In a bid to revive the Indian economy and restart an investment cycle in India, Finance Minister Nirmala Sitharaman, in an unprecedented move, reduced the corporate tax rate to 15% for new manufacturing companies and 22% for other companies. To move forward in this direction, the 2020 Union budget gives new impetus by abolishing the Dividend Distribution Tax (DDT). This bold move is likely to make India one of the most attractive destinations for foreign investment, albeit at an estimated cost of 25,000 crore to the Treasury.
Prior to June 1997, dividends were taxed in the hands of shareholders like any other income. However, to facilitate the administration and collection of tax in a single point, the taxation of dividends has been transferred from shareholders to companies distributing dividends, with such dividends being exempt from tax in the hands of the shareholders.
That said, the investor fraternity had raised concerns about taxation at multiple levels. At the first level, dividends are distributed out of a company’s profits after tax. At the second level, companies pay DDT on the distribution of these profits. With the super-rich tax levied on shareholders who earn dividends above 10 lakh, there is a three-tiered tax.
In addition, foreign shareholders were subject to DDT at 20 percent, which is usually higher than the dividend tax rate provided for in tax treaties, and these shareholders were not eligible for a tax credit in their country. original for DDT paid for by Indian companies.
A much needed relief
The abolition of DDT provides much needed relief to foreign shareholders, resulting in dividend tax being taxed at lower rates as provided for in tax treaties, and allowing them to claim a tax credit in their home country. From the perspective of the resident shareholder, the super-rich tax is abolished, removing an additional layer of taxation on the profits made by the Indian company.
Taxation of dividends at the shareholder level has made investing in jurisdictions like Mauritius and Hong Kong attractive, with tax treaties providing for a favorable 5 percent tax rate on dividends. However, having substance in these jurisdictions continues to govern the availability of convention benefits.
In the DDT regime, the cascading tax effect has been mitigated for domestic and foreign dividends, subject to the prescribed participation threshold. To address the cascading tax effect of the taxation of dividends under the proposed scheme, an Indian company is allowed to tax deduct dividends paid on the dividend received from another Indian company without any participation threshold. That said, the cascading tax effect on foreign dividends is still not addressed. This will likely discourage Indian multinationals from repatriating the profits of their foreign affiliates to India.
Under the DDT regime, mutualised investment vehicles such as UCIs were previously subject to double taxation: DDT paid by the company distributing dividends to UCIs; and DDT payable by mutual funds at the time of distribution to unitholders. Under the proposed regime, there will be one-tier taxation in the hands of unitholders. There is no tax evasion on the distribution of dividends by the company to mutual funds.
FPI and InvIT
In the case of investment vehicles such as REITs and InvITs, as long as single level taxation continues, the proposed regime would have an impact on cash flow. In this case, an Indian company will be required to withhold tax on dividends distributed to REITs and InvITs. However, under the current tax regime of REITs and InvITs, dividend income from Indian corporations is not taxable. Therefore, taxes withheld by Indian companies will need to be claimed as a refund.
One of the main justifications for adopting the DDT regime was the increased burden of compliance on businesses. With advancements in technology, although some of the compliance issues may be resolved, administrative issues may persist. As the taxation of dividends is transferred to the shareholder, companies will be required to withhold taxes on dividends payable to shareholders.
In the case of resident shareholders, the withholding tax will be 10 percent subject to certain de minimis. In the case of non-resident shareholders, dividends are taxable at 20 percent subject to the favorable tax rate under the tax treaty. However, in order to apply the favorable tax rate under the tax treaty, the Indian company would be required to obtain the legally prescribed documents from the foreign shareholders, which could be a difficult task.
Under the proposed regime, while dividends are taxable in the hands of shareholders, the only deduction allowed would be the interest expense incurred to earn those dividends, subject to a cap of 20 percent of dividend income.
In short, this is a bold and positive step to meet the long-awaited demands of investors. Prior to the adoption of the budget proposals, the removal of the cascading tax effect on foreign dividends received by Indian multinationals is planned. In any case, this approach to rationalizing the taxation of dividends should make it possible to regain the confidence of foreign investors and put the Indian economy back on track.
The author is Partner and Leader, Corporate & International Tax, PwC India. Views are personal