THE Special Bench of the Tribunal has recently rendered an important decision in an unnecessarily contrived issue that had the potential of substantially damaging the revenue effort of the country. The decision was rendered in the case of Total Oil (2023-TII-88-ITAT-MUM-INTL-SB) and related to the nature of the now discontinued Dividend Distribution Tax that India had been following since 1997 in taxing certain types of dividends declared by Indian companies. At the outset, it may be mentioned that even though India was an outlier in the manner of taxing such dividends in comparison to its peers, there was no significant controversy till 2017 when, consequent to some tinkering in the manner of taxation of this important stream of income, particularly by foreign companies, the Kolkata Bench of the Tribunal took a curious stand that was then followed by other coordinate benches of the tribunal till such time that the Mumbai tribunal doubted the logic and recommended the constitution of a special Bench to resolve the controversy. The Special Bench on the 20th April, 2023 has by a well-reasoned order settled the issue. But, knowing the litigious nature of some of the influential taxpayers and their advisors, it is not yet sure if there will be a quietus even though the main issue of the nature of the DDT has now become redundant as a result of legislative action.

Before going into the facts, arguments, and the order of the Special Bench decision, it may be useful to have a brief picture of the taxation of dividends in India. Dividend was made taxable for the first time in India under the Income Tax Act, 1922. Thereafter there were many experimentations with its taxation. After independence, it was necessary to ensure that companies invest in the economy rather than fritter away their profits through dividends. To that effect, differentiation was made in the rate of taxation depending on whether a company was one in which the public were substantially interested or not. All these different forms of taxation were gradually given up by the 1990s. However, dividend was till now taxable in the hands of the shareholders with the obligation on the companies being restricted to ensuring that tax is deducted at source in appropriate cases.

World over, countries tax dividends differently depending on the overall economic situation in the country. Some countries do not tax dividend at all, some do not tax non-residents on dividends received from local companies, some tax dividends received by companies differently from dividends received by individuals. Then there are some that tax dividends but grant credit for the underlying corporate tax paid by the companies. In the USA, for example, dividends received by US citizens or US residents from US domestic corporations are fully included in the taxable income. The tax rate applied is the regular individual income tax rate restricted by applicable treaty rate, if any. Dividends received by non-resident individuals from US domestic corporations are treated as US-sourced income and are subject to withholding tax at the 30% or at a lower rate as provided by an applicable US tax treaty. The US keeps the domestic withholding rate high so as to gain leverage in treaty negotiations, an aspect that India had perhaps forgotten. Companies are taxed at reduced rate and there are provisions for relief for inter-company dividends.

Generally speaking, the essence of dividend taxation is that dividends are paid out of taxed profits of corporations and where dividends are taxed, normally it is the shareholder that is the subject of taxation. The rate of tax may, of course, vary. We may call this the classical system of taxation of dividends. Till 1997, India also followed this classical system in that it is the shareholders that were subjected to tax on dividends declared/paid by companies. The companies obviously had the obligation of deducting and depositing tax deducted at source. There was one exception for some early years when in the case of privately held Indian companies, there was an additional income tax on undistributed profits, the provisions of which were contained in sections 104-108 of the ITA.

The underlying justification of these provisions as enumerated by courts was that in many tax systems of advanced States in the world, accumulation of undistributed corporate profits was considered either unhealthy from certain economic points of view or as opening up avenues for evasion of higher personal tax liability and hence there were regulations for deterring certain corporate bodies, from accumulating the undistributed profits beyond a certain limit, considering that there was a differential in the taxation rate of individuals and corporates. These provisions were therefore introduced to ensure that the government does not lose revenue on account of tax on dividends when private companies chose not to distribute or distribute less than a percentage of the distributable income of the company. There was provision for exemption of manufacturing companies etc from its scope. Different rates were prescribed for a trading company and an investment company. Here, the charge was on the company itself but all these provisions were given up long back in the year 1987.

