Direct Tax Alert

BACKGROUND

Under the Dividend Distribution Tax (DDT) regime, the Company declared the dividend, paid DDT and the dividend was exempt in the hands of shareholders. The DDT was levied at 15% (excluding surcharge and cess), under section 115-O of the Income Tax Act, 1961 (‘IT Act’). As the dividend under the Double Tax Avoidance Agreement (DTAA) was taxable at a rate less than the DDT rate, a debate was ongoing as to whether the DTAA rate could be applied instead of DDT. In this regard, recently, the Hon’ble Bombay High Court¹ pronounced a significant ruling wherein it has examined the interplay between the DDT and DTAA. The Court analysed whether the DDT rate could be limited to the tax rate prescribed in the DTAA or whether the statutory DDT should apply. It also deliberated over the true nature of DDT, the extent of DTAA override under section 90(2)² of the IT Act, and whether the DDT is paid by the Company in its own capacity or as a withholding agent for the foreign shareholder.

We, at BDO India, have analysed and summarised the key aspects of this Ruling and provided our comments on its impact hereunder:

FACTS OF THE CASE

• The taxpayer, an Indian private limited company, is a wholly owned subsidiary of Colorcon Limited, United Kingdom (Colorcon UK). It is engaged in the business of manufacturing, supply and technical support of formulated film, coating systems, modified release technologies, and functional excipients for the pharmaceutical industry.

• During the year, the taxpayer paid dividends and interim dividends to Colorcon UK and discharged the DDT at the rate prescribed in the IT Act.

• The taxpayer filed an application seeking an advance ruling from the Board for Advance Ruling (BFAR) on whether the taxpayer is entitled to restrict the DDT rate on dividends paid to Colorcon UK to 10 per cent as per Article 11³ of the India-UK DTAA.

• Following the Mumbai Tax Tribunal Special Bench decision in Total Oil Pvt. Ltd.⁴, BFAR ruled that the DDT paid by the taxpayer to its shareholder is outside the scope of the India-UK DTAA. It further held that DDT does not come within the ambit of “taxes covered” under Article 2⁵ of India-UK DTAA.

• Aggrieved, the taxpayer filed an appeal before the Bombay High Court.

BOMBAY HIGH COURT RULING

The Bombay High Court, while permitting to apply the India-UK DTAA rate for DDT, made following key observations:

1. The Gamut of section 115-O of the IT Act

• Section 115-O of the IT Act mandates that this additional tax always remain a tax on dividends, which can be declared out of the Company's reserves and is not an additional tax on profits of the Company. Even if the Company has no taxable income or incurs a loss during the fiscal year and does not pay income tax, it is still required to pay DDT upon declaration of dividend, reinforcing its nature as a tax on dividend income.

• Hence, DDT is a tax on dividends, which is income of the shareholder, but its incidence has been shifted to the Company purely for administrative convenience, though there is no change in the substantive concept of “Dividend”. Since under the IT Act, DDT is levied on the dividend distributed, which amounts to income in the hands of shareholders and being an “additional tax”, it is covered within the definition of “Tax” as defined in section 2(43) of the IT Act and covered by charging section 4⁶ of the IT Act.

2. Legal Effect of DTAAs in the context of section 90 of the IT Act

• Section 90 of the IT Act empowers the Central Government to enter into DTAAs with foreign governments for granting relief in respect of income taxed in both jurisdictions and for avoidance of double taxation. It clarifies that once such a DTAA is notified, its provisions override those of the IT Act wherever they are more beneficial to the taxpayer.

• Under Article 11 of the India–UK DTAA on dividends, India may tax dividends paid to a UK resident only at a capped rate of 10 per cent. Reliance was placed on various judicial pronouncements.⁷

• Although India is not a signatory to the Vienna Convention on Law of Treaties (1969) (VCLT), the Andhra Pradesh High Court in Sanofi Pasteur Holding SA⁸ held that VCLT contains many principles of customary international law, and the principles of interpretation in Article 31 of VCLT provide broad guidelines as to what should be an appropriate manner of interpreting the DTAA in the Indian context. Therefore, regard must be given to international conventions (i.e. VCLT) and norms while interpreting domestic tax law.

