Dividend income - Taxation of two regimes
The journey so far
Since the inception of the Income Tax Act, 1961 (‘IT Act’), dividend income in India has been taxed in the hands of shareholder(s). However, in 1997, the Indian Government brought about a radical change in dividend income taxation by introducing the Dividend Distribution Tax (‘DDT’) regime (placing an obligation on Indian companies declaring dividends to pay tax, whereas in the hands of shareholders the same dividend income was not taxed). Then, in 2002, for a year, the DDT regime was discontinued and dividend income was once again taxed in the hands of shareholders. However, in 2003, the regime was reinstated. Now, the Finance Act, 2020 (from 1 April 2020) has reintroduced the classical system of taxing dividend income in the hands of the shareholder(s) by abolishing the DDT regime.
New regime, and consequential amendments
With abolition of the DDT regime, from 1 April 2020, dividend income is now taxed in the hands of shareholder(s). The Indian company distributing dividend is required to withhold tax (WHT) at the prescribed rate. Transitional dividends (i.e. where the dividend was declared on or before 31 March 2020 but paid post-31 March 2020), subject to prescribed conditions, have been grandfathered. Accordingly, on such dividends, DDT will be levied.
The classical dividend taxation regime has brought about many changes in the IT Act. Some of the key changes (other than from a WHT perspective) are summarised hereunder:
- Tax relief has been provided whereby dividend income earned by an Indian company can be set off against the onward dividend distributed by such Indian company, subject to fulfilment of specified conditions.
- Imposition of Interest deduction restriction up to 20% of the dividend income.
- Removal of erstwhile taxation of dividends in excess of INR 1 million in the hands of shareholder(s).
- Dividend stripping provisions made not applicable.
Key considerations for shareholders
- Determination of Head of Income
Deduction of expense from any income would depend upon classification of such income under appropriate heads. While the list of expenses that can be claimed against Business Income is vast, when it comes to Income from Other Sources, the provision of section 57 of the IT Act restricts the deduction to Interest expense to 20% of the dividend income.
Accordingly, one needs to evaluate the proper head under which the dividend needs to be disclosed/classified and thereafter offered to tax.
For claiming tax treaty benefits, non-resident shareholder(s) are required to provide various documents (such as Tax Residency Certificate, Form 10F, Beneficial ownership declaration, etc – on an indicative basis). If such documents/information are not furnished, the Indian company (declaring the dividend) may not be in a position to take into account the applicable tax treaty rate, and thereby the tax treaty benefit may be denied. Until 31 March 2020, under the erstwhile DDT regime, these documents were not mandated, and hence most Indian companies may or may not have such documents/information on its non-resident shareholder(s).
It is pertinent to note that in the case of non-resident shareholder(s), a relaxation in tax return filing requirement is granted, subject to conditions that the total income consists of dividend income (or any other passive income such as interest, etc) only, and that tax on such income has been duly withheld at a rate specified under the IT Act. Hence, if the Indian company withheld tax (on dividend income) at a rate lower than mentioned in the applicable tax treaty (say 5% or 10%) then, the non-resident shareholder(s) would have to file tax returns in India disclosing such dividend income and tax withheld.
Further, where tax is withheld at rate under the IT Act i.e. 20%, without considering the beneficial rate as per the applicable tax treaty, then taxpayers desirous of claiming the benefit of a lower rate under the applicable tax treaty will need to file their returns in India and claim the refund of excess tax withheld.
Furthermore, non-resident shareholders may be regarded as an Associated Enterprise of the Indian Company, and therefore would be mandatorily required to comply with the Indian Transfer Pricing (‘TP’) regulation. In this regard, apart from maintaining TP documents, the non-resident shareholders will need to furnish a TP Audit Report before the prescribed due date.
Where the non-resident shareholder(s) fail to maintain TP documentation and/or furnish a TP audit report, or fail to file a tax return, a penalty may be imposed.