It was in 1997, that India took a path-breaking step by changing the system of taxation of dividends completely by introducing a dividend distribution tax and giving up taxation of dividends in the hands of the recipients. The then Finance Minister while presenting his budget, in his budget speech stated as follows:

"100.Another area of vigorous debate over many years relates to the issue of tax on dividends. I wish to end this debate. Hence, I propose to abolish tax on dividends in the hands of the shareholder.

101. Some companies distribute exorbitant dividends . Ideally, they should retain the bulk of their profits and plough them into fresh investments. I intend to reward companies who invest in future growth. Hence, I propose to levy a tax on distributed profits at the moderate rate of 10 per cent on the amount so distributed. This tax shall be an incidence on the company and shall not be passed on to the shareholder."

Although the FM did not elaborate on the type of debates that he wished to end, one could guess that this related to the argument relating to the supposed double taxation of the corporate profits and then taxation of dividends in the hands of the shareholder distributed from out of the taxed profits of the company. According to the new scheme, there will be no tax on dividends in the hands of the shareholders at all.

He does not mention that the proposed DDT will be the replacement for the old system. The FM actually gives a different reason for the additional income tax, that is to prevent companies from declaring dividends and instead encourage companies to utilise the earnings for making fresh investments. The FM's speech clearly mentions that the incidence of this tax is on the company and is not to be passed on to the shareholder.

This intention was to be actually translated as provisions of the Finance Bill and the Memorandum to the Finance Bill mentioned that the instant system of taxation of dividends was cumbersome involving a lot of paperwork and explained the new provisions as follows:

"The Bill also proposes to introduce new provisions for levying a moderate tax on distributed profits. Under the new provisions, the amounts declared, distributed or paid on or after 1st June, 1997 by a domestic company by way of dividends shall be charged to additional income-tax at a flat rate of ten per cent., in addition to the normal income-tax chargeable on the income of the company. The principal officer of the company and the company shall be liable to pay income-tax to the credit of the Central Government within fourteen days from the declaration of dividends. If the principal officer and the company fail to so pay the income-tax to the credit of the Central Government, he or it shall be liable to pay simple interest at the rate of two per cent. for every month or part thereof on the amount of tax payable and such principal officer and the company shall also be deemed to be assessee in default in respect of the amount of tax payable. It is further proposed that no deduction under any of the provisions of the Income-tax Act shall be allowed to the company or the shareholder in respect of the tax on distributed profits . It is also proposed that the additional income-tax so paid by the company shall be treated as the final payment of tax in respect of the amount distributed and no further credit for such tax shall be claimed either by the company or by any other assessee."

No doubt, the system worked smoothly but, it was not without some moral issues relating to its fairness. These were, in fact, considered by the then FM in his 2002 budget wherein he stated:

"(…) There is also an inherent inequity in the present system, which allows persons in the high-income groups to be taxed at much lower rates than the rates applicable to them . These issues have been troubling me over the past four years, and I am now convinced that the existing system must go. I, therefore, propose to abolish the distribution tax of 10% on companies and mutual funds on the dividends or income distributed by them. Such income will henceforth be taxed in the hands of the recipients at the rates applicable to them, and will be subject to tax deduction at source at the rate of 10%.(…)"

Following the same, the classical system was restored in 2002-03. However, the very next year, in budget 2003, we reverted to DDT. The Memorandum explained:

"It has been argued that it is easier to collect tax at a single point, i.e., from the company rather than compel the company to compute the tax deductible in the hands of the shareholders.

It is, therefore, proposed to substitute sub-section (1) of section 115-O of the Income-tax Act to provide that the amounts declared, distributed, or paid on or after 1 st April, 2003 by a domestic company by way of dividends shall be charged to additional income-tax at the flat rate of twelve and one-half per cent., in addition to the normal income-tax chargeable on the income of the company." Thus, DDT was restored albeit with a hike in the rate but the shareholders again got exemption in respect of the distributed dividend.

