| At a glance
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One of the key areas of concern for foreign investors doing business in India is to structure an efficient mechanism for repatriation of profits. It is critical to design and maintain an appropriate structure that complies with all regulatory requirements, and at the same time ensures tax efficiency.
There are various modes available for repatriation of profits from India.
While several factors, including corporate law, regulatory and exchange controls have a bearing upon the method adopted for repatriation of profits earned in India, tax efficiency continues as one of the key drivers influencing such decisions.
An appropriately designed structure could bring substantial efficiencies from the tax, functional and regulatory perspective.
Present scheme of dividend taxation
The scheme of taxation of dividends for and up to assessment year 2003-04 (year ended March 31 2003) was as follows:
dividend income was taxable in the hands of the recipient;
dividend income was subject to withholding tax at 20% under the domestic law or as per the rates determined by the treaty; and
where the income of a domestic company included dividend from another domestic company, deduction was available to the recipient company to the extent of dividends distributed by it on or before the due date.
Example structures |
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Structure 1: Direct holding in an Indian company (Ind Co ? which may be a wholly owned subsidiary (WOS) or a joint venture company (JV Co)) |
Structure 2: Investment in an Indian holding company (Ind Hold Co) which in turn invests in an Indian company (WOS or JV Co) |
Structure 3: Investment in an Indian company through an offshore holding company in an appropriate jurisdiction, say Mauritius. |
Structure 4: A branch in India (which may be either direct out of headquarters or through an offshore structure in an appropriate jurisdiction) |
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The recent Budget proposals means significant changes in the tax treatment of dividends distributed by domestic Indian companies. The ultimate impact of the proposed changes in the scheme of dividend taxation would vary depending upon the adopted structure. |
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Legislative history
Before June 1 1997 dividends were taxable as income in the hands of the shareholders. The law was amended with effect from June 1 1997, shifting the burden of dividend tax from the shareholders to the companies. This remained effective till March 31 2002. Hence from June 1 1997 to March 31 2002, domestic companies distributing dividends were liable to pay a dividend distribution tax (DDT) and the dividend was exempt in the hands of the shareholders. However, from April 1 2002, the law reverted to taxing shareholders instead. The present Budget proposes to reintroduce DDT with effect from April 1 2003. The legislative history as regard to tax treatment of dividends is summarized in table 1.
While the changes in the past six years suggests lack of clear thinking as regard the policy of dividend taxation, it throws up added challenges while developing an appropriate structure in such an environment, due to the absence of a stable tax regime. Given the frequent shifts in the policy, it would be worthwhile adopting a proactive approach and put in place a structure that would work in a tax-efficient manner under both the scenarios - irrespective of whether there is in place a withholding tax or a DDT.
Dividends declared, distributed or paid |
Tax on the domestic company distributing dividend |
Tax on the shareholders receiving dividend |
Before June 1 1997 |
Nil |
Taxable |
On or after June 1 1997 and up to March 31 2002 |
DDT |
Exempt |
On or after April 1 2002 and up to March 31 2003 |
Nil |
Taxable |
On or after April 1 2003 (proposed) |
DDT |
Exempt |
Proposed scheme of dividend taxation
From April 1 2003 dividends whether paid out of current profits or accumulated profits will be charged to an additional income tax (in addition to corporate income tax on profit of the company) by way of DDT at 12.8125% (inclusive of surcharge) of the dividends declared and paid.
Simultaneously the Budget proposes that such dividends that have been subject to DDT in the hands of the company would be exempt from tax in the hands of the recipient shareholder.
Admittedly DDT being a single point tax on the company brings an element of simplicity and efficiency in tax collection, compared to the scheme of levy of tax on the shareholders, which was cumbersome and involved considerable logistics effort especially for listed companies with large number of shareholders.
Applicability of the new scheme
The provisions of DDT would apply to all dividends distributed by a domestic company whether paid to resident or non-resident shareholders and covers all categories of shareholders (including corporate shareholders). Correspondingly, dividend income will be exempt in the hands of all categories of shareholders including non-residents/ foreign companies receiving dividends from domestic companies.
The proposed amendment would apply to dividends in respect of all classes of stock and accordingly would apply to dividends in respect of equity (whether voting or non-voting) as well as preference stocks irrespective of whether the securities are listed or otherwise.
