Interest on NRE accounts not always exempt from tax

There are certain scenarios, when such an interest income becomes taxable..

Individuals who are not residing in India usually have a Non-Resident External (NRE) bank account in India to invest their foreign earnings. An NRE account is an Indian Rupee (INR)-denominated account which can be in the form of savings, current, or fixed deposits. If the individual is returning to India, he/she has to convert his/her NRE account to a resident savings account or to a RFC – Resident Foreign Currency account. The individual can continue to hold the NRE account if he/she has received permission from the RBI to do so.

Many individuals are under the wrong impression that interest earned on an NRE account is always exempt from tax. It is therefore important to understand the taxability of interest income from an NRE account as there are certain scenarios, when such an interest income becomes taxable.

Taxable interest

Let us take an example of A, who was living outside India for the last 10 years and has returned to India to take up permanent employment in India. She has an existing NRE account in India on which she earns interest income and has been claiming exemption from tax under section 10(4)(ii) of the Income Tax Act,1961 (Act). A has not closed her NRE account. The account will be closed in the next financial year after her return to India.

After her return to India, does the NRE interest income still remain exempt from tax?

As per section 10(4)(ii) of the Act, the NRE interest is exempt from tax for those who are treated as a ‘Person Resident Outside India (PROI) as per the Foreign Exchange Management Act, 1999 (FEMA) or if the person is permitted to continue holding such an account by the RBI. In other words, NRE interest is taxable for a person who qualifies as a Person Resident in India (PRI) as per FEMA and does not have permission from the RBI to maintain it.

According to the FEMA, a person is considered as a PRI if he/she resides in India for a period of more than 182 days during the course of the preceding financial year. There is an exception to the above rule; a PRI would not include a person who has come to or stays in India, in a case, other than:

1. For, or on taking up employment in India, or
2. For carrying on in India a business or vocation in India, or
3. For any other purpose, in such circumstance as would indicate his intention to stay in India for an uncertain period.

Hence, as a corollary, it may be deduced that a person who has returned to India for taking up permanent employment or carrying on business in India would be treated as PRI, as per FEMA.

Continuing the above example, A may not be treated as PROI as per the provisions of the FEMA. A is returning to India for taking up employment in India and, hence, she would be treated as a PRI, as per FEMA.

Availing exemption

In such a scenario, once A qualifies as a PRI as per FEMA, she cannot avail the exemption under section 10(4)(ii) of the Act and the NRE interest income earned for the entire year shall become taxable till the time the account is operational. Further, the taxable interest earned from the NRE account will be eligible for deduction of up to Rs 10,000 (for savings interest only), under section 80TTA and up to INR 50,000 (for senior citizens) under section 80TTB of the Act.

We may highlight that the person may claim the NRE interest as exempt under section 10(4)(ii) of the Act for a part of the year, i.e. the period before his/her arrival to India, if he/she is able to establish that he/she was a person resident outside India as per FEMA before his/her arrival in India. In such a case, the individual may claim the interest income before arriving in India as exempt and offer to tax the NRE interest income from the date of arrival in India for taking up employment, i.e., from the day she is treated as PRI as per FEMA. There is no guidance on this position from the tax authorities and this position is prone to litigation.

There is an another view; one may take a position that in order to treat an individual as PRI of India, she must satisfy the basic condition of staying for more than 182 days in the preceding financial year. Hence, to apply this view in our example, A may claim exemption of interest from NRE account in the year of return, as she would be treated as PROI (since her stay was for less than 183 days in the preceding financial year). In the next financial year after returning to India, she would be liable to tax on the entire interest income as she would be treated as PRI, as per FEMA.

Thus, NRE interest income is exempt from tax only if a person is treated as a PROI as per FEMA, or is permitted by the RBI to maintain the account. If the person is a PRI as per FEMA and does not have permission to maintain the account, the interest income cannot be claimed as exempt and needs to be offered to tax.