Then in 2014, as a measure for additional revenue mobilisation, the government introduced the concept of grossing up for the purpose of the levy of DDT. The Memorandum explained: Prior to introduction of dividend distribution tax (DDT), the dividends were taxable in the hands of the shareholder. The gross amount of dividend representing the distributable surplus was taxable, and the tax on this amount was paid by the shareholder at the applicable rate which varied from 0 to 30%. However, after the introduction of the DDT, a lower rate of 15% is currently applicable but this rate is being applied on the amount paid as dividend after reduction of distribution tax by the company . Therefore, the tax is computed with reference to the net amount. (…) In order to ensure that tax is levied on proper base , the amount of distributable income and the dividends which are actually received by the (…) shareholders of the domestic company need to be grossed up for the purpose of computing the additional tax. Necessary changes were made in section 115-O and other sections.

In 2016, again as a measure of additional resource mobilization and rationalisation, a change was made in the taxation of dividends for Indian residents this time on the ground of alleged vertical inequity by incorporating a new section 115BBDA. It was stated that under section 115-O dividends are taxed only at the rate of fifteen percent at the time of distribution in the hands of company declaring dividends. This creates vertical inequity amongst the tax payers as those who have high dividend income are subjected to tax only at the rate of 15% whereas such income in their hands would have been chargeable to tax at the rate of 30%. With a view to rationalise the tax treatment provided to income by way of dividend, it was proposed to amend the Income-tax Act so as to provide that any income by way of dividend in excess of INR.1 million shall be chargeable to tax in the case of an individual, Hindu undivided family (HUF) or a firm , at the rate of ten percent on gross basis and the exemption given in section 10(34) did not apply to such cases. The provision was further amended in the very next year, this time on the ground of horizontal equity and it was extended to all taxpayers barring domestic companies, certain trusts, funds etc.

Then in 2020, the government reverted back to the classical system. The FM in her budget speech concentrated mainly on foreign investors for the reason of reversion to the classical system: "It has been argued that the system of levying DDT results in increase in tax burden for investors and especially those who are liable to pay tax less than the rate of DDT if the dividend income is included in their income.

Further, non-availability of credit of DDT to most of the foreign investors in their home country results in reduction of rate of return on equity capital for them. In order to increase the attractiveness of the Indian Equity Market and to provide relief to a large class of investors, I propose to remove the DDT and adopt the classical system of dividend taxation under which the companies would not be required to pay DDT. The dividend shall be taxed only in the hands of the recipients at their applicable rate."

The memo however, referred to a number of additional justifications. It was stated that the incidence of the DDT presently falls on the payer company/Mutual Fund and not on the recipient, where it should normally be; that dividend is income in the hands of the shareholders and not in the hands of the company and hence the incidence of the tax should be on the recipient. Moreover, the present provisions levy tax at a flat rate on the distributed profits, across the board irrespective of the marginal rate at which the recipient is otherwise taxed are considered iniquitous and regressive.

It was clarified that the system of taxation of dividend in the hands of company/ mutual funds was reintroduced by the Finance Act, 2003 since it was easier to collect tax at a single point and the new system was leading to increase in compliance burden. However, with the advent of technology and easy tracking system available, the justification for current system of taxation of dividend has outlived itself. Accordingly, amendments were carried out so that dividend would be taxable in the hands of shareholders at the applicable rate and the domestic companies are no longer required to pay any DDT.

With this background we may now examine a few decisions that led to the constitution of the Special Bench and its decision. The main issue relevant for our discussion that came up for consideration before the Delhi Bench in Giesecke & Devrient India Pvt Ltd Vs ACIT (2020-TII-343-ITAT-DEL-TP) was whether the preferential treaty rate as laid down in the India-Germany tax treaty in respect of taxation of dividends would operate to limit the rate of the DDT that was charged on the Indian subsidiary when it distributed dividends to shareholders in Germany.

We may note that India has entered into any number of tax treaties even after 1997. For those not conversant with tax treaty negotiations, it may be useful to note that in the course of such negotiations, each country generally explains its domestic tax provisions for taxing important streams of income to the other party and depending on the congruence or otherwise of the two tax systems, a tax treaty finally takes shape after rounds of negotiations. Such an issue as raised before the Tribunal never arose so far either in respect of treaties signed before 1997 or those signed thereafter.

