DDT turns deadlier for companies, mutual funds after govt plugs loophole

Written by Devangi Gandhi | Updated: Jul 23 2014, 08:44am hrs
Thanks to an anomaly addressed by the government, companies will face a higher effective tax rate on the dividend distributed to shareholders if they want to maintain their average dividend payout ratios. The Union Budget for 2014-15 proposes that companies and mutual funds should be taxed on the gross dividends distributed to investors rather than on the income distributed net of taxes.

Last year, Hindustan Unilever and Infosys appropriated R3,273 crore and R4,233 crore, respectively, from their profits to dividends including taxes of R461.54 crore and R613.5 crore. The total dividend disbursed, therefore, stood at R2,811 crore and R3,619.5 crore. With the revised dividend distribution tax (DDT) calculations, their tax outgo for the same amount of gross dividend can go up to R556.24 crore and R719.14 crore, translating into an effective rate of 20.5%.

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The finance minister has argued that when dividends were taxed in the hands of investors, they paid the tax on the gross dividend. But companies and mutual funds currently pay taxes on the amount distributed after accounting for the basic tax rate. In order to remove this discrepancy the DDT will now be applicable on the gross amount and experts say the effective tax rate on dividends paid by companies may go up by 3%.

In the case of mutual funds, which are also required to gross up the dividend amount, the increase could range between 9.4% and14.6% for different sets of investors.

The earlier effective tax rate on dividend distribution, including the surcharge and the education cess, was 16.995%, which has now changed to 19.995% for companies, Dilip B Desai, chairman, DH Consultants, explained. According to Desai, after this hike, only the more generous companies will bear this cost.

With a time window of about three months till the new norms come in effect from October 1, companies and mutual funds are also looking for some clarifications. CA Gupta, partner, Deloitte Haskins & Sells, points out that while the DDT payable is to be determined on a grossed-up basis, there appears to be some apprehension and ambiguity as to the level of grossing up. If it is applied on the dividend amount with the basic DDT rate of 15%, the effective DDT rate works out to be approximately 20%. However, if the grossing up is applied to the currently applicable rate including surcharge and cess (ie, 16.995%), then the new effective tax rate would be approximately 20.47% with a resultant effective increase of 3.47%, Gupta explained.

Typically, blue-chip IT and FMCG players and a host of public sector undertakings (PSUs) are known to be generous dividend payers with the payout ratio ranging between 30% and 80% . However, with the new norms, this payout ratios may get moderated.

The new tax regime is set to impact the effective tax distribution across all mutual fund schemes, which may lead to a move towards growth funds from dividend funds. Currently, dividend outgo to individuals and HUFs (Hindu undivided families) is charged at 25% (effective rate 28.325%) while distribution to non-individuals or companies is taxed at 30% (effective rate 33.99%). However, from October the effective rates for these groups of investors are set to move up to 37.77% and 48.55%, respectively.

Industry observers say that this change is set to to remove the yield arbitrage between the difference on interest income on a fixed deposit and dividend earned on a debt fund. However, the alteration can impact only the flow towards short-term products.

Investors with less than a year of investment horizon opt for dividend-focused products while growth option is preferred by investors with a medium- to long-term investment period. Hence, the change in DDT regime is likely to impact the first category of funds, said B Sarath Sarma, executive director, IDBI Mutual Fund.