Applicability of Tax Treaty Rate on DDT
- Blog|International Tax|
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- Last Updated on 19 July, 2022
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1. Introduction:
The taxation of dividend is specifically prescribed in Income-tax Act, 1961 (‘the Act’) as well as the relevant tax treaties, however, a recent judgment by ITAT-Mumbai in the case of SGS India (P.) Ltd. v. Addl. CIT [2017] 83 taxmann.com 163 has examined an interesting question as to whether the rate of DDT as prescribed in the Act can be limited to the rate as specified in the tax treaty. Although ITAT-Mumbai has not given its conclusion and has remanded this issue back for detailed examination, this article seeks to analyse the possible arguments around this issue.
2. Relevant statutory and tax treaty provisions :
Before we examine this issue in detail, it is pertinent to note the relevant statutory provisions in this regard. DDT is levied vide section 115-O of the Act, which specifies:
“Notwithstanding anything contained in any other provision of this Act and subject to the provisions of this section, in addition to the income-tax chargeable in respect of the total income of a domestic company for any assessment year, any amount declared, distributed or paid by such company by way of dividends (whether interim or otherwise) on or after the 1st day of April, 2003, whether out of current or accumulated profits shall be charged to additional income-tax (hereafter referred to as tax on distributed profits) at the rate of fifteen per cent.” (Emphasis supplied)
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The enactment of section 115-O was accompanied by the introduction of a new clause (34) in section 10, which excludes dividends from the scope of total income.
Tax treaties signed by India contain specific provisions relating to the taxation of dividends. While the exact language and applicable rates may differ from treaty to treaty, the language used in the India-Swiss tax treaty (relevant extract reproduced below) can be referred to as a representative sample:
“ARTICLE 10: DIVIDENDS:
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 10 percent of the gross amount of dividends
3. The term “dividends” as used in this Article means income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders’ shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the taxation law of the State of which the company making the distribution is a resident……”
3. Analysis:
The issue of applicability of the tax treaty rate to DDT must be approached after addressing another critical issue – whether DDT is a tax on the Company or the shareholder, since the distributable surplus stands reduced to the extent of DDT. In this regard, attention is drawn to the decision of the Bombay High Court in the case of Godrej & Boyce Mfg. Co. Ltd v. Dy. CIT [2010] 194 Taxman 203/328 ITR 81 which was rendered in the context of Section 14A vis-à-vis Section 115-O of the Act. The Court observed that –
“The effect of section 115-O is that in addition to the Income-tax chargeable on the total income of a domestic Company, additional Income-tax is charged on profits declared, distributed or paid. This tax which is referred to as a tax on distributed profits is what it means, namely, a tax on the profits of the Company. This is not a tax on dividend income. Under section 115-O, the charge is on a component of the profits of the Company; that component representing profits declared, distributed or paid. The tax under section 115-O is not a tax which is paid by the Company on behalf of the shareholder, nor does the Company act as an agent of the shareholder in paying the tax.
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Provisions contained in Chapter XII-D are special provisions relating to tax on the distributed profits of domestic companies. Even section 115-O in Chapter XII-D clearly states that the additional income-tax liability thereunder is on the amount of profits declared, distributed or paid by a domestic company as dividend. Thus, the additional Income-tax under section 115-O is a tax on profits and not a tax on dividend
The general principle of law is that a Company is chargeable to tax on its profits as a distinct taxable entity and has to pay tax in discharge of its own liability and not on behalf of or as an agent of its shareholders. This position of the general law is recognized and incorporated in section 115-O and is not overridden by the statutory provision”
Thus, the Court had unequivocally held that DDT is a tax on the company and not a shareholder. A similar position has been consistently upheld by the ITAT Mumbai in the cases of Sunash Investment Co v. Asstt. CIT [2007] 14 SOT 80 (Mum. – Trib.), Mohananlal M. Shah v. Dy. CIT [2007] 105 ITD 669 (Mum) and Asstt. CIT v. Dakshesh S. Shah [2004] 90 ITD 519 (Mum).
The issue which now arises and needs deliberation is whether a lower tax rate as specified in the treaty can be invoked when the tax is considered to be paid by the company and not the shareholder.
The context of Article 10 appears to suggest that it was designed to apply to cases where dividends are sought to be taxed in the hands of shareholders by the country where the company is tax resident. Reference may be made to the provisions of the India-Hungary tax treaty where specific language has been considered necessary in order to bring DDT within the scope of Article 10 dealing with dividends.
It is expressly provided in this treaty that any dividend which is paid by an Indian company and which is subjected to tax on distributed profits is deemed to be taxed in the hands of the shareholders and it shall not exceed 10% of gross amount of dividend. In the absence of a similar provision in other tax treaties, it could be argued that the DDT rate should not be replaced with the tax treaty rate.
