[Rupam Dubey is a third year B.A.LLB student at the National Law School of India University Bangalore]
The landscape of dividend taxation in India has experienced significant changes over the past two decades, leading to a perplexing situation for courts and income tax tribunals. This uncertainty surrounding the nature of the dividend distribution tax (DDT) has resulted in contradictory judgments and a murky jurisprudence, ultimately leading the Government to abolish the tax in 2020. However, a ruling earlier this year by the Income Tax Appellate Tribunal, Mumbai Bench (ITAT) in Deputy Commissioner of Income Tax v Total Oil India has revived the debate.
The implications of this decision are particularly relevant now that the provision has been abolished, as a wave of non-resident shareholders is expected to seek treaty relief to claim refunds for excess DDT paid. It is crucial to determine whether DDT primarily taxes the income of shareholders or companies. In this regard, this post argues that DDT can be viewed as an inverse split-rate levy, independent of the source of income and not a source agnostic one. Such an interpretation not only clarifies whose income is being taxed, but it also helps determine the applicability of the double taxation avoidance agreement (DTAA) in assessing claims made by non-resident shareholders.
By delving into the nature and implications of DDT, one can obtain a better understanding of its impact on dividend taxation and the potential complexities that arise in the absence of a clear framework. This analysis aims to shed light on the intricacies of DDT, the relevance of the recent ITAT ruling, and the significance of determining the parties subject to taxation in order to address the claims of non-resident shareholders effectively.
DDT Dilemma: Unraveling the Tangle of Conflicting Jurisprudence
The dividend income in India is subject to taxation at both the corporate and individual levels. However, the Ministry of Finance introduced section 115-O in the Income Tax Act, 1961 to simplify the process and for administrative convenience. This section establishes a combined statutory tax imposed on the distributed profits given to shareholders. However, such a provision has been interpreted broadly in two manners which lead to the present situation and the cause of confusion. For instance, the Indian tribunals have interpreted the provisions of section 115-O in an isolated manner, suggesting that it supersedes the charging provisions of section 4 of the Act, which defines income tax and the tax obligations under the Act.
In CIT v Elphistone Spg, it was argued that the charge under section 115-O is levied on the distributable profits of the company rather than the dividend itself. The Supreme Court ruled that this provision pertains to undistributed profits rather than accumulated profits. Therefore, section 115-O imposes an additional tax on the distributable profits of the company, not on the shareholders. Similarly, in Tea Estate India v CIT, the Supreme Court held that the growing and manufacturing of tea are subject to taxation in the hands of the company, and when such profits are distributed as dividends, they become taxable. Additionally, in Small Industries Development Bank of India v CBDT, it was argued that the charge under section 115-O is a tax on the company’s profits.
This demonstrates that the levy is explicitly on the company itself, as is the incidence of taxation. This can be understood by referring to the essential elements of taxation, as stated in the landmark judgment of Mathuram Agarwal v State of Madhya Pradesh, where the Supreme Court determined that the entity liable to pay the tax is the one on whom the tax is imposed. In this case, it is the domestic company that is distributing or paying an amount as dividends, as specified in section 115-O (1) of the Act.
However, another line of reasoning followed by the courts and tribunals stems from the intention behind the introduction of section 115-O through the Finance Act 1997. According to this reasoning, the tax under section 115-O refers to the tax on the distributable profits of the company rather than a tax on the company itself. The origin of the charge under section 115-O is seen as an additional tax on the profits declared, distributed, and paid by corporate assesses in the form of dividends, which can be traced back to the charging provisions of section 4 of the Act. This is further supported by the fact that section 115-O(2) allows for the taxation of distributed profits even if no income tax is payable by the domestic company on its total income. Therefore, the DDT paid has no connection to the primary income tax liability in respect of the company’s profits declared as dividends. This line of reasoning was upheld in Engineering Analysis Centre of Excellence v CIT, where the Supreme Court referred to the OECD Commentary on the OECD Model Tax Convention to determine that section 115-O of the Act levies tax on dividends distributed to shareholders rather than on the companies paying them. The Court in CIT v Clive Insurance also held that the mere collection of tax does not determine who is ultimately responsible for paying the tax. In India Oil Petronas, the Supreme Court ruled that DDT is a tax on dividend income and not on the undistributed profits of the company. Therefore, the company paying the dividend is the entity responsible for distributing the dividend income among shareholders, including non-resident shareholders. Lastly, the ITAT Delhi Bench in Giesecke & Devrient India also determined that DDT is a tax on distributed profits, which essentially means it is a tax on the dividend income of the shareholders rather than on the company’s.
