1.0 Background
India has undergone several significant changes in its taxation policies in recent years, aiming to create a more conducive environment for economic growth and investor confidence. One major area which needs rationalisation is the taxation of dividends for resident shareholders.
While the abolition of the Dividend Distribution Tax (DDT) in FY 2020-21 was a step towards aligning with global best practices, the current framework has led to the issue of double taxation which disproportionately impacts resident shareholders, discourages equity investments, and creates disparities between resident and non-resident investors.
In this article, we discuss about the need for rationalising the current dividend tax structure in order to enhance economic efficiency, reduce compliance burdens, and promote a more investor-friendly environment.
2.0 Understanding the Double Taxation of Dividends
The Dividend