A dividend distribution tax (DDT) is levied on companies before distribution of dividend to its shareholders or investors. The main feature of this tax is that dividend is exempt in the hands of the shareholder of a domestic company so that the government gets hold of the entire tax from a single entity.

Companies and mutual funds (MFs) are required to pay DDT out of the distributable profits and distribute the rest as dividend to shareholders/investors. The companies are required to pay DDT at 15% while distributing dividend to shareholders whereas MFs are required to pay DDT at 25% at the time of distributing dividend. While the Finance Bill, 2014, has retained DDT rates, it has changed the way in which it is computed. This will impact companies, MF houses and even investors. Let us look at the provisions before and after the Finance Bill, 2014.

Before

Earlier, DDT was calculated on the amount of net dividend to be distributed. However, companies and MFs used to compute DDT on the net distributable profits (i.e., after reducing the amount of tax) by tweaking the formula to reduce the tax outgo. Hence, DDT was calculated on a lower base, reducing the effective payout.

After

The amount of distributable income or dividend to be received by the unitholder of mutual fund or shareholder of a domestic company would now be grossed up for the purpose of computing DDT.

Before Finance Bill, 2014, since the DDT was computed on net distributable profits, the effective DDT was 22.07% of the distributable profits of a mutual fund. After the changes, the net dividends would be grossed up and, then, the prescribed rate of 28.325% (including surcharge and cess) would apply, leading to a higher DDT outgo.

Impact on stakeholders

The companies would suffer the burden as they would have to increase reserves for dividend declaration. The surplus of the companies would decrease by this distribution and would hamper other investment opportunities for the company. However, if companies wish to maintain their total outgo, they may choose to declare lower dividends, which will then impact earnings of shareholders.

MFs would be the worst hit as dividend is paid out of earnings, which, itself, are not very high and an increase in tax levy would affect earnings, making debt funds less popular and unattractive. This increase in the DDT may not have a direct impact on shareholders, but will effectively hit returns.

From the point of view of an MF investor, the impact of grossing up would be severe. The tax impact will be adjusted through the net asset value of the fund and, hence, the investor will end up earning less. Under the earlier provisions, for an MF investor in the 30% tax slab, the tax arbitrage was 8.83% (30.9 ? 22.07%). Now, this would be 2.58% (30.9 ? 28.325%). Thus, the reduction in tax arbitrage is a massive 6.25%.

This amendment will be effective October 1. One of the reasons for the change is to bring MF investments on a par with bank FDs. The methodology is complex and could have been simplified by increasing tax rates directly.

The writer is managing partner,

Nangia & Co. With inputs from

Neha Malhotra, Nangia & Co.