Finance Act 2020 re-introduced the classical system of taxing dividends in the hands of the shareholders as was prevalent in the past and will apply to dividends distributed on or after 1 April 2020. The effective DDT rate of 20.56% was also significantly higher than the maximum rate at which India would have had the right to collect tax under most of the relevant tax treaties. 

Upamanyu Manjrekar and Unnati Sharma (Chartered Accountants) in their article, examine deduction of tax at source on dividends as per the IT Act, 1961 and the correlation with the DTAAs while analysing the impact of BEPS and its implementation via the MLI. The authors highlight that where the total income of a non-resident or a foreign company includes dividend income and appropriate taxes have been deducted at source, the non-resident need not furnish his ROI. However, considering that the wordings used in Section 115A state deduction of tax at source as per the Act and not as per the DTAA, thus, where taxes are deducted in consonance with rates as per the DTAA, the non-resident is still under an obligation to furnish his ROI. The authors also analyze International Tax perspective, GAAR & MLI impact on the re-introduced provisions of tax on dividend income in the hands of the shareholders.

A DEEP DIVE INTO WITHHOLDING TAXES ON DIVIDEND INCOME

Since time immemorial, dividend income has been the most common form of providing a return to shareholders of corporations. It is often seen as a mode of repaying the faith put by the shareholders in the corporation and providing them a periodic return in order to keep them invested in the fortunes of the corporation and taking a business journey collectively with the corporation.

The deduction of tax at source on dividends paid to shareholders has been a complex tax issue for a long time. The era of Base Erosion and Profit Shifting (BEPS) and the Multilateral Instrument (MLI) has ushered in paradigm shifting changes in the tax deduction of source on dividend income. With that said, the deduction of tax at source on dividend income cannot be viewed as a silo. It has to be viewed as an integration and interaction of domestic tax rules and allocation of taxing rights by treaties. This article attempts to comprehensively cover the deduction of tax at source as per the Income-tax Act, 1961 (“the Act”) and the correlation with the Double Taxation Avoidance Agreements while analysing the impact of BEPS and its implementation via the MLI.

1. DOMESTIC TAX PERSPECTIVE

The abolition of Dividend Distribution Tax and the resulting taxation of dividends in the hands of the shareholders along with the re-introduction of withholding taxes on dividends were the show stoppers in the Budget 2020. The taxation of dividends in the hands of the shareholders is often termed as the ‘classical system’ of taxation of dividend income.

The withholding tax provisions pertaining to residents^[1] lays down the requirement to deduct tax at source (“TDS”) on Indian companies or any other company making prescribed arrangements for declaration and distribution of dividend within India at the rate of 10%. The fundamental principle that no surcharge or health and education cess is to be added while making a payment to a resident remains intact here. The threshold for deduction of tax at source in case of individual shareholders is INR 5,000 (INR 2,500 before the amendment by Finance Act 2020). For other types of assessees there is no threshold limit for deduction of tax at source.

Section 195 deals with the liability to deduct tax in case the recipient of income is a non-resident. It states that tax shall be deducted on dividend income as per ‘the rates in force’. The rates in force for the assessment year 2021-22 are contained in The Finance Act 2020.^[1]The rate for deduction of tax at source for dividends to non-resident shareholders is 20% plus the applicable surcharge and cess. There is no threshold limit under this section. The rate of surcharge applicable in the case of non-resident shareholders, other than foreign companies, shall not exceed 15% and in case of foreign companies shall not exceed 5%.

In the original Finance Bill 2020 presented on 01 February 2020, there was no specific category under the Finance Bill 2020 for deduction of tax at source on dividends. But the Finance Act 2020 has specifically provided in Part II of the First Schedule the rates for tax deduction at source on dividend income to non-residents (being individuals, or other non-residents, or foreign companies) at 20% owing to representations and clarifications asked by stakeholders

Another issue is the tax to be withheld on deemed dividends as defined by the Act^[3]. Earlier, the deemed dividends under section 2(22) were subjected to DDT till 31 March, 2020 which is now i.e., from FY 2020-21 has been brought into the net of withholding tax under section 194 and section 195, as applicable in the case.