The term dividend has an extended meaning and includes inter alia any distribution made to shareholders, on liquidation of a company or on reduction of capital to the extent it has accumulated profits, whether capitalized or not. The proposed amendments would equally apply even to such distributions that are deemed to be dividends.
Since the shift to the new scheme is proposed to be made effective from April 1 2003, in the absence of the proposals having been enacted into law (the Budget is typically passed by the Parliament in May) one would need to carefully examine the tax treatment that would be applicable in respect of dividends declared, distributed or paid on or after April 1 2003 but prior to the enactment of the new law. The law provides that in such situations, the scheme most beneficial to the taxpayer would apply.
Withholding tax
With dividend income exempt in the hands of the shareholders, the Budget proposes consequential amendment of the various withholding tax provisions to ensure that dividend income will not be subject to withholding tax in respect of dividends declared, distributed or paid on or after April 1 2003.
Expenditure
It has been proposed that expenditure incurred for the purposes of realizing such dividends would not be admissible for tax purposes.
Hence expenses directly relatable to such exempt dividends would clearly be inadmissible while computing the income. But there is some room for debate on whether expenses of a general nature that are not directly relatable to such exempt dividend income would need to be proportionately allocated (see table 2) to such dividends and disallowed on the ground that to the extent of the said proportion they are to be regarded as expenditure incurred in relation to such dividend income.
Amount |
|
Dividend income (exempt) (a) |
200 |
Non-exempt income (b) |
300 |
Total income (a) + (b) = (c) |
500 |
General administrative expenses (d) |
100 |
Expenditure proportionately allocated to dividend income (d) / (c) X (a) |
40 |
Dividend-stripping provisions
Another consequential impact arising from the new proposal would be reactivation of the dividend-stripping provisions.
The law stipulates that if a taxpayer, having purchased shares during a period of three months prior to the record date, transfers the said shares within three months after such date, the loss, if any, arising from such transactions would not be admissible for tax purposes to the extent of the amount of the exempt dividends earned on the stock.
Inter-corporate dividend income deduction
The law presently provides that in the case of dividends received by an Indian company, from another Indian company, the former (recipient) will be granted a deduction in respect of its dividend income to the extent of amount distributed by it as dividend on or before October 31 immediately following the expiry of the financial year in which the dividend is earned.
Since dividend income is now sought to be made exempt in the hands of the recipient, the said provision is proposed to be dropped. However, a company having dividend income for assessment year 2003-04 (year ended March 31 2003) would continue to qualify for such deduction if it in turn distributes the dividend received by it to its shareholders on or before October 31 2003. Such distribution would of course attract DDT in the hands of the latter company.
Cascading effect
While taxing dividend income in the hands of a shareholder may be regarded as resulting in double taxation, the inter-corporate deduction ensured that there was no cascading effect of dividend taxation. However, with the proposed deletion, there would be multiple levying of DDT, with each company's distribution to its immediate holding company being separately subject to DDT.
Minimum alternate tax
The law currently levies a minimum alternate tax (MAT) on the book profits of companies. Consequently, domestic-holding companies receiving dividends could presently become subject to MAT even if they distribute the entire dividends received to their shareholders. This is in view of the fact that the dividends received enters the computation of book profits for the purposes of MAT, notwithstanding the deduction for normal tax computation (see table 3).
Taxable income as per normal provisions |
Book profits for the purposes of MAT |
|
Dividend income (there is no other income) |
100 |
100 |
Less: deduction for inter-corporate dividends |
100 |
Not deductible |
Taxable income / book profits |
Nil |
100 |
Tax at 36.75% MAT at 7.875% |
Nil |
7.875 |
As a result of the proposed amendment, the provisions of MAT would not be applicable to such dividends since for the purposes of computing book profits, any income exempt from tax (including dividends) has to be excluded from book profits (see table 4).
Taxable income as per normal provisions |
Book profits for the purposes of MAT |
|
Dividend income (there is no other income) |
100 |
100 |
Less: deduction for inter-corporate dividends |
100 |
100 |
Taxable income / book profits |
Nil |
Nil |
Tax at 36.75% MAT at 7.875% |
Nil |
Nil |
Withholding tax on dividends to non-resident shareholders
Presently, dividends are chargeable to tax in the hands of non-residents at 21% (with a special lower rate applicable in the case of certain category of non-residents).
