By Mayur B. Nayak, Tarunkumar G. Singhal, Anil D. Doshi, Chartered Accountants
International Taxation
1. Overview :
The taxation of dividends has its origin in the classical
system of taxation, which in fact taxes corporate profit twice: once at the
company level and again at the shareholder level where the company’s profits
after tax are distributed by way of dividend to its shareholders. This is known
as economic double taxation as distinct from juridical double taxation. In
simple words, economic double taxation means double taxation of the same items
of economic income in the hands of different taxpayers.
From a tax policy perspective, economic double taxation
distorts investment decision making, and therefore the optimally efficient
allocation of resources, by inducing tax payers to invest by means of channel
that provides the best after-tax return, rather than by means of the most
appropriate commercial route to achieve the best pre-tax return.
2. Meaning of underlying Tax Credit :
Underlying tax credit relieves the economic double taxation
on foreign dividend income. The underlying tax credit is given for the pro-rata
share of the corporate tax paid by the foreign dividend distributing company. It
is computed as percentage of the corporate tax paid by the company that the
gross dividend distribution bears to the after-tax profits. The net dividend
received plus the withholding tax, if any, is taken as percentage of the related
after-tax profits of the paying company and multiplied by the corporate tax
paid. Dividend is grossed up by the underlying tax credit to compute the foreign
income subject to tax in home country. The ordinary credit limitation is applied
on the grossed-up dividend.
The underlying tax (or indirect) credit system on foreign
dividends is found in several countries under their domestic laws or tax
treaties. These countries include Argentina, Australia, Austria, Canada,
Denmark, Estonia, Finland, Germany, Greece, Ireland, Japan, Korea, Malta,
Mauritius, Mexico, Namibia, Nigeria, Singapore, Spain, Poland, the UK and the
US. It typically only applies if :
- The shareholder has a significant shareholding in the dividend distributing
company (e.g. in the UK, 10% is needed), and
- The shareholder is a company.
Upon receipt of a dividend by the shareholder, the pre-tax
income of the distributing company is included as a taxable income. The
shareholder jurisdiction’s normal rate of company tax is then applied, but the
resulting tax (mainstream tax) is reduced by the company tax paid by the
dividend distributing company (i.e., reduced by the underlying tax). If
the underlying tax exceeds the amount of mainstream tax then there will be no
further tax to pay by the shareholder, who will, thus, receive tax-free
dividends.
The result is that the group will always pay the higher of
the two taxes — the dividend distributing company tax or the shareholder country
tax.
It is referred to as underlying tax credit because credit is
given for the tax paid in the underlying entity. It is also referred to as the
‘Indirect tax credit’ method because shareholder receives credit for tax which
it has only paid indirectly. In the U.S. Internal Revenue Code the same is
referred to a ‘Deemed paid credit’. The concept of ‘Imputation Credit’ is almost
similar to underlying tax credit.
In addition, most jurisdictions provide for a tax credit to
the parent company for the foreign tax paid by the subsidiary when its
undistributed income is attributed under the Controlled Foreign Corporation
Rules. In this article the focus is on underlying tax credit in respect of
dividend income.
3. Example of the underlying tax credit :
Company X is a resident of the UK and owns 60% share capital
of Company Y, a resident in India. Tax rate in India is assumed to be 34% and
tax rate in the UK is assumed to be 28%. Company X has no other taxable income
in the UK.
Since the dividends may be paid out of both current and past profits, domestic law or practice generally provides the ‘ordering rules’. These rules relate the dividends to the relevant post-tax profit out of which the distribution has been made and the creditable tax is determined by the effective tax rate imposed on those profits. In the US, the dividends are deemed to be distributed from a pool of retained profits and the underlying foreign tax is the average effective tax rate.
The computation is also affected by the exchange rate used to translate the creditable foreign tax. It could be either the rate prevailing at the time of payment of the foreign tax (historical rate), or the rate when the dividend was distributed (current rate). The US law requires that the foreign tax be translated at the historical rate, while the United Kingdom generally applies the current rate.
4. Underlying tax credit in respect of taxes paid by the lower tier companies:
In the context of International business structuring, it is quite common for the Multinational Enterprises (MNEs) to structure their business operations in various countries by way of creating various subsidiaries of the same parent company and to have further downward subsidiary companies of its subsidiary companies, to achieve their business objective in most efficient and profitable manner. The subsidiaries and the subsidiaries of the subsidiary companies are commonly referred to as ‘lower tier companies’.
Many countries allow the underlying tax credit computation to include taxes paid by lower tier companies. For example, Australia, Ireland, Mauritius, South Africa, and the UK allow the credit for taxes suffered by all lower tier companies, provided prescribed minimum equity or voting rights are maintained at each tier. Similarly Argentina, Japan and Norway permit the underlying tax credit upto two tiers of subsidiaries, Spain gives the underlying tax credit for taxes paid upto three tiers and the United States grants them upto 6 tiers, of qualifying foreign subsidiaries.
Thus, for example, a UK parent company investing in a Mauritian subsidiary, which in turn invests in its Indian subsidiary, subject to fulfillment of the shareholding percentage and other relevant conditions and compliance with regulations, would be eligible to take credit of underlying corporate taxes paid by the Indian subsidiary, to the extent of dividends paid by Indian Company, which are forming part of the dividends paid by the Mauritian Company, against the tax payable in respect of dividends received by the UK Company in UK.
5. Significance of underlying tax credit :
Foreign tax credit planning plays a major role in structuring investments in a foreign tax jurisdiction, in case of various multi-nationals based in jurisdictions such as the UK, the US and Ireland etc., where the credit system predominates and where the underlying tax credit is given. India’s Double Taxation Avoidance Agreements (DTAAs) with ten countries contains the provisions regarding underlying tax credit in respect of dividends paid by a company resident of India. Similarly India’s DTAAs with Mauritius and Singapore contain the provisions regarding underlying tax credit in respect of dividends paid by a Mauritian or Singaporean company.
