FPIs stare at higher withholding tax on dividends owing to tax treaty

Foreign portfolio investors (FPIs) may have to pay a higher withholding tax on dividends received though their final liability may be lower owing to tax treaty arrangements. Companies may withhold tax at the rate of 20 per cent plus surcharge and cess on the dividend paid to FPIs even if they invest from a jurisdiction that provides for a lower rate based on India’s double taxation avoidance agreement (DTAA) with that country.

The Budget had created an uncertainty regarding the quantum of tax that had to be withheld on dividends paid to non-residents. This was because the exact tax rate was not specified under section 195, which covers tax deducted at source (TDS) or withholding tax for non-residents.

The Finance Act 2020 recently clarified that a withholding tax rate of 20 per cent plus surcharge and cess be applied for dividends paid to non-residents under this section. Also, lower rates could be applied for residents coming from jurisdictions with which India has entered into a DTAA.

 

But here is the catch. While FPIs are also classified as non-residents, the withholding tax rates for these are provided under a separate section 196D of the Income Tax Act. This section specifies a rate of 20 per cent (plus surcharge and cess) on dividends paid. However, it does not provide for a lower withholding rate even if the FPIs’ tax liability is lower on account of an existing tax treaty.

“If an FPI’s liability under the tax treaty is 5, 10 or 15 per cent, then conceptually, companies ought to withhold tax at this rate. Treaty rates are codified in section 195, which applies to all non-residents, and which talks about withholding tax at 'rates in force'. The question is can you read section 196D, which is specific to FPIs, along with section 195 or do you just apply section 196D?" said a tax expert, on condition of anonymity.

“There was a possibility that the tax deducted for non-residents (other than FPIs) could be as high as 30-40 per cent if they did not have a treaty arrangement. This issue has been taken care of by the amendment in the Finance Act," said Sunil Gidwani, partner, Nangia Andersen. "For FPIs, however, the tax deducted at source (TDS) is at 20 per cent under section 196D, and this section does not allow for treaty rates even if they are lower."  

Anish Thacker, partner at EY India points out that the effective TDS rate for non-corporate FPIs can be significantly higher if the surcharge is at the highest slab. FPIs structured as trusts, for instance, will have to pay a TDS of 28.5 per cent, which includes 20 per cent tax on dividends, 37 per cent surcharge and 4 per cent educational cess.

The surcharge/cess is a tax on tax and is levied on the tax payable.

According to Gidwani, the excess tax collected will have to be adjusted against the FPI’s aggregate annual tax on all sources of income including capital gains and interest income. Alternatively, it will have to be claimed as refund.

GAAR/MLI play for other non-residents
 

Non-residents other than FPIs can pay lower withholding tax rates as applicable under various treaties with India. They can also claim credit for the tax paid in India. However, these investors will have to be mindful of the domestic general anti avoidance rule (GAAR) and the international multilateral instrument (MLI) provisions.

Under GAAR, for instance, the benefit of lower withholding tax for dividends and other such tax concessions may be denied unless the choice of jurisdiction is made on the basis of other non-tax considerations.

“The eligibility to claim DTAA relief, considering GAAR and MLI, would need to be tested for examining tax implications,” said Daksha Baxi, head of international taxation at Cyril Amarchand Mangaldas.

The MLI contains a provision that targets aggressive tax planning strategies, involving transfer of shares a few days prior to the date of distribution of dividends, to countries having beneficial tax treatment.

“This provision denies benefit of the reduced rate of tax under applicable DTAA of the transferee location, if the shares in respect of which dividends have been paid, have been transferred within 365 days preceding the distribution of dividends,” said Baxi.

Tax cut: How dividends will be taxed in case of overseas investors

For FPIs
 

Taxation governed by section 196D

Tax on dividends@20% plus surcharge, cess

Total tax on dividends for non-corporates@28.5% after applying surcharge, cess

Lower treaty rates not taken into account

Excess tax can be adjusted against aggregate annual tax or claimed as refund

For other non-residents other than FPIs
 

Taxation governed by section 195

Tax on dividends@20% plus surcharge, cess

Lower treaty rates@5%, 10%, 15% can apply