The Hon’ble Finance Minister, Ms Nirmala Sitharaman, had presented the Union Budget for the financial year 2020-21 on February 1, 2020, and introduced the Finance Bill, 2020 (“Bill”) in the Lok Sabha. The Bill comprised of financial proposals, including taxation related proposals, to amend the provisions of the Income-tax Act, 1961 (“IT Act”) for financial year 2020-21. The final Bill, incorporating certain amendments, was passed by the parliament on March 26 and received the assent of the President of India on March 27, 2020, and has now been enacted as the Finance Act, 2020 (the “Finance Act”).
In this post, we are covering the provisions of the Finance Act related to dividends distributed by Indian companies. For the changes impacting the tax on dividend distributions to the unitholders of Real Estate Investment Trust and Infrastructure Investment Trusts please see our earlier post here.
Background – Declaration of Dividend by Listed Entities in accordance with the Companies Act and the SEBI Listing Regulations
Under Section 123 of the Companies Act, 2013 (the “Companies Act”), a company may declare and pay dividends in a financial year: (i) out of the profits of the company for that year or out of the undistributed profits of the company for any previous financial year or years, in each case after providing for depreciation and excluding unrealised gains, notional gains or revaluation of assets and any change in carrying amount of an asset or of a liability on measurement of the asset or the liability at fair value; or (ii) out of money provided by the Government of India or a State Government for the payment of dividend by the company in pursuance of a guarantee given by the relevant government. Further, under Section 127 of the Companies Act, subject to limited exceptions, if dividend has been declared by a company, but has not been paid within 30 days from the date of declaration to any shareholder entitled to such payment, the company shall be liable to pay simple interest at the rate of 18% p.a. for the period for which the default in payment of dividend is continuing.
Further, under Regulation 43 of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the “SEBI Listing Regulations”), a listed entity is required to declare dividends on a per share basis only. Further, listed entities are proscribed from forfeiting unclaimed dividends before the claim becomes barred by applicable law. The SEBI Listing Regulations also require the top 500 listed entities (based on market capitalisation) to formulate a dividend distribution policy, which shall include, amongst others, parameters such as: (i) circumstances under which shareholders may or may not expect dividends to be declared; (ii) financial parameters to be considered whilst declaring dividend; (iii) policy on utilisation of retained earnings; and (iv) parameters to be adopted for various classes of shares.
Taxation of Dividends Under the DDT Regime Prior to Enactment of the Finance Act
Under Section 115-O of the IT Act, distribution of dividends by a domestic company was subject to an additional income tax, called Dividend Distribution Tax (“DDT”) at an effective rate of 20.56% (inclusive of the applicable surcharge and cess) payable by the company distributing the dividend. The DDT thus paid by the Indian company was treated as the final tax on dividends and the dividends were exempt from any further incidence of tax in India in the hands of the shareholders.
While the actual payment of the DDT was made by the company distributing the dividends, the economic consequences of DDT was also borne by the shareholders, as it was paid from accumulated profits, thereby impacting the amount available for dividend payout. Under that regime, the distributing company was liable to pay DDT, irrespective of whether the shareholder was liable to pay taxes in India on such income. Retail resident investors also had cause to complain against DDT at the rate of 20.56% since there were many instances where retail investors were either subject to tax at a rate lower than 20.56% or were not liable to pay any tax at all if their total income didn’t cross the minimum threshold limit. Catering to the multiple representations made by industry stakeholders and market constituents, the Finance Act 2020 has abolished the DDT regime and has re-introduced the classical method of taxing dividends in the hands of the shareholders.
Abolition of DDT
The Finance Act provides that DDT will not be payable in respect of dividends declared, distributed or paid by a domestic company after March 31, 2020, and accordingly, such dividends would not be exempt in the hands of the shareholders – resident as well as non-resident. The Finance Act has also, amended Section 194 of the IT Act to impose a withholding tax at the rate of 10% on all dividends paid by an Indian company, by any mode whatsoever, to a resident shareholder. The ensuing paragraphs discuss the position applicable to non-resident shareholders.
Key factors for non-resident investors
Under the new regime, non-residents would be subject to withholding under Section 195 of the IT Act. As the Bill had not specified the rate of withholding for non-residents, there were doubts regarding the applicability of the rate to non-residents. The Finance Act removes this doubt and provides for withholding tax rate of 20% (plus applicable surcharge and cess) for dividends paid to non-residents.
