A dividend is a return by a company to its shareholders out of post-tax profits made by it during a particular year. They are usually declared or distributed in proportion to the number of shares owned. In normal parlance, dividend distribution entails cash outflow for the company distributing dividends. However, the Income Tax Act 1961 (the Act), deems certain distributions of assets during liquidation, capital or corporate restructuring besides including grant of advances by closely held companies, to be dividends for the purpose of taxation. As may be imperative, while taxmen widened the tax net to cover as many forms of distributions of assets by companies to the extent of availability of accumulated profits, tax-payers resorted to newer avenues to minimise tax incidence arising on account of such distributions.
In the recent past, the Government has been on an overdrive to counter attempts by the taxpayers to avoid or minimize taxes. Amendments in relation to definition of income, GAAR, limitation of interest deduction, introduction of law to curb Black Money, inclusion of the concept of ‘place of effective management’ under the residence test for companies are instances of Government’s efforts to counter tax avoidance and maintain a broadened tax base. This trend continues with the following amendments as proposed by Finance Bill 2018 relating to widening the scope of dividend taxation:
Widening the definition of the term ‘accumulated profits’ under section 2(22)
The Memorandum to the Finance Bill 2018 has indicated the objective of expanding the term ‘accumulated profits’. Explanation 2A has been inserted to plug abusive arrangements which are undertaken with an intent to escape the tax liability on distributed profits under section 2(22)(d) of the Act. Taxpayers, in the past, have engaged into transactions wherein companies with large accumulated profits amalgamate with companies having accumulated losses or minimal accumulated profits and thereafter such companies undergo the capital reduction process. Such reduction in capital circumvents the provisions of section 2(22)(d) dealing with deemed dividend on account of capital reduction since typically in such multiple stage transactions, profit-making companies are merged with loss making companies and thereafter tax-free capital reduction is carried out.
In order to curb such tax abusive practices, the Finance Bill 2018 proposes to insert Explanation 2A to section 2(22) of the Act. As per the said Explanation, in case of amalgamated company, the accumulated profits whether capitalized or not or loss as the case may be shall be increased by the accumulated profits, whether capitalized or not of the amalgamating company on the date of amalgamation. Thus, while calculating deemed dividend under section 2(22)(d) on a transaction of capital reduction, amalgamated companies shall have to even include the accumulated profits of the amalgamating company as on the date of amalgamation in order to determine the deemed dividend in the hands of the shareholder.
This amendment shall be effective from 1 April 2018 and will apply from assessment year 2018-19 onwards.
Dividend Distribution Tax on deemed dividend under section 2(22)(e)
Another important amendment relating to deemed dividend is taxation of deemed dividend arising under section 2(22)(e) in the hands of the company instead of the shareholder. Presently, any dividend paid by the domestic company is taxable in the hands of such company under section 115O and is exempt in the hands of the shareholder under section 10(34). However, as per Explanation to Chapter XII-D, “dividend” for the purpose of Chapter XII-D (which includes section 115O) shall not include deemed dividend under section 2(22)(e). Thus, presently deemed dividend under section 2(22)(e) is taxable in the hands of the shareholder at the applicable marginal rate. In case if the shareholder is a foreign company, tax rate would be 40% (plus applicable surcharge and education cess). If the shareholder is a non-resident then he may take shelter of the relevant Double Taxation Avoidance Agreement for a beneficial tax rate. Moreover, the non-resident shareholder can claim the credit of the tax so paid in India in his country of residence.
Now, as per the Finance Bill 2018, the aforesaid Explanation to Chapter XII-D is proposed to be deleted. Thus, deemed dividend under section 2(22)(e) shall now be taxable under section 115O in the hands of the company and shall be exempt in the hands of the shareholder under section 10(34). Further, it is proposed to tax such deemed dividend at the rate of 30% (without grossing up) by inserting a proviso to section 115O(1).
This amendment has been inserted with a view to simplify the collection of taxes and to avoid litigation. In cases where the shareholders are foreign entities, it becomes difficult for the tax authorities to pursue such shareholders for the relevant taxes. Thereby, the onus is now put on the company to pay taxes for such transactions. This shall increase the tax expense for the company thereby reducing the quantum of profits distributed.
Dividend Distribution tax on income distributed to unitholders of equity oriented funds
The Finance Bill 2018 proposes to levy dividend distribution tax on income distributed by equity-oriented mutual funds. Currently as per section 115R, the specified company or a Mutual Fund which distributes amount to its unit holders shall be chargeable to tax on such distributed income at the specified rate. However, income distributed to a unit holder of equity-oriented funds was exempt from tax under said section.
It is now proposed that the aforesaid exemption be withdrawn and the income distributed to the unit holders of equity-oriented funds be taxed at the rate of 10% in the hands of the Mutual Fund distributing such income. The Memorandum to the Finance Bill 2018 specifies that the said amendment has been brought about to provide a level playing field between growth oriented funds and debt funds in the wake of the amended capital gains tax regime wherein the unit holders of equity oriented funds shall be liable to long-term capital gains tax.
The amendments in relation to the taxation of long-term capital gains arising from equity shares and equity oriented funds and the applicability of dividend distribution tax on equity oriented funds may discourage investments in the equity market in India.
Since understandably the intent is to broaden the tax base and increase the tax cost for the investors, it will induce newer means of structuring investments and shareholder payouts, of course, within the contours of the various anti-avoidance measures under the Act.
Information for the editor for reference purposes only
Sandeep Dasgupta is a Senior Manager and Zainab Bookwala is a Manager with Deloitte Haskins & Sells LLP.