The tax department’s motive on taxing the means to return gains to shareholders via dividends and buybacks was to encourage them to invest more into their business.
By Siddarth M Pai & TV Mohandas Pai
Misfortune comes in threes—we have often heard it appended to routine issues (missed one’s alarm, missed one’s ride, and missed a meeting) or in deaths (CS Lewis, Aldous Huxley, and John F Kennedy), but India has taken it a step forward, applying it to taxes as well. In the era of double taxation avoidance agreements, Indian investors and shareholders are groaning under a triple taxation regime in the form of the dividend distribution tax (DDT)—a fossil that has increased India’s average corporate taxes, and decreased India’s attractiveness as an investment destination.
India’s history with dividend taxation has been complicated—up to 1959, dividends were taxed in the hands of the shareholders only. India followed a form of taxation known as “dividend imputation”, wherein the tax paid by the company was imputed to the benefit of the shareholder, thus enabling the shareholder to only pay the differential between the corporate tax rate and his/her marginal tax rate on the dividend income. However, due to the byzantine system of rebates, concessions, etc, enjoyed by corporates, the grossing up process became subjective, leading to it being changed in 1959. Since then, tax authorities adopted a method which promised simpler computation process, but a higher computed tax amount; all dividends would be paid out of post-tax profits, and would also be taxed in the hands of the shareholders. After liberalisation, the Finance Act 1997 brought in dividend distribution—a 10% tax on the dividend amounts being distributed by corporates, with all dividends becoming tax-free in the hands of shareholders.
Finance Act 2014 stipulated that dividend amount payable be grossed up for taxes. Previously, companies would deduct 15% of the dividend amount being distributed, and remit it to the government along with the additional surcharge and cess. But, from 2014, the dividend amount would need to be grossed up for taxes before distribution. The taxman’s argument for this in the explanatory circular to the Finance Act 2014 (2) reads thus—“Prior to introduction of DDT, the dividends were taxable in the hands of the shareholder… However, after the introduction of the DDT, a lower rate of 15% was applicable but this rate was being applied on the amount paid as dividend after reduction of distribution tax by the company. Therefore, the tax was computed by the company with reference to the net amount. Due to difference in the base of the income distributed or dividend on which the distribution tax is calculated, the effective tax rate was lower than the rate provided in the respective sections. In order to ensure that tax is levied on proper base, the amount of distributable income, and the dividends which are actually received by the unit holder of the mutual fund or shareholders of the domestic company, as the case may be, were required to be grossed up for the purpose of computing the additional tax.”
The above word salad was graciously explained by the tax department as an example—“where the amount of dividend paid or distributed by a company is Rs 85, then DDT under the amended provision would be calculated as follows:
Dividend amount distributed = Rs 85
Increase by Rs 15 [i.e. (85*0.15)/(1-0.15)]
Increased amount = Rs 100
DDT @ 15% of Rs 100 = Rs 15
Tax payable u/s 115-O is Rs 15
Dividend distributed to shareholders = Rs 85”
Thus, in 2014, all finance professionals and corporates were reintroduced to the elementary school mathematical concept of grossing up. The department’s stance was that since the introduction of DDT in 1997, it was misapplied by corporates on the amount distributed as dividend, and should instead be included as part of the dividend amount declared and subsequently paid out. This is illustrated in the accompanying graphic. Corporate India should be happy that this change was prospective instead of retrospective, sparing them the accumulated interest, penalties, and fines for lower taxes.
The Finance Act 2016 saw the delicate balance established by the introduction of DDT in 1997 being tinkered with again. Thereon, dividend amounts in excess of Rs 10 lakh received by an Indian resident from a company would be taxed at 10%. Thus, the same income would be taxed thrice—twice in the hands of the company via corporate taxes and DDT, and once in the hands of the shareholder in excess of 10%. The Finance Act (2) 2019 saw the introduction of the “super-rich” surcharge of 37%, further exacerbating the attractiveness of dividends. The sum total of all these changes is that dividends are taxed thrice at a cumulative rate of 47.36% of the pre-tax profits! One income. Two parties. Three taxes.
For a company with a turnover of Rs 1,000 crore and a profit of Rs 100 crore, tax expenses would be Rs 25.63 crore. Assuming they declare a 100% of their Rs 74.37 crore post tax profits, they would need to fund an additional Rs 12.99 crore as DDT. This drives up the effective corporate tax rate for those declaring dividends to 43.10% (25.63% corporate tax plus DDT of 17.47%, as per the grossed-up regime), thereby increasing the cost of capital for corporates. Due to the grossing up provisions, the post-tax profits would have the DDT loaded on to it, lowering the amount available for distribution to Rs 61.38 crore. Assuming that the shareholders are in the highest tax bracket, their dividend income of Rs 61.38 crore would cost them another Rs 8.74 crore as tax, bringing the total tax to Rs 47.36 crore (see graphic).
The tax department’s motive on taxing the means to return gains to shareholders via dividends and buybacks was to encourage them to invest more into their business. But, corporate India doesn’t require tax disincentives to spur investments, they do so based on available opportunities. Firms which are in a growth phase choose to reinvest their earnings so long as the cost of capital is low; firms that are mature choose to return the money back to shareholders so that they can decide to invest the money as they believe. These economic axioms are deeply ingrained in business decision making, and excessive taxes distort these core principles.
It behoves the current government to step in and unravel these dividend distortions. Triple taxation is a perversion of the tax system, and systematically drives up the cost of capital for Indian businesses. The fairest system is the system of dividend imputation, followed by countries like Australia and New Zealand, wherein tax is paid on the difference between the tax rate for the corporate and the tax rate for the shareholder. Barring this, either DDT or the tax paid by the shareholder should be removed, or rationalised to reduce the overall tax rate on corporates to below the current 43.10% level.
This government created history by removing triple talaq, corporate India hopes that the prime minister, Narendra Modi, can boost investor sentiment by removing this pernicious form of triple taxation as well. If not, investors in Indian companies who rely on dividends will find themselves reminded of Hotel California by The Eagles.
“You can check out any time you like, But you can never leave!”
Siddarth is managing partner, 3one4 Capital & Mohandas is chairman, Aarin Capital Partners (VIews are personal)