The Indian union budget has multiple objectives, the key ones being updating the nation on the fiscal situation, unveiling policy initiatives, introducing direct and indirect tax proposals, and presenting the government budget for the coming year. Through the Finance Bill 2002, introduced on February 28 2002, the finance minister has proposed amendments to the existing direct and indirect tax provisions, and the introduction of new proposals. Amongst other changes, the finance minister has brought about a shift in the tax base for dividends distributed by an Indian company.
This article discusses the classical regime of dividends taxability, a temporary shift from the classical regime and the shift back to the classical regime under Indian tax laws and the implications for India's double tax avoidance agreements.
It should be noted that the budget proposals would become law only after they have been approved, with or without modifications, by the Indian Parliament, expected in May 2002.
Classical regime
Under the classical regime, prevailing until May 31 1997, there was dual taxation of profits earned by Indian companies: first the business profits were subject to corporate tax in the hands of the company, and subsequently in the hands of the shareholders, when they were distributed as dividends. Hence, the same profits were taxed twice, although in the hands of separate taxpayers.
The Indian tax law at that time provided certain tax exemptions to individuals and Indian companies. Dividends up to a prescribed monetary ceiling, though not substantial, were not taxable in the hands of individual shareholders. Further, dividends received by an Indian company from another Indian company were not taxable to the extent the recipient Indian company further distributed them as dividends to its shareholders.
Dividend distribution tax regime
A new regime for taxing dividends was introduced in the Finance Act 1997. Under this regime, Indian companies declaring, distributing or paying dividends were liable to pay 10% dividend distribution tax on the amount declared, distributed or paid as dividends. Such dividends were tax-exempt in the hands of the shareholders (whether Indian resident or non-resident). The dividend distribution tax was a tax levied on the Indian company distributing the dividends and was not in the nature of a withholding tax.
However, even under the dividend distribution tax regime, to a certain extent there was dual taxation of the same profits. Further, the dividend distribution tax regime discouraged the use of multiple layer holding company structures, since each company distributing dividends was subjected to dividend distribution tax. Until recently, the dividend distribution tax rate was 10% plus a surcharge of 2%, taking the effective rate to 10.2%.
The dividend distribution tax regime also created complications in respect of the home tax credits available to foreign shareholders. A question arose of whether a foreign shareholder would be eligible to claim the underlying tax credit in respect of the dividend distribution tax paid by the Indian companies on the dividend distributed. Certain jurisdictions such as Mauritius issued clarifications, stating that the dividend distribution tax paid in India would be eligible as a tax credit in Mauritius.
Budget proposal
The Finance Bill 2002 proposes the abolition of the dividend distribution tax regime and its replacement with the erstwhile classical regime (with certain modifications). Accordingly, the dividends distributed by Indian companies would henceforth be taxable in the hands of the shareholders. The impact of the proposal on various categories of shareholders is summarized below.
Taxability of Indian companies
The dividends received by Indian companies from other Indian companies would be taxable at the rate of 36.75%. However, if the Indian company receiving dividends distributes dividends to its shareholders, then the amount of dividends distributed would be eligible as a deduction. For example, if an Indian company (B) receives Rs1,000 by way of dividends from another Indian company (A), then normally Rs1,000 would be taxable in the hands of B. However, if B distributes Rs900 by way of dividends to its shareholders, then only Rs100 would be taxable in its hands.
Taxability of foreign companies
Dividends received by foreign companies from Indian companies would be taxable in India. The tax rate under the Indian tax law is 21% (including a surcharge) on a gross income basis. However, the foreign company could be entitled to a lower tax rate, depending on the applicable tax treaties. It should also be eligible to claim a tax credit or an exemption from the tax on dividends, depending on the applicable agreement and the domestic tax laws of that country.
Minimum alternate tax
Under Indian domestic tax law, if the tax payable by a company on its total income is less than 7.5% of its book profits, then the minimum alternate tax (MAT) payable would be deemed to be 7.875% of the book profits (ie 7.5% tax plus a surcharge of 5%).
While computing the book profits, no deduction would be available for dividends distributed. Taking the previous example, if the only income of B is Rs1000 (ie dividend income) then its normal tax liability would be Rs36.75 (ie after deducting the dividend distributed). However, under MAT, its tax liability would be Rs78.75 (ie without any deduction for dividends distributed).
Withholding obligation
Box One |
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* The rate mentioned is subject to the condition that the foreign beneficial recipient of such dividends is a company and holds more than 10% shares in the Indian company paying dividends. |
Indian companies distributing dividends to Indian residents are obliged to withhold tax at the rate of 10.5% (including a surcharge of 5%). However, in the case of a foreign company, taxes would be withheld at the rate prescribed under the Indian domestic tax law or the rates prescribed under the applicable tax treaty, if it provides for a lower withholding tax rate.
Box One sets out the applicable withholding tax rates on dividends under the tax treaties between India and the relevant country.
Permanent establishment v Indian wholly owned
subsidiary
As the Finance Bill 2002 also proposes a reduction in the corporate tax rate on foreign companies from 48% to 42% (including a surcharge), it is worth considering which form of business presence provides the optimal repatriation of funds invested in India.
Permanent establishment
Foreign entities could, among other things, operate in India through a branch, project or liaison office. The first two ? branch and project office ? could normally constitute a permanent establishment in India. Assuming that profits are attributable to the permanent establishment in India, such profits would normally be taxable at the rate of 42% on a net income basis. Since there is no tax in India on the repatriation of profits by a branch/project office, the net outflow to the foreign parent could be approx Rs580 (assuming Rs1,000 is the profit before tax).
Wholly owned subsidiary
A foreign entity could also have a business presence in India in the form of a wholly owned subsidiary. The wholly owned subsidiary would normally be taxable at the rate of 36.75% (unless MAT is applicable) on a net income basis. Considering a pre-tax profit of the wholly owned subsidiary of Rs1,000, the maximum repatriable amount would be as shown in Box Two.
In view of the above, the total tax payable under both the options discussed has been substantially narrowed down.
Box Two |
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* If the dividends to be distributed are more than 20% of the share capital, 10% of the post-tax profits are required to be transferred to reserves. |
