Dividend as an ‘International Transaction’ – Will the opinion stand divided or united?
Executive Abstract & Issue Thesis
“Dividend made a big splash in the Finance Act 2020, wherein, the traditional method of taxing dividends in the hands of the shareholders has been reintroduced. In the past, many intercompany transactions like advertising, marketing, and promotion expenses (AMP expenses), issue of shares, intercompany borrowing, guarantees, cost sharing arrangements etc. have been scrutinized, debated, and continue to be contentious issues. This article discusses the applicability of TP provisions to ‘intercompany dividend’, which has till date remained an unchartered territory for the Indian Tax Authorities (ITA). Read on…”
I. What is Dividend?
Every company thrives on two main sources of funding, namely capital contribution by its shareholders and borrowings. The word dividend comes from the Latin word dividendum (thing to be divided). Black’s Law Dictionary defines dividend as a portion of a company’s earnings or profits distributed pro rata to its shareholders, usually in the form of cash or additional shares. Dividend in layman’s terms is a return on capital in proportion to ownership (shares held) in a company.
a. Dividend is an Appropriation of Profits – Judicial Analysis
In one of the rulings the Punjab and Haryana High Court mentioned that dividend is an appropriation of profits in the landmark case of Punjab Distilling Industries Ltd. vs. CIT, (1963) 48 ITR 288:
“Speaking generally, ‘dividend’ is a sum of money or portion of divisible thing to be distributed according to a fixed scheme being what the shareholder earns as return on his investment; it is his share of corporate earnings credited to his account. The characteristic feature of ‘dividend’ is that it is declared and paid wholly from the net profits or undivided earnings leaving intact the shareholder’s fractional interest represented by his holding in the capital stock. A ‘dividend’ is not capital but the produce of capital. Subject to well recognised limitations, ‘dividend’ is a word of general and indefinite meaning without any narrow, technical or rigid significance. The term ‘dividend’ is applied to a distributive sum, share or percentage arising from some joint venture as profits of a corporation. In the second sense, it is a proportionate amount paid on liquidation of a company. In this context ‘dividend’ is being referred to in the sense of corporate profits set apart for rateable division amongst the shareholders, being surplus assets obtained in excess of capital”.
Having understood the nature of dividend, i.e., appropriated from a post-tax distributable profit (current or previous year), one needs to understand its implications under the Indian TP Regulations.
b. Provisions under the Act Dealing with Transfer Pricing
The provisions of Section 92 of the Income Tax Act, 1961 (the Act) deal with the applicability of transfer pricing provisions (TP provisions) to transactions between two Associated Enterprises (AEs). Section 92(1) of the Act provides that:
“Any income arising from an international transaction shall be computed having regard to the arm’s length price”.
In order to apply the provisions of Section 92(1) of the Act to dividend payment, firstly it must qualify as a ‘transaction’; and secondly it must be possible to benchmark the transaction with ‘arm’s length price’. Accordingly, it is important to analyze the definition of ‘international transaction’ and ‘arm’s length price’ as provided in the Indian TP provisions and evaluate its applicability to ‘dividends’.
II. Meaning of an International Transaction [Section 92B]
As per Section 92B of the Act, the following four conditions should be satisfied to be covered by the definition of international transaction:
There should be a transaction.
The transaction should be between two or more associated enterprises (AEs).
At least, one of the transacting parties should be a non-resident.
Purchase, sale, lease of tangible/intangible property, services, lending/borrowing, or having bearing on profits, income, losses, or assets.
Thus, all the four conditions as listed above should be cumulatively fulfilled for a transaction to be called an ‘international transaction’ under the Indian TP provisions.
III. Can Dividend be Construed to be a Transaction? [Section 92F(v)]
For evaluating whether dividend can be a transaction, one needs to refer to its definition under Section 92F(v) of the Act. It refers to any kind of arrangement, understanding or action would be a transaction even if it is not in writing and intent to transact is evident from the conduct of the parties (i.e., oral). Further, even if there is no legal remedy for enforceability of such arrangement, understanding or action, it would still qualify as a transaction.