In this context, it may be pointed out that the DDT rate of 12.813% may not be directly comparable with the withholding tax rate of 21%. This is because while the withholding tax rate applies to the gross amount of dividends, the DDT rate is to be applied on the dividends actually distributed. Hence the effective rate of DDT on the gross amount available for distribution of dividends would be 11.357% (see table 5).
Amount |
|
Dividend [(a)] |
100 |
DDT at 12.8125% (12.5% + surcharge at 2.5%) [(b)] |
12.8125% |
Total dividend outflow [(c) = (a) + (b)] |
112.8125 |
DDT as a percentage of dividend outflow [(b) / (c)] |
11.357% |
Consequently for non-resident shareholders (foreign investors), the proposed move to DDT may be beneficial from an Indian tax perspective and may reduce the overall tax cost on dividends from 21% to 11.357%.
Withholding tax under the relevant treaty
India has a wide network of tax treaties and depending on the applicable treaty, the dividend withholding tax rate could be even lower, ranging say from 5% to 15% (see table 6).
Present withholding tax rates |
Amount |
Under the Income-Tax Act |
21% |
Under the DTAA with USA, UK, Australia, Japan |
15% |
Under the DTAA with Switzerland, Netherlands, France, Germany, South Africa |
10% |
Under the DTAA with Mauritius |
5% |
Proposed rate |
|
DDT under the Act |
11.357% |
Consequently, the proposed move to DDT may or may not be beneficial depending on the jurisdiction through which the investments in India have presently been structured.
The focus of the present article is to analyze the proposed changes in the scheme of dividend taxation, the impact of the proposed changes on each of the structures is summarized below.
Impact on structure 1
The proposed amendment would result in saving in tax cost (of 2.21) in case of structure 1 (see table 7). The saving arises due to the fact that the effective DDT rate of 11.357% is less than the dividend withholding tax rate of 15% under the India-US Treaty.
AY 2003?04 |
AY 2004-05 (proposed) |
Change |
|
Profit before tax |
100 |
100 |
|
Less income-tax at 36.75% or 35.875% (a) |
36.75 |
35.88 |
|
Profit available for distribution of dividend |
63.25 |
64.12 |
|
Withholding tax at 15% / DDT at 11.357% (b) |
9.49 |
7.28 |
(2.21) |
Total tax (a) + (b) |
46.24 |
43.16 |
Impact on structure 2
While a similar saving (of 2.28) arises due to the lower DDT as compared to the dividend withholding tax in case of structure 2 (see table 8), due to the cascading effect of DDT (discussed earlier), the savings are eroded and there is a nominal increase in tax cost (0.02, which is 2.30 less 2.28). In fact the additional tax cost due to the cascading effect of DDT would have been much higher (7.28 instead of 2.30) if the Indian Holding Company had not been subject to MAT in assessment year 2003-04.
AY 2003?04 |
AY 2004-05 (proposed) |
Change |
|
Profit before tax |
100 |
100 |
|
Less income-tax at 36.75% or 35.875% (a) |
36.75 |
35.88 |
|
Profit available for distribution to Ind Co |
63.25 |
64.12 |
|
MAT at 7.875% (Ind Hold Co) DDT at 11.357% (Ind Co) (b) |
4.98 |
7.28 |
2.30 |
Profit available for distribution of dividend |
58.28 |
56.84 |
|
Withholding tax at 15% / DDT at 11.357% (c) |
8.74 |
6.46 |
(2.28) |
Total tax (a) + (b) + (c) |
50.47 |
49.62 |
Impact on structure 3
In case of structure 3, the proposed amendment would lead to an increase in the tax cost (by 4.12) as is evident from table 9. The increase arises due to the effective DDT rate of 11.357% being more that the dividend withholding tax rate of 5% under the India Mauritius Treaty. Although admittedly the DDT of 11.357% is payable by the domestic company and not by the shareholder (who is a Mauritius resident entitled to treaty benefits), it may be worthwhile examining whether it would be possible to contend that the DDT should be capped at 5% in accordance with article 10 read with article 2(2) of the India-Mauritius Treaty.
AY 2003?04 |
AY 2004-05 (proposed) |
Change |
|
Profit before tax |
100 |
100 |
|
Less income-tax at 36.75% or 35.875% (a) |
36.75 |
35.88 |
|
Profit available for distribution of dividend |
63.25 |
64.12 |
|
Withholding tax at 5% / DDT at 11.357% (b) |
3.16 |
7.28 |
4.12 |
Total tax (a) + (b) |
39.91 |
43.16 |
For tables 7, 8 & 9, if dividend rate exceeds 10%, statutory transfer to reserves would be required, which may range between 0-10% of the profits.
