Several foreign funds and holding companies investing into Indian stocks through tax-friendly jurisdictions, like Mauritius and Singapore, have been declined treaty benefits and are being asked to pay tax on dividends, said people with direct knowledge of the matter.
The Income Tax department had sent queries to these offshore entities asking why their dividend incomes should not be taxed. Foreign funds, which were unable to demonstrate ‘commercial substance’ to it, have been denied the tax treaty benefit. An entity is said to fulfil commercial substance requirements, if it has an office, working staff, cash flows and management there.
Most of these tax assessments pertain to dividends received by the foreign entities in FY21. The tax department sent these queries to these foreign funds between October and December, said people cited above.
In the Union Budget FY20-21, the government made dividends taxable in the hands of investors. In case of FPIs, the effective dividend rate varies from 5% to 20% depending on factors such as country of origin of FPI, how it is structured and how much dividend is being earned.
Several double tax avoidance agreements (DTAAs) allow foreign funds to be taxed in their home jurisdiction instead of India. The tax rates for dividends are much lower in jurisdictions like Mauritius.
However, tax rules also say that a beneficial rate of dividend can be availed only if the dividends are being paid to beneficial owners. Overseas funds set up intermediaries in Mauritius or Singapore that receive the dividend. The Singapore or Mauritius entity then transfers the dividend to the original fund or company. The tax department is taking a view since the dividends were not received by the beneficial owners and instead to pass-through entities, treaty benefit cannot be availed.