Nevertheless, after the DDT was abolished by the Finance Act 2020, the Delhi Bench in the abovementioned case, went through the legislative history of DDT and reversion to the classical system and purportedly relying on the Memorandum to the Finance Bills of 1997, 2003 and 2020 took the view that the levy of tax on the company was driven by administrative considerations rather than legal necessity and for all intents and purposes, it was a charge on dividends . It also took note of the decision of the Bombay High Court in the case of Godrej & Boyce albeit in the context of section 14A wherein the Court specified that it was a tax on the company and not on the shareholder. Nevertheless, the ITAT reasoned that DDT, being an additional tax is covered by the definition of 'tax' as defined u/s. 2(43) of the Act which is covered by the charging section 4 of the Act and that it was definitely a tax on income and hence was subject to the provisions of section 90 of the Act that gives primacy to the provisions of the tax treaty and that the liability to DDT under the Act which falls on the company may not be relevant when considering applicability of rates of dividend tax set out in the tax treaties. It also referred to the fact that the India-Germany tax treaty was concluded before the 1997 change. It was thus that the Tribunal in this case chose to unsettle the understanding of the DDT and its interaction with the provision relating to taxation of dividends in tax treaties.

Subsequently, more or less the same logic, was adopted by the Kolkata bench in the case of Indian Oil Petronas Pvt Ltd (2021-TII-72-ITAT-KOL-INTL) with the additional point that the Supreme Court had in the case of Tata Tea had held that DDT was leviable on the entire income even if it was paid partly out of agricultural income. Purportedly relying on this logic, the Kolkata Tribunal held that dividend was still income even if the incidence of the payment is shifted from the shareholder to the company.

As a result of these decisions, some taxpayers are reported to have sought refund in respect of past years.

However, when a similar case, reached the Mumbai Tribunal in the case of Total Oil , that involved the India-France tax treaty, the Bench doubted the correctness of these decisions of the other Benches. The Mumbai division bench rightly pointed out that under the scheme of the tax treaties, no tax credits are envisaged in the hands of the shareholders in respect of dividend distribution tax paid by the company in which shares are held. The DDT is levied on a domestic company and such a company cannot be entitled to a treaty benefit. It held that the DDT cannot be equated with a tax paid by, or on behalf of, a shareholder in receipt of such a dividend. In fact, the payment of dividend distribution tax does not, in any manner, prejudice the foreign shareholder, and any reduction in the dividend distribution tax does not, in any manner, act to the benefit of the foreign shareholder resident in the treaty partner jurisdiction . This taxability is wholly tax-neutral vis-à-vis foreign resident shareholder and the treaty protection, when given in respect of dividend distribution tax, can only benefit the domestic company concerned. The treaty protection thus sought goes well beyond the purpose of the tax treaties.

Accordingly, considering the difference in opinion amongst the benches, it requested the formation of a special bench to consider the following question:

"Whether the protection granted by the tax treaties, under section 90 of the Income Tax Act, 1961, in respect of taxation of dividend in the source jurisdiction, can be extended, even in the absence of a specific treaty provision to that effect, to the dividend distribution tax under section 115 'O' in the hands of a domestic company?"

The Special Bench concurred with the decision of the Mumbai division bench and disagreed with the conclusion of the Delhi and Kolkata tribunals. In particular, it cleared some cobwebs in the thinking of some of the litigants.

The Special Bench dealt with two issues- the nature of the DDT- Is it a tax on the company or on the shareholder? And secondly, the applicability of the double tax avoidance agreements to DDT.

As for the first issue, the SB pointed out that there were challenges to section 115-O earlier including its constitutional validity, particularly in the context of tea companies where the income of a company could be partly agricultural in nature. The Supreme Court in the case of Tata Tea had upheld the constitutional validity of s. 115-O and held that the power to levy DDT on domestic company was well within the scope of List I Entry 82 "tax on income". Relying on the same, the taxpayer had tried to argue that the SC had held that DDT was nothing but a tax in the hands of the shareholder. Rebutting the same, the SB pointed out that the Supreme Court in that case was not dealing with the nature of DDT as to whether it was tax on the company or a tax on the shareholder and that case does not help the taxpayer.

