Budget 2016-17: In Support Of A Modified Dividend Distribution Tax

What could be done to make Dividend Distribution Tax (DDT) become more in sync with the present times?

In one of Swarajya’s recent articles, “The Dividend Distribution Tax Is A Favour To The Super-Rich; It Must Go” the author has opined that Dividend Distribution Tax (DDT)is pro-rich and has also called for its removal in the upcoming Budget. At present, dividend is taxed in the hands of the company at a uniform rate. The alternative, as suggested by the author, is to club the dividend in the hands of the shareholder with his/ her other income and to shift the incidence of taxation from the company to the receiver of dividend, i.e. the shareholder.

The present effective rate of DDT is 20.474 percent whereas the topline income-tax rate is 30.9 percent and it may go up to 34.61 percent for the super-rich. Thus, if the dividends were to be made taxable in the hands of the rich and super rich falling in topline tax slab rate, it will definitely fetch more tax revenues but doing so will be against the very fundamental principle of taxation – “the same income cannot be taxed twice”.

Dividends are nothing but a share on the post-tax profits of the company, i.e. profits remaining with the company after meeting out all its expenses and tax liability. Even in cases where a company pays “interim dividend” (dividend paid before the completion of the financial year), such dividends can be paid only after creating a provision for depreciation and tax payable. Thereby the dividend that a shareholder receives from a company has already attracted tax in the hands of the company. That is to say, the company has already paid tax on its profits before distributing these profits to its shareholders in the form of “dividend”. If the same dividend were to be taxed once again in the hands of shareholders, it would result in double taxation of the same income.

Let us now have a look at the tax treatment given to partners drawing their share of post-tax profits from a partnership. Till FY 1991-92, the share on post-tax profits drawn by the partners of a partnership firm were treated as income in the hands of the respective partners, and thus the same income was taxed twice. In the 1992-93 budget presented by the then Finance Minister Manmohan Singh, this draconian double taxation was done away with by exempting the income (share on post-tax profits) in the hands of the partners. An extract of Manmohan Singh’s speech, which was introducing the proposal to exempt post-tax profits in the hands of partners, is as follows:

There has been a long standing criticism that by subjecting the income of both partnership firms as well as the partners to taxation, we are engaging in double taxation. The Chelliah Committee has also stressed that double taxation in this regard should be avoided. I agree that we should avoid double taxation, and I propose, as a measure of relief, to treat the firm as a separate tax entity and do away with the taxation of the same income in the hands of partners……. The partners will not be taxed on their share in the income of the firm though they will be liable to pay tax on salary and interest income.

If the partners’ share on the post-tax profits of the firm can be exempted, then why not exempt the shareholders’ share of post-tax profits on the companies? The shareholders, very much like the partners of a partnership firm, are the owners of the company (even though management and control are vested in the hands of a few) and hence eligible for a share in the post-tax profits. The clamour for exempting the dividend in the hands of shareholders, on the strength of this view, began growing and finally P. Chidambaram the then Finance Minister, relented by exempting dividend income in the hands of a shareholder in the famous dream budget 1997-98. An extract of his budget speech is as follows-

Another area of vigorous debate over many years relates to the issue of tax on dividends. I wish to end this debate. Hence, I propose to abolish tax on dividends in the hands of the shareholder.  Some companies distribute exorbitant dividends. Ideally, they should retain the bulk of their profits and plough them into fresh investments. I intend to reward companies who invest in future growth. Hence, I propose to levy a tax on distributed profits at the moderate rate of 10 per cent on the amount so distributed. This tax shall be incidence on the company and shall not be passed on the shareholder.

The author’s suggestion to shift the incidence of tax in the hands of shareholders is based on his view that taxes on dividends are pre-deducted by the companies at a uniform rate (on behalf of shareholders), but that is not the case. His view that DDT is pro-rich is also based on the assumption that the (uniform) rate at which companies pre-deduct DDT (on behalf of shareholders) is lesser than the top-line income tax slab rate. The suggestion to shift the incidence of taxation on shareholders is also based on this view.

As it is evident from P Chidambaram’s speech quoted above, DDT is not a pre-deduction on the dividend but a levy on the company to dissuade it from declaring its bulk of profits as dividend and to encourage it to plough back its profits for future expansion. The shareholder will get the dividend amount as exactly declared in the General Meeting and because of this levy, there is not going be any cut in his/her dividend amount. Shifting the incidence of the tax in the hands of shareholder will take us back to the pre-1997 double taxation era, and it is for this reason, I am against this idea.

DDT, which was just 10 percent when it was first introduced, after some repeated increases in various budgets, now stands at an exorbitant rate of 20.47 percent. Needless to say, owing to this exorbitant rate, it has outlived its utility. From being a levy to encourage a ploughback of profits, it has now become a burden for companies causing very high cascading effects. Of course, companies should be encouraged to plough back profits, but that doesn’t mean they should be dissuaded from declaring even a nominal amount of dividends. In fact, “dividend yield” is one of the important factors based on which a potential investor takes an investment decision. Therefore levying DDT even on a nominal amount of dividend isn’t justifiable.

What could be done to make this DDT become more in sync with the present times? In my opinion, it would augur well to exempt DDT in all those cases where dividends paid are not more than (say) 40 percent of post-tax profits. DDT may be levied on those companies where dividends paid exceed this limit. This could be one possible way to ensure that companies don’t pay the bulk of their profits as dividends and at the same time is also able to satisfy the reasonable expectations of the investors without facing any cascading effects on the cost of dividends.