Let’s understand it with the help of an example:

An Indian Company named ABC Ltd. distributed dividends to following shareholders^[4] in FY 2020-21. Therefore, the TDS required to be deducted by company has been tabulated under: 

       

S.No.	Shareholders	Amount of dividend	Rate of TDS	Surcharge	Cess	Amount of TDS with surcharge and cess*
1	A - Resident individual	4,500/-	NA	NA	NA	NIL
2	B - Resident individual	7,500/-	10%	NA	NA	750/-
3	C - Resident individual	51,00,000/-	10%	NA	NA	5,10,000/-
4	D - Non-resident individual	4,500/-	20%	NA	NA	900/-
5	E - Non-resident individual	51,00,000/-	20%	10%	4%	1,16,688/-
6	F - Non-resident individual	1,01,00,000/-	20%	15%	4%	24,15,920/-
7	G- Domestic company	4,500/-	10%	NA	NA	450/-
8	H - Domestic company	51,00,000/-	10%	NA	NA	5,10,000/-
9	I - Foreign company	4,500/-	20%	NA	NA	900/-
10	J - Foreign company	1,01,00,000/-	20%	2%	4%	21,42,816/-
11	K - Foreign company	10,01,00,000/-	20%	5%	4%	2,18,61,840/-

                

*wherever applicable.

Further, as per the Act^[5], where the total income of a non-resident (not being a foreign company) or a foreign company includes dividend income and appropriate taxes have been deducted at source^[6], the non-resident need not furnish his return of income. It is pertinent to note that the wordings used in Section 115A state deduction of tax at source as per the Act and not as per the DTAA. Therefore, where taxes are deducted in consonance with rates as per the DTAA, the non-resident is still under an obligation to furnish his return of income.

2. INTERNATIONAL TAX PERSPECTIVE

International Tax perspective- Elements of WHT obligation on Dividend Income included in the treaty

However, in the context of investment in a foreign corporation, several tax issues arise for both the shareholder and the foreign corporation. This article seeks to analyse the withholding tax obligations for a corporation when it is paying out a dividend to a shareholder who is not resident under the tax laws of the Contracting State where the corporation is situated.

ARTICLE 10(2) OF THE OECD MODEL- SOURCE STATE TAXATION OF DIVIDEND INCOME- WITHHOLDING TAXES ON DIVIDEND INCOME FROM AN INTERNATIONAL TAX PERSPECTIVE

Article 10 of The OECD Model Tax Convention deals with taxation of dividend income in a cross-border payout of dividend income. The UN Model Convention also has an identical article with insignificant differences with respect to taxability of dividend income.

Article 10(1) lays down the right of the Contracting States to tax dividend income. It states that dividends paid by a resident corporation to a non-resident maybe taxed in the state of residence of the non-resident shareholder. The term maybe taxed can be interpreted via the explanation given in the introductory paragraphs to the OECD Model Tax Convention. The OECD Model Convention states that “it follows from the preceding explanations that, throughout the Convention, the words “may be taxed in” a Contracting State mean that that State is granted the right to tax the income to which the relevant provision applies and that these words do not affect the right to tax of the other Contracting State, except through the application of Article 23 A or 23 B when that other State is the State of residence”

Therefore, the OECD Model Tax Convention gives the right to both the Contracting States to tax dividend income. The term maybe taxed quite simply refers to a distribution of taxing right in favour of both the Contracting States. In such a scenario, generally the State of Residence will have an obligation to grant credit of taxes paid in the State of Source. The credit may be granted via an exemption method or a credit method.

In every DTAA, sub article 2 of the articles dealing with interest, royalty, dividends and Fees for Technical/ Included Services are referred to as the ‘withholding taxes’ articles from an international tax perspective. The reason being, these articles dictate taxation of these types of incomes at source. The source of an income is generally the place where the income arises and where it is generally paid from in case of a dividend income. Generally, discharge of taxes at source is done at the point of payment of such taxes via the taxation laws of the source country imposing an obligation on the payor of such income. Therefore, a sub article defining the taxation at source will often be a withholding tax article.  

Article 10(2) of The OECD Model Tax Convention reads as

“ However, dividends paid by a company which is a resident of a Contracting State may also be taxed in that State according to the laws of that State, but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed:

a) 5 per cent of the gross amount of the dividends if the beneficial owner is a company which holds directly at least 25 per cent of the capital of the company paying the dividends throughout a 365 day period that includes the day of the payment of the dividend (for the purpose of computing that period, no account shall be taken of changes of ownership that would directly result from a corporate reorganization, such as a merger or divisive reorganization, of the company that holds the shares or that pays the dividend);

b) 15 per cent of the gross amount of the dividends in all other cases. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of these limitations. This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.”

