India: DDT abolished and equalisation levy expanded
Significant developments in the India tax regime create benefits for multinational companies even as further clarity is needed.
2020 has been a challenging year with the COVID-19 pandemic, natural disasters and also political turmoil around the world. In the same year, significant changes have also taken place in the tax world, be it the continuous attempt to bring consensus on digital taxation by the Organisation for Economic Co-operation and Development (OECD) or unilateral actions by many countries on the taxation of digital businesses.
India has its fair share of significant changes to the tax and regulatory environment. One of the biggest changes – and most applauded by the international tax community – was the long-awaited abolition of the dividend distribution tax (DDT) and its replacement with a simpler dividend withholding tax regime. In addition, India further expanded the equalisation levy (digital tax) provisions and introduced land border regulations.
These are some of the key provisions that multinational corporations (MNCs) must evaluate with regards to their India-related operations.
Removing DDT and moving to classical system of taxing dividend in the hands of shareholders
In fulfilling the ask of foreign players, the Finance Minister of India introduced a significant change in the country’s direct tax regime in the Union Budget 2020 by abolishing the DDT and moving to a system of taxing dividends in the hands of shareholders. According to the government, this single move would cost the Exchequer Rs 25,000 crore (approximately US$ 3.4 billion) in tax revenue.
The erstwhile DDT system had the following issues:
- DDT, being a tax on the Indian company distributing the dividends, resulted in an increase in tax burden for investors, especially those who were eligible for lower tax rates due to tax treaty eligibility. This also includes small domestic investors in India due to otherwise lower income thresholds
- Non-availability of credit of DDT to most of the foreign investors in their home country, as the DDT was a distribution tax on the Indian company and technically not a tax on shareholders
While the amendment of taxing dividends in the hands of shareholders indeed increased the effective tax rates for certain sections of domestic shareholders, the above amendment will result in significant increase in the rate of return on equity capital for foreign investors as the withholding tax rate can go as low as 5% under certain tax treaties.
Beneficial ownership and corporate tax return filing
Most of the treaties contain the beneficial ownership clause and thus it is extremely important that the foreign entity enjoying the lower tax rate under the treaty is also the beneficial owner of such income. There has been significant litigation around this aspect and with the introduction of Multilateral Instruments and General Anti-Avoidance Rules in India and other anti-abuse provisions, it is likely that the tax authorities will look into the structures with greater detail.
Another key amendment arising from the Union Budget 2020 is the requirement to file tax returns (including obtaining tax registration number) for foreign investors who are paying tax as per the treaty rates and not as per the domestic tax law. This requirement is applicable even if dividend is the only source of income in a particular year.
Indian equalisation levy (digital tax) 2.0
Digitalisation is one of the most significant developments since the industrial revolution, transforming the way in which businesses are carried out across the globe. It has also accelerated the need to address the deficiencies and unresolved issues within the international tax system.
The OECD and the G20 group initiated the base erosion and profit shifting (BEPS) project, to inter-alia, address the taxation issues of the digital economy. India, being one of the early movers, introduced the equalisation levy (EL 1.0) in 2016 at 6% on payments received by a non-resident service provider from an Indian resident (carrying on business or profession) in respect of online advertising, provision of online advertising space and related services.
In 2020, the Indian Government further expanded the provisions of the equalisation levy (EL 2.0) to bring within the net any consideration received by non-resident e-commerce operators for e-commerce supply or services at 2% (hereinafter referred to as ESS EL) with effect from 1 April 2020. This was a significant change as the foreign e-commerce operator now needs to register in India directly to undertake the compliance and pay the levy. The first due date for payment of ESS EL was 7 July 2020 and further due dates are on quarterly basis.
It was expected that digital offerings of non-residents such as online books, online games and online gaming services (under specified circumstances) would come under the purview of ESS EL. However, the provisions pertaining to ESS EL are widely worded and one could also interpret them to cover the sale of physical goods and services enjoyed offline. While many businesses negotiate supply and service agreements online and use digital or electronic means for contract confirmation, the delivery of goods and services is largely offline. An example of this could be orders placed online on an e-portal for hotel stays.
Traditional brick-and-mortar businesses also use digital or electronic facilities in some form, such as for the maintenance of a website, email correspondence and digital forms of payment, as well as i for inter-company transactions across different geographies. In the absence of clarification, the above services may also come under the ambit of the new equalisation levy and we have seen organisations initiating steps to undertake compliance and pay tax in these situations.
Additionally, the amount on which the ESS EL is to be applied i.e., on gross or net amount, is also a fact-based exercise depending on the terms of the agreement between parties and thus needs to be carefully examined.
Land border restrictions
The impact of the COVID 19 pandemic has not only been felt on the health of people and organisations but also the policy directions of governments around the world.
The Indian Government introduced changes to its foreign direct investment policy (FDI Policy) vide Press Note No. 3 dated April 17, 2020, (Press Note). The Press Note seeks to curb "opportunistic takeovers/acquisitions of Indian companies" due to the current COVID-19 pandemic.
Based on the amendment, investments by entities incorporated in Afghanistan, Bangladesh, Bhutan, China, Myanmar, Nepal and Pakistan (Specified Country) or where the beneficial owner (direct or indirect) of an investment into India is situated in or is a citizen of any Specified Country, will require prior approval of the Indian Government.
On account of the amendment, certain investments that will otherwise fall under the automatic route i.e., do not require any approval, now falls under the government approval route and will require an approval if it is from an entity of which itself or its beneficial owner is from a Specified Country.
While there has been no approvals made, the Indian Government is working on certain clarifications set out below:
- Beneficial ownership
- The Press Note does not elaborate the manner in which the beneficial ownership test is to be calculated and applied. The term "beneficial owner" has different meanings under different laws in India. In the absence of clarification, the authorised dealers are taking different stands based on their legal view. Prior government approval would be triggered even if a single share of an investing entity is beneficially held by an investor from any Specified Country i.e., indirect beneficial ownership and this could impact many FDI transactions in India.
- Industry specific guidance
- There is ambiguity in certain areas like the fund space as several global private equity funds (not based in any Specified Country) have Chinese limited partners.
Additional areas where clarity is required are Indian downstream investments, investment from Hong Kong, mergers, conversion of entities, etc.
As seen, some of these changes have significant tax benefits whereas others result in increased compliance burden and even timelines with regards to doing business in India. MNCs will need to keep track of the ever-changing tax and regulatory landscape in India, be nimble to adapt to changes and understand the impact on their businesses to get the most benefit out of them.
The co-authors of this article are Gagan Malik, EY Asia-Pacific Global Tax Desk Network Leader and India Desk Leader from Ernst & Young Solutions LLP, and Gaurav Ashar, Manager, India Tax – Asia-Pacific from Ernst & Young Corporate Advisors Pte Ltd.