ISSUES IN TAXATION OF DIVIDEND INCOME, Part – 2

1. APPLICATION OF DTAA TO THE ERSTWHILE DDT REGIME
From A.Y. 2004-05 to A.Y. 2020-21, India followed the DDT system of taxation of dividends. Under that regime, the company declaring the dividends was liable to pay DDT on the dividends declared. One of the issues in the DDT regime was whether the DTAAs would restrict the application of the DDT. While this issue may no longer be relevant for future payments of dividends, with the Finance Act, 2020 reintroducing the classical system of taxation of dividends, this may be relevant for dividends paid in the past.

This controversy has gained significance because of a recent decision of the Delhi ITAT in the case of Giesecke & Devrient (India) (P) Ltd. vs. Add. CIT [2020] (120 taxmann.com 338). However, before considering the above decision, it would be important to analyse two decisions of the Supreme Court which, while not specifically on the issue, would provide some guidance in analysing the issue at hand.

The first Supreme Court decision is that of Godrej & Boyce Manufacturing Company Limited vs. DCIT (2017) (394 ITR 449) wherein the question before the Court was whether section 14A applied in the case of dividend income (under the erstwhile DDT regime). The issue to be addressed was whether dividend income was income which does not form part of the total income under the Act. In the said case, the assessee argued that DDT was tax on the dividends and, therefore, dividends being subject to tax in the form of DDT, could not be considered as an income which does not form part of the total income of the shareholder. The Supreme Court did not accept this argument and held that the provisions of section 115-O are clear in that the tax on dividends is payable by the company and not by the shareholders and by virtue of section 10(34) the dividend income received by the shareholder is not taxable. Therefore, the Apex Court held that the provisions of section 14A would apply even for dividend income in the hands of the shareholders.

Interestingly, in the case of Union of India & Ors. vs. Tata Tea Co. Ltd. & Anr. (2017) (398 ITR 260), the Supreme Court was asked to adjudicate on the constitutional validity of DDT paid by tea companies as the Constitution of India prohibits taxation of profits on agricultural income. In this case the Court held that DDT is not a tax on the profits of the company but on the dividends and therefore upheld the constitutional validity of DDT.

Now the question arises, how does one read both the above decisions of the Supreme Court, delivered in different contexts, to give effect to both the orders in respect of DDT. One of the interpretations of the application of DDT, keeping in mind the above decisions of the Supreme Court, is that while DDT is not a tax on the shareholders but the company distributing dividends, it is a tax on the dividends and not on the profits of the company distributing dividends.

One would need to evaluate whether the above principle emanating from both the above judgments could be applied in the context of a DTAA. Article 10 of the UN Model Convention reads as under:

‘(1) Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.
(2) However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State, but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed:…..’ (emphasis supplied).

Therefore, the UN Model Convention as well as the DTAAs which India has entered into provide for taxation of the stream of income and do not refer to the person in whose hands such income is to be taxed. Accordingly, one may be able to take a view that a DTAA restricts the right of taxation of the country of source on dividend income and this restriction would apply irrespective of the person liable for payment of tax on the said dividend income. In other words, one may be able to argue that DTAA would restrict the application of DDT to the rates specified in the DTAA.

Interestingly, the Protocol to the India-Hungary DTAA provides as under,

‘When the company paying the dividends is a resident of India the tax on distributed profits shall be deemed to be taxed in the hands of the shareholders and it shall not exceed 10 per cent of the gross amount of dividend.’

In other words, the Protocol deems the DDT to be a tax on the shareholders and therefore restricted the DDT to 10%.

Further, as Hungary is an OECD member and the DTAA between India and Hungary was signed in 2003, one could also have applied the Most Favoured Nation clause in the Protocols in India’s DTAAs with Netherlands, France and Sweden to apply the above restriction on shareholders resident in those countries.

The Delhi ITAT in the case of Giesecke & Devrient (India) Pvt. Ltd. (Supra) also held that the DDT would be restricted to the tax rates as prescribed under the relevant DTAA. The argument that the Delhi ITAT has considered while applying the tax treaty rate for dividends is that the introduction of the DDT was a form of overriding the treaty provisions, which is not in accordance with the Vienna Convention of the Law of Treaties, 1969 and hence the DTAA rate should override the DDT rate.

Now, the question is whether one can claim a refund of the DDT paid in excess of the DTAA rate applying the above judicial precedents and, if so, which entity should claim the refund – the company which has paid the dividends or the shareholder? In respect of the second part of the question, the Supreme Court in the case of Godrej & Boyce (Supra) is clear that DDT is a tax on the company declaring the dividends and not on the shareholders. Therefore, the claim of refund, if any, for DDT paid in excess of the DTAA rates should be made by the company which has paid the dividends and not by the shareholders.