Impact on structure 4
For obvious reasons, the proposed amendment in the scheme of dividend taxation does not have any impact in case of structure 4. The reduction in tax cost from 42 to 41 (see table 10) arises entirely due to reduction in the rate of corporate tax surcharge.
AY 2003?04 |
AY 2004-05 (proposed) |
|
Profit before tax Less income-tax at 42% / 41% |
100 42 |
100 41 |
Profit available for remittance |
58 |
59 |
Total tax |
42 |
41 |
While there is no change proposed in the corporate income tax rates (35% for domestic companies and 40% for foreign companies), the surcharge is proposed to be reduced from 5% to 2.5%, thus reducing the effective corporate tax rate from 36.75% to 35.88% for domestic companies and from 42% to 41% for foreign companies.
A comparison of the total tax cost for assessment year 2004-05 under each of the four structures would suggest that structure 4 is the most tax efficient.
The corporate tax rates applicable to foreign companies in India have historically been higher than the rates applicable to domestic companies. The result has been that in case of a subsidiary structure, the total tax cost (comprising corporate tax plus withholding tax on dividends (or DDT)) has always been lower than the tax cost of a branch structure. However, the total tax cost of a subsidiary structure aggregating to 43.157% (see table 11) for the first time exceeds the tax cost of a branch structure, 41%.
Amount |
|
Profit before tax |
100.00 |
Less Income-tax at 35.875% (a) |
35.875 |
Profit available for distribution of dividend |
64.125 |
DDT at 11.357% (b) |
7.282 |
Total tax (a) + (b) |
43.157 |
A domestic subsidiary company may or may not be in a position to repatriate its entire post-tax profits in view of the Companies Rules 1975 (transfer of profits to reserves), requiring mandatory transfer of a stipulated percentage of profits to reserves, up to a maximum of 10%.
Again the tax inefficiency arising from the possible denial of tax credit in the home country in respect of the Indian DDT (refer discussion on foreign tax credit mentioned below) would not arise in the case of a branch structure.
In summary, the choice of the structure would need to take into account other tax consequences including capital-gains tax, impact in the home country and intermediary offshore jurisdiction, if any. Further, the impact of Indian corporate law and exchange control needs to be adequately factored into the decision-making process.
Foreign tax credit
Further, in order to have an overall tax perspective, one needs to examine the impact on the entitlement to tax credit in the home country in respect of the DDT paid in India. While under most treaties (and domestic tax laws of the home country), withholding tax on dividend clearly qualifies for tax credit, the same may or may not be true in regard to DDT.
Admittedly most of the Indian treaties generally define tax to include "any identical or substantially similar taxes which are imposed after the date of signature of the Convention in addition to, or in place of, the existing taxes".
The Indian Finance Minister, in his Budget speech, categorically stated that it is proposed that dividends be tax-free in the hands of the shareholders and that there will be a dividend distribution tax on domestic companies. In light of the above, it remains to be seen whether it can be argued that DDT is a tax identical or substantially similar to dividend withholding tax, and therefore should qualify for tax credit.
Again, several treaties signed by India provide for grant of underlying tax credit to the parent company in the home country. Accordingly, if it can be argued that DDT is income-tax paid by the domestic company with respect to the profits out of which dividends are paid, the same would qualify for tax credit as underlying tax. The language of the proposed provision seems to indicate that DDT is an income-tax in addition to the normal corporate income-tax.
Further, DDT being a levy under the Income Tax Act, is a charge/tax on the income of the taxpayer (domestic company). Hence, it can be argued that DDT should qualify for underlying tax credit. In the past, Mauritius revenue authorities have taken a liberal view and ruled that suitable credits would be available on Indian DDT, and UK's Inland Revenue guidance note had also confirmed that Indian DDT would qualify for relief as underlying tax. The issue under the US treaty continues to be debated.
Nonetheless, a firm conclusion as to whether or not DDT would be creditable in the home country would need to be examined in the light of the relevant applicable treaty as well as the domestic tax laws in the home country.
Mukesh Butani (mukesh.butani@in.ey.com), New Delhi