On the other hand, the same was considered by the Bombay High Court and later by the SC in the case of Godrej & Boyce . Before the Bombay High Court in the context of section 14A it was argued that "income which does not form part of the total income" should be interpreted to mean income which is exempt from tax and hence Section 14A will not apply to dividend income because the Revenue has already received its share of tax . The High Court rejected the argument holding that the tax which is paid by the Company on profits declared, distributed or paid by way of dividend is not a tax which is paid on behalf of the shareholder; that the Company does not act as an agent of the shareholder in paying the tax under Section 115-O. In the hands of the recipient shareholder dividend does not form part of the total income. On the contrary, Section 10(33) (subsequently renumbered 10(34)) clearly evinces parliamentary intent that incomes from dividend are not includible in the total income.

When the matter reached the Supreme Court, it held that the fact that section 10(33) and section 115 O of the Act were brought in together; deleted and reintroduced in a composite manner, does not assist the assessee and that "if the argument is that tax paid by the dividend paying company under section 115-O is to be understood to be on behalf of the recipient assessee, the provisions of Section 57 should enable the assessee to claim deduction of expenditure incurred to earn the income on which such tax is paid" which is wholly incongruous in view of the provisions of Section 10(33). The payment of dividend distribution tax under section 115 O does not discharge the tax liability of the shareholders. It is a liability of the company and discharged by the company. Whatever be the conceptual foundation of such a tax, it is not a tax paid by, or on behalf of, the shareholder.

The taxpayer tried to argue that the decision of the Bombay High Court about the nature of the DDT was overruled by the Supreme Court. In that context, the Special Bench added that the aspect which weighed with the Supreme Court was the fact that the payment of DDT was not a payment on behalf of the shareholder. Leaving aside the question whether it is a tax on company or shareholder, the position that remains undisturbed is the conclusion that "DDT is not a payment on behalf of the shareholder" by the domestic company.

The Special Bench also referred to another decision of the Bombay High Court in the case of SIDBI where again the HC held that the charge of DDT was not that on the shareholder.

As for the applicability of the provisions of the relevant tax treaty relating to taxation of dividends, the Special Bench pointed out that for the provisions of the tax treaty to be invoked, the taxpayer concerned must be a non-resident. (There are certain exceptions in articles 9,24 etc) In the present case, since it has been held that the tax is on the company that is resident in India, the question of the application of tax treaty does not arise.

Referring to the protocol of the India- Hungary tax treaty the Special Bench concluded that if domestic company has to enter the domain of DTAA, the countries should have agreed specifically in the DTAA to that effect. In the Treaty between India and Hungary, the Contracting States have extended the Treaty protection to the dividend distribution tax. It has been specifically provided in the protocol to the Indo Hungarian Tax Treaty that, when the company paying the dividends is a resident of India the tax on distributed profits shall be deemed to be taxed in the hands of the shareholders and it shall not exceed 10 per cent of the gross amount of dividend.

The decision of the Special bench is important in understanding the application of treaty provisions in purely domestic situations notwithstanding the fact that the particular dispute regarding the nature of the DDT may not arise in view of the fact that since 2020 India has reverted to the classical system. Besides, the decision also sheds light on the interaction of domestic tax policy and tax treaties. It quoted with approval from the Mumbai Division Bench's following observation:

"Taxation is a sovereign power of the State- collection and imposition of taxes are sovereign functions. Double Taxation Avoidance Agreement is in the nature of self-imposed limitations of a State's inherent right to tax, and these DTAAs divide tax sources, taxable objects amongst themselves. Inherent in the self-imposed restrictions imposed by the DTAA is the fact that outside of the limitations imposed by the DTAA, the State is free to levy taxes as per its own policy choices. The dividend distribution tax, not being a tax paid by or on behalf of a resident of treaty partner jurisdiction, cannot thus be curtailed by a tax treaty provision."

Besides, this decision should also lay to rest the claims of refund reportedly filed by some taxpayers relying on the two earlier decisions of the tribunal that now stand overruled.