In order to evaluate whether one can claim refund of the excess DDT paid, it is important to analyse two scenarios – where the case of the taxpayer company is before the A.O. or an appellate authority, and where there is no outstanding scrutiny or appeal pending for the taxpayer company.

In the first scenario, where the taxpayer is undergoing assessment proceedings or is in appeal before an appellate authority, such a refund may be claimed by making such a claim before the A.O. or the relevant appellate authority. While the A.O. may apply the principle of the Supreme Court in the case of Goetze (India) Ltd. vs. CIT (2006) (284 ITR 323), the appellate authorities are empowered to consider such a claim even if not claimed in the return of income following various judicial precedents, including the Bombay High Court in the case of CIT vs. Pruthvi Brokers & Shareholders (P) Ltd. (2012) (349 ITR 336).

In the second scenario, the options are limited. One may evaluate whether following certain judicial precedents this could be considered as a mistake apparent from record requiring rectification u/s 154 or whether one can obtain an order from the CBDT u/s 119.

In the view of the authors, if the taxpayer falls in the category as mentioned in the first scenario, one should definitely consider filing a claim before the A.O. or the appellate authority as even if such claim is rejected or subsequently the Supreme Court rules against the taxpayer on this issue, given that the DDT has already been paid by the taxpayer company, there may not be any penal consequences.

2. ISSUE IN APPLICATION OF MFN CLAUSE IN SOME TREATIES
Another recent issue is the application of the MFN clause to lower the rate of taxation of dividends. While application of the MFN clause is not a new concept, this issue has been exacerbated with the reintroduction of the classical system of taxation.
Article 10(2) of the India-Netherlands DTAA provides for a 10% tax in the country of source. Paragraph IV(2) of the Protocol to the India-Netherlands DTAA provides as follows,

‘If after the signature of this Convention under any Convention or Agreement between India and a third State which is a member of the OECD, India should limit its taxation at source on dividends, interests, royalties, fees for technical services or payments for the use of equipment to a rate lower or a scope more restricted than the rate or scope provided for in this Convention on the said items of income, then as from the date on which the relevant Indian Convention or Agreement enters into force the same rate or scope as provided for in that Convention or Agreement on the said items of income shall also apply under this Convention’ (emphasis supplied).

The India-Netherlands DTAA was signed on 13th July, 1988. Pursuant to this, India entered into a DTAA with Slovenia on 13th January, 2003. Article 10(2) of the India-Slovenia DTAA provides for a lower rate of tax at 5% in case the beneficial owner is a company which holds at least 10% of the capital of the company paying the dividends.

While the DTAA between India and Slovenia was signed in 2003, Slovenia became a member of the OECD only in 2010. In other words, while the Slovenia DTAA was signed after the India-Netherlands DTAA, Slovenia became a member of the OECD after the DTAA was signed.

Therefore, the question arises whether one can apply the MFN clause in the Protocol of the India-Netherlands DTAA to restrict India from taxing dividends at a rate not exceeding 5%.

In this context, the Delhi High Court in a recent decision, Concentrix Services Netherlands BV vs. ITO (TDS) (2021) [TS-286-HC-2021(Del)] has held that one could apply the rates as provided under the India-Slovenia DTAA by applying the MFN clause in the India-Netherlands DTAA. In this case, the assessee sought to obtain a lower deduction certificate from the tax authorities u/s 197 by applying the rates under the India-Slovenia DTAA. However, the tax authorities issued the lower deduction certificate with 10% as the tax rate. Following the writ petition filed by the taxpayer, the Delhi High Court upheld the view of the taxpayer. The Delhi High Court relied on the word ‘is’ in the India-Netherlands DTAA in the term ‘….which is a
member of the OECD…’ of the Protocol. The High Court held that the said word describes a state of affairs that should exist not necessarily at the time when the subject DTAA was executed but when the DTAA provisions are to be applied.

Interestingly, the High Court also referred to the contents of the decree issued by the Netherlands in this respect wherein the India-Slovenia DTAA was made applicable to the India-Netherlands DTAA on account of the Protocol. In this regard, the Court followed the principle of ‘common interpretation’ while applying the interpretation of the issue in the treaty partner’s jurisdiction to the interpretation of the issue in India.

Therefore, one may be able to apply the lower rates under the India-Slovenia DTAA (or even the India-Colombia DTAA or India-Lithuania DTAA which also provide for a 5% rate) to the India-Netherlands DTAA by virtue of the MFN clause in the latter.

Similarly, India’s DTAAs with Sweden and France also contain a similar MFN clause and both the DTAAs are also signed before the India-Slovenia DTAA. Therefore, one can apply a similar principle even in such DTAAs.

