By Sunil K Parameswaran
Interest paid by firms on bonds, debentures, and bank loans is a tax deductible expense, while dividends paid to preferred and equity shareholders is not. Consequently, interest on debt or borrowed capital gives the issuer a tax shield and brings down effective cost. Thus, debt is cheaper than equity and if a firm assumes more debt, it can bring down its cost of capital.
However, there is no unanimity on how returns from securities should be taxed at the hands of investors. Interest or coupons received by investors is taxed at the hands of the recipients. The logic is that this cash flow stream has come out of the pre-tax earnings of the issuing firm, and consequently should be taxed at least once.
Equity dividends, however, are taxed at the hands of the recipient in certain countries. The same is true for dividends on preferred shares. The rationale for not taxing them at the hands of the recipients is that they have already been taxed once. The counter viewpoint is that although they are generated out of post-tax profits at the level of the firm, they are nevertheless income for the investors and consequently should be taxed again. In some countries there is a dividend distribution tax (DDT).
This tax is paid by the company remitting the dividends, and in such cases shareholders do not have to pay income tax on dividend income received by them. In this case all shareholders face an identical tax burden. However, if individual shareholders have to pay tax on dividend income, the levy would depend on the tax bracket in which they fall. Consequently, people in lower tax brackets would pay tax on dividends at a lower rate.
In certain countries corporate shareholders are exempted from paying income tax on preferred and equity dividends. The dividends received constitute income for a corporate shareholder. If they are taxed at its hands, the same rupee has been taxed twice. At some stage this income will form a source of the dividends paid by it to its shareholders. If individual shareholders are required to pay taxes on dividend income, it would mean that the same rupee will be taxed thrice. Thus, in certain countries, dividend income, or a portion of it, received by corporate shareholders is tax free. However, such income is taxable at the hands of individual shareholders.
The writer is CEO, Tarheel Consultancy Services