In respect of planning for all inbound investment into India, from the countries where the respective DTAAs with India/ domestic law contain the underlying tax credit provisions, it is very important to keep in mind the exact operation of respective -1 underlying tax credit provisions in the DTAAs/ domestic law, to arrive at the net tax cost of the MNE/Group in respect of dividend income. This will facilitate a proper decision-making in respect of investments into India. However, it is important to note that a detailed knowledge of the domestic law provisions of the underlying tax credit in the respective jurisdictions is of utmost importance. Therefore, wherever required, the services of the local consultants/tax experts may be utilised to know the law and practice in respect of exact operations of the underlying tax credit provisions.
In respect of outbound investments also, a proper consideration of the underlying tax credit would be of great help in properly arriving at the actual net tax cost of the enterprise/ group in respect of dividends and thus making the right investment decisions.
6. Underlying tax credit under Indian Scenario:
India does not have any domestic regulations in respect of underlying tax credit. However, as mentioned above, India’s DTAAs with ten countries contain the provisions relating to underlying tax credit. The relevant provisions relating to underlying tax credit contained in various articles are given below for ready reference:
In most of the above mentioned DTAAs, the definition of the term ‘Indian tax payable’ include provisions relating to tax sparing for the ordinary tax credit. However, in respect of DTAA with Ireland, the provisions relating to tax sparing are includible only in respect of clause relating to underlying tax credit.
It is interesting to note that in case of India’s DTAAs with 9 counties (except Singapore), the relevant provisions of the Articles mention about the under-lying tax credit where a dividend paid by a company which is a resident of India to a company which is a resident of the other state. However, in case of Singapore in Article 25(4) of the India-Singapore DTAA, it is mentioned that a dividend paid by a company which is a resident of India to a resident of Singapore. Thus apparently, in case of Singapore underlying tax credit would be available even if the shares in Indian company are not held by any Singaporean Company but are held by any other resident of Singapore.
7. Domestic regulations in respect of underlying tax credit in some of the important jurisdictions:
(a) Mauritius:
Provisions relating to underlying foreign tax credit are contained in Regulation 7 of the Income-tax (Foreign Tax Credit) Regulations, 1996. These regulations have been made by the Ministry u/s.77 and u/s.161 of the Income-tax Act, 1995.
(b) Credit for underlying taxes
As regards dividends received from subsidiary, the state in which the parent company is a resident gives credit as provided for in paragraph 2 of Article 23A or in paragraph 1 of Article 23B, as appropriate, not only for the tax on dividends as such, but also for the tax paid by the subsidiary on the profits distributed (such a provision will frequently be favoured by States applying as a general rule the credit method specified in Article 23B).”
(c) United States:
The provisions relating to underlying tax credit referred to in the Internal Revenue Code of 1986, as ‘Deemed Paid Credit’ are contained in section 78 and 902 of the Code.
8. OECD Commentary:
Paras 49 to 54 and para 69 of the commentary on Articles 23A & 23B summarise the OECD approach towards tax credit in respect of dividends from substantial holdings by a company. It recognises that recurrent corporate taxation on the profits distributed to parent company: first at the level of subsidiary and again at the level of the parent company, creates very important obstacle to the development of international investments. Many states have recognised this and have inserted in the domestic laws provisions designed to avoid these obstacles. Moreover, provisions to this end are frequently inserted in double taxation conventions. In view of the diverse opinions of the states and the variety of the possible solutions, it preferred to leave the states free to choose their own solution to the problem. For states preferring to solve the problem in their conventions, the solutions would most frequently follow one of the principles i.e. credit for underlying taxes.
Paragraph 52 of OECD Commentary on Article 23A & 23B mentions as under:
“(b) Credit for underlying taxes
As regards dividends received from subsidiary, the state in which the parent company is a resident gives credit as provided for in paragraph 2 of Article 23A or in paragraph 1 of Article 23B, as appropriate, not only for the tax on dividends as such, but also for the tax paid by the subsidiary on the profits distributed (such a provision will frequently be favoured by States applying as a general rule the credit method specified in Article 23B).”
9. Dividend Distribution Tax:
It is important to note that the Dividend Distribution Tax (DDT) paid by the Indian company u/s.115-0 of the Indian Income-tax Act, 1961 may not be the same as “the Indian tax payable by the company in respect of the profits out of which such dividend is paid” as used in relevant articles of the various DTAAs mentioned above containing underlying tax credit provisions. Whether the DDT will be available as ordinary tax credit, is an issue not free from doubt and litigation. We have been given to understand that U.S. allows credit for DDT in USA under the provisions of S. 904 of the Internal Revenue Code. Similarly, we understand that Mauritian authorities have issued a circular clarifying that DDT credit would be available in Mauritius.
10. Conclusion:
From the above, it is evident that the concept of underlying tax credit is very important in mitigating the economic double taxation of dividends paid to companies. This is equally important in planning both inbound and outbound investments. However, in view of the complexities, one will have to carefully understand the provisions of the domestic laws of the applicable foreign tax jurisdictions and treaties before applying the same.
Bibliography:
1. Basic International Taxation, Second edition, Volume-l : Principles, by Roy Rohatgi, Chapter 4, Para 8.4.3 page 281.
2. International Tax Policy and Double Tax Treaties – An introduction to Principles and Application by Kevin Holmes. Chapter 2, page 37 to 38.
3. Interpretation and Application of Tax Treaties, by Ned Shelton. Chapter 2, Para 2.52, page 101.