It is important to note that a similar argument on applicability of tax treaty to DDT was considered and rejected by the South African High Court in the case of Volkswagen of South Africa (Pty) Ltd. v. CIT South African Revenue Service [Case No. 24201/2007, dated 25-4-2008]. The issue before the High Court was whether ‘secondary tax on companies’ (STC) (akin to DDT) levied as per the South African domestic tax law could be regarded as a tax covered within the ambit of the South Africa-Germany tax treaty. Article 7 of the South Africa-Germany tax treaty provided for a withholding tax rate of 7.5% under the Dividend Article whereas the STC was levied at 12.5%. The High Court held that that STC was not a tax on dividends but was a tax imposed on the company declaring the dividends and hence outside the ambit of the tax treaty (unlike in the case of non-resident shareholder tax, which is imposed on the shareholder).
However, it is worthwhile to note that the language of Article 10 makes no reference to the person in whose hands such dividend income is taxable. It simply states that the tax charged on dividends declared by a company resident in a contracting state shall not exceed a specified percentage. Accordingly, the fact that the liability to DDT under the Act falls on the Company may arguably not be relevant when considering the applicability of rates of dividend tax set out in tax treaties.
Also, if one were to consider the generally accepted principles regarding interpretation of treaties in the light of their stated objective of eliminating double taxation, the application of tax treaties to DDT does not appear to be barred. As held by the Supreme Court in the case of Ram Jethmalani v. Union of India [2011] 13 taxmann.com 189/202 Taxman 115, a treaty does not need hyper-technical or hair splitting interpretation. The treaty needs to be interpreted as a commercial document between two private parties. On this basis, it may be possible to suggest that the treaty rate could be adopted for the purposes of DDT, especially considering the potential double taxation which could arise.
It is also important to examine the legislative history of Section 115-O of the Act. The Memorandum to the Finance Bill, 1997 discusses the erstwhile system of collecting income-tax on profits distributed (i.e. dividends) by companies and the relevant extract is reproduced below –
“Under the existing system of collection of tax on dividends, every company, at the time of paying dividend to a shareholder in excess of Rs. 2500, is required to deduct tax at the specified rate and deposit it in the Central Government account. The company is also required to issue TDS certificates to all shareholders in whose cases the tax has been deducted. The shareholders, in turn, have to show the dividend in their return of income and pay the tax at the rate applicable in their case. They also have to enclose the TDS certificates along with the return and claim credit for the tax deducted at source. Many a time, the tax deducted or a part thereof is required to be refunded to the assessee. Thus the procedure for tax collection is cumbersome and involves a lot of paper work.“
The Memorandum further discusses that since the aforementioned mechanism in the erstwhile system was cumbersome, it was advisable to adopt a single point Income-tax levy approach with respect to dividends. Accordingly, the Finance Bill, 1997 proposed to levy additional Income-tax on the profits (i.e. dividends) distributed by domestic companies to their shareholders.
The Memorandum to the Finance Bill, 2003 reiterated that it is easier to collect income-tax from a single point (i.e. from the company distributing the dividends) rather than compel companies to compute the income-tax deductible from the dividend income in the hands of the shareholders. The Memorandum to the Finance Bills supports the view that the levy of tax on the company was driven by administrative considerations, and that the levy is, for all intents and purposes, a charge on dividends. Economically as well, the burden of DDT falls on the shareholders, rather than the company, as the amount of distributed profits available for shareholders stands reduced to the extent of the DDT levied.
In light of the above, there are possible arguments to take a position that the tax rate on dividends under tax treaties with countries where the shareholders are resident may be applied in respect of DDT instead of the rate set out in section 115-O. However, considering the express provision of section 115-O, which states that DDT is an ‘additional income-tax’ on companies, such a position may be subject to extensive litigation by the tax authorities. Authorities may seek to argue that it is the resident company which is subject to tax under section 115-O and not the shareholder and, hence, the tax treaty benefits should be denied.
4. Conclusion:
The argument raised before ITAT-Mumbai is certainly an interesting one and merits deeper examination. The ITAT has not adjudicated on this issue yet and has chosen to remand it back for examination on merits leaving no precedent on this issue so far. However, adopting a contentious position that the tax treaty rate can be applied in respect of DDT is bound to be challenged by the tax authorities, resulting in protracted litigation. The practical considerations of adopting such a position must also be weighed, since the tax return form automatically calculates the DDT amount (as per the rate prescribed under the Act) and does not provide any option to take recourse to the tax treaty rate. Additionally, tax would have to be computed separately for each non-resident shareholder depending on the applicable tax treaty, upon furnishing of a tax residency certificate by such shareholder.
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