3. Interplay between DTAA and section 115-O of the IT Act

• In view of Article 253 of the Constitution of India, section 90(2) of the IT Act provides that the Parliament has the power to make any law for the whole or any part of the territory of India and it must exercise the said power for implementing any DTAA, agreement or convention with any other country, or any decision made at any International Conference. Therefore, the effect of a DTAA must override any provision of the domestic tax law.

• Reliance is placed on the decision of the Delhi Tax Tribunal in Giesecke & Devrient (India) Pvt. Ltd.⁹ wherein it was held that the burden of DDT falls on the shareholders rather than on the Company, as the amount of distributed profits available for shareholders stands reduced to the extent of DDT levied.

• Further, benefit was drawn from the observations in Azadi Bachao Andolan (supra) to the effect that States are expected to fulfil obligations under the DTAA in good faith and this includes the obligation not to defeat the purpose and object of the DTAA as the obligations are rooted in customary international law codified by VCLT and hence, the tax specified in DTAA in respect of dividend must prevail over DDT.

4. Analysis of the India-UK DTAA

• As per Article 1 of the India-UK DTAA, the taxpayer in the present case being a UK resident, is entitled to seek relief under the DTAA.

• Article 2 of the India-UK DTAA lists down the taxes covered, and in paragraph 1(b), it covers income tax, including any surcharge thereon, under the definition of ‘tax’ for the purpose of ‘Taxes Covered’ in India. Therefore, Article 2(2) of the India-UK DTAA makes the definition wider by including any identical or substantially similar taxes imposed by either India or the UK.

• Under Article 11(2)(b) of the India-UK DTAA, India is obliged not to tax dividend income at a rate greater than 10 per cent. Thus, the payments made by the taxpayer to Colorcon UK are covered by the aforesaid definition of dividend provided under the DTAA.

• Accordingly, DDT being an additional ‘income tax’ on such dividend, it is covered under Article 11(3) of the DTAA and necessarily has to be charged in accordance with the rate prescribed under the DTAA.

• Reliance is placed on the decision of the Supreme Court in Engineering Analysis¹⁰ wherein substantial unilateral changes made to the definition of ‘royalty’ under the IT Act were sought to be applied to negate the DTAA benefit under various treaties, whereby royalty was already defined in a manner favourable to the taxpayer. The Supreme Court accepted the plea of resident taxpayers, who were obliged to deduct taxes at an appropriate rate on payment of such royalty to their counterparts outside India and allowed the tax rate capped under the DTAA. Accordingly, it held that unilateral amendments to the domestic tax law cannot alter the DTAA provisions.

• Reliance is placed on the decision of the Kolkata Tax Tribunal in Indian Oil Petronas (P) Ltd.¹¹ wherein the decision of the Supreme Court in Tata Tea & Anr.¹² was followed, which held that “the dividend is still taxable as income though the incidence of tax has shifted from the shareholder to the company paying a dividend.” Therefore, once the Supreme Court has confirmed that dividend connotes income, the logical conclusion is that, as per section 4 of the IT Act, the said income should be chargeable to tax in the hands of the person earning such income.

BDO INDIA COMMENTS

The Bombay High Court’s ruling provides significant clarity on the long-standing controversy surrounding the taxability of DDT vis-à-vis beneficial DTAA rate. The Court has reaffirmed that DDT is, in substance, a tax on the dividend income of the shareholder, irrespective of the fact that its incidence is shifted to the distributing company. This interpretation directly supports the view that DDT falls within the scope of “income tax” referred to in Article 2 of the India–UK DTAA and is therefore subject to DTAA-mandated rate limitations.

Importantly, the Court reiterated the overriding effect of section 90(2) of the IT Act, which mandates application of DTAA provisions where they are more beneficial to the taxpayer. The ruling draws reference from judicial precedents such as Azadi Bachao Andolan, Sanofi, and Engineering Analysis to reinforce that unilateral domestic amendments cannot dilute or rewrite DTAA obligations unless the DTAA itself is renegotiated. This strengthens DTAA stability and reinforces the principle that India must interpret and apply tax treaties in good faith and in line with established international norms.

The judgment also underscores that administrative convenience cannot alter the true nature of the levy. Overall, this ruling provides welcome relief to taxpayers and enhances certainty for cross-border structures that existed before the abolition of DDT in 2020.