“To ascertain whether the declaration and payment of dividend can be considered to be a transaction, one needs to understand the nature, circumstances permitting payment of dividends and procedural aspects relating to dividend.”
Relevant Judicial Rulings in India on the Term ‘Transaction’ (AMP Expense Analogy)
The existence of a ‘transaction’ and consequent ‘international transaction’ has been deliberated by the Indian Tax Authorities while adjudicating whether Advertising, Marketing, and Promotion (AMP) expenses incurred by an Indian company was an ‘international transaction’ requiring ALP compensation from Foreign AE:
| Case / Judicial Authority | Ruling in the Context of Arrangement, Understanding and Action in Concert |
|---|---|
|
Maruti Suzuki India Ltd. (ITA-710/2015, Delhi High Court) |
Even if the word ‘transaction’ is given its widest connotation, … it is still incumbent on the Revenue to show the existence of an ‘understanding’ or an ‘arrangement’ or ‘action in concert’ between MSIL and SMC as regards AMP spend for brand promotion. |
|
Bacardi India Pvt. Ltd. (ITA No. 1970/Del/2017, ITAT Delhi) |
The Courts held that the existence of an international transaction will have to be established de hors the Bright Line Test (BLT), the burden is on the Revenue to first show the existence of an international transaction. The objective of Chapter X is to make adjustments to the price of an international transaction which the AEs involved may seek to shift from one jurisdiction to another. An ‘assumed’ price cannot form the reason for making an ALP adjustment. Since a quantitative adjustment is not permissible for the purposes of a TP adjustment under Chapter X, equally it cannot be permitted in respect of AMP expenses either.
[Note: BLT was first deliberated by US Tax Court in DHL Inc. v Commissioner (TCM 1998-461) and challenged in Maruti Suzuki India Ltd. (2010) 328 ITR 210].
|
|
Daichi Sankyo v. J. Chiguripati (Civil Appeal No. 7148 of 2009, Supreme Court of India) |
Supreme Court held that action in concert would necessarily entail a shared common objective or purpose between two or more persons. In the absence of such shared objective or purpose, no presumption of a transaction can be made. |
|
Whirlpool of India Ltd. (ITA Nos. 610/2014 & 228/2015, Delhi High Court) |
The Delhi High Court while negating the AMP adjustment quoted: “A unilateral action by one of the partners without any binding obligation on the other could not be termed as a transaction. There could not be an inference of the existence of such an ‘international transaction’. The onus is on the Revenue to demonstrate the existence of such transaction between the two parties”. |
Based on the above judicial pronouncements, it needs to be evaluated whether declaration and payment of dividend can be considered to be arrangement, understanding or action in concert between the company and its shareholders at the time of investing in the shares of the company.
IV. Declaration and Distribution of Dividend is at Management’s Discretion
It would be the endeavour of every company to maximize return on investments of its shareholder’s funds and maintain a good dividend payout ratio to attract further investments. When the shareholder invests in any company (Private or Public) he is not assured of a yearly return in the form of dividend at the outset (i.e., at the time of investing in the company). This is in consonance with any business activity, which can face either of the extremes, profits or losses. But the ability of a company to pay dividends is governed by the applicable laws and management’s discretion. Payment of dividend is discretionary and is dependent on many factors (internal and external) to the organization.
Management which oversees day to day running of the business must observe prudence and decide when (timing and frequency), whether to pay or not to pay and how much (quantum) based on the following comprehensive matrix:
Internal Factors Influencing Dividend
- Capital Commitments: Capital expenditure plans, funding for acquisitions / mergers.
- Operating & Financing: Operating Profit After Tax (PAT), operating cash flows, long-term and short-term debt service obligations, working capital requirements.
