The proposal to exempt dividends from tax in the hands of the recipients, and companies from dividend distribution tax, might find place in the coming Union Budget. There have been several flip flops on this. In 1997, dividends of manufacturing companies were first exempted from tax in the hands of the recipient and a distribution tax of 10 per cent imposed on the companies. The exemption was later extended to other companies and mutual funds. Along the way, the dividend tax was doubled to 20 per cent. Finally in the previous Budget, all exemptions were withdrawn and the situation reverted more or less to that existing prior to 1997.
The argument for exempting dividends in the hands of the recipient is an old one. Namely, that dividends are paid out of the profits of companies after payment of corporation (or profit) tax, and therefore taxing this profit after tax (PAT) as income in the hands of the shareholders amounts to taxing the same income twice over. This is indeed a powerful argument in principle, but weak on the facts.
Tax rules are convoluted the world over, and no less in India. With the objective of encouraging investment, fiscal relief is extended in many ways, of which the most common is accelerated rates of depreciation for the purpose of computing taxable profit. Thus, companies in India produce two computations of profit ? one for the limited purpose of estimating tax liability and the other reproduced in the annual report. The first computation uses deductions allowed under the income tax (IT) provisions and the second uses those permitted under company law (CL). So, while corporation tax is based on the profit assessable under IT, the shareholders see only the accounts prepared under CL.
Most importantly, dividend is paid out of the PAT as obtained by deducting the IT provision from the pre-tax profit as computed under CL. It is entirely possible that the PAT under CL would be sizeable, while the PAT under IT would be less than zero. Which was the reason for introduction of the Minimum Alternate Tax to eliminate the embarrassment of zero-tax companies.
It will not be uncommon to find a company with say a profit before tax (PBT) (CL) of Rs 60 crore, but with a PBT (IT) of Rs 30 crore and a consequent tax liability of Rs 10.7 crore. The PAT (CL) of this company would therefore be Rs 60 – 10.7 = Rs 49.3 crore, significantly larger than the PAT (IT)of Rs 30 – 10.7 = Rs 19.3 crore. Now, if the company chooses to distribute, say, 50 per cent of its PAT (CL) of Rs 49.3 crore, the total dividend payout would be Rs 24.7 crore. The profit tax paid is 50 per cent of what would have been due, were tax to be computed on the CL profit under which conditions alone, the assertion that dividend is being paid out of fully taxed profits would be wholly true.
Clearly, it is disingenuous to argue that dividends are paid out of profits already taxed. The truth is that the profit out of which dividend is paid has been taxed to a varying degree ? depending on how ?tax efficient? the company was. In our example, the profit tax is paid to the extent of 50 per cent; in very ?tax efficient? companies this might approach zero, while occasionally it might be 100 per cent. Which is why the recent initiatives of the Bush administration in the United States to exempt dividends from tax includes attempts to ensure that companies have paid ?adequate? profit tax.
One solution is to unite the CL and IT accounts; another would be to check for ?adequacy? of profit tax on dividends distributed. However, the simplest solution to the ?variously partially prior taxed dividend? problem is to make dividends tax deductible for the company and taxable in the hands of the shareholder. It has the merit of eliminating all elements of double taxation, howsoever partial, while avoiding the inequitable principle of creating two classes of incomes ? dividend income that is tax exempt and income from labour that is not.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)