India: Clarification With Respect To Applicability Of Explanation 5 To Section 9(1) On The Dividend Declared By Foreign Company

The Central Board of Direct Taxes [CBDT] on 26th March 2015 issued a Circular no. 4/2015 wherein they have clarified that while interpreting the provisions of Section 9(1)(i) of the Income Tax Act, 1961 [herein after referred to as 'Act'] read with Explanation 5 inserted to the said section by Finance Act, 2012, only that income will be taxable in India which is deemed to arised outside India from any transaction in respect of any share or interest in a foreign company or entity, which has the effect of transferring, directly or indirectly, the underlying assets located in India.

The circular clarified that the applicability of the explanation to the transactions not resulting in transfer, directly or indirectly of assets situated in India will not come under the ambit of taxation as such an extended application of the provisions of the Explanation may result in taxation of dividend income declared by a foreign company outside India. Further, this may also cause unintended double taxation.

Section 9 of Income Tax Act, 1961 deals with the provisions of Income deemed to accrue or arise in India. Sub-section (i) reads as follows:

"all income accruing or arising, whether in directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India".

Explanation 5 to this sub section reads as: For the removal of doubts, it is hereby clarified that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India.

The board have received many representations from corporate houses since the inclusion of the explanation wherein they have sought clarification that whether "the applicability of explanation 5 will be extended to the transactions not resulting in any transfer, directly or indirectly of assets situated in India like taxation of dividend income declared by a foreign company outside India in respect of shares which deriver their value substantially from assets situated in India.

While referring to the explanatory memorandum of legislature while adding the Explanation 5 to Section 9(1)(i) by finance Act 2012, the board in the circular mentioned that "one of the limbs of clause (i) of Section 9 is income accruing or arising directly or indirectly through the transfer of a capital asset situate in India. The intention of this insertion is to widen the application as it covers incomes, which are accruing or arising directly or indirectly. The section codifies source rule of taxation wherein the state where the actual economic nexus of income is situated has a right to tax the income irrespective of the place of residence of the entity deriving the income." Further, the objective of the legislature was that where corporate structure is created to route funds, the actual gain or income arises only in consequences of the investment made in the activity to which such gains are attributable be brought under the ambit of Section 9(i) and not the mode through which such gains are realized. Internationally this principle is recognized by several countries, which provide that the source country has taxation right on the gains derived of offshore transactions where the value is attributable to the underlying assets.

Accordingly, declaration of dividend by a foreign company outside India does not have the effect of transfer of any underlying assets located in India. It is further clarified that the dividends declared and paid by a foreign company outside India in respect of shares which derive their value substantially from assets situated in India would not be deemed to be income acquiring or arising in India by virtue of the provisions of Explanation 5 to Section9(1)(i) of the Act.

Meaning thereby clearing all apprehensions, doubts, the department vide the present circular reiterated that Explanation 5 would be applicable in relation to deeming any income arising outside India from any transaction in respect of any share or interest in a foreign company or entity, which has the effect of transferring, directly or indirectly, the underlying assets located in India, as income accruing or arising in India.

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