Foreign portfolio investors (FPIs) across the globe have been puzzled by reassessment notices from India's Income Tax Department for years when they held Indian shares but received no actual income. This administrative development stems from complex tax provisions that existed before recent reforms, creating compliance obligations even for dormant investments.
The Deemed Dividend Problem
The core issue relates to a provision in Indian tax law that existed before April 2020. Under Section 2(22)(e) of the Income Tax Act, certain transactions between companies and their shareholders were treated as "deemed dividends" even when no actual dividend was paid. This arcane rule was designed to prevent domestic companies from disguising dividend distributions as loans to shareholders.
For foreign investors, the complication arose when Indian companies they invested in had certain shareholding structures or accumulated profits. Even if the FPI simply held shares without receiving any cash dividend or selling them, the tax authorities could potentially classify internal company transactions as deemed dividends attributable to shareholders.
Why Reassessment Notices Are Being Issued Now
The Income Tax Department has been undertaking scrutiny of past assessment years, particularly focusing on:
- Foreign portfolio investments made between 2016 and 2020
- Cases where Indian companies had significant accumulated reserves
- Shareholding patterns that triggered deemed dividend provisions
- Investments through complex corporate structures
Tax authorities are empowered to reopen assessments within certain time limits if they believe income has escaped assessment. Many FPIs are now receiving notices for assessment years that fall within the permissible reassessment window, even though the deemed dividend provisions were abolished in 2020.
The 2020 Tax Reform Context
The Finance Act 2020 eliminated the deemed dividend tax regime and the Dividend Distribution Tax (DDT) that companies previously paid. From April 1, 2020, dividends became taxable in the hands of recipients under the classical system. However, this change did not provide retrospective relief for earlier years.
FPIs that held Indian shares during the pre-2020 period may therefore face tax demands for deemed dividends they were unaware existed, based on internal transactions within Indian companies they had invested in.
Impact on Portfolio Investors
Foreign investors typically make portfolio investments expecting straightforward tax treatment – taxation on dividends received and capital gains on share sales. The deemed dividend provisions created unexpected complications:
- Tax liability without corresponding cash flow to pay the tax
- Complex compliance requirements for understanding Indian company internal transactions
- Administrative burden of responding to reassessment notices
- Potential double taxation issues with home countries
Many FPIs invested through fund structures that pooled capital from multiple global investors, making it particularly challenging to allocate and manage deemed dividend tax liabilities retrospectively.
Documentation Challenges
Responding to these notices requires FPIs to:
- Gather historical records of shareholding patterns
- Obtain details of Indian company internal transactions from years past
- Demonstrate whether deemed dividend provisions actually applied
- Claim benefits under tax treaties with India if applicable
- Show that income was not actually earned or was already taxed
The documentation burden is significant, especially for investors who may have exited positions years ago or who invested through fund structures that have since been restructured.
The Path Forward for Affected Investors
Foreign investors receiving reassessment notices should take several steps:
- Engage qualified Indian tax advisors immediately to review the notice
- Gather all historical investment and transaction records
- Analyze whether deemed dividend provisions actually apply to their specific case
- Examine applicable tax treaty provisions that might provide relief
- Respond within the stipulated timelines to avoid adverse orders
- Consider settlement options if legitimate tax exposure exists
Broader Implications for FPI Confidence
These retrospective reassessment actions, even if legally valid, raise concerns about tax certainty for foreign investors. India has made significant efforts to improve ease of doing business and attract foreign investment. However, unexpected tax demands for transactions from years past – particularly for income that was never received in cash – can impact investor confidence and decision-making for future investments.
The government and tax authorities face the delicate balance of ensuring tax compliance while maintaining India's attractiveness as an investment destination in an increasingly competitive global environment.
This article provides general information about tax reassessment notices and should not be considered as tax or legal advice. Foreign investors facing such notices should consult qualified tax professionals familiar with Indian tax law and relevant tax treaties for guidance specific to their circumstances.
