Introduction

The purpose of tax treaties is to relieve the double taxation of income in the treaty partner countries. Relief from tax, however, is contingent upon a variety of factors including the identity of the person on whom tax is imposed. Indeed, tax treaties primarily relieve juridical double taxation (i.e. where the same person is subject to tax on the income in both countries), and seldom apply to instances of economic double taxation (i.e. where the same income is taxed in the hands of different persons). These nuances are well brought out in context of the Dividend Distribution Tax (DDT), a tax India imposed on its resident companies on account of their profit distributions. While understood to be a tax on dividends, for various reasons the DDT has not been brought within the purview of India's tax treaties and thus double taxation on its account has remained. DDT has been abolished since April 2020. However, the controversy in respect of past years has remained. This article brings into perspective the issue, a recent order of the Indian Income Tax Appellate Tribunal (Tribunal) which brings DDT within the fold of India's tax treaties, its implications and the way forward for affected non-residents earning dividend income from India.

Context

Ordinarily, since dividends are income of the shareholder, they are taxed in the hands of the shareholders. This implies that the tax residence status, taxability, etc. of each shareholder become relevant in order to determine the taxability of the dividend. The tax is then generally levied through a dividend withholding tax suffered by the shareholder, and tax treaties may reduce the rate of tax applicable in the source country and provide for a tax credit in the country of residence. This was the position in India before 1997 and resumed since April 2020. In the interregnum, however, India applied the DDT, which is characterized not as a dividend withholding tax on account of the recipient, but as an 'additional tax' in the hands of the Indian company declaring the dividend. This was achieved in the Indian law¹ by insertion of a special provision² which obliged the Indian company making a distribution to pay a flat 15% tax on the dividend, without allowance for any deduction³. Simultaneously, all recipient shareholders received the dividend tax-free (i.e. without a dividend withholding tax proper).

The Indian tax authorities took the position that since the DDT was a tax on the Indian company making the profit distribution and not on the (non-resident) shareholders receiving the distribution, it is not a withholding tax on dividends so as to be eligible for tax treaty relief. This position, though undocumented, was perhaps premised on the fact that tax treaty relief is intended for the non-resident recipient, whilst in the case of the DDT, the tax is suffered by the Indian distributing company. It follows that since the non-resident shareholder receives the dividends technically without a withholding tax, no relief can be granted in application of tax treaties. Further, it is the non-residents' State that should determine whether or not to grant a credit for the DDT under its domestic laws. It is understood that the treaty partners of India joined chorus to deny foreign tax credit of DDT paid in India by their tax residents. Interestingly, the tax treaty between India and Hungary specifically provides that DDT would be recognised as a tax on dividends in the hands of the Hungarian resident recipients, and permitting them to claim treaty benefit. These reasons resulted into an additional outgoing in India which added to the cost of earning for foreign investors making equity investments in India⁴.

Tax Tribunal's Decision and its Implications

In a recent decision⁵ in the context of India-Germany tax treaty, the Tribunal had the occasion to consider the issue of DDT's compatibility with the treaty framework. The Tribunal has taken note of the fact that the India-Germany treaty was signed in 1996 where the DDT, as a law of 1997, is seeking to unilaterally amend the legal position vis-à-vis the treaty and is therefore impermissible⁶. There are various implications of this decision on which we had an occasion to elaborate elsewhere⁷. The key takeaway is that the Tribunal has effectively upheld the taxpayer's claim of treaty relief qua DDT.

The foremost aspect of the Tribunal order is that an eligible non-resident would be able to cite the upper tax limit under their respective treaties (which generally range from 5 to 10%, subject to satisfaction of 'beneficial owner' test) to challenge the 15% DDT rate. Furthermore, such reduced tax rate of DDT would be eligible for credit in the residence country. Thus, effectively, the ruling of the Tribunal would obviate the DDT woes altogether for eligible non-residents.