- Credit of tax withheld on dividend income
Under the erstwhile DDT regime, there was an ambiguity as to whether the credit for DDT paid in India would be available in the non-resident shareholder’s home country. Now, with the DDT regime abolished, non-resident shareholders may be able to claim credit of tax paid in India in their home country, subject to the provisions of the applicable tax treaty with India, and the home country’s tax laws.
Key considerations for the company
In the DDT regime, the dividend income (subjected to DDT) was not taxed in the hands of shareholder(s). Accordingly, the Indian company was not required to withhold tax, and consequently was not required to undertake tax withholding compliance. With the abolition of the DDT regime, the Indian company is required to withhold tax, as well as undertake all other compliance (such as filing WHT returns on a quarterly basis, issuing certificates acknowledging tax withheld to shareholder(s), etc). Also, most of the tax treaties entered by India provide for a beneficial or lower rate for dividend taxation. Additionally, depending upon the Most Favoured Nation (MFN) clause, the dividend rate can be reduced further.
However, with India ratifying Multilateral Instrument (MLI) with effect from 1 April 2020, the Indian tax treaties are impacted by the MLI provisions. In this regard, in addition to Article 7 of the Principal Purpose Test, it is imperative to note the impact of Article 8 of the MLI on the dividend income. Under this Article, the beneficial treaty rate shall be applicable on fulfilment of additional conditions, i.e. a minimum holding period of 365 days. At present, this Article is applicable to the tax treaties signed by India with Canada, Denmark, Slovenia, Serbia and Slovak Republic as both parties have opted to apply this provision. Accordingly, in order to ascertain the rate of WHT, the Indian company needs to request all necessary documents from its shareholder(s) (such as PAN, Tax Residency Certificate, Form 10F, beneficial ownership confirmation, etc).
If the Indian Company does not fulfil the WHT compliance, the usual non-compliance provisions pertaining to no deduction/short deduction of WHT will apply, which may require payment of WHT (along with interest), and may attract penal consequences.
In view of the above, Indian companies need to incorporate the necessary checks in their systems to ensure the necessary compliance from a dividend perspective.
DDT regime - Tax treaty provisions
Interplay between DDT rate and Treaty rate for pre-DDT abolition regime
For years prior to 1 April 2020, some Indian companies who had non-resident shareholder(s) contended before the Indian Revenue Authorities that the beneficial treaty rate be replaced for the DDT (having an effective rate up to 20.56%). In this regard, recently, some of the Tax Tribunals [in the Giesecke & Devrient (India) Private Limited and Reckitt Benckiser (India) Private Limited cases] have in principle accepted this contention, which will now restrict DDT to the tax treaty beneficial and lower rate. Accordingly, the excess DDT paid (over and above the lower tax treaty rate) will now be refunded to the Indian companies, subject to verification. Our detailed alert on Giesecke & Devrient (India) Private Limited’s decision can be read here.
The abolition of DDT is another radical change made by the Indian Government, and this could serve to be a game-changer for attracting foreign investment. However, for the DDT era, Indian companies or non-resident shareholders may, in light of recent judicial rulings, consider claiming a refund of excess DDT paid (i.e. the difference between the DDT rate and the Treaty rate).
With the return of the classical taxation regime for dividend income, from a compliance perspective, the process will become time-consuming and cumbersome, which needs simplification. The increasing volume of compliance, together with strict timelines, may lead many Indian companies to replace traditional methods with advanced technology-enabled tax tools for undertaking tax compliance in India.
 WHT at 10% on dividends paid to Indian shareholder(s) if the amount exceeds INR 5,000. WHT at 20% on dividend paid to non-resident shareholder(s), subject to beneficial tax treaty rate as applicable. However, Indian companies cannot apply the beneficial tax treaty rate when the dividend is paid or payable to Foreign Institutional Investor or Foreign Portfolio Investor and will be required to WHT at 20%.