- Statutory & Solvency: Future tax demands / contingencies, capital adequacy ratios, solvency margins, immediate liquid funds.
External Factors Influencing Dividend
- Statutory & Legal: Mandatory statutory restrictions, regulatory requirements, tax laws, governing accounting standards.
- Macroeconomic Climate: Industry-wide payout ratios, general GDP growth of the host country, capital market trends and cost of alternate debt.
- Other Factors: Geopolitical risks, currency volatility, and systemic market uncertainties.
“Declaration and payment of dividend is solely the management’s judgement and based on the combination of a variety of internal and external factors and commercial realities specific to the company.”
V. Restriction under the Companies Act 2013
Though dividend is a return on capital invested in the company, its declaration and distribution are discretionary upon the Management of the company as per the Companies Act 2013. Section 123(1) of the Companies Act 2013 provides that dividend shall be paid by a company for any financial year only out of the profits for that year after providing for depreciation, subject to certain exceptions. Accordingly, the company must strictly comply with the Companies Act 2013 before it decides to declare dividend.
VI. Declaration and Payment of Dividend is a ‘Unilateral Act’
The following key gates must be evaluated and satisfied by the management before declaring dividend:
If and only if the above conditions have been met, the Board of Directors (BOD) would recommend the dividend out of profit available for appropriation. Such recommendation is presented for approval of the shareholders in the general meeting. Neither the BOD nor the shareholders can have a say in the dividends unless the above conditions have been satisfied. From the above discussion, it can be observed that declaration and payment of dividends is dependent on Management’s sole discretion, after considering internal and external factors and applicable laws.
It needs to be appreciated that no third party would be ready to transact for a consideration which is at the discretion of the recipient of the service (i.e., the company declaring the dividend in the instant case). In other words, if a view otherwise is taken that dividend is a bilateral act, (i.e., it is a return on the capital invested in the company), it needs to be understood that this return is discretionary (timing, quantum, frequency may differ from year to year for the same company) and sometimes never even be paid (if the company continues to be in losses and goes into dissolution).
While a transaction involves two parties who discharge their respective obligations, payment of dividend does not arise from any contractual obligation, whether oral or in writing. The company’s ability to declare and pay the dividends for the year is not decided by way of any arrangement or understanding or action between the company and its shareholders. It is merely representing a distribution of post-tax profits that belong to shareholders. Dividend being merely a distribution of post-tax profit belonging to shareholders, payment of dividend does not partake the character of ‘transaction’ between company and shareholders.
“Therefore, considering the above discussions it can be concluded that dividend is a unilateral act and in the absence of a bilateralism, dividend fails the quintessential condition to qualify as a ‘transaction’ and consequently ‘international transaction’.”
VII. No International Transaction – No Arm’s Length Price
Another important aspect for any international transaction is to determine what is the arm’s length price. The arm’s length price under TP provisions (Section 92F) means a price which is applied or proposed to be applied in a transaction between third parties, in uncontrolled conditions.
The judicial decisions relating to AMP make it amply clear that in the absence of international transaction, there cannot be an arm’s length price for the same. The celebrated decisions in CIT v. B.C. Srinivasa Setty (1981) 128 ITR 294 (SC) and PNB Finance Ltd. v. CIT (2008) 307 ITR 75 (SC) further seconds the said view and mentions that in the absence of any machinery provision, bringing an imagined transaction to tax is not possible.
VIII. No Available Mechanism for Determination of ALP
Even if one attempts to determine the ALP, the quantum, timing, frequency of dividends is specific to the facts of each company and cannot be calibrated with respect to similar transaction with a third party. In the case of dividends declared and paid by Companies to third party shareholders too, there could be a very unpredictable trend in terms of the quantum, timing, frequency of dividends for every company and from year to year for the same company. There is no clear-cut statutory provision / method available to benchmark the payment of dividend, and determination of arm’s length price for such dividend is not possible.
