Indian entities and U.S. taxation: U.S. shareholders of Indian corporations

In our blog series on the U.S. taxation of Indian entities, we have discussed how Indian corporations are generally taxed in the U.S. A quick recap, U.S. taxes foreign corporations on their effectively connected income (ECI) with the U.S. trade or business and certain fixed or determinable annual or periodical (FDAP) income that may not be ECI. The taxation of Indian corporations in the U.S. may seem to be limited in comparison to the taxation of a U.S. shareholder owning shares in an Indian corporation.

This blog addresses how U.S. taxes its citizens, residents or domestic corporations that own interest in Indian corporations.

Taxation of profits that are distributed as dividends

In India, dividend distribution is currently tax free for shareholders of Indian domestic corporations. Indian corporations are required to pay dividend distribution tax (DDT) at an effective rate of 20.36 percent. In the recent Indian Budget 2020-21, the abolition of DDT has been tabled which means that shareholders of Indian corporations would have to pay tax. It further implies that Indian corporations would have to withhold tax on distribution of dividends to its U.S. shareholders.

In the U.S., dividends received from Indian corporations is taxable. However, U.S. corporations receiving dividends can claim deduction. Foreign tax credit is available to avoid double taxation of dividends for U.S. citizens or residents.

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Taxation of profits irrespective of actual distribution

The U.S. taxes profits of Indian corporations (irrespective of actual distribution of such profits) through its shareholders who are U.S. citizens, residents or U.S. corporations under various tax provisions. These provisions include, taxation of profits or income earned by U.S. shareholders for holding prescribed interest or voting right in an Indian corporation that may be considered as a foreign personal holding company, controlled foreign corporation or passive foreign investment company, and thus, the sub part F income or global intangible low-taxed income is taxable. There are reporting and disclosure requirements even if there are no taxable profits.

The U.S. taxation provides an anti-deferral taxation framework on profits of foreign corporations. The imposition of tax may further depend on the characterization of Indian corporations for U.S. tax purposes. For example, profits of an Indian corporation flow-through to the U.S. shareholder where a check-the-box election has been made for U.S. tax purposes. U.S. shareholders of Indian corporations should be mindful of the reporting obligations that apply even if there is no taxable income. In addition to taxation of dividends, U.S. shareholders should be aware of the capital gains tax implications that adds to the cost of holding investments in foreign structures.