Tax on Dividend.

In yet another bold move after the Ordinance announcements, the Finance Bill, 2020, inter alia, proposes to abolish dividend distribution tax (DDT), thereby, boosting investible funds and higher dividend payouts by corporates.

Currently, DDT is payable by domestic companies at the effective rate of 20.56% on the dividends proposed to be paid to shareholders. These dividends are exempt from tax in the hands of shareholders, except specified resident shareholders.

The levy of DDT created hardships for the business ecosystem and the Government faced criticism on the following grounds:

– Companies were forced to adjust pay-outs for DDT liability;

– All shareholders were taxed at a standard DDT rate, regardless of their income brackets;

– Effective DDT at 20.56% was levied on the post-tax profits of a company;

– Additional tax at 10% (including surcharge and cess, effectively 14.25%) payable by specified resident shareholders on dividend earned above INR 10 lakhs;

– Non-availability of credit for DDT in the hands of foreign shareholders in their home country; and

– Non-deductibility of expenses incurred in relation to such dividend income.

The Finance Bill, 2020, also addresses the cascading effect (Section 80M) of tax on dividends received by a domestic company from another domestic company. There is no mandate for the companies to have a holding-subsidiary relationship.

Under the proposed provisions, any dividend received by Company 1 from Company 2 will be taxable in the hands of Company 1 at applicable rates. However, if Company 1 further declares dividend at any time up to one month prior to the date of filing income-tax return for the financial year in which it received dividends from Company 2, then Company 1 will be allowed to claim the first-mentioned dividend as a deduction while computing its tax liability. In effect, dividend will not be taxed in the hands of Company 1, but tax will be ultimately borne by the shareholders of Company 1.

Note that the cascading effect of dividend taxation has not been addressed for domestic companies receiving dividends from its foreign subsidiaries.

As per the extant regime, expenses incurred to earn exempt income are not allowed as a tax-deductible expenditure in the hands of the shareholder while computing tax liability. The Finance Bill, 2020, proposes that interest expense up to 20% of the dividend income will be allowed. A noteworthy comparison is that the 20% cap has been newly introduced in the Finance Bill, 2020, as there was no such cap/ limit to claim expenditures in the pre-DDT era.

The Finance Bill, 2020, proposes that dividends paid to non-resident shareholders will be subjected to withholding tax at 20% under section 115A of the Income-tax Act, 1961. The non-resident shareholder can also be eligible to avail a lower rate under the relevant tax treaty. For instance, the United States (15%), Singapore (10%), Mauritius (5%) and most other countries having tax treaties with India have a rate ranging from 5%-15% for dividends. Essentially, the abolition of DDT will result in significantly enhancing return on equity capital for foreign investors, as the taxes withheld in India on such dividends can now be claimed as a credit in their respective home country.

Similarly, dividends paid to resident shareholders will be subjected to a withholding tax rate of 10%. While the abolition of DDT lends significant cheer in the foreign investment market, the trade-off is that certain resident shareholders may be taxed at rates as high as 42.74% under the new proposal, compared to 34.81% (DDT 20.56% + additional tax 14.25%) under the existing regime. As promoters constitute the largest shareholder community for corporates, the removal of DDT results in materially higher taxation for promoters in the highest tax slab.

Similarly, the new proposal will also have an impact on the valuations of real estate investment trusts (REITs) and infrastructure investment trusts (InVITs), as dividends that were earlier exempt from DDT will now be subjected to tax in the hands of its investors.

The DDT, which was originally introduced at 7.5% in 1997, has nearly trebled over the years and currently stands at a whopping 20.56%. While the discontinuation of DDT is a welcome move for foreign investors, it will do very little in creating cheer amongst domestic investors.