Tax Talk: Tax on dividend leading to consequences no one had thought

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Published: May 24, 2016 7:04:12 AM

The Finance Act 2016 levied dividend tax at the rate of 10% on dividend over Rs 10 lakh per annum.

The Finance Act 2016 levied dividend tax at the rate of 10% on dividend over Rs 10 lakh per annum. Dividend income received by investors was already taxed through dividend distribution tax (DDT). Prior to DDT dividend was taxable in the hands of recipients and a small amount of dividend was exempted from tax in the hands of individual tax payer.

Companies were taxed on their dividend income as well. DDT was introduced as it was difficult to tax dividend in the hands of millions of investors, cost of administration was high, there was TDS on dividend beyond a limit and reconciliation was also a problem. Further there was double taxation of dividend in case of corporate shareholder.

Though DDT was introduced to make tax administration and collection easier there are unintended consequences of the same — Did the low earners (say in 10% income bracket or those below the exemption limit) get a refund of the DDT paid by the companies, the answer is NO. Rather, a small investor was subsidising a big investor as far as dividend tax was concerned.

DDT debuted at 12.5%, when it eliminated individual tax on dividends. This rate crept up to 15%, then grossing-up made it effectively 20% and now in addition to DDT paid by the companies, dividend tax @ 10% will amount to double taxation of the same sum of money.

While this dividend tax @ 10% has been introduced to remove the vertical inequity of high dividend income earners being subjected to tax at the concessional rates of 15% as opposed to the maximum chargeable rate of 30%, it is a hardship to the corporate structure of India, which would now pay a 34.6% corporate tax on income, 2% corporate social responsibility spend, 20% effective DDT on distributed profits and 10% additional tax on the promoters and other large individual shareholders. As an unintended consequence, businesses will avoid the corporate structure and may start using alternatives like sole proprietorship, partnerships and LLPs.

Different tax rates for dividends and capital gains would change the net post-tax returns in the hands of the investors. Depending on their tax status, this may, in turn, change their preferred form of payout. So the investors may start rebalancing their portfolios to give them a relative advantage over other investors in terms of dividend taxes.

There was a surge in the interim dividend payouts in March to promoter dominated companies. But now they would avoid paying dividends and will instead use the money for share buybacks, acquisitions or diversification. Wipro announcing a buy-back of shares, showing that companies would start moving away from dividend to a more tax efficient buy-back route.

Dividends paid in the system will shrink and could also lead to higher promoter compensation and bad capital allocation. As against dividend, promoter compensation or capital appreciation is taxed only once. So the rich promoters will get richer and the minority shareholders would continue to suffer.

DDT was levied to make tax administration and collection easier, but now most of the shares/securities are held in electronic form. In effect tax administration has become lot easier with technology, use of PAN and DEMAT accounts. Tax authorities can find out total amount of dividend paid to any individual across all companies in any financial year and can also track its credit in any account.

In such a scenario, it would have been more appropriate to phase out DDT and levy dividend tax in hands of recipient at taxation rate applicable to recipient.

The writer is managing partner, Nangia & Co

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