India: Tax treaty overrides dividend distribution tax, rules Delhi Tax Tribunal
Shashidhar Upinkudru and Vishal Lohia of Dhruva Advisors assess the impact of the Tax Tribunal’s ruling and consider how this may affect the tax position of Indian companies with significant foreign parentage.
The Delhi Tax Tribunal made a landmark judgment in the case of Giesecke & Devrient (India) Pvt Ltd. The judgment held that dividend distribution tax (DDT) on dividends distributed to foreign shareholders would be circumscribed by the tax rate mentioned in the tax treaty applicable to the foreign shareholders.
In order to understand the ruling of the Tax Tribunal and its far-reaching impact, it is important to note the background of dividends taxation in India.
Prior to 1997, dividends were taxable in the hands of the shareholder. In 1997, for administrative convenience, the Indian tax laws were amended to provide for a levy of DDT at the rate of 15% (plus applicable surcharge and cess) on the company distributing the dividends. This meant that the brunt of the tax was shifted to the companies declaring dividends and that dividends were exempt from such taxation in the hands of the shareholders.
The DDT was discharged by Indian companies at the said rate irrespective of whether the shareholders were residents or non-residents. The shareholders who were tax residents of countries with which India had entered into a tax treaty were not given the benefit of the tax rate prescribed under the relevant tax treaty at the time of levying the DDT on the dividends distributed by Indian companies. While most of the tax treaties entered into by India provide for a lower tax rate for a beneficial owner of dividend income (as compared to the DDT), it was generally believed and accepted that a tax treaty would not override the DDT provisions.
Tax Tribunal’s ruling
An Indian company had paid dividends to its German parent and shareholder in FY 2012-13 and discharged DDT at 15% plus the applicable surcharge and cess (disregarding the dividend tax rate of 10% under the India-Germany tax treaty). The Indian company subsequently raised an additional ground (for the first time) before the Tax Tribunal that it should be entitled to a refund of the DDT paid in excess of the tax rate stipulated by the tax treaty.
The Tax Tribunal, while allowing the ground to be admitted, held, on the merits of the case, that the DDT paid by the Indian company to its German shareholder (parent) would be subject to taxation under the relevant tax treaty (i.e. 10% under the India-Germany tax treaty in the present case) for the following reasons:
The definition of ‘income’ under Indian tax laws includes dividends and the definition of ‘tax’ includes additional income tax (i.e. DDT). This implies that DDT is a tax on such dividends. In other words, DDT is a tax on the ‘income’ earned by the shareholder that is payable by the Indian company;
Having regard to the rationale for the introduction of the DDT regime and subsequent amendments over the years, we note that DDT was introduced to recover tax on dividends from Indian companies for administrative convenience;
The India-Germany tax treaty predates the introduction of DDT; and
The beneficial provision in the tax treaty would override the provisions of the Indian tax laws for the purpose of determining the rate to be applied at the time of levying the DDT.
One aspect that should be highlighted with respect to this ruling is that the tax treaty with Germany was signed before the introduction of the DDT and this played a significant role in the conclusion reached by the Tax Tribunal. The Tax Tribunal held that a domestic tax law provision (i.e. the introduction of the DDT) cannot override what had been agreed in the tax treaty between two sovereign nations.
While the Tax Tribunal has held that the beneficial tax rate provided under the tax treaty prevails over the DDT rate to be applied when a company distributes dividends, the Tax Tribunal has restored the matter to the lower tax authorities, which are now tasked with the limited verification of the existence of the German shareholder’s permanent establishment (PE) in India. If the PE does indeed exist, the lower tax authorities will then determine whether the dividends are effectively connected with such a PE.
The way forward
The ruling of the Tax Tribunal is the first to have ruled on the merits of the issue (i.e. whether DDT on dividends distributed to foreign shareholders should be circumscribed by the tax rate mentioned in the tax treaty). The ruling will now pave the way for several Indian companies with significant foreign parentage (with tax treaty benefits) to make claims for refunds of excess DDT paid over the years.
While the tribunal makes a specific reference to the fact that the India-Germany tax treaty was entered into prior to the introduction of the DDT, in our view, that would not be material in other cases as the Tax Tribunal itself has rightly observed that a domestic tax provision cannot override the provisions of a tax treaty. Accordingly, even where the relevant tax treaty has been entered into after the introduction of the DDT, the Indian company is still eligible to make a claim for a refund by applying the tax rate mentioned in the relevant tax treaty.
Before making the claim for the refund of the DDT, the Indian company will need to determine the strategy with respect to the forum before which the claim should be made. Also, the mode through which the claim for the DDT refund should be made would need to be evaluated based on the facts of each case and certain recent amendments with respect to the form/manner of making the claim for tax refunds.
In addition to the above, the Indian company making the claim for a refund should be able to substantiate that the foreign shareholder:
Is the beneficial owner of the dividend income;
Does not have a PE in India to which the dividend can be said to be effectively connected; and
Is a tax resident of the country whose tax treaty is being sought to be applied to restrict the DDT rate (i.e. a tax residency certificate should be obtained).
The Tax Tribunal’s ruling is not likely to be the final word on the matter and the Indian revenue authorities are likely to contest it before higher courts. In the meantime, the Indian companies that are assessing whether to make a refund claim should do so after careful evaluation of the facts. Matters to examine include the applicability of the most favoured nation (MFN) clause in the relevant tax treaty, the years for which the claim can be made, and the mode/manner of making the claim.
The views reflected in this article are the views of the authors and do not necessarily reflect the views of Dhruva Advisors.
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