Towards the end of March 2018, the Income Tax Department (ITD) of India froze the bank accounts of the Indian arm of global IT firm Cognizant in Chennai and Mumbai for alleged evasion of Dividend Distribution Tax (DDT).

What is DDT? What Are the Allegations on Cognizant?

When any company in India declares dividends to its shareholders, it is liable to pay the Indian Government a certain percentage as tax, called the Dividend Distribution Tax. A 20% DDT is levied on the total dividends paid by a company.

Cognizant’s Indian unit carried out a share buyback in May 2016 from its shareholders under an ‘Arrangement and Compromise’ scheme. The shareholders that the company bought back shares from belong to Cognizant’s parent company in the US and its subsidiaries in Mauritius, which held 46% and 54% of its shares respectively.

Cognizant reportedly did not deduct tax on the payments made to the Mauritius company and deducted 10% TDS on the remittances to the US company.

The Income Tax (IT) authorities claim that the company paid only face value of INR10 (US$0.15) from its share capital. The authority also alleged that the company paid the entire balance from the collected profit which was actually dividend on which INR2,500 Crore (US$385 M) of DDT was not paid.

The IT department also said that there should be a dispute between two parties for ‘Arrangement and Compromise’ scheme. In Cognizant’s case, all shares were held by the same management, which was also party to all decision-making and there was no opportunity for dispute for the said scheme.

Why Does Cognizant Have to Pay DDT?

The Indian Income Tax Act requires DDT on any distribution, on the reduction of capital, to the extent accumulated profits defined as dividends. Cognizant was required to pay DDT of more than INR2500 Crore (US$385 M) in Financial Year 2016-17 itself, but failed to pay.

While Cognizant distributed dividends to its parent company in Financial Year 2017, the same should be subject to DDT, which when levied at 20% of the total dividends paid, comes up to approximately INR2500 Crore (US$385 M). Essentially, any payment to the company’s shareholders counts as distribution of profits, irrespective of the schemes.

The only exception to this is the buyback under section 77A of the Companies Act and Cognizant was not covered under it.

According to Section 77 of the Companies Act, 1956, a listed company is not allowed to buy its own shares. This came into effect to avoid companies to sell and buy their own shares and also to prevent unhealthy practices such as insider trading, or influencing stock prices in the stock market. However, the Companies Act, 1956 was amended to grant companies to buy back their own shares to give a boost to the Indian capital market. However, Cognizant is not a listed company in India and does not come under this exception.

Comments from Cognizant

Cognizant asserted that since the ‘Arrangement and Compromise’ scheme between the company and its shareholders was in conformity with the necessary sections of the Companies Act and approved by the court, no DDT was required to be paid by the company to the Indian Government.

Cognizant’s spokesperson commented that the company’s business operations, its associates, and its work with clients were not impacted by actions of the Income Tax Department and that the positions taken by the IT Department were contrary to law and without merit. The spokesperson also stated that Cognizant paid all applicable taxes due for the transaction at issue and will continue to defend itself.

Cognizant’s Chief Financial Officer Karen McLoughlin commented that payroll, promotions, and wage revisions would not be impacted by the Indian subsidiary’s ongoing DDT dispute with the Income Tax Department.

Current Status of the Dispute

In the first week of April 2018, the Madras High Court ordered Cognizant to deposit US$75 M, representing 15% of the disputed tax, to be kept in a suspense account by the ITD, with the remainder under lien. To aid the payment, the court ordered unfreezing of Cognizant’s JP Morgan bank account in Mumbai, but its accounts with other banks remained frozen. The High Court Judge further directed Cognizant to provide securities to the remaining tax demand, post which the ITD would defreeze the remaining bank accounts. The Court further granted Cognizant’s request to address the ITD’s collection actions and has scheduled a hearing at the end of April 2018.

A Regular Procedure or a Year-End Target Pressure?

It is not unusual for the ITD to scrutinize bank accounts of a company where the amount of tax involved is significant. At times when the ITD freezes bank accounts, the concerned company can go to court and get the freeze removed. However, if the money in account does get transferred to the ITD, it would take some time before the money is refunded. In cases like that, the ITD can show it in the revenue collection figure for the year and will also help the department to meet the year-end target.

Share Buy-Back Complications

Financial year 2018 witnessed a lot of buyback activity with 41 companies completing their share repurchase offers worth INR49,067 Crore (US$7,411 M), the highest-ever. Of this, buyback offers by seven IT services companies accounted for INR44,984 Crore (US$6,794 M) or 92%. This includes the INR16,000 Crore (US$2,416 M) TCS buyback and the INR13,000 Crore (US$1,963 M) Infosys buyback.

The ITD is agitated by companies refusing to pay dividends and its concomitant DDT and, instead choosing the buyback route to reward shareholders, given the tax advantages. But it is for the Parliament to take action on it. There is no point in being complacent on tax matters when the law itself through design or accidentally has left a loophole.

It does not seem proper for the department to question which route a company chooses to reward its shareholders. It is irrational for it to say that buybacks are nothing but a camouflaged dividend, arising as it does out of accumulated profits and hence, DDT should have been paid. Of course, everyone is aware that at times a buyback is a camouflaged dividend as far as the shareholders are concerned but it remains legit so long as the law says it is legit. It is for the Parliament to swing into action and take a call on this tax evasion route.

Outlook

A company of Cognizant’s stature should have taken care to ensure that the ambiguity in taxation was indicated to the tax authorities. However, Cognizant might not witness much impact from its ongoing case with the Indian Income Tax Department and is also unlikely to see any long-term impact on its Indian prospects. This seems to be a case where the Indian tax authorities are making a lot of noise over an issue which is likely to be resolved adequately in due course.

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