Everyone is conversant with the proverb ‘Old wine in new bottles‘. On similar lines, the Finance Act, 2020 shifts the incidence of taxation of dividends in the hands of shareholders by abolishing the DDT regime. Under the new regime (effective 1 April 2020), the dividends earned by foreign shareholders are usually subject to a tax rate of 20% (plus applicable surcharge and cess) under S.195 read with S.115A of Income-tax Act, 1961 subject to beneficial rates under tax treaties.
It would be interesting to evaluate the interplay of tax rate of dividend among different tax treaties and analyse whether a non-resident shareholder can reduce its tax exposure even below the negotiated tax rate for dividend under the applicable tax treaties. This would help the non-resident investor to manage its working capital effectively by reducing the tax obligation.
Under the context of tax treaties, an MFN clause is incorporated where one of the contracting countries decide to grant MFN status to the other contracting country in relation to specified income streams. The residents of the MFN country are given the same beneficial treatment that India has extended to a resident of a third country (OECD countries). The beneficial treatment is accorded in form of lower rate of tax or restricted scope. The MFN clause is intended to provide a level playing field to all the OECD members.
The MFN clause in a tax treaty entitles the eligible tax residents to adopt the beneficial treatment (by way of lower rate or restricted scope) accorded to a third country (OECD members). The tax rate under dividend article in most tax treaties usually ranges around 10%-15%. By virtue of MFN clause, the negotiated tax rate of dividend of 10% or 15% can be further reduced say to 5%.
At present, India has MFN clause with respect to dividend article with Netherlands, France, Hungary, Sweden, Switzerland and Finland. The tax residents of the said countries who are eligible for treaty benefits can apply the MFN benefit with respect to dividend article.
Tax treaties of Netherlands, France, Hungary and Sweden can invoke the MFN clause automatically pertaining to lower rate and restricted scope of dividend. In case of Finland, for application of MFN clause there is a requirement of formal notification between the contracted countries. As regards Switzerland, the MFN benefit is applicable only for lower rate of dividend on automatic basis.
Illustratively India-Netherlands tax treaty provides for a tax rate of 10% for dividend income. By invoking the MFN clause, the negotiated tax rate of 10% for dividend under India-Netherland tax treaty can be further reduced to 5% by adopting favourable tax rate from Slovenia/Lithuania tax treaties.
An interesting question arises with respect to selection of country for adopting favourable tax rate of 5%. Generally, the MFN analysis for dividend article is restricted to adoption of favourable rates from Slovenia/Lithuania tax treaties.
A comparative table showing relevant extract from tax treaties of Slovenia, Lithuania and Columbia is reproduced below:
|Rate of taxation in source country||5% of the gross amount of the dividends if the beneficial owner is a company which holds directly at least 10 percent of the capital of the company paying the dividends;||5% of the gross amount of the dividends if the beneficial owner is a company (other than a partnership) which holds directly at least 10 per cent of the capital of the company paying the dividends;||5% of the gross amount of the dividends for the beneficial owner of the income who is a resident of the other Contracting State|
It is pertinent to note that Columbia has become an OECD member on 28 April 2020. The rate of 5% under India-Columbia tax treaty (unlike Slovenia/Lithuania) is not subject to condition of any minimum shareholding in the company declaring dividend. Further, Article 8 of MLI is applicable to India-Slovenia tax treaty and hence an additional condition of minimum holding period of 365 days shall apply. Also, Lithuania has reserved its right on Article 8 of MLI.
Considering that there is no condition of minimum shareholding and MLI impact, India-Columbia tax treaty is likely to be beneficial while conducting the MFN analysis.