However, it is important to consider the practical aspects such as how should one disclose the same in Form 15CB or in the TDS return filed by the payer as the TDS Centralised Processing Centre may process the TDS returns with the actual DTAA rate without considering the Protocol.

3. SOME ISSUES RELATING TO BENEFICIAL OWNER
In the first part of this article, we analysed the meaning of the term ‘beneficial owner’ in the context of DTAAs. This article seeks to identify some other peculiar issues around beneficial owner in DTAAs.

Firstly, it is important to understand that the term ‘beneficial owner’ is used in relation to ownership of income and not of the asset. Therefore, in respect of dividends one would need to evaluate whether the recipient is the beneficial owner of the income. The fact that the recipient of the dividends is a subsidiary of another company may not have any influence on the interpretation of the term. If, however, the recipient is contractually obligated to pass on the dividends received to its holding company, it may not be considered as the beneficial owner of the income.

Article 10 relating to dividends in most of India’s DTAAs requires the recipient of the dividends to be a beneficial owner of the income. For example, Article 10(2) of the India-Singapore DTAA provides as follows,

‘However, such dividends may also be taxed in the Contracting State …… but if the recipient is the beneficial owner of the dividends, the tax so charged shall not exceed….’ (emphasis supplied).

On the other hand, some of India’s DTAAs require the beneficial owner to be a resident of the Contracting State as against the recipient being the beneficial owner. For example, Article 10(2) of the India-Belgium DTAA provides as follows,

‘However, such dividends may also be taxed in the Contracting State ….. but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed….’ (emphasis supplied).
 
Now, the question arises whether the difference in the above languages would have any impact. In order to understand the same, let us consider an example wherein I Co pays dividends to A Co which is a resident of State A and A Co is obligated to transfer the dividends received to its holding company HoldCo, which is also a resident of State A. In other words, the recipient of the income is A Co and the beneficial owner of the income is HoldCo, and both are tax residents of State A.

In case the DTAA between India and State A is similar to that of the India-Singapore DTAA, the benefit of the lower rate of tax under the DTAA may not be available as the lower rate applies only if the recipient is the beneficial owner of the dividends, and in this case the recipient, i.e., A Co, is not the beneficial owner of the dividends.

On the other hand, if the DTAA between India and State A is similar to that of the India-Belgium DTAA, the benefit of the lower rate of tax under the DTAA would be available as the beneficial owner of the dividends, i.e., HoldCo, is a resident of State A. Therefore, one should also carefully consider the language in a particular DTAA before applying the same.

Another peculiar issue in respect of beneficial owner is the consequences of the recipient not being considered as the beneficial owner. The issue is further explained by way of an example.

Let us consider a situation where I Co, a resident of India, pays dividend to A Co, a resident of State A, and A Co is obligated to transfer the dividends received to its holding company B Co, a resident of State B.

In this scenario, the benefit of the DTAA between India and State A would not be available as the beneficial owner is not a resident of State A. This would be the case irrespective of whether the language is similar to the India-Singapore DTAA or the India-Belgium DTAA. Now the question is whether one can apply the DTAA between India and State B as the beneficial owner, B Co, is a resident of State B. While B Co is the beneficial owner of the income, the dividend is not ‘paid’ to B Co. Therefore, the Article on dividend of the DTAA between India and State B would not apply. Moreover, in the Indian context, the entity in whose hands the income would be subject to tax would be A Co and therefore evaluating the application of the DTAA between India and State B, wherein A Co is not a resident of either, would not be possible. Accordingly, in the view of the authors, in this scenario the benefit of the lower rate of tax on dividends in both the DTAAs would not be available.

4. APPLICATION OF THE MULTILATERAL INSTRUMENT (‘MLI’)
Pursuant to the Base Erosion and Profit Shifting Project of the OECD, India is a signatory to the MLI. The MLI modifies the existing DTAAs entered into by India. Some of the Indian DTAAs are already modified, with the MLI being effective from 1st April, 2020. We have briefly evaluated the relevant articles of the MLI which may apply in the context of dividends.

(a) Principal Purpose Test (‘PPT’) – Article 7 of the MLI
Article 7 of the MLI provides that the benefit of a Covered Tax Agreement (‘CTA’), i.e., DTAA as modified by the MLI, would not be granted if it is reasonable to conclude that obtaining the benefit of the said DTAA was one of the principal purposes of any arrangement or transaction, unless it is established that granting the benefit is in accordance with the object and purpose of the relevant provisions of the said DTAA.

In respect of dividends, therefore, the benefit under a DTAA may be denied in case it is reasonable to conclude that the transaction or arrangement was structured in a particular manner with one of the principal purposes being to obtain a benefit of that DTAA.

