The Union Budget 2020 is round the corner. It will be presented by the Finance Minister in what may be described as a challenging economy. The government recently took a significant step in introducing the corporate tax rate reforms. Such reforms have triggered taxpayers' expectations from this Budget, especially in the context of taxation of dividends.
Dividend tax regime
Presently an Indian company is required to pay the dividend distribution tax (DDT) of around 20.56 per cent on the declaration of dividends which are correspondingly exempt in the hands of the shareholder (Indian or foreign). One of the key expectations is abolishing the DDT, and taxing the shareholders directly on dividends.
Historically, the dividend was always taxable in the hands of shareholders. In 1997, DDT was introduced whereby the levy on dividends moved from the shareholder to the company distributing dividends.
The rationale for introducing DDT was that the procedure for tax collection from shareholders was cumbersome and involved a lot of paperwork. This was because every company, at the time of paying the dividend to a shareholder, was required to deduct tax, issue tax deduction certificates, etc.
The shareholders, in turn, had to show the dividend in their return of income, claim credit for the tax deducted at source and pay the balance tax or claim refund based on their tax position.
Interestingly, in 2002 the DDT scheme was replaced with the earlier system of taxing dividends in the hands of the shareholder. The rationale for this shift was that there was inherent inequity in the DDT system, which allowed persons in high-income groups to be taxed at much lower rates.
This, however, lasted for only a year and in 2003, DDT was re-introduced with the similar reason that was offered in 1997, i.e. it is easier to collect tax at a single point, from the company, rather than compel the company to compute the tax-deductible in the hands of the shareholders.
Challenges in current regime
In 2016, there was another twist in the dividends saga, whereby dividends earned in excess of Rs 10 lakh from domestic companies was made taxable in the hands of individuals, partnership firms, private trusts, etc at 10 per cent rate (plus surcharge and cess) on a gross basis.
The rationale again was the same as in 2002 when the DDT scheme was replaced for a year - vertical inequity amongst the taxpayers as those who have high dividends are subjected to tax at lower rates.
The current mechanism of levying tax on dividends by way of DDT, and once again in the hands of resident shareholders, amounts to economic double taxation.
The government recently reduced the corporate tax rate for companies to 22 per cent, and to 15 per cent for new manufacturing companies, subject to conditions.
Although the general tax rate of 22 per cent (25.17 per cent after surcharge and cess) appears to be very attractive at first blush, the picture is not so rosy once the DDT is factored. After considering DDT, the effective tax rate is 37.93 per cent, which is clearly very high.
India has entered into tax treaties with various countries in order to avoid double taxation of income. Generally, most tax treaties entered into by India limits taxation on dividends in India at 10 per cent; the shareholder typically gets a credit for the tax deducted in the country of residence of the shareholders.
Since DDT is levied on the company distributing dividend, it may make tax treaty benefits ineffective for foreign shareholders. To compound the problem, shareholders may face challenges in claiming credit for DDT in their home country. This results in high tax cost for foreign shareholders.
Reform of taxation of dividends
If it happens, the abolishment of DDT, and consequent re-introduction of taxation of dividends in the hands of shareholders will likely provide impetus to the economy.
It will remove the economic double taxation for resident shareholders. Withdrawal of DDT will rationalise the effective tax rate for companies from 37.93 per cent to 25.17 per cent, which would be in line with the objective of the government to reduce corporate tax rates.
It will also remove anomalies in taxation of dividends for foreign shareholders and will enable such foreign shareholders to avail tax treaty benefits in India, and credit for Indian tax in their home country.
Additionally, it will help in reducing tax litigation, as a sizeable number of cases in appeal relate to disallowance of expenses incurred to earn exempt dividends (section 14A of the Income-tax Act, 1961).
From a policy perspective, the objective of introduction and re-introduction of DDT was convenience in tax administration. The challenges in 1997 and 2003 of difficulty in monitoring taxation of dividends, granting credit for tax deduction at source, etc. may not be a roadblock in the current environment that has a robust information technology infrastructure, especially in relation to deduction of tax at source. Accordingly, even from a policy standpoint, there is no reason to continue with the DDT regime.
While taxpayers' expectation on withdrawal of DDT has been on for several years now, the probabilities are stronger due to the objective of the government to rationalise corporate tax rate and promote economic growth.
Abolishment of DDT will likely be welcomed by all taxpayers and will be considered as one of the steps towards ease of doing business in India. It may also contribute to paving the way for achieving the government's aspiration to make India a $ 5 trillion economy.
(Pritin Kumar is a Partner and Anil Kadam is a Senior Manager with Deloitte Haskins & Sells LLP.)