INTRODUCTION

Dividends from IDRs to non-resident IDR Holder held to form a ‘business connection’ in India.

Dividend assessable under ‘Other Income’ article of Mauritius Treaty, as requirements of ‘Dividends’ under Article 10 of Mauritius Treaty were not satisfied.

Recently, the Mumbai bench of the Income Tax Appellate Tribunal (“Tribunal”) held1 that dividends received by Morgan Stanley, Mauritius (“Taxpayer”), by virtue of holding Indian Depository Receipts (“IDRs”) representing shares of Standard Chartered Bank, UK (“Foreign Company”), were not taxable in India under the India-Mauritius Double Taxation Avoidance Agreement (“India Mauritius Treaty” or “Treaty”).

The Tribunal held that the dividend received was taxable in India under section 9(1)(i) of the Income Tax Act, 1961 (“ITA”), but did not qualify the requirements of Article 10 of the Treaty that governed taxation of ‘Dividends’, and could only be assessed as ‘Other Income’ under Article 22 which gave exclusive taxation rights to the residence state i.e. Mauritius.

BACKGROUND

An IDR is a financial derivative instrument listed on an Indian stock exchange, which derives its value from underlying shares of a company incorporated outside India. IDRs are issued to an IDR holder by a domestic Indian depository, authorised by the company whose shares form the underlying asset. From a transaction perspective, the foreign company issues shares to the Indian depository, which then issues IDRs to investors. However, even the Indian depository does not have possession of the shares of the foreign company, as these shares are held by a foreign custodian on behalf of the Indian depository.

The legal regime surrounding IDRs is governed by the Companies Act, 2013 read with the relevant rules, along with applicable regulations of the Securities and Exchange Board of India. Taxation of IDRs has been a subject of mystery since the introduction of the IDR regime, and lack of clarity on the subject has purportedly been one of the main causes of scant IDR issuances in the country. The ITA currently does not address IDRs at all, even though it provides specifically for taxation of income from Global Depository Receipts.

FACTS

In the present case, the Taxpayer is a company resident in Mauritius that invested in IDRs issued by Standard Chartered Bank – India (“Domestic Depository”), with its underlying assets being shares of the Foreign Company. The shares were held by the Bank of New York, USA (“Foreign Custodian”) on behalf of the Domestic Depository. The Foreign Company paid dividend, which was first received by the Foreign Custodian - being in possession of the shares - and then transferred to the Domestic Depository, being legal holder of the shares. The Domestic Depository then distributed the dividends to the IDR holders, including the Taxpayer.

The Assessing Officer (“AO”) held that the first point of receipt of the dividend was when the amount was deposited in the bank account of the Taxpayer in India, making it taxable under the ITA. The Dispute Resolution Panel (“DRP”) confirmed the AO’s stand, however on treaty protection the DRP held that the dividends were distributed by the Domestic Depository to the Taxpayer, and so Article 10(2) of the Treaty would apply between the Domestic Depository and the Taxpayer rendering the amount taxable in India.

TAXPAYER’S ARGUMENTS

Before the Tribunal, the Taxpayer argued that:

The Domestic Depository acted as a trustee for the IDR holders (including the Taxpayer), and hence the receipt of dividend in the hands of the Taxpayer was at the point when the Domestic Depository received the amount from the Foreign Custodian, which receipt occurred outside India.

The dividend was paid by the Foreign Company, hence the income could not be deemed to accrue or arise in India, as Section 9(1)(iv) of the ITA is applicable only if dividends are paid by an Indian Company.

There is no business connection of the dividend income with India as even the Central Board of Direct Taxes’ Circular No. 4 of 2015 (relating to indirect transfer provisions) provides that dividend paid by foreign companies cannot be subjected to tax in India.

Article 10 of the Treaty that governs taxation of dividends would only operate when the company paying the dividend is resident in one of the contracting states i.e. India or Mauritius. Since the Domestic Depository was only a branch of the Foreign Company, it was a Permanent Establishment (“PE”) of a UK tax resident in India and not independently a resident of India. The requirement of Article 10 could not be fulfilled and accordingly only Article 22, the residuary article, of the Treaty could apply, under which the income could be taxable only in the residence state i.e. Mauritius and not in India.

TRIBUNAL’s RULING

On taxability under the Income Tax Act

The Tribunal rejected the Taxpayers contention and held the amount to be taxable under ITA on the basis that:

The dividend income has a business connection in India under Section 9(1)(i) as the Domestic Depository was based in India, and it held the underlying shares for which the dividends were received, the IDRs were issued by it, the IDRs were listed on Indian stock exchanges and the entire management and control of the Domestic Depository was based in India.

The dividend income arose from the foreign shares which is the property of the Domestic Depository, which shares were the source of such dividend income, hence the income should be deemed to accrue or arise in India as per section 9(1)(i) of the ITA. The foreign shares, though being in physical possession of the Foreign Custodian, were legally the property of the Domestic Depository.

The Taxpayer’s reliance on Circular No. 4 of 2015 was not justified, as that circular covered persons who received dividends but did not have any business connection in India except the underlying assets being situated in India, whereas in the current situation the position was the opposite as the central point of investment activity was in India and the business connection was clearly evident.

