Grossing up of Dividend for distribution tax

Grossing up of Dividend for distribution tax –  increase in effective Dividend Distribution tax rate of 3.47%

The Finance (No.2) Bill, 2014 proposes to levy dividend distribution tax by grossing up the dividend payable for the purpose of computing liability towards dividend distribution tax. As per the existing provision of Section 115-O dividend distribution tax at the rate of 15% is to be paid on the amount of the dividend paid to shareholders. Further under section 115R, tax at the rate of 15% is to be paid on the income distributed by the Mutual Fund to its investors.

Presently the effective tax rate after levy of surcharge and education cess is 16.995% (15% tax + 10% surcharge + 3% education cess thereof) and tax at this effective rate of 16.995% is paid on the amount of dividend paid/income distributed. The Finance (No.2) Bill, 2014 proposes to gross up the dividend paid with the income distributed for computing the tax liability on account of dividend distribution tax. With the grossing up, the effective tax rate will be 20.47%, with the result, there will be an additional tax liability of 3.475%.

In the Memorandum explaining the provision of the Finance (No.2) Bill, 2014, it has been stated that prior to introduction of dividend distribution tax, the dividends were taxable in the hands of the shareholder. After introduction of dividend distribution tax, a lower rate of 15% is being applied on the amount paid as dividend after deduction of distribution tax by the company and hence tax is computed with reference to the net amount. Accordingly in order to ensure that tax is levied on a proper base, the dividend actually received need to be grossed up for the purpose of computing the dividend distribution tax. This explanation to the Memorandum is contrary to the reasoning given while introducing the dividend distribution tax way back in the year 1997. It may be relevant to refer to the Budget speech of the then Finance Minister, the relevant paras read as under:-

“100. 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.

101. Some companies distribute exorbitant dividends. Ideally, they should  retain 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.

On going through the above reasoning given way back in 1997, it is quite clear that tax on dividend was abolished and this dividend distribution tax was introduced to encourage companies to retain the income for the future growth. Thus to say that dividend distribution tax is a tax on the dividend income of the shareholder is not correct. Further in case the present Government is of the view that dividend income should be taxed, then there is no reason why company should bear the dividend distribution tax. The dividend may be taxed in the hands of the shareholder at the appropriate tax rate applicable as the case may be with benefit of old Section 80M to avoid cascading effect of this tax in the hands of corporate. It may also be important to note that the dividend distribution tax in the present form is being retained not because any concession is to be provided to the shareholder but by way of revenue compulsion as substantial amount of dividend distribution tax is paid by the public sector companies in respect of the dividend, these PSUs pay to the Government. In case dividend is taxed in the hands of the shareholder, substantive amount of this dividend paid by public sector companies and banks (estimated at Rs. 90229 crore in the receipts budget for 2014-15) to the Government will not be liable for taxation as income of the Government is not chargeable to tax and consequently collection on account of income tax will go down.

The reasoning given in the Memorandum also runs contrary to the provision of  Section 14A of the Income Tax Act. As per provisions of Section 14A, no deduction is allowed of expenditure incurred in relation to the income which does not form part of the total income i.e. tax free income. Dividend income in the hands of the shareholder, for the purposes of this Section 14A, is considered to be tax free income and accordingly substantial amount of expenditure is disallowed in the hands of the shareholder being incurred towards earning dividend income under section 14A. If dividend distribution tax is considered to be a tax paid by the company for and on behalf of the shareholders, as is being explained in the Memorandum, there is no justification for considering dividend income as tax free income in the hands of the shareholder so as to attract disallowance under Section 14A.

The proposed grossing up provision shall be applicable from 1st October, 2014.  Accordingly it will be advisable that corporates and mutual funds declare and pay dividend of the financial year 2013-14 including interim dividend of financial year 2014-15, if any, before 1st October, 2014 so as to save tax of 3.475%. Similarly it will be advisable to Mutual Funds to distribute its income before 1st October, 2014 to save burden of increased tax liability.