Dividend distribution tax rate cannot exceed tax treaty rate - The new buzz in the town
A dividend is a classic mode of repatriation of profits of the company to its shareholders and remunerating them. Many multinational groups, amongst other factors, also consider the country’s dividend taxation policy before setting up a company in a particular jurisdiction (especially holding company structures).
Ideally, the dividend is the income of the shareholder, and hence the primary liability of the tax on dividend is that of the shareholder. However, India had shifted the burden of dividend tax onto the companies by charging Dividend Distribution Tax (DDT) on amounts distributed as dividends and exempting the dividend income in the hands of shareholders way back in 1997. Later on, in 2016, India also introduced tax at 10% on individual shareholders earning dividend income of more than INR 1 million.
DDT was to be paid by the company at an effective rate of 20.56%1. However, this was unfavorable for foreign investors, mainly on account of the following:
- DDT paid by the Indian company was not allowed as a tax credit in the home country resulted in double taxation;
- The benefit of the beneficial dividend tax rate provided under the tax treaties was disregarded.
Recently, w.e.f. 1 April 2020, we have reverted to the classical regime of taxing dividends in the hands of shareholders, and it is an interesting coincidence that the first major and direct ruling on DDT is out just after this reversal.
There were always some intermittent litigations at different levels but it was always perceived that a tax treaty could not reduce DDT, and thus, no treaty benefit was to be given for dividends paid to foreign companies/non-residents. However, recently the Delhi ITAT in the case of Giesecke & Devrient [India] Pvt Ltd. pronounced a path-breaking judgment favoring the taxpayer that beneficial rate of tax on dividend under DTAA shall prevail over the DDT rate under the domestic law. The ruling follows DDT’s journey to the Finance Act, 2020, and concludes that it was a tax on shareholders, the levy of which was shifted upon dividendpaying companies for administrative convenience. The other key observations of the tax tribunal were as follows:
- The tribunal emphasized on the fact that economically the burden of DDT falls on the shareholders rather than on the company, as the amount of distributed profits in the hands of shareholders is reduced as DDT is levied.
- In the Delhi Tribunal’s opinion, it is absurd to hold that the liability of the DDT falls on the company, and thus rates of dividend tax set out in the tax treaties shall not be applicable. In fact, in light of the generally accepted principles relating to the interpretation of treaties with the object of eliminating double taxation, the mere responsibility of collecting tax on the company does not bar the application of tax treaties to DDT.
- Lastly, it was held that the government, under the disguise of DDT, has made an attempt to unilaterally amend the dividend taxation. Such a unilateral action is a disregard to the general rule under Article 39 of The Vienna Convention on the law of treaties, 1969 (VCLT) regarding the amendment of treaties, which provides that a treaty may be amended only by an agreement between the parties.
- Thus, no amendment, either retrospective or prospective that can be read in a manner so as to extend in operation to the terms of an existing international treaty unless it has been renegotiated between the contracting states.
There was always buzz in the industry about the government’s action on imposing an additional tax on dividends under the garb of tax on distributed income of the company. The Delhi Tribunal’s decision would pave the way for many other additional claims from taxpayers across the industry. By accepting the applicability of the tax treaty rates to DDT, it has opened a floodgate of claims, which many companies will now want to exploit. This move will potential increase financial implications for the government - perhaps more substantial than any other tax dispute India has witnessed.
Companies seeking to claim a refund of additional taxes collected on account of DDT may have to evaluate all legal and procedural options primarily amongst them are:
- Additional claim in all earlier years where the matter is pending under litigation before any forum with tax/appellate authorities;
- Make an additional claim in the tax assessment proceedings;
- Revision of tax return for the financial year 2018-2019 (time available up to 30 November 2020)
- Making a claim for the financial year 2019-2020 in the tax return to be file by 31 January 2021
- Application to tax authorities for revision of order (Section 264 of the Income Tax Act, 1961)
- Application to Authority for Advance Ruling
Each of these options would have to be evaluated on a case to case to basis by the companies.
While this decision would be welcomed by the taxpayers, it is expected that tax authorities would fight tooth and nail on this matter to the highest level. The taxpayers adopting this position while relying on the above decision may also have to consider the following aspects:
- The judgment clearly highlights that it would be unfair to read the unilateral amendment into the treaties signed before the introduction of the DDT regime to restrict the advantage of beneficial provisions. This also poses a question on the availability of benefits in respect of the Treaty signed post the introduction of DDT.
- Refund by virtue of lower rate under the tax treaty can be claimed by the company only when the shareholder receiving the dividend is a tax resident of the respective country, and it is Beneficial Owner (BO) of the dividend. The company would have to ensure that relevant documentation like Tax Residency Certificate (TRC), BO declaration, etc. is available.
- Even though the decision favors the taxpayers, several important aspects have been left untouched by the tribunal. The companies should consider the following arguments while deciding on the tax position it wants to adopt:
- It would be interesting to note that the India-Hungary tax treaty is a single salutary treaty that was amended through a protocol in 2003 (post re-introduction of DDT) to provide that even where a resident company pays tax on dividend on distributed profits, the same would be considered as tax in the hands of the shareholder and hence the rate cannot exceed treaty rate. To some extent, the benefit of India-Hungary tax treaties can be extended to countries having an MFN clause like the Netherlands, France, Belgium, Spain, etc. For the other tax treaties, this can be interpreted adversely since no specific amendment was made in other treaties after DDT, the treaty rate is not applicable. Nearly all the tax treaties provide that the agreement shall apply to any identical or substantially similar taxes which are imposed after the date of signature in addition to, or in place of, the existing taxes.
- In the majority of the tax treaties, the dividend article specifically provides that “This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.” In cases where DDT is deemed as a tax on distributed profits, the beneficial rate mentioned in the tax treaty for dividend taxation may not be applicable based on the language of the tax treaty itself.
- Treaties with certain countries (like India-Cyprus) also clarify that the dividend is exempt in India and thus a lower tax rate is not relevant. This also indicates that the DDT tax does not impact shareholders. It may be difficult to claim an exemption in case of such treaties.
In our view, it would be worthwhile for companies to carry out a cost-benefit analysis before lodging a claim with the tax authorities and also evaluate the litigation risks considering the above aspects. While the taxpayers are rejoicing this decision, the tax authorities would have begun their preparation to take this to the next level. It is expected to be an interesting battle until the authorities reach a final decision.
1. During Financial Year 2019-20