Last year's Budget had created uncertainty about the quantum of tax to be withheld on dividends paid to non-residents, as the exact tax rate was not specified under section 195.
Foreign portfolio investors (FPIs) have reached out to the government to reexamine laws that deal with withholding tax on dividends in light of uncertainty over the quantum to be levied on such investors, and market observers believe the government might correct this in the upcoming Union Budget.
Last year’s Union Budget had created uncertainty regarding the quantum of tax to be withheld on dividends paid to non-residents.
This was because the exact tax rate was not specified under section 195, which covers tax deducted at source (TDS) or withholding tax for non-residents.
The Finance Act, 2020, had clarified that a withholding tax rate of 20 per cent plus surcharge and cess be applied on dividends paid to non-residents under section 195.
Also, lower rates could be applied for residents coming from jurisdictions with which India entered into a double tax avoidance agreement (DTAA).
But while FPIs are classified as non-residents, the withholding tax rates for these are provided under a separate section, 196D of the Income Tax Act.
This section specifies a rate of 20 per cent (plus surcharge and cess) on dividends paid.
However, it does not provide for a lower withholding rate even if the FPIs’ tax liability is lower on account of an existing tax treaty.
At present, companies withhold tax at the rate of 20 per cent plus surcharge and cess on the dividend paid to FPIs, even if they invest from a jurisdiction that provides for a lower rate based on India’s DTAA with that country.
The lower rate could be five per cent, 10 per cent or 15 per cent.
“The current laws do not allow a company to deduct tax at the rate at which it is finally taxable for FPIs.
"Treaties have different rates, which could be lower than the 20 per cent required to be levied under section 196D of the IT Act,” said Sunil Gidwani, partner, Nangia Andersen.
According to Nehal Sampat, executive director, financial services, PwC India, one way to address the anomaly could be to amend section 196D to provide for withholding of taxes on dividends to FPIs at the applicable “rates in force” instead of 20 per cent.
Alternatively, FPIs could be permitted to approach the revenue authorities for a lower withholding certificate under section 197 of the IT Act.
“This would result in the correct amount of taxes being deducted, thus, easing the investment process for FPIs,” said Sampat.
The FPIs will need to claim credit for excess taxes withheld by the Indian companies in their respective home countries in accordance with the laws of their respective home countries.
According to Gidwani, the excess tax collected will have to be adjusted against the FPIs’ aggregate annual tax on all sources of income, including capital gains and interest income.
Alternatively, it will have to be claimed as refund.
FPIs are one of the biggest drivers of Indian equities and pumped in a record $16.8 billion in November and December, taking the benchmark indices to new highs.