The scope of section 9(1)(iv) does not restrict the scope of section 9(1)(i). Hence, if dividend is not taxable under section 9(1)(iv) since it is not paid by an Indian company, it could still be subject to tax under section 9(1)(i).

If dividend is considered to be received from the Domestic Depository, since it pays the amount net of any charges, in such case also the dividend accrues to the Taxpayer when the amount is finalised by the Domestic Depository and is received when the Domestic Depository pays the money to the IDR holder, including the Taxpayer. Hence, the amount should be considered to be received in India.

On taxability under the Treaty 

However, on coming to the Treaty analysis, the Tribunal held that even though the dividend received by the Taxpayer was taxable under the ITA, the same was exempt under the India-Mauritius Treaty.

The Tribunal held that whether the payment was considered to be made by the Domestic Depository or by the Foreign Custodian, either way it could not be held that the payment was made by a ‘company which is resident in India’. Hence Article 10 of the Treaty could not apply. Further, there being no other specific article covering taxation of dividend income, the amount could only be subjected to Article 22, where paragraph 1 provided that such income could be taxed only in the residence state i.e. in Mauritius.

CONCLUSION

The Tribunal ruled in the Taxpayer’s favour on the basis of treaty benefit under Article 22 of the India-Mauritius Treaty to the Taxpayer. However, from April 1, 2017 Article 22 has been amended with the effect that ‘Other Income’ can now be subjected to tax in the source country as well. Therefore, the finding of the Tribunal may not hold much precedential value going forward.

On the operation of tax treaties, the Tribunal made an important observation that treaty protection is not concerned with who paid the income, and once eligibility in terms of residence is established, the treaty protects the resident from taxes covered under Article 2. Hence, the Tribunal did not provide a specific finding as to who distributed/paid the dividend in question – the Foreign Company or the Domestic Custodian - although going forward a specific finding on this point would have been relevant.

Specifically with respect to the Tribunal’s findings on nexus of the dividend arising from the IDRs, the Tribunal concludes on the existence of a ‘business connection’ in India under Section 9(1)(i) of the ITA. The Tribunal appears to conflate the concept of a ‘business connection’ of a non-resident taxpayer in India, with a ‘business connection of the dividend income’ which is not a concept that Section 9 espouses. Even if the Tribunal’s finding were to be taken a step further, the analysis under Section 9 for purposes of determining whether there is a ‘business connection’ would need to be undertaken vis-à-vis a non-resident taxpayer. In this case, since the non-resident taxpayer is the Taxpayer in Mauritius, the Tribunal does not evaluate how the presence of the Domestic Depository amounts to a ‘business connection’ of the Taxpayer in India. Going purely by the text of Section 9(1)(i) read with Explanation 3, the Taxpayer should be undertaking some business activity in India through such a ‘business connection’ and only such income that is attributable to such business connection should be taxed in India. However, the Tribunal nowhere explains what activity is being carried out in India by the Taxpayer for it to amount to a ‘business connection’, or how the dividend income can be attributed to a business connection of the Taxpayer in India.

The Tribunal’s analysis regarding ‘business connection’ notwithstanding, the uncertainty around taxation of IDRs has typically revolved around the central question of the source of income arising from the IDRs. Whether the nature of the income is the dividend arising from the IDR or capital gain from its transfer, it can be argued that the ‘source’ of the income is the location of the non-Indian company, which lies outside India. Indian jurisprudence, in the context of shares of companies, has consistently held that the situs of shares of a company lies at the place of incorporation of the company or the place where the register of the company is kept and hence income from transfer of such shares is sourced at such place.2 In respect of dividend income from shares, the dividend income has been held to accrue where it has been declared and it is by the deeming fiction under section 9(1)(iv) that dividend declared by an Indian company abroad is also rendered taxable in India.3 Hence as a corollary, dividend or capital gain arising to a non-resident IDR holder, such as a Foreign Portfolio Investor, from underlying shares of a non-Indian company, should not be regarded as having its source in India as neither would the foreign company’s register be not maintained in India and nor would the dividend be declared in India.

The concept of IDRs was brought in by the Government of India in 2004. However, the IDR regime did not find much success in India, and only a single IDR issue took place - the current Standard Chartered one, which was also was delisted in 2020. Though there are a number of reasons for the lack of success of the IDR regime so far, including regulatory hurdles such as restricting participation to limited investors, tax uncertainty has been a key reason.

In today’s interconnected world, regimes enabling the listing and raising of funds from alternate jurisdictions, in a manner that ensures complete disclosure and investor protection, have been on the rise. IDRs are one way of accomplishing this, but the issue of IDRs is a complex exercise, where parties from multiple jurisdictions have different rights and obligations. In this background and considering the current global investment climate, the Government could consider more detailed and clear tax provisions for addressing the taxation of IDRs, perhaps in a manner similar to provisions for taxation of Global Depository Receipts.

^{1 ITA no. 7388 of 2019}

^{2 Vodafone International Holdings BV v. UOI 341 ITR 1 (SC), Bradbury v. English Sewing Co. 8 TC 481}

^{3 Pfizer Corpn. v. CIT [2003] 259 ITR 391 (Bombay)}