Introduction:

Dividend is a distribution of some portion of the profits / earnings by a company to its shareholders based on the company’s future plans and prospects. Portions of profits that have not been distributed is re-invested back in the business.  Further, Dividend Distribution Tax (“DDT”) is the tax imposed by the Indian Government on Indian companies according to the dividend paid to a company’s shareholders. The debate on whether to tax dividends in the hands of the shareholder or the company is an age-old controversy. In this article we aim to analyze and explain the different DDT schemes prevalent in India over a course of time.   

History and background of Dividend Taxation in India:

Predominantly, modes of taxing dividend could be categorized as follows:

  1. Classical/ Progressive system
  2. Simplistic system (DDT regime)

Classical / progressive System: Up to the year 1997, every domestic company was required to withhold tax on payment of dividend in excess of INR 2,500 at the specified rate and issue a Tax Deducted at Source (“TDS”) certificate to the shareholder. The shareholders were liable to pay tax on such dividend at the specified rate and had to enclose the withholding tax certificates along with the return of income and claim credit for the tax deducted at source. In most of the situations, the tax deducted by the companies or a part there of were to be refunded to the taxpayer which caused a lot of administrative struggles back then. In summary, the classical system mandates that the company distributing the dividend is not required to discharge the DDT liability, instead dividend would now be taxed in the hands of the recipients at rates applicable to them.

In most countries, dividends are taxed in the hands of the investors. Until 1997, in India too, dividend income used to be taxed in the hands of the shareholders. From the beginning of the tax legislature in India i.e. from the year 1961, the  Indian government has discouraged distribution of dividends in order to encourage firms to invest their profits towards their future investments so as to enhance growth of economy as a whole. The incidence of DDT is on the distributing company and not on the recipient, i.e. the shareholders. Moreover, the present simplistic system of DDT taxation is at a flat rate on the distributed profits, across the board, irrespective of the marginal rate at which the recipient is otherwise taxed. Therefore, this system of DDT taxation is considered, iniquitous and regressive. The Budget 2020 proposes to abolish the current DDT regime and re-adopt the classical system of dividend taxation.

Simplistic system (DDT regime): The classical system of dividend distribution had led to complex collection and administrative issues on taxation of dividend. Accordingly, in order to make the collection of tax on dividend administratively easier, the Government vide Finance Act, 1997 inserted section 115-O of the Income-tax Act, 1961 (“Act”) which provided for DDT. The DDT was inserted as an additional income tax on the company itself and consequently such dividend income was exempt in the hands of shareholders under section 10(34).

Under Section 115-O of the IT Act, distribution of dividends by a domestic company was subject to an additional income tax, called DDT at an effective rate of 20.56% (inclusive of the applicable surcharge and cess) payable by the company distributing the dividend. The DDT, thus paid by the Indian company, was treated as the final tax on dividends and the dividends were exempt from any further incidence of tax in India in the hands of the shareholders.

The Finance Act of 2002 abolished the newly introduced DDT and reverted to the classical system, to address the inequity caused by uniform treatment of dividends earned by corporates, high net worth individuals (HNIs) and small retail shareholders. However, this brought with it all the above-mentioned compliance related issues, and the government reintroduced DDT the very next year, in Finance Act of 2003 since it was easier to collect tax at a single point and the new system was leading to increase in compliance burden. However, with the advent of technology and easy tracking system available, the justification for current system of taxation of dividend has outlived its reasoning.

 Changes in DDT over a period of time:

Over a period of time, a number of changes have been carried out under the Act in the context of DDT.

  • The Finance Act, 2014 provided for grossing up of DDT rate in order to ensure that DDT is levied on a proper base.
  • The Finance Act, 2017 inserted section 115BBDA to provide for additional rate of tax at the rate of 10% in the hands of shareholders in excess of receipt of Rs. 1,000,000 of dividend and corresponding amendment was made under section 10(34) of the Act. This was aimed at bringing certain high dividend taxpayers under the tax ambit.

Abolishment of DDT in the Budget 2020:

It has been argued that the system of levying DDT results in increase in tax burden for investors, especially for those who are liable to pay tax at a rate less than that of DDT (@ 20.56%), where such dividend income is included in their income.