Key Principles from Maruti Suzuki India Ltd. (Delhi High Court):
- Assessing Officers could not apply ‘best judgment’ assessment as a device to disallow what he considers to be an excessive expenditure under section 40A(2) of the Act.
- There was no corresponding ‘machinery’ provision in Chapter X to compute excessive expenditure.
- Brand could derive its value from nature of the industry, the geographical peculiarities, economic trends both international and domestic, the consumption patterns, market behaviour, etc.
- An alternative approach to what was provided under Section 92C of the Act, was not legally permissible and arbitrary.
- To address tax avoidance, a provision in the statute giving a clear policy was required to check subjectivity.
IX. International Practices & Global Transfer Pricing Rulings (Poland Guidance)
In one of the international precedents analysing the non-applicability of TP provisions to dividend transaction, Poland’s Minister of Finance on 6 August 2020 issued official guidance on whether a dividend payment among ‘associated companies’ falls within the scope of the definition of a ‘controlled transaction’ for TP purposes.
Economic Activity vs. Produce of Economic Activity
A plain reading implies that any activity to be considered as of ‘economic in nature’ needs to satisfy the condition of being an activity (for the purpose of) earning money. Thus, economic activity would consist of activities of ‘economic nature’ i.e., (for the purpose of earning money). Thus, payment of dividends cannot be construed as an economic act in itself (carried out to earn profits). It is the generation, distribution and payment of the profits resulting from an economic activity – e.g., sale of goods or services etc.
Accordingly, it was clarified by the Polish tax authority that the dividend payment does not fall within the definition of a ‘controlled transaction’ and therefore there was no need to prepare (local) TP documentation w.r.t payment of dividends. In principle the Polish tax authority clarified that dividend is ‘produce of an economic activity’ and not the ‘economic activity itself’. It is the fruits of the economic activity which is being distributed to the owners (i.e., profit is appropriated, in proportion to the shareholding in the company) in the form of dividend. Thus, the Polish tax authority also concluded that ‘dividend’ needs to be kept out of the rigors of TP.
X. Conclusion & Compliance Safeguards
Based on the detailed discussion above, it can be observed that taxation of ‘dividend’ till date remains to be a very interesting subject in India. For dividend to be reviewed as an ‘international transaction’ under the Indian TP Regs, it must satisfy the quintessential condition of being a transaction i.e., it needs to be substantiated to be a transaction. Transaction is a two-way act i.e., an arrangement, understanding action in concert to do something for which there would be a consideration.
Dividend is a ‘unilateral act’ as the declaration of dividend factors into management’s discretion and regulatory compliance. Therefore, quantum and timing of declaration and payment of dividend is in the hands of the management and not the shareholders (i.e., recipient of the dividend). Also, there is no mechanism by which dividend can be benchmarked under any of the methods envisaged under section 92C of the Act. In the absence of a ‘transaction’ and with ‘no statutory machinery’ to benchmark the transaction, it can be reasonably concluded that Dividend has rightly stayed away from the rigors of TP.
Prudent Ring-Fencing Against Severe TP Penalties:
Having said this, dividends declared and paid (or received) by closely held private companies in India need to be properly supported with commercial rationale. The timing and quantum of payment / receipts with all the regulatory approvals, needs to be documented proactively while declaring the dividends for ring-fencing from penal consequences for non-disclosure and non-compliance with the arm’s length standard:
- Section 271AA of the Act: Penalty for non-maintenance of prescribed record/documents – Prescribes imposition of penalty equal to 2% of the value of each international transaction on account of failure to maintain information and document.
- Section 271BA of the Act: Penalty for failure to submit audit report within prescribed time limit – Penalty equal to Rs. 1,00,000 for failure to furnish audit report from an accountant as required u/s 92E.
- Section 271G of the Act: Penalty for failure to submit records/documents called for – Penalty of 2% of the value of international transaction for each failure to produce information and document as requisitioned by Income Tax authorities.