Prior to the Multilateral Instrument (MLI) coming into effect, there was an enhanced lower withholding tax rate prescribed in majority of the tax treaties based on The OECD and UN Model Convention if the beneficial owner of dividend income is a company, resident in the treaty partner state holds a prescribed percentage of shareholding in the company paying the dividends. If the recipient, who was a beneficial owner of the dividends and a resident of the treaty partner state is without a substantial shareholding there is a regular reduced rate available. However, there has now been an additional condition laid down for the obtaining the enhanced reduced rate of withholding taxes. This measure is an extremely logical step in light of the tightening of tax measures and a host of anti-avoidance measures prescribed via the 15 Action Plans laid down by the Base Erosion and Profit Shifting Action Plans which are now into effect for countries with no reservation regarding the Dividend Article of the MLI. The same will be discussed in the MLI section of this article.

Analyzing the same in further detail, one can state for a lower withholding tax rate to apply, both in the case of regular and enhanced reduced withholding tax rate, the recipient of income has to be the beneficial owner of the income.  The term ‘beneficial owner’ is not defined in a tax treaty, therefore reference must be drawn to the OECD Model tax commentaries and relevant judicial precedents. The term beneficial owner refers to the person who is the ultimate recipient of the income, in a very general sense. It means the person who has the right to receive the income unfettered of any obligation to this income which may include but is not included to receiving this income as an agent/nominee for any other person (in the form of a trust, most commonly).

Establishing whether a recipient is indeed a beneficial owner of the income can indeed be a tricky task for the payor of dividend who would generally not have a clear picture of the ownership structure of the recipient. Therefore, a practical solution out of the same can be to obtain a declaration from the recipient of income to safeguard against liability for short deduction of taxes at source. There is no such prescribed document under the Indian Tax Laws presently. Hence, a custom declaration to that effect would suffice. In a circular^[7] however, it was held that a tax residency certificate would act as a sufficient test for beneficial ownership. This stand seems to be highly litigious and flawed in its inherent ideology. However, the same has been upheld by the Supreme Court^[8] and later by the High Court^[9]. However, to reiterate the ideology of a tax residency certificate being equivalent to beneficial ownership may not hold true in the current scenario owing to increased focus on the substance over form doctrine in international tax law.

In content of the Indian tax law, the Act lays down the prescribed procedure for obtaining a tax residency certificate. There are various details to be provided and forms to be filled in order to obtain a tax residency certificate. However, once obtained, it is conclusive proof of residency and might surely go a long way in obtaining foreign sourced dividends at a lower withholding. 

However, establishing the beneficial ownership is not by itself a sufficient means for deducting tax at beneficial rates as per DTAA. The same is also subject to Limitation of Benefit (LoB) Test as laid down in the tax treaties. Put simply, as per the measures laid down in Action Plan 6 of BEPS- Countering Harmful Tax Treaties, the benefit of tax treaties should not be granted in situations which are clearly an abuse of the beneficial provisions of a tax treaty. To implement this Action Plan, one of the measures laid down is the insertion of, at the option of the signatories to the MLI, either a simplified LoB clause or a detailed LoB clause. Both clauses contain litmus tests of varying degrees to determine if the recipient of income should be entitled to the beneficial provisions of tax treaties. If a person therefore is entitled to treaty benefits, taxes can be withheld at lower rates from dividend income. However, again there is a practical difficulty in establishing the same. Therefore, a declaration can be obtained from the recipient to that effect to safeguard the payor against liabilities of short/ non deduction of tax at source.

3. PRINCIPAL PURPOSE TEST, GAAR AND MLI IMPACT

General Anti Avoidance Rules (GAAR) under the Act^[10] became effective from A.Y. 2018-19. GAAR provisions are applicable on an arrangement, the main purpose of which is to obtain tax benefit and contains tainted elements in it. It codifies ‘substance over form’ basis of tax law.

For instance, An Indian company (A Ltd.) wants to make payment of dividend to a corporation resident in the United States (B Inc.). C Co., from Mauritius is a wholly owned subsidiary of B Inc. and has invested in shares of A Ltd.

