Photo: iStock (Photo: iStock)
Photo: iStock (Photo: iStock)

Opinion | Will our dividend tax rules promote treaty shopping?

Loopholes that let investors use foreign treaties to dodge taxes on dividends do exist but these will be plugged

Budget 2020 has changed the way dividend income gets taxed. Although it is a virtuous move, it incentivizes foreign investments to come into India through conduit countries that have bilateral tax treaties with New Delhi, and, in turn, lets investors minimize their tax liability.

Dividends are an income that a company’s shareholders get from its profit reserve. Since it is an income in the hands of shareholders (the recipients), it is usually taxed in their hands. But in India, a dividend distribution tax (DDT) was being imposed on the company paying dividends, while recipients did not have to bear any tax liability. This Indian innovation was done away with in the latest budget and was replaced by the classical system of taxing dividends.

The classical system is both progressive and logical. Under the DDT regime, dividends paid to foreign shareholders were taxed in the hands of the company in India and often also in their own hands by their home country, because most countries impose a dividend tax on recipients. Such shareholders, however, could not take refuge in a Double Taxation Avoidance Agreement (DTAA) between India and their home country. The DDT and dividend tax are different. But with the classical system coming into force in India from 1 April 2020, tax incidence will fall uniformly on all recipients of earnings distributed by a company operating in the country. This would let some overseas shareholders invoke a DTAA against the double taxation of these dividends.

Double taxation under the DDT system was a deterrent to foreign investors. The introduction of the classical system, however, would promote foreign investment.

Notably, though, the budget move also raises apprehensions of double non-taxation, implying that foreign investors may not have to pay tax either in India or their home country. That’s because they may resort to treaty shopping—a phenomenon in which investors route their investments through countries that have a DTAA arrangement with the host country.

In our case, an investor could make phantom investments in a shell entity in a third country that has a favourable DTAA with India. The shell entity would then bring foreign direct investment into India. By one estimate, phantom investments across the world totalled $15 trillion in 2017, equivalent to the combined annual gross domestic product of China and Germany.

For dividends to be taxed in India in the hands of shareholders after 1 April 2020, the applicable rate would be 30% plus surcharge and cess. But under India’s DTAAs with Hong Kong, Saudi Arabia and Columbia, shareholders there who get dividends in India can be taxed at a maximum rate of 5%. The rate under India’s DTAA with Mauritius and Qatar is also 5% if shareholders from these two countries hold more than 10% of the capital of the Indian company paying these dividends.

Those dividends will face no home tax in Hong Kong, Mauritius, Saudi Arabia and Qatar. So treaty shopping through these countries could lead to what may broadly be called double non-taxation of dividend income. As we have seen, treaty shopping can help investors abroad reduce their effective dividend tax rate to just 5%.

There is also a possibility that high net-worth individuals based in India would structure their investments in such a way as to route them through the jurisdictions of India’s treaty partners in order to avoid tax.

However, such apprehensions are largely misplaced. India is a signatory of the Multilateral Instrument (MLI)—a multilateral convention of the Organization for Economic Cooperation and Development that combats tax avoidance by base erosion and profit shifting. A minimum standard of the MLI is that when the principal purpose of an entity behind any arrangement is avoidance of tax in the host country, the host can refuse shelter of the DTAA. Such a refusal would be on the basis of a “principal purpose test", or PPT.

Qatar and Saudi Arabia are both signatories of the MLI, like India. So, adequate anti-abuse safeguards in the form of PPTs are now being provided for in India’s DTAAs with these countries.

The India-Mauritius DTAA was amended in August 2016 to limit benefits available under this DTAA only to businesses actually operating in Mauritius. This provides regulators adequate grounds to deny these benefits to shell entities routing phantom investments into India.

There is no special anti-abuse provision in India’s DTAA with Hong Kong, although miscellaneous rules under Article 28 provide some safeguards. While both India and Hong Kong are signatories of the MLI, Hong Kong’s MLI compliance has not been harmonized with its DTAA with India. This could make Hong Kong a jurisdiction of choice to route investments into India. For now.

As and when Hong Kong decides to makes its DTAA with India MLI-compliant, it would no longer be advantageous for investors to route their investments through that jurisdiction. In addition, there is no certainty that investments in India would yield returns before Hong Kong introduces anti-tax avoidance safeguards. This implies that the window of opportunity for investors to benefit from the apparent tax anomaly may be far too small, if at all. Since there is no grandfathering provision under the MLI, such investments routed through Hong Kong will be exposed to high litigation risk.

Smarak Swain works in foreign tax and tax research division of government of India and is the author of ‘Loophole Games’. These are the author’s personal views

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