H P Agrawal: Rationalise additional income tax

FOREIGN ENTERPRISES

The Finance Act, 2003 made a major change in respect of taxation of dividend income in the hands of shareholders.

Section 115(O) was amended to provide that the amount declared, distributed or paid after March 31, 2003 by a domestic company by way of dividends shall be charged to "additional income tax" in the hands of the company at the flat rate of 12.5 per cent, in addition to the normal income tax chargeable on the income of the company.

But the dividend income was made tax-free in the hands of the recipient shareholders in respect of dividends received on or after April 1, 2003.

The amendment may appear beneficial to all shareholders inasmuch as dividends received by them are now tax-free. But an analysis will show that the new law has inflicted an unintended hardship on the foreign investors.

If dividend income is taxed in India, the non-resident shareholder, in most cases, gets a credit for the tax paid in India in his home country.

This is so because the tax treaties, which India has signed with a large number of countries, provide that taxes paid in India on a particular income shall be allowed as a credit against the tax payable in the other country on that income.

On the other hand, if the dividend income is not taxed in India, the same will generally get taxed in the country of shareholder's residence.

Thus tax paid on dividend income in India does not make any difference to the non-resident investor because he gets the credit for the same in his home country.

In this manner, the benefit of exemption from tax is meaningless to a non-resident investor despite the fact that dividend is free from tax in India.

It seems the "additional income tax" on distributable profits was introduced to compensate the exchequer for the expected loss of revenue on account of exemption of dividend income in the hands of shareholders. These provisions would certainly be welcome to Indian shareholders, but have little value to the foreign investors.

On the other hand, the levy of "additional income tax", which reduces the quantum of dividend to be declared by a domestic company hits a foreign investor because the said additional income tax does not qualify for the underlying tax credit in the investor's home country.

The reason is simple: additional income-tax is paid by the Indian domestic company (and not by the shareholder). The credit for tax will be available only of the taxes paid in India by the shareholder himself.

The crux is, whereas the income tax paid in India entitles the shareholders to claim a credit against the tax payable by him in his home country, no such tax credit is available to non-resident shareholders for the "additional income tax" paid by the dividend distributing company.

Since the "additional income tax" effectively reduces the quantum of dividend, the said tax, though technically paid by the dividend distributing company, is effectively borne by the shareholder.

It is, therefore, advisable that a suitable amendment be made in the Income Tax Act to ensure that non-resident shareholders become entitled to avail tax credit for the additional income tax paid by the Indian domestic company. Such an amendment will directly benefit foreign investors without any impact on Indian tax revenues.

agar@nda.vsnl.net.in