Since the dividend is being paid to C Co. by A Ltd., India-Mauritius treaty shall be applicable, which provides for lower tax rates on dividends as compared to tax rates as per India-US treaty (subject to C Co. passing the beneficial owner test). Instead of directly paying the dividend to B Inc., C Co. has been interposed so as to avoid the higher tax rates on dividends as per India-US tax treaty.

It is clearly visible from the arrangement that C Co. has been formed for the purpose of taking tax benefit and there is no commercial substance in incorporating C Co.

Hence, in such a case GAAR may be invoked as there is presence of both the elements, tax benefit and tainted element. Therefore, lower withholding tax rate benefits should ideally be denied to such a structure. Judicial precedents prior to GAAR^[11] and the introduction of the Principal Purpose Test (PPT) had blessed such a form of ‘treaty shopping’ as it commonly termed.

Another significant amendment brought about by BEPS Action Plan 6 “Preventing Tax Treaty Abuse” is the introduction of the Principal Purpose test in DTAA^[12]. In effect, the Principal Purpose Test states that where one of the main objectives of a transaction/ arrangement is to take advantage of the tax treaties, tax treaty benefits shall be denied. With respect to dividend withholding, the benefit of a lower withholding tax rate as per the DTAA shall not be given if the arrangement to receive dividends is considered to be abusing the provisions of a tax treaty (like in the example Supra). The deductor would then have to deduct tax at source as per the domestic tax laws of the Contracting State of which the company paying the dividends is a resident.

MLI Article 8 ‘Dividend Transfer’ Transactions states that where the recipient of dividends has a substantial shareholding^[13] in the payor of dividends and is looking for an enhanced reduced rate of taxation^[14], the de-minimus time period of the shareholding has to be a period of 365 days including the date of payment of dividend. If the same is not satisfied, the enhanced reduced rate will not be granted and the regular reduced rate may be granted subject to satisfaction of other criterias explained above. From a withholding perspective, one may have to obtain declarations from the recipient of income in order to indemnify oneself against monetary and penal exposure under the domestic tax laws of the Contracting State of which the company is resident for short deduction/ non-deduction of tax at source. However, in cases of substantial shareholding the deductor may be in a position to call for the financial statements of its related parties (since substantial investment would make it a related party) in order to satisfy itself about the de-minimus time period of shareholding being met. However, practically, the procedure becomes onerous and hence it is better off to call for a declaration. An important point to note is that a combined solution can be in the form of a composite declaration covering LoB, PPT, MLI and beneficial ownership aspects for administrative convenience.

4. CONCLUDING REMARKS

The withholding of taxes on dividend income has assumed greater importance in light of the re-introduction of tax on dividend income in the hands of the shareholders instead of the erstwhile system of Dividend Distribution Tax. Deductors are now looking to safeguard themselves from penal exposure and having knowledge of the latest developments in the BEPS and MLI arena along with a holistic awareness of domestic tax laws are a must to ensure correct tax deduction at source.

 

^[1] Section 194 of The Income-tax Act, 1961

^[2] Part II to The First Schedule appended to The Finance Act 2020

^[3] Section 2(22) of The Income-tax Act, 1961

^[4] For the sake of simplicity, it is assumed that dividend income is the only income earned by the recipient of dividends. Marginal relief will also be applicable at the relevant income levels, which has not been considered in the tax deduction at source for the sake of brevity.

^[5] Section 115A of The Income Tax Act, 1961

^[6] As per Chapter XVII-B relating to provisions of deduction of tax at source

^[7] Circular No.789 dated 13 April 2000

^[8] [TS-5-SC-2003-O]

^[9] [TS-56-HC-2013 (BOM-O)] 

^[10] Chapter X-A of The Income Tax Act,1961

^[11] [TS-5-SC-2003-O]

^[12] Article 29 of The OECD Model- Entitlement to Benefits

^[13] At least 25 per cent of the capital as per Article 10(2)(a) The OECD Model Tax Convention on Income and Capital (2017)

^[14] 5 per cent of gross amount of dividends as opposed to 15 per cent of gross amount of dividend in other cases as per Article 10(2)(a) The OECD Model Tax Convention on Income and Capital (2017)