However, where the non-resident shareholder is a resident of a jurisdiction with which India has entered into Double Taxation Avoidance Agreement (“DTAA”), and the non-resident is eligible to the benefit from the provisions of such DTAA, the withholding tax rate prescribed in the relevant DTAA for taxing dividend would be applicable. It is in this respect, that the eligibility to claim benefits under the DTAA, assumes significance. One would need to be mindful of the fact that the General Anti Avoidance Rules (“GAAR”) has become effective from April 1, 2017 and would operate to deny benefits of the DTAA, where the main purpose of an arrangement or structure is to obtain tax benefit. Thus, if the investor chooses to locate its investment vehicle in a low tax jurisdiction and if the jurisdiction also has a favourable DTAA with India, providing lower withholding tax for dividends and other such tax concessions to its residents, these benefits may be denied unless the choice of jurisdiction is made on the basis of other non-tax considerations.
Additionally, as India has signed and ratified the Multilateral Instrument (“MLI”), on June 25, 2019, its network of bilateral DTAAs would be impacted by the provisions of the MLI where its treaty partner is also a signatory. It is, therefore, necessary now to read the applicable DTAA with MLI, based on the DTAA partner’s position and reservations on the provisions of the MLI. In this respect, it is critical to note that the MLI contains a provision that targets aggressive tax planning strategies, involving transfer of shares a few days prior to the date of distribution of dividends, to countries having beneficial tax treatment. This provision denies benefit of the reduced rate of tax under applicable DTAA of the transferee location, if the shares in respect of which dividends have been paid, have been transferred within 365 days preceding the distribution of dividends. Thus, non-residents claiming relief under applicable DTAA where India’s DTAA partner also opts for MLI provision, would need to own the shares beneficially for a period of at least 365 days preceding the distribution of dividend.
Impact on ability to claim credit
The DDT regime under Section 115-O of the IT Act, prior to the amendment by the Finance Act, prevented the taxpayer (i.e. the investor shareholder) from claiming any credit for DDT. As DDT was a tax levied on the distributing company rather than the shareholder, non-resident shareholders, in the absence of enabling language in the applicable DTAA between India and their state of residence, were not able to claim foreign tax credit for the DDT paid by the Indian company against their tax liability on dividend income in home jurisdiction. In contrast to this, as now the DDT is replaced with a tax on the shareholders, requiring the Indian distributing company to withhold tax while paying dividend, the non-resident investors would be able to claim credit for tax paid in India, subject to the application of the local laws in their state of residence.
Deduction on inter corporate dividends
In order to reduce the cascading effect of dividend taxation, the Bill had proposed to introduce deduction under Section 80M of the IT Act, on dividends received by a domestic company from another domestic company, in computing the total income of the shareholder company. However, the Bill had not proposed any similar deduction on dividends received by an Indian company from any foreign company – including a specified foreign subsidiary company, which is subject to a 15% tax under Section 115BBD of the IT Act in its hands. To restore the position to the same as under the DDT regime, the Finance Act has extended this deduction under Section 80M to dividends received by an Indian company from a foreign company as well. The Finance Act has also extended this benefit of deduction on dividends received by an Indian company, from a business trust.
Please note, however, this deduction is limited to the amount of dividend distributed by the Indian shareholder company before the due date i.e. one month prior to the date of furnishing the return. Thus, where the investee company does not distribute dividends before the due date of furnishing return, it may not be possible for the shareholder Indian company to avail of this deduction. Further, it may be relevant to note that this deduction would be available, irrespective of the percentage of shareholding of the shareholder company in the investee company.
With the re-introduction of dividends being taxed in the hands of the shareholders, the relevance of the dividend taxation article in the DTAAs has re-assumed significance where dividends are distributed by Indian companies. To this extent, the equity investment in India and repatriation of income by way of dividend should regain their attractiveness. However, as discussed above, the changes to India’s network of the DTAAs would need to be assessed in light of the MLI, and the dividend transfer provision contained therein. In addition to this, the eligibility to claim DTAA relief, considering GAAR and MLI, would need to be tested for examining tax implications.