In a bold move aimed at increasing foreign investment, India has announced the withdrawal of its dividend distribution tax (DDT). It unveiled the measure in its Union Budget for 2020–2021 on 1 February, proposing to replace the tax with a dividend withholding tax with effect from 1 April 2020, bringing it in line with similar taxes in most other countries, such as China, Japan, Korea, and the United States1. The proposed rate will be 10% for dividends paid to shareholders resident in India and 20%2 if paid to foreign shareholders. India's parliament is widely expected to pass the new tax into law.
Under the present income tax law, an Indian company which distributes a dividend has to pay DDT within 14 days of declaration, distribution or payment of the dividend, at a rate of 15% which is subject to a surcharge of 12% and a health and education cess of 4%, making the effective rate approximately 20.553%.
As the DDT is not payable by the recipient company but by the Indian company that distributes the dividend, the foreign recipient cannot avail of a reduced rate under India's tax treaties. Furthermore, it is often unable to claim a tax credit in its home jurisdiction thereby making the dividend subject to double taxation. This resulted in foreign investors finding innovative ways to invest in India typically using debt structures.
The new 20% withholding tax will make it possible for foreign investors to enjoy the reduced dividend withholding tax rate under a favourable tax treaty with India3, provided that the company which holds the shares of the Indian company (i) is a tax resident of the jurisdiction concerned4 and (ii) satisfies India's domestic law requirements for tax treaty protection, which stipulates that the foreign holding company's main purpose should be to serve a credible business purpose other than saving or avoiding Indian tax. While the current law lacks guidance on this point, India's case law suggests that an active business function or an investment holding function for subsidiaries in multiple jurisdictions are helpful factors to support having a credible business purpose.
Historically, foreign investors have used Mauritius as an investment holding jurisdiction for their investments into India because of the favourable treatment of capital gains in the tax treaty between the two countries (the tax treaty contained an exemption from the Indian income tax for gains if the foreign investor sold or reorganised its shares of an Indian company). In recent years however, as Indian tax authorities have challenged the use of Mauritian holding companies for this purpose , Singapore, which had a similarly favourable tax treaty with India, emerged as the preferred holding jurisdiction. India's tax treaties with both Mauritius and Singapore were amended in 2017, each losing their tax exemption on gains.
When the dividend withholding tax replaces the DDT in April, this will make it relevant again for foreign investors to hold their investments in India through a company located in a favourable tax treaty country, as this will reduce the Indian dividend withholding tax if the abovementioned conditions are satisfied. In this regard, India has favourable tax treaties with Cyprus, France, Hong Kong, Malaysia, Mauritius, the Netherlands, Qatar, Singapore and the UAE.
This is a very important development for foreign investors as it changes the way they will structure their investments. Although debt funding of Indian investments will continue to be a tax-efficient means of investing into India5, the proposed replacement of the DDT will prompt a renewed focus on tax-efficient holding structures into India. Foreign investors with existing Indian investments may, where appropriate, wish to restructure to reduce their Indian tax cost.
1 This is in fact a reintroduction of the dividend withholding tax, which India had until 1996.
2 Plus a surcharge of 12% and a health and education cess of 4%, resulting in a tax rate of 21.84%.
3 India's tax treaties generally provide for a reduced dividend withholding tax rate ranging between 5 and 15%, with no surcharges.
4 As evidenced by a valid tax residence certificate issued by the competent tax authority of that jurisdiction.
5 Because interest expenses, unlike dividends, are tax deductible for the Indian borrower unless they exceed certain prescribed amounts.