Flipping the Script: Resolving the DDT Dilemma through the Inverse Split System
The confusion surrounding the nature of levy of DDT could have been avoided if it had been treated as an inverse split rate tax rather than a source agnostic tax. Understanding the nature of dividends in the Indian framework is essential for determining whether it is a corporate or personal tax imposed on the company. Dividends, as defined in section 2(35) of the Companies Act, 2013, represent returns on share capital paid to shareholders from company profits. However, the taxability of dividends does not necessarily have to be borne by the shareholders. The government has the authority to tax dividends either at the recipient’s end or through alternative means.
For example, after the abolition of DDT in 2020, India returned to a pre-1997 approach where dividends are taxed in the hands of the recipients at their applicable rates. The introduction of Section 115-O in the Finance Act, 1997 aimed to streamline tax collection by shifting the burden from recipients to the company, which was administratively more convenient. Additionally, shareholders would not face tax incidence, encouraging investment in domestic company shares. The logic behind split rates is similar to systems like the German three-tiered split-rate system, which incentivizes reinvestment and consumption by taxing reinvested profits at a lower rate than dividends. This approach stimulated the German economy post-war.
Section 115-O creates an additional income tax charge beyond the domestic income tax paid by the company. The Circular released by the Central Board of Direct Taxes (CBDT) specifies that the gross amount of dividend representing the distributable surplus is subject to a tax ranging from 0 to 30 percent. DDT applies a lower tax rate of 15 percent to the amount paid as dividend after the company deducts the distribution tax. For example, if a dividend of Rs 100 is distributed, the DDT of 15 percent amounts to Rs 15, resulting in a post-DDT dividend of Rs 85.
It is impractical to argue that a company would distribute all its profits to allow the DDT to erode its capital, except in cases of liquidation. Companies often have accumulated profits much higher than their capital. For instance, a company with a capital of 100 may have accumulated profits of 1000. In such cases, if the DDT were treated as a tax on undistributed profits rather than a source-agnostic tax, the maximum dividend amount would be 869.6 (1000/1.15), with a DDT levy of 130.4. This interpretation avoids the absurdity of a charge failing basic arithmetic despite available funds.
Therefore, interpreting DDT as an inverse split rate system of taxing corporate profits at a higher rate upon distribution rather than retention is also supported by the Supreme Court cases of Jayshree Tea Industries v Union of India and George Williamson v Union of India. The courts in both cases held that dividends, regulated by a company’s articles of association, fall under the definition of income in section 2(24) of the Income Tax Act, and section 115-O pertains to the declaration, distribution, or payment of dividends by domestic companies.
Bridging the Gap: Unraveling the Impact of Inverse Split Rate on Excess Claims of Non-Resident Shareholders via DTAA
As discussed earlier, section 115-O of the Income Tax Act pertains to the declaration or distribution of dividends by domestic companies. The company is not responsible for paying the DDT on behalf of the shareholders, as it is an additional levy on the distribution of profits. For resident shareholders, the fixed rate of 15 percent ensures a predictable deduction during the distribution of profits.
However, the situation becomes more complex when it involves non-resident shareholders, where the DTAA comes into play. India has signed DTAAs with other countries based on the provisions of section 90(1)(b) of the Income Tax Act to prevent double taxation based on the OECD Model Tax Convention.
Article 10 of the OECD Model Tax Convention allows for the taxation of dividends in the host country or the country of residence, depending on the residential status of the shareholders. The article also permits setting a maximum limit for DDT that the host country cannot exceed. One might argue that if DDT is considered an inverse split rate, it becomes a tax on the company’s income or profits and not on behalf of the shareholders. However, such a simplistic interpretation would undermine the purpose of entering into DTAA agreements, which enable sovereign states to determine tax rates for cross-border investments. Considering it this way would essentially allow unilateral changes to the clauses of DTAA through domestic laws.
The India-Hungary Double Taxation Avoidance Agreement has already addressed this issue, emphasizing that if the contracting states intend to protect DDT, it must be explicitly provided for in the treaty itself. It is entirely up to sovereign states to limit the tax liability of non-resident shareholders.
Therefore, taxation is a sovereign power of the state, and DTAA agreements impose limitations on a state’s inherent right to tax. Consequently, the impact on non-resident shareholders regarding excess claims after the abolition of DDT in 2020 needs to be assessed individually in light of the relevant DTAA. The ceiling for taxation must be explicitly mentioned in the DTAA for non-resident shareholders to pursue a claim for relief from excessive taxation under section 115-O.
In conclusion, if we consider DDT as a tax on distributed profits under section 115-O, it should be subject to the DTAA agreements India has with other countries. Disregarding the nature of DTAA or international treaties by using domestic laws would undermine the flow of cross-border investment and goods. Furthermore, for claims by non-resident shareholders, it is necessary to demonstrate that the treaty provides the intended protection. Tax treaties are agreements between treaty partner jurisdictions, and they should be interpreted based on their existing provisions rather than ideal expectations.
– Rupam Dubey