The Finance Act 2020 has shifted back to the classical system of taxing dividend in the hands of shareholders/unit holders from 01 April 2020, and abolished dividend distribution tax (‘DDT’), wherein the incidence was on the company.
With this amendment, the following corresponding changes have been made to reduce the tax burden on shareholders:
a) As per the amended section 57 of the Income Tax Act, 1961 (‘Act’), interest expense incurred for the purpose of earning the dividend income would be allowed as a deduction up to a maximum of 20% of such income.
b) Section 80M of the Act has been introduced in order to remove the cascading effect of tax on dividend income for corporate shareholders. Domestic holding companies receiving dividend income from subsidiaries will be allowed to set off such amounts from their total taxable income. This set off shall not exceed the amount of dividend further distributed by it up to one month prior to the due date of filing of return.
Further, by making dividend taxable in the hands of shareholders, the Finance Act 2020 has rendered section 14A of the Act inapplicable in computing such dividend income.
Taxability in the hands of resident shareholders
Individual – For an individual shareholder, dividend shall be taxable as per the applicable slab rates.
Moreover, the government has abolished additional tax of 10% on dividend income in excess of Rs 10 lakh per year for resident non-corporate taxpayers (section 115BBDA of the Act).
Companies – For corporate shareholders, dividend shall be taxable as per the effective tax rates, which would range from 25.17% to 34.94% (including surcharge and cess).
Taxability in the hands of non-resident shareholders
Indian companies shall be liable to withhold taxes at the rate of 20% on payment of dividend to a non-resident shareholder, as per the provisions of the Act. Non-resident shareholders can claim benefit of the lower tax rate under the relevant tax treaty, provided they are ‘beneficial owners’ of the dividend income. Various tax treaties provide for a lower withholding tax rate, typically ranging from 5% to 15%.
The term ‘beneficial owner’ has been neither defined in tax treaties nor in the domestic tax laws, and the determination of the same is a fact based exercise. The OECD commentary indicates certain criteria for ascertaining beneficial ownership. The criteria, such as agent, nominee, conduit company acting as a fiduciary etc., cannot be considered as ‘beneficial owner’ or company should not be bound by contractual/ legal obligation to pass on dividends received from another person.
Various Indian judicial precedents have also laid down certain principles to determine ‘beneficial ownership’, such as the principle that a taxpayer should make independent decisions vis-à-vis investment, expenditure, etc. or should enjoy unrestricted right to use the income, etc.
Further, the impact of Multilateral Instruments (‘MLI’) needs to be evaluated. MLI came into force in India from 01 October 2019, and the provisions of MLI were effective on the Indian tax treaties from 01 April 2020. Article 8 of the MLI, which deals with dividends, provides that the concessional rate of tax on dividend in case of beneficial ownership will be available only in a case where the shares are held by the shareholder for at least 365 days.
In addition to ‘beneficial ownership’ and MLI, the Most Favoured Nation (‘MFN’) clauses of tax treaties also need to be looked into. MFN clauses forge a link between taxation agreements by ensuring that the parties to one treaty provide each other with treatment no less favourable than the treatment they provide under other treaties in areas covered by the clause.
Separately, non-resident shareholders should also get credit of withholding tax against tax payable in their home country, subject to local regulations.
Compliance burden for non-resident shareholder
# Non-resident shareholders applying the lower withholding rate as per tax treaty are liable to submit all requisite documents which includes TRC, Form 10F, beneficial ownership confirmation, etc.
# Requirement to file return of income in India, if the non-resident shareholder wishes to claim the benefit of lower rate as per tax treaty. For filing such return, a non-resident shareholder has to obtain a PAN in India.
# Requirement to file Accountant’s Report in Form 3CEB needs to be evaluated, as there is a view that dividend is an appropriation of profits, and not specifically a transaction between two parties.
The abolition of DDT may improve the attractiveness of Indian markets to foreign investors and domestic small retail investors, from a dividend yield perspective.
Prior to the Finance Act, 2020, DDT was only applicable to domestic companies; hence, entrepreneurs preferred setting up firms / LLPs instead of companies. However, post reduction of corporate tax rates for domestic companies and abolition of DDT, entrepreneurs may lean towards the company format.
(By KS Prasad, Partner; Vijai Jayaram, Director; and Sourav Agrawal, Deputy Manager with Deloitte Haskins and Sells LLP)