Pragmatically, however, the Tribunal order seems to have lost the sheen considering the delayed adjudication of the issue and given that the DDT has been abolished from April 2020. The decision, obviously, is relevant only to those non-residents who would have suffered DDT and whose assessments or pending appeals are still within the time limit for revision, or those who have claimed a refund or have challenged the DDT on similar grounds. In the event the DDT relates to the period where such limitation has expired, it may be difficult to claim the benefit of the Tribunal's order. Even within those cases where such leeway exists, the availability of relief is neither automatic nor imminent. This is because, given the contentious nature of the issue and the stated position of the Indian tax administration, it is highly unlikely that the issue will not be canvassed in further appeal including up to the Supreme Court of India. Thus, enforcement of the Tribunal's decision would be a challenging task.

There are certain additional aspects which the affected non-residents need to consider. The first is the intrinsic limitation of the reasoning assigned by the Tribunal to grant relief which is contingent upon the fact that the India-Germany treaty predates the DDT law. Considering that a large number of Indian treaties were signed after the enactment of the DDT, it may be difficult to directly transpose the Tribunal's decision across-the-board in all Indian treaties. The second and considerably ominous aspect is that the possibility of a retrospective legislative amendment against the taxpayers cannot be ruled out with fortitude, though, questions can arise in the context of the 'good faith' principle under the Vienna Convention on the Law of Treaties (VCLT). The purported reason assigned for the retrospectivity is the need to clarify and reaffirm the original legislative intent, similar circumstances existing even in the context of DDT. The fact that certain Indian treaty partners have officially confirmed India's position that the DDT is outside the treaty framework, such as the Netherlands, may propel such an approach.

Way Forward

Conservative non-residents may choose a wait-and-watch approach, seeking more definitiveness on the issue once the outcome of the likely appeal by the tax administration is known. The shortcoming in this approach is the likely delay which may occur in staking a claim considering that it will take a while before the final appellate outcome is known. It is likely that the tax administration, and even the appellate forums, may not be sympathetic to a delayed claim considering that the bonafides for such delay may be difficult to explain and instead may appear to be a free-ride situation considering the significant time-lag. Practical sense, therefore, directs that non-residents who have so far not taken a position, stake an immediate claim for tax treaty relief qua DDT. A favourable resolution of the issue at the appellate level, in such eventuality, is very likely to apply even to the pending claims.

Considered from another angle, non-resident shareholders who have already suffered the tax incidence on account of DDT would have been denied the treaty benefit. Thus, the tax effect has already been borne by them. Staking a claim and its subsequent denial, in the event the dispute is ultimately concluded against the taxpayer, would not create any further prejudice, except on account of the legal costs for pursuing the claim. In fact, a build-up of a large number of similar claims would impress upon the stakeholders for an expedited resolution. In short, there is nothing to lose for the non-residents reviving tax treaty relief for DDT qua the earlier distributions and the Tribunal ruling provides a welcome leeway to explore recouping of past-DDT incidence.

Footnotes

¹ Income Tax Act, 1961. (ITA).

² Section 115-O, ITA.

³ Except credit of DDT (paid by the Indian subsidiary distributing the dividend) made available to Indian parent entity, which credit could be set-off against the DDT liability of the parent.

⁴ For details, Tarun Jain & Shreyash Shah, Budget 2020: Contextualising cravings for abolition of Dividend Distribution Tax, https://www.moneycontrol.com/news/economy/policy/budget-2020-contextualising-cravings-for-abolition-of-dividend-distribution-tax-4874911.html

⁵ Giesecke & Devrient dia] Pvt Ltd v. Additional Commissioner of Income Tax come Tax Appeal No. 7075/DEL/2017, order dated 13.10.2020] available at https://www.itat.gov.in/files/uploads/categoryImage/1602586537-7075.Giescke%20&%20Devrient.pdf

⁶ Relying upon Director of Income Tax v. New Skies Satellite BV (2016) 382 ITR 114 (Delhi) available at https://indiankanoon.org/doc/16626780/ to conclude that it is impermissible to unilaterally amend the tax treaties.

⁷ See, Mukesh Butani & Tarun Jain, India's Dividend Distribution Tax: An Anomaly Outside Tax Treaties!, available at http://kluwertaxblog.com/2020/10/23/indias-dividend-distribution-tax-an-anomaly-outside-tax-treaties/