By Bhavin Shah & Nehal Sampat
With signs of revival in economic activities, the engine of investment activities is also revving. As NRIs evaluate investment opportunities in capital markets, to avoid any “speed bumps,” it is imperative for them to better understand some recent changes to the taxation regime for mutual funds.
Dividends … “to be or not to be question”
While presenting Budget 2020, the finance minister made a big-ticket change in the taxation regime for dividends. Hitherto, dividends declared by companies were liable to Dividend Distribution Tax (DDT) payable by companies. Such dividends were exempt from tax in the hands of non-resident shareholders and liable to tax at 10% on sums in excess of `10 lakh in the hands of resident shareholders. Similarly, income distributed by equity-oriented funds was subject to an Income Distribution Tax (IDT) of 10% with no further tax in the hands of unitholders. The income distributed by debt and other mutual funds was subject to IDT at 25%/ 30% with no further tax in the hands of unitholders.
With effect from April 1, the FM moved to the classical system of taxing dividends in the hands of shareholders/unitholders. Pursuant thereto, dividends declared by companies or income distributed by mutual funds are no longer liable to DDT or IDT but are taxable in the hands of shareholders/ unitholders. Mutual funds clearly offer an advantage over directly investing in portfolio companies in the form of deferral of taxes on dividends received from companies, as their incomes are exempt from tax. This advantage can be optimised by investing in growth plans rather than dividend or dividend reinvestment plans of mutual funds.
Tax rates on dividends and deduction of taxes (TDS)
Income accruing to NRIs in respect of mutual fund units purchased in foreign currency is taxable at 20%. In parallel, a deduction of tax at source at 20% is provided on income distributed by mutual funds.
The tax treaties signed by India with several countries provide for a lower rate of tax at 10% or 15% on “dividends” paid by companies. The term “dividends” is generally defined in tax treaties to mean income from shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights, which is subjected to the same taxation treatment as income from shares. While one would need to analyse the provisions of each tax treaty, a literal reading of the generic provision suggests that the concessional tax rate may not be available to income distributed by mutual funds. However, we may highlight that the decision of the Authority for Advance Ruling in the case of Rajnikant R Bhatt, 222 ITR 562, seems to suggest that the lower rate of tax could extend to income distributed by mutual funds.
The Finance Act, 2020, has capped surcharge on “dividends” earned by individuals at 15% (instead of the higher rates of 25% and 37%). Given the meaning of the term “dividends” and its usage in the law and for the reasons discussed above, it may be difficult to cap the surcharge rate on income distributed by mutual funds to 15%.
TDS on capital gains/redemption
With respect to payment of income on units to resident investors, the TDS provisions expressly exclude capital gains arising on redemption of units from their ambit. However, a similar exclusion is not provided in the TDS provision for non-residents. Hence, a question may arise whether taxes should be deducted at 20% on capital gains arising on payment of redemption proceeds to unitholders (akin to dividends distributed by a mutual fund) or, alternatively, withheld at “rates in force,” as is the current practice?
TDS deducted at 20% may result in higher taxes deducted on capital gains on equity-oriented funds, which could be taxable at lower rates, or capital gains on redemption of units that are exempt under certain tax treaties. This may result in capital gains on debt or other funds that are taxable at 30% subjected to lower TDS.
Various arguments support both the views discussed above, including analogies from other provisions and the ratio of other judicial precedents.
Thus, there could be a risk of non-compliance of TDS obligation and litigation from a mutual fund’s perspective. However, prima facie, TDS as per the “rates in force” provision may represent a better view, although one needs to analyse the issue holistically and take a considered call.
In addition, NRIs availing benefits under tax treaties need to be mindful of the General Anti-Avoidance Rules and the recently implemented Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI). NRIs will also require a Certificate of Residence or Tax Residency Certificate and a duly filled Form 10F for claiming treaty benefits.
To summarise, the impact of the changes promulgated by the Finance Act, 2020, on the investment portfolios of NRIs merits review. Considering the changes, investing through growth plans of mutual funds may become more popular.
Ketki Shah also contributed to the article.
Shah, is partner & leader, Sampat is Director-Financial Services Tax, PwC India. Views are personal