Bombay High Court resolves the DDT-DTAA controversy: Treaty rate held applicable notwithstanding domestic levy mechanism

Introduction 

In a significant and precedent-setting ruling, the Bombay High Court has settled the long-standing controversy concerning the applicability of tax treaty protection to Dividend Distribution Tax (‘DDT’). In Colorcon Asia Pvt. Ltd.[1], the Court set aside the ruling of the Board for Advance Rulings (‘BFAR’) and declined to follow the Special Bench decision of the Mumbai Tribunal in Total Oil India Pvt. Ltd.[2], holding that dividend income distributed to a UK resident shareholder cannot be subjected to tax in India at a rate exceeding the limitation prescribed under the India-UK Double Taxation Avoidance Agreement (‘DTAA’), merely because the levy is collected as DDT under domestic law.

The judgment is notable for reaffirming the primacy of treaty interpretation based on the nature of income, rather than the mechanism or incidence of collection under municipal law, and has far-reaching implications for pending disputes under the erstwhile DDT regime.

Factual background

The appellant, an Indian company and a wholly owned subsidiary of a UK resident parent company, distributed dividends during assessment years 2016-17 to 2019-20. While distributing such dividends, the appellant discharged DDT under Section 115-O of the Income-tax Act, 1961 (‘Act’) at the effective rate of approximately 20%.

Taking the position that the dividends were paid to a UK tax resident who was the beneficial owner of such income, the appellant sought an advance ruling on whether the tax on dividends could be restricted to 10% in terms of Article 11(2)(b) of the India-UK DTAA, and whether DDT paid in excess of such rate was refundable.

The BFAR rejected the application, holding that DDT was a tax on the distributing company and fell outside the scope of the DTAA, primarily relying on the Special Bench ruling in Total Oil India Pvt. Ltd. (Supra).

Issues before the Court

The appeal before the High Court raised the following central issues:

• Whether DDT constitutes a tax covered under Article 2 of the India-UK DTAA;
• Whether treaty protection under Article 11 can be denied on the ground that the incidence of tax is statutorily shifted to the distributing company; and
• Whether India is entitled to collect tax on dividend income at a rate exceeding the treaty cap by characterizing the levy as DDT.
• If treaty protection applied, whether the 10% treaty rate needs to be grossed up before application.
   

Findings and analysis of the High Court

Treaty application depends on the nature of income, not the person taxed

The Court held that Article 11 of the DTAA is triggered by the character of income as ‘dividends’, and not by the identity of the person upon whom tax is imposed under domestic law. In other words, the Court noted that there is no requirement that dividend income must be taxed in the hands of the shareholder in India for the treaty limitation to apply.

The Court categorically observed that DDT, though collected from the distributing company, is in substance a tax on dividend income belonging to the shareholder, with the shift in incidence being a matter of administrative convenience rather than a change in the character of the levy.

Treatment of grossing-up issue

While answering the principal question on applicability of the treaty rate, the Court also addressed the ancillary issue concerning grossing-up of the tax rate.

The appellant had contended that once the dividend income is subjected to the limitation prescribed under Article 11(2) of the India-UK DTAA, the rate of 10% should apply without any further grossing-up. The Court, however, did not accept this contention in absolute terms

The High Court clarified that upon holding that Article 11 applies and that tax on dividend income cannot exceed the treaty-prescribed rate, the Department would nevertheless be at liberty to gros-up the tax rate in an appropriate manner, in accordance with the applicable provisions of law.

Accordingly, while the Court conclusively settled that the treaty cap of 10% governs the taxation of dividend income, it consciously left the mechanics of grossing-up open, to be determined by the Revenue in accordance with statutory provisions, and did not rule out grossing-up per se.

This clarification assumes significance as it indicates that the judgment does not prohibit grossing-up once treaty protection applies, but only ensures that the effective tax burden does not transgress the treaty limitation.

Legislative history of Section 115-O reinforces treaty protection

By examining the evolution of Section 115-O and its legislative intent, the Court held that the introduction of DDT did not alter the fundamental nature of dividends as shareholder income. The levy was designed to simplify collection and administration, not to convert dividend income into corporate profits.

Accordingly, DDT was held to fall within the scope of ‘income tax’ as contemplated under Article 2 of the DTAA, including taxes that are identical or substantially similar to those existing at the time of treaty execution.

Disapproval of the Total Oil Special Bench ruling

The Court expressly disagreed with the approach adopted by the ITAT Special Bench in Total Oil (Supra), which had proceeded on the assumption that treaty benefits could be availed only where tax is levied directly in the hands of the non-resident shareholder.

The High Court held that such an approach introduces considerations alien to the treaty text and impermissibly allows domestic law characterization to override treaty obligations.

Section 90(2) mandates application of the beneficial treaty rate

Reaffirming settled principles, the Court held that Section 90(2) of the Act entitles an assessee to apply treaty provisions where they are more beneficial. Since Article 11(2)(b) of the India-UK DTAA restricts India’s taxing rights on dividend income to 10%, collection of DDT in excess thereof was held to be unauthorized and contrary to law.

The Court further observed that retention of tax collected beyond treaty limits would violate Article 265 of the Constitution of India, which mandates that no tax shall be levied or collected except by authority of law.

Conclusion

The decision in Colorcon Asia Pvt. Ltd. (Supra) conclusively settles the controversy on the interaction between DDT and tax treaty provisions, decisively tilting the balance in favour of treaty primacy. By holding that India cannot circumvent treaty limitations through unilateral domestic collection mechanisms, and by clarifying that the Revenue is not precluded from grossing up the tax in an appropriate manner, the Bombay High Court has aligned Indian jurisprudence with internationally accepted principles of treaty interpretation.

While DDT has since been abolished, the ruling carries significant relevance for legacy disputes including the ones relating to the refund claims of DDT paid in excess of the treaty rate.

[The first author is Senior Associate while the other two are Consultants in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys]

[1] TS-1623-HC-2025 (Bom)

[2] TS-197-ITAT 2023 (Mum)