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This article has a special reference to the amendment made by the India Union Budget 2020 wherein Dividend Distribution Taxation (DDT) was abolished and dividends were made taxable in the hand of the shareholders. The blog tries to act as a think tank to explore any possible transfer pricing implications on such a changed scenario where the incidence of taxability has changed from the company to the shareholder. Further, such a blog has a reference drawn from the earlier blog on ‘Top 10 Impacts on Investors – Indian Dividend Tax‘, where transfer pricing was considered as one of the impacts for the investor/ shareholder.
The discussion in the blog is relevant in the scenario where the shareholder and the company are considered as Associated Enterprises under Section 92A of the Income-tax Act, 1961 (the Act). In short, the discussion is relevant in the scenario where there is an Indian company with foreign shareholders and the Indian company is a part of the Multinational Group. Transfer Pricing is then considered to be applicable to the transaction between such Associated Enterprises.
Dividends are ideally considered as an appropriation of profits. Such profits are after-tax profits and therefore, while the DDT was in force, all taxes were paid on net profits, the applicability of transfer pricing on dividends from a practical point of view had no or little relevance. Often payment of dividend to foreign shareholder company was shown as an international transaction in the form 3CEB (disclosure report), however the same was not fully benchmarked, as there was no means of avoiding taxes on such dividend payout. Taxes were in control of the company declaring the same and the investor had no scope to plan for such taxes. Things could be set to change now, with the taxability now being made in the hands of the shareholder (after 1 April 2020), and the company being covered through the provisions of withholding tax via the Act or the tax treaties. With such a scenario on hand dividends may need to stand the test of transfer pricing reasoning, compliance and scrutiny. Transfer Pricing is a special tax anti-avoidance rule, where the onus to prove non-tax avoidance is on the taxpayer. The blog intends to cover the top 5 of the thoughts on transfer pricing that could have far-reaching impacts on the taxability of dividends in India as a source country taxation.
Top 5 transfer pricing thoughts to consider while declaring the dividend to foreign parents by an Indian subsidiary are as follows:
- GAAR and dividend: An Indian subsidiary company may either choose to accumulate the profits over the years rather than declaring the same as dividends to the foreign company. The company may have to maintain detailed documentation to prove that there is no tax benefit embedded in the decision of accumulation of profits rather than declaring the same in the year of accrual. As per the definition of tax benefit under Section 102 (10) of the Act, a tax benefit also includes tax deferment, so any act to defer the payment of dividend could also fit in the bracket of tax benefit. Legal structuring of the transaction, to effectively plan future dividend payouts to a tax-efficient jurisdiction may also come under tax lenses if not covered through documentation and business rationale.
- Beneficial owner test: Most of the tax treaties with India are now covered by the principal purpose test, where the preamble of the tax treaty does not only cover cases of ‘avoidance of double taxation’ but also ‘avoidance of double non-taxation or promotion of treaty shopping’. Certain tax treaties with India have the benefit of lower taxes at source (withholding) in India ranging from 5%-15%, as against domestic companies that could be charged at the effective tax rate. Such a lower benefit is available only to the beneficial owners of the dividends and not to conduits. Therefore, it is important to prove the test of beneficial ownership in the payer’s documentation, as the payer would be responsible for tax deduction at source under the provisions of the Act (40%+ surcharge + education cess) or the beneficial provisions of the tax treaty. Transfer Pricing study for the payer is the best place to prove such a position and document the rationale of beneficial ownership.
- Valuation of dividends: Dividend is the return on capital invested. An investor investing capital would look forward to a return in terms of appreciation of capital or return in terms of dividend. Now let us consider an example of a captive. The objective of the captive unit is to be cost-efficient and undertake functions for the parent company on strict directions of the parent company. A captive is ideally never set up with an objective of capital appreciation. In such a case, it may be necessary to defend the reason for non-declaration of dividend and also the value or proportion of the declared dividend as compared to the other comparable companies. Again transfer pricing document is the best place to provide such reasoning.
- Benchmarking of dividend: The gap between return on equity and return on debt funds have just got reduced. Possibly a way to benchmark declared dividends of the payer’s company could be to compare to the comparable’s return on equity by undertaking a search in the public domain or by using databases. Such an approach may not be a consistent approach followed across the board, however, could be one of the options to prove the arm’s length nature of dividend payout.
- Shareholder’s activity: India does not have specific guidance on the concept of shareholder activity. An observation has been made by India in the UN transfer pricing manual stating that shareholder activity would not be considered as services at all. The OECD takes a position that such activities are activities undertaken by a shareholder solely because of ownership interest. Taxpayers in India have taken positions to categorise certain activities as shareholder activities, however the same have not been favoured by the tax authorities and most of the judicial precedents do not provide conclusive evidence on what could be considered as a shareholder activity. For example, provision of corporate guarantee is one of the biggest debate whether it could be regarded as a shareholder’s activity. A guarantee is provided by the parent to banks/ fund houses in cases where the subsidiary’s standing is not enough to prove the creditworthiness for the provision of loans. As such a corporate guarantee could be given only by the group company and may not be possible to obtain such a facility in independent circumstance, then such activity may be regarded as a shareholder activity. In such a case, one may have a view that any additional dividends declared than what is considered as a normal rate on return on equity may be considered and attributed as a return on the function of performing shareholder activity.
Considering that India has never tested a transfer pricing regime with the taxation of dividends in the hands of the shareholder, the abolishment of DDT along with the inception of a regime of withholding and chargeability of dividends may open up a new Chapter for the taxpayers and the tax administrations to ponder upon.
In case the reader has any further clarifications or observations on the topic, the author could be contacted at firstname.lastname@example.org
By: Team TransPrice.