of NRE and FCNR accounts and repatriation of funds, defeating the policy objective.

Applicability to Other Jurisdictions

It is proposed that the framework be applied equally to NRIs resident in other countries that tax global income, including the United Kingdom and Australia, and could be implemented on a uniform basis.

Conclusion

It is proposed that this approach offers a pragmatic and balanced way to augment revenue, aligns with global tax practices, and preserves the attractiveness of NRE and FCNR deposits by ensuring certainty and ease of compliance. It is positioned as a policy option for consideration during Union Budget and Finance Bill deliberations.

(Rao has sent this as an open letter to India’s Finance Minister, Nirmala Sitharman before the presentation of the country’s annual budget)