Foreign shareholders of Indian companies may be liable to tax on deemed dividends

The Bombay High Court handed down an important decision on 22 March 2010 on the application of India's deemed dividend provisions (CIT v. Universal Medicare Pvt. Ltd. (UMPL)), concluding that, where a loan or an advance is made between group companies, where the recipient is not a shareholder in the company making the loan/advance, the recipient company will not be treated as having received a deemed dividend. However, the loan or advance will be taxed as a deemed dividend in the hands of a shareholder that has a common holding in the two group companies.

Indian law envisages certain situations in which a payment will be deemed to be a dividend. One such situation is where a payment is made by a closely held company by way of a loan or an advance to:

- An equity shareholder that beneficially holds 10% or more of the voting power in the company; or
- A company in which such a shareholder has a substantial interest, i.e. a beneficial equity shareholding of 20% or more of the voting power.

The provision is triggered only to the extent the payer company has accumulated profits. Subsequently, if a dividend is declared by the payer company and is set off against the outstanding loan or advance, that dividend will not be again liable to tax. (The general rule regarding the payment of the dividend distribution tax by a company declaring dividends and the corresponding exemption in the hands of the shareholders is not applicable in relation to the deemed dividend provisions.) The taxpayer in the UMPL case had received INR 32 lakh from a group company, Capsulation Services Pvt. Ltd. (CSPL). An individual director of CSPL held more than 10% of the equity capital of CSPL and also owned more than 20% of the equity capital of the taxpayer, UMPL. The Indian assessing officer taxed the amount as a dividend in the hands of UMPL by applying the deemed dividend provisions, and the matter was ultimately appealed to the Bombay High Court.

After examining the deemed dividend provisions, the High Court observed that the effect of the provisions is to broaden the scope of the term "dividend" by including certain payments a company makes by way of a loan or an advance. The Court stated that the deemed dividend rules do not alter the legal position that a dividend is taxed in the hands of the shareholder. On this basis, the High Court concluded that the payment – assuming it was a dividend – would have to be taxed not in the hands of UMPL, but in the hands of the shareholder, i.e. the individual who was the common shareholder of UMPL and CSPL.

Other courts have reached similar conclusions. For example, in CIT v. Hilltop, the Rajasthan High Court held that liability to tax on a payment deemed to be a dividend can only arise in the hands of a shareholder, and, in ACIT v. Bhaumik Colour P. Ltd., the Special Bench of the Mumbai Tribunal held that a deemed dividend is not to be taxed in the hands of a person other than a shareholder of the lender company.

It should be noted that, in 1987, the Central Board of Direct Taxes issued a circular suggesting that the recipient of the payment – and not the shareholder – is liable to tax on the deemed dividend. That Circular was not taken into account by the Bombay or Rajasthan High Courts, although it was examined by the Mumbai Tribunal, which ultimately did not agree with the interpretation adopted in the Circular.

In the above context, the taxation of a foreign company with Indian subsidiaries that have loan or advance arrangements among themselves raises interesting issues relating to taxation of the foreign company, including the characterization of the deemed dividend under an applicable tax treaty. If the payment is characterized as business income under a treaty, the foreign company cannot be liable to tax in India in the absence of a permanent establishment in India. However, if the payment is treated as "other income" or a dividend of the foreign company under a treaty, there may be tax liability in India. Another issue that could arise is whether the foreign company can per se be liable to tax under the terms of a tax treaty when it has not received any payment from India.

If it is determined that the foreign company is liable to tax in India, the question of whether a credit would be available for the Indian tax would be crucial since the payment typically would not be taxable in the country of residence of the foreign company. In other words, the Indian tax liability could ultimately become a real cost for the foreign company and might not, in turn, be deductible for the foreign company.

Another issue that could arise with regard to taxation in the hands of the shareholder would concern the subsequent setoff of a dividend against the loan or advance. As indicated above, if a dividend is subsequently declared by the payer company and is set off against the outstanding loan or advance, that dividend would not be subject to tax again. In the UMPL case, the person to whom the dividend would be distributed would be the shareholder (i.e. the individual), whereas the loan or advance would be outstanding in the name of the sister company (i.e. CSPL). In this case, it is unclear how the benefit of the provision relating to the setoff could be claimed. It is also relevant to note that no tax benefit would be provided in relation to the repayment of the loan or advance. The issue becomes even more complicated if foreign shareholders are involved because India's foreign exchange regulations would come into play, which contain strict guidelines relating to loans and advances, tripartite arrangements, setoffs, receivables and payables, etc.

In conclusion, foreign companies should take care when structuring their loans and advances among their Indian subsidiaries, as such arrangements could trigger the deemed dividend provisions in the hands of the foreign shareholder. Because there is no clarity under Indian law as to how the benefit of a setoff on a subsequent dividend distribution can be claimed, a foreign company that fails to protect itself from the application of the deemed dividend provisions may find itself at a considerable disadvantage.