For example, US Co, a company resident in the US, wishes to invest in I Co, an Indian company. However, as the tax rate on dividends in the India-US DTAA is 15%, it interposes an intermediate holding company in the Netherlands, NL Co, with an objective to apply the India-Netherlands DTAA to obtain a lower rate of tax on dividends (5% after applying the MFN clause and the India-Slovenia DTAA as discussed above). In such a scenario, the tax authorities in India may deny the benefit of the dividend article in the India-Netherlands DTAA as one of the principal purposes of investment through the Netherlands was to obtain the benefit of the DTAA.

The PPT is wider in application than the General Anti-Avoidance Rules (‘GAAR’). Further, as it is a subjective test, there are various issues and challenges in the interpretation and the application of the PPT.

(b) Dividend transfer transactions – Article 8 of the MLI
Article 10(2) of some of the DTAAs India has entered into provide two rates of taxes as the maximum amount taxable in the country of source, with a lower rate applicable in case a certain holding threshold is met. For example, Article 10(2) of the India-Singapore DTAA provides for the following rates of tax as a threshold beyond which the country of source cannot tax:
(i) 10% of the gross amount of dividends in case the beneficial owner is a company which owns at least 25% of the shares of the company paying dividends; and
(ii) 15% in all other cases.

Such DTAAs provide a participation exemption by providing a lower rate of tax in case a certain holding threshold is met.

Article 8 of the MLI provides that the participation exemption which provides for a lower rate of tax in case a holding threshold is met would not apply unless the required number of shares for the threshold are held for at least 365 days, including the date of payment.

Therefore, in case of an Indian company paying dividends to its Singapore shareholder which holds more than 25% of the shares of the Indian company, the tax rate of 10% would be available only in case the Singapore company has held the shares of the Indian company for a period of at least 365 days.

One of the issues in the interpretation of Article 8 of the MLI is that the Article does not specify the manner of computing the period of holding – whether the period of 365 days should be considered for the period immediately preceding the date of payment of dividends, or can one consider the period after the dividend has been paid as well. While one may be able to take a view that as the Article does not require the holding period to be met on the date of the payment of the dividend, the period of holding after the payment of dividend may also be considered. However, there may be practical challenges, especially while undertaking withholding tax compliances for payment of such dividend.

5. ISSUES RELATED TO TAX CREDIT ON DIVIDENDS RECEIVED
Having analysed various aspects in the taxation of dividends in the country of source, we have also analysed some specific issues arising in respect of dividends in the country of residence. India follows the credit system of relieving double taxation.

One of the issues in respect of tax credit is that of conflict of interpretation between both the Contracting States. Let us take an example; F Co, a resident of State A, pays dividend on compulsorily preference shares to I Co, an Indian company. Assume that under the domestic tax law of State A such a payment is considered as interest. Assume also that the tax rate for interest and dividends is 15% and 10%, respectively, under the DTAA between India and State A.

In this scenario, State A would withhold tax at the rate of 15%. Now the question is whether India would provide a credit of 15% or would the tax credit be restricted to 10% as India considers such payment as dividends? The Commentary on Article 23 of the OECD Model Convention provides that in the case of a conflict of interpretation, the country of residence should permit credit for the tax withheld in the country of source even if the country of residence would treat this income differently. The only exception to this rule provided by the Commentary is when the country of residence believes that the country of source has not applied the provisions of a DTAA correctly, would the country of residence deny such higher tax credit.

In the present case, one may be able to contend that the country of source, State A, has correctly applied the DTAA in accordance with its domestic tax law and therefore India would need to provide tax credit of 15% subject to other rules relating to foreign tax credit.

Another peculiar aspect in respect of tax credit for dividends received from a foreign jurisdiction is that of the underlying tax credit. Some of the DTAAs India has entered into provide for an underlying tax credit.

For example, Article 25(2) of the India-Singapore DTAA, dealing with tax credit, provides as under,

‘Where a resident of India derives income which, in accordance with the provisions of this Agreement, may be taxed in Singapore, India shall allow as a deduction from the tax on the income of that resident an amount equal to the Singapore tax paid, whether directly or by deduction. Where the income is a dividend paid by a company which is a resident of Singapore to a company which is a resident of India and which owns directly or indirectly not less than 25 per cent of the share capital of the company paying the dividend, the deduction shall take into account the Singapore tax paid in respect of the profits out of which the dividend is paid.’

Therefore, tax credit would include the corporate tax paid by the company which has declared the dividend. This is explained by way of an example. Let us consider that I Co, an Indian company, is a 50% shareholder in Sing Co, a tax resident of Singapore. Assuming that Sing Co has profits (before tax) of 100 which are distributed (after payment of taxes) as dividend to the shareholders, the tax credit calculation in the hands of I Co would be as follows:
 

6. CONCLUSION

It is also important to evaluate the tax credit article in respect of dividends received from foreign companies in order to examine whether one can apply underlying tax credit as well.