The Union Budget 2020 has proposed, of what can be termed as a sigh of relief especially to the India inbound investors community and is likely to attract foreign investments. Finance Minister Mrs. Nirmala Seetharaman has proposed to make the provisions of section 115-O redundant and inoperative, in a move to tax the shareholders in the conventional manner and has further, proposed to introduce a new section 80M, to avoid any cascading effect, in the case of distribution of dividends through multiple layers of holding companies before reaching the ultimate shareholders. Authors Deepak Manoharan and Nathansha Dilip, (Chartered Accountants) evaluate the impact of the proposed amendments. In the context of its impact on foreign investors in light of higher tax rates in India, the authors opine that “...foreign companies can now pay taxes on dividend at this reduced rate and claim the credit of the same in the country of residence.”.  Speaking of the reduction of tax cost that the amendment brings about to companies, the authors state that “This also diminishes the upper hand an LLP structure had over a company.”. Going by the sign of impetus that the Government is providing towards inclusive growth, they sign off with an anticipation that “It may not be surprising if the Government does away with the provisions of buyback tax as well, which was introduced as a measure to counter the alternate repatriation strategy adopted to avert DDT”

DDT abolished – A sigh of relief for taxpayers! 

The Union Budget 2020 has proposed, of what seems to be a huge sigh of relief especially to the India inbound investors community. One of the most awaited demands from several industrial bodies, on which several representations were made, has now been implemented, with the Government forgoing a major chunk of its revenue, and abolishing distribution tax on dividends declared by a domestic company.

Considering this welcome amendment, we have undertaken a brief analysis of the fine prints and attempted to gauge the impact this move is to cause.

History of DDT 

Dividend Distribution Tax (‘DDT’) was initially introduced vide Finance Act 1997. The move was primarily to curb the cumbersome process of collecting taxes on dividend from each of the shareholders, and to establish a single point of collection of taxes. However, vide Finance Act 2002, section 115-O was made redundant and the responsibility to pay taxes was shifted back to the recipients. This short-lived relief was withdrawn vide Finance Bill 2003 and the provisions in relation to DDT were again inserted into the Indian tax laws the very next year. 

As we may all be aware, under the existing provisions of section 115-O, any dividend declared, out of the already taxed profits of a domestic company, is chargeable to tax at the rate 15% (plus applicable surcharge and cess and grossing up – leading to an effective rate of 20.56%). Consequently, to avoid double taxation, the recipient of dividend is allowed an exemption under section 10(34). However, the double taxation is not completely curbed by the exemption, as section 115BBDA, taxes any receipt of dividend in excess of INR 10 Lakhs at the rate of 10%. 

Considering the series of taxes involved, the cost of equity turns high, and proves India to be an unattractive market in the global economy. Further, since DDT had itself covered alternate repatriation options like capital reduction, there existed a very few opportunities available to an investor to repatriate profits or exit the market, with a tax effective strategy. 

The New Regime 

Vide Finance Bill 2020, the Government has made the provisions of section 115-O redundant and inoperative, in a move to tax the shareholders in the conventional manner. As per the amendment, only the dividends declared on or before March 31, 2020, would attract DDT. Consequently, section 115BBDA and 10(34) have also been made redundant. 

Further, the Finance Bill has introduced a new section of what is called section 80M, to avoid any cascading effect, in the case of distribution of dividends through multiple layers of holding companies before reaching the ultimate shareholders.  This provision is illustrated below: 

Company S Pvt Ltd (‘S’) is a 100% subsidiary of Company H Pvt Ltd (‘H’). H is completely held by Mr. A. During FY 2020-21, S declares a dividend of INR 100, and some dividend is in turn paid by H to Mr. A.

As illustrated above, with the insertion of section 80M, the intention of taxing only the ultimate recipient of dividend is made clear. 

The Impact 

The Hon’ble Finance Minister, in her budget speech has indicated the increased cost of equity due to the tax costs on repatriation. It is needless to say that abolishment of DDT is a positive move to attract foreign investments. The cash repatriations in the past have proven to be costly. While the inbound domestic wing of foreign companies paid taxes on its profits, it additionally paid taxes under section 115-O on the repatriation of the same to its holding company. Further, since the liability of DDT was cast on the domestic entity, the credit of such DDT was also not available to the foreign holding company. This made the foreign entities bear significant taxes, which ultimately resulted in lower returns. 

With DDT being abolished, cash repatriation is made far more tax effective.  The rate of tax on dividends in India prescribed in most of the tax treaties is 10%, and there are a few treaties with an even lower 5% rate. Hence, foreign companies can now pay taxes on dividend at this reduced rate and claim the credit of the same in the country of residence. 

Under the existing regime, there were considerable discussions and brainstorming around the applicability of the lower rates prescribed under the tax treaties for DDT, which is a tax levied on the domestic company declaring the dividend as against the foreign shareholders.  Though the eligibility to claim treaty benefit has been demystified for future dividends, there is still room to ponder upon the DDT paid so far on the past dividends at the rate of 20.56%, and the strategic possibilities to obtain a refund of the excess taxes vis-à-vis the rates prescribed under tax treaties. 

With the Ordinance passed last year effecting reduced rates of taxes for a domestic company, and now the abolishment of section 115-O, the tax cost of a domestic company can now be really and effectively as low as 15%. This also diminishes the upper hand an LLP structure had over a company.  We have provided below a comparison of the effective tax costs prior to and post the introduction of the new tax regime in the case of a foreign holding company.

The final tax cost would however depend on case to case basis, depending on the recipient. In case the end recipient is a resident individual, the maximum rate at which the dividend may be taxed is 30% (as increased by surcharge and cess). However, the significance would be higher with increased surcharge if the individual earns a substantial amount as dividend income.

Although section 80M intends to provide benefit from the cascading tax, it is restricted to dividends received from domestic companies, unlike a similar provision to avoid cascading effect under section 115‑O.  Accordingly, if the Indian holding company receives dividends from its foreign subsidiaries, no deduction shall be available under section 80M.  Although a tax credit may be available against the tax on dividend from foreign subsidiaries under section 115BBD, this discrimination in section 80M may give an edge to the outbound holding structures routed through jurisdictions which enable the benefit of underlying tax credit in their tax treaties with India.  

A need may arise for deliberations around the requirement to benchmark dividends declared by Indian subsidiary in the hands of the foreign shareholders for the purpose of transfer pricing compliance.  It might also be interesting to understand if a report in Form 3CEB will be required if the foreign shareholder takes an exemption from filing of return of income as per section 115A. 

From the perspective of a domestic shareholder, this refreshing amendment also dwindles the impact of disallowance under section 14A, which is otherwise a considerable impediment from a tax cost and litigation standpoint.  

It is a clear sign of impetus from the Finance Minister to march towards inclusive growth amidst fears of global recession.  It will be interesting to note what further is in store, to be unleashed.  It may not be surprising if the Government does away with the provisions of buyback tax as well, which was introduced as a measure to counter the alternate repatriation strategy adopted to avert DDT. 

The views expressed in this article are the personal views of the authors.