[Author: Palak Kumar, 3rd Year student, NLIU, Bhopal]
Since the announcement of the Budget 2020-21 the abolition of the Dividend Distribution Tax ("DDT") has been much talked about among the investors. There has been an ambivalent response with some class of people applauding the move while others not so much, at the thought of paying copiously their hard-earned money as taxes.
The Finance Minister in her speech said that this tweak in the tax regime is likely to benefit the investors and increase the attractiveness of foreign investment. The move will also lead to forgoing of government revenue to the tune of 25000 Crore claims the Finance Ministry.[1]
This article seeks to analyze the probable consequences of scrapping DDT to analyze whether this move is a hit or a miss.
Historical Background
DDT was introduced through Section 115O vide the Finance Act 1997. The Section provided that the tax is to be borne by the companies before paying dividend to the shareholders. Since it is practically difficult to get hold of every shareholder and make them pay the taxes, therefore for easy collection and administration of taxes the section mandated the domestic companies to pay taxes before the dividend was distributed among the shareholders.
Following this, a new provision was incorporated in the Income Tax Act 1961, which provided for the exclusion of Dividend income from total income.[2] This meant that Dividend in the hands of investors was not taxable subject to the exception that people with aggregate dividend income exceeding 10 lakh had to pay dividend tax at the rate of 10%.[3]
In 2002 vide the Finance Act 2002 the incidence of the tax was again shifted to the shareholders by the abolition of DDT, which was restored in 2003 (vide Finance Act 2003) and has continued haunt the companies until March 31, 2020, at an extremely high rate.
Pre Finance Act 2020 Scenario
Under the current regime, the company had to bear the brunt of paying the DDT after paying other taxes. DDT was to be paid at the rate of 20.56%, which had to be paid by the company in addition to the taxes borne by it. For example: Let’s assume the profit before tax of a company XYZ Ltd for a particular financial year is Rs. 100 and the tax rate is 10% so the profit after tax will be 90. It is this profit after tax on which the DDT was charged before it could be distributed among the investors. This means that a company was subjected to double taxation – one in the form of corporate tax and other in the form of DDT, thereby affecting the company’s profit, which in turn had an effect of decreased dividend income for the investors.
Moreover, from a shareholder perspective, all those shareholders whose dividend income exceeded 10 Lakh were subjected to a tax on such income at the rate of 10%. This again amounted to double taxation since the tax has already been paid by the company under Section 115O before distribution of dividend income among the shareholders.
In addition, the partnership firms did not have to pay any such tax on their profits before disbursing the profits to their partners. This amounted to unequal taxation levied on companies and partnership firms.
Another important point to notice here is that even after the deduction of DDT from the profits, individual retail investors whose income was less than 10 lakh had to pay dividend income tax at a uniform rate of 20% irrespective of income slab they fall in. This amounted to unequal treatment of investors falling in different categories based on their income.
Scenario post-DDT abolition
With the scrapping of the DDT, let us see how the revised tax regime looks like. DDT will no longer be charged on the companies or on mutual funds. It will be charged from the individual investors based on the slab rates. In case of mutual funds, the tax will be deducted at source for a dividend income exceeding 5,000 per year at the rate of 10%. This is likely to have a great impact on the return of the investors as the part of dividend income which was taxed (in the form of DDT) until now will no longer be taxed and will form a part of income that will be taxed at a marginal rate.
In case of individuals whose dividend income exceeds 10 lakh, they have to bear a tax burden of 31.2% as opposed to the DDT rate of 20.56%. This aftermath is likely to impact the investment patterns of retail investors.
Up till now, the foreign investors had to pay 20% DDT and they could not receive credit for payment of these taxes from their home country which only added insult to injury. The move is likely to see a boost of foreign investment as foreign investors will longer have to pay DDT thereby resulting in increased dividend income. The tax that these investors have to bear in their jurisdiction ranges from 5 %-15% only. On the other hand, this will make the Indian Investors bitter since DDT abolition does not relieve them from the burden of paying tax on the dividend received which is levied at whopping tax rates.
In case of pooling investment vehicles like mutual funds, the dual taxation regime has been done away with. Initially, the DDT had to be paid by the company paying dividends to mutual funds and then paid by mutual funds on further payment of dividend to unitholders. Under the upcoming regime, the tax is only to be paid at the unit holders end thereby leading to single-tier taxation.
The Act provides a sigh of relief to foreign investors as it omits the proviso[4], seeking to exclude payment of dividend to non-residents from tax deducted at source[5]. This essentially means that payment of dividend to foreign investors will now be subjected to tax deducted at source.
The axing of DDT from the Indian regime is likely to have a setback on High net worth individuals who until now irrespective of the income group they fell in had to pay DDT at a uniform tax rate. Now, the HNIs will have to pay taxes on their dividend income based on the slab rates depending on the income category they fall into.
Similarly, the promoters are also like to face the brunt of the removal of DDT as these individuals fall into the highest tax rate of 42.7%. This will have the company resorting to a share buyback instead of paying dividend since tax on buyback is at an effective rate of 23% as opposed to high rate of taxes payable on dividend income.[6]
Another downside of the abolition is discrimination between an Indian entity having a shareholding stake in a domestic company and an Indian company having a shareholder stake in a foreign company. Insertion of section 80M[7] vide the Finance Act 2020 provides that a domestic company with a threshold shareholding stake in a domestic company can claim a tax deduction from dividend income. The reason behind it was to remove the cascading effect of taxation. However, the same leverage is not provided to an Indian company having a shareholding stake in a foreign company.
Conclusion.
The fact that the Act will have the impact of boosting the market sentiment and attract foreign investment is undeniable. However, the bill has received backlashes and has disappointed the investor fraternity in a variety of aspects. This is likely to have a counterbalancing effect on investment as it appeases the foreign investors through various measures but at the same time throws cold water at the interest of domestic investors at multiple junctures. In addition the bill has led the government to forego tax revenues to the tune of 25000 Crore which is another stumbling block. Amidst all these knockbacks, we are yet to experience its impact on the investments.
[1]https://economictimes.indiatimes.com/wealth/tax/dividend-income-becomes-taxable-in-receivers-hands-ddt- /articleshow/73836773.cms?from=mdr. [2] Income Tax Act, 1961, Section 10(34). [3] Income Tax Act, 1961, Section 115BBDA. [4] Finance Act, 2020, Clause 85. [5] Income Tax Act, 1961, Section 195. [6] Income Tax Act, 1961, Section 115QA. [7] Finance Act, 2020, Clause 40.
The opinions expressed herein are those of the author in their personal capacity and are not intended to be construed as legal, financial or investment advice.