The Finance Minister in her budget speech stated that, “Further, non-availability of credit of DDT to most of the foreign investors in their home country results in reduction of rate of return on equity capital for them”. The Budget 2020 has proposed to abolish the DDT and adopt the classical system of dividend taxation as discussed above.

The Finance Act, 2020 provides that DDT will not be payable in respect of dividends declared, distributed or paid by a domestic company after March 31, 2020, and accordingly, such dividends would not be exempt from tax in the hands of the shareholders – resident as well as non-resident.

The Finance Act has also amended all the corresponding sections with regard to declaration of dividend:

  • Section 194 of the Act to impose a withholding tax at the rate of 10% on all dividends paid by an Indian company, by any mode whatsoever, to a resident shareholder if the aggregate amount of dividends distributed exceeds INR 5,000 in the particular financial year ( April to March) .
  • Section 195 to delete exemption provided to dividend referred to in section 115-O thereby non-residents to be taxed at rates in force.
  • To prevent the cascading tax impact, it is also proposed to re-introduce section 80M to allow deduction to a domestic company in respect of dividend received by it from any other domestic company to the extent of dividend declared / distributed to its shareholders, till one month prior to the due date of filing return of income. Unlike erstwhile provisions, allowing set-off only for dividend received from a subsidiary company, section 80M allows deduction in respect of dividends received from any domestic company regardless of the percentage of the shareholding.

Further, from a cash flow perspective, distributing companies should benefit in the simplistic regime which will also induce higher dividend pay-outs from such companies. Erstwhile in the classical regime, DDT was a separate cash outflow for the distributing company over and above the actual dividend distributed. Now, in the simplistic regime, the obligation to withhold TDS will be from the amount of dividend to be distributed therefore no separate cash flow for the distributing company.

DDT for Promoters:

After the abolishment of DDT, the tax outgo (at the maximum marginal rate, which with highest rate of surcharge is 42.74%) of Indian promoters/ investors who hold companies/ investments in their individual capacity would substantially increase. Accordingly, it may become necessary to review and evaluate their shareholding structure.

Inter-corporate dividends:

Revival of the erstwhile section 80M is seen as a welcome move for allowing deduction for inter-corporate dividends. Re-inserting the new section 80M as it existed before it’s removal by the Finance Act, 2003 is mainly intended to remove the cascading effect of DDT in a multi-tier structure.by giving a tax deduction on dividends received by the company to the extent of dividends that are distributed by the company itself.. This deduction is allowed with respect to the dividend received as long as the same is distributed as dividend one month prior to the due date of filing return. This section is applicable in respect of dividend distributed on or after April 1, 2020.

Similar mechanism of credit was also available under the DDT regime (to ensure DDT is not paid twice on the same income). Further, in respect of the dividend distribution tax liability, holding companies received a deduction to the extent of dividend received from subsidiary companies since the subsidiary companies already paid DDT in respect of the same dividend. Hence double taxation of the dividend income was avoided only in case of domestic holding-subsidiary companies as against section 80M which extends the deduction to dividends from any domestic company. To this extent, the new provision is more beneficial than the DDT regime. Having said that, section 80M benefit is not available in respect of dividends received by an Indian company from its foreign subsidiaries  and thus it  would not benefit companies who have foreign subsidiaries, where dividend is received from such foreign subsidiaries.

Conclusion:

The simplistic regime is likely to impact different classes of shareholders differently, therefore shareholder profiling and impact analysis would be necessary from a case to case basis. The re-insertion of section 80M is a boon for domestic companies but not a welcome move for foreign subsidiaries. With the re-introduction of dividends being taxed in the hands of the shareholders, the relevance of the dividend taxation article in the Double Taxation Avoidance Agreements (“DTAAs”) has re-assumed significance where dividends are distributed by Indian companies. To this extent, the equity investment in India and repatriation of income by way of dividend should regain their attractiveness. However, the changes to India’s network of the DTAAs would need to be assessed in light of the Multilateral Instrument (“MLI”), and the dividend transfer provision contained therein. In addition to this, the eligibility to claim DTAA relief, considering General Anti-Avoidance Rules (‘GAAR’) and MLI, would need to be tested for examining tax implications.

This material and the information contained herein prepared by Algo Legal is intended to provide general information on a subject or subjects and is not an exhaustive treatment of such subject(s). Algo Legal is not, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision. Algo Legal shall not be responsible for any loss whatsoever sustained by any person who relies on this material.