Earlier this month, the Finance Minister of India proposed the 2020 budget to be effective from April 1, 2020. One of the major provisions, which has a favorable impact on US – India tax structures, is the elimination of the Dividend Distribution Tax (DDT).*
Under the current tax system, when an Indian corporation (a Private Limited or Public Limited entity) generates a profit, that profit is subject to Indian corporate income tax. When the Indian corporation subsequently pays a dividend to its shareholders, the corporation then pays a second layer of tax of approximately 20% of the amount of the dividend. This second layer of tax is the DDT. Subject to certain exceptions for high-income shareholders, the dividend was not taxed in the hands of the shareholder.
In comparison, when a US corporation generates a profit, the profit is also subject to a US corporate income tax, but the dividend is subject to a second layer of tax in the hands of the shareholder, not the corporation. Thus, both countries impose two layers of tax on distributions of corporate earnings, but the mechanism is different.
Multiple Taxation on Dividends
When a US shareholder receives a dividend from an Indian corporation (which has already been taxed twice), there is yet another layer of tax with respect to the dividend in the US under normal individual tax rules. If the double taxation can’t be eliminated under the US – India Income Tax Treaty (which is often the case), then the logical thought is that the US shareholder should receive a foreign tax credit for the DDT.
This is where the conflict arises. Under Indian law, the DDT is legally imposed on the corporation issuing the dividend. Many other countries, including the US, impose the tax on the shareholder receiving the dividend (but impose a withholding mechanism to ensure collection of the tax)**.
For US foreign tax credit purposes, to receive a benefit of a US foreign tax credit, any foreign tax paid must be the legal liability of the taxpayer claiming the credit. Thus, when a US shareholder receives a dividend from an Indian corporation, it is not possible to claim a US foreign tax credit with respect to the DDT paid. Thus, the original dividend amount was often subject to three levels of tax : (1) the Indian corporate tax; (2) the Indian DDT; and (3) the US dividend tax.
Under the Budget proposal, the DDT will be replaced with a 20% (or lower treaty rate) tax imposed on foreign shareholders on the amount of the dividend.*** While this amount will be subject to withholding by the Indian corporation paying the dividend, the legal liability for the tax should rest with the shareholder. Thus, it is expected that the US shareholder will be eligible for a foreign tax credit to be claimed under the new provisions, effectively limiting the layers of tax imposed to two instead of three.
While planning for US – India cross-border dividends is a highly complex area and based on the individual facts of each situation, the repeal of the DDT is a major step forward towards bilateral tax efficiency.
* This Alert focuses on the impact of the DDT with respect to Indian corporations owned by US shareholders who are individuals. Different rules may apply if the US shareholder is a business entity. Also, while not enacted yet, the DDT repeal is expected to be adopted and assumed in force for the purposes of this Alert.
** US state and local taxes are not considered here
*** Under Article 10 of the US – India Tax Treaty, dividends will be subject to a rate of tax of 15% if the shareholder owns at least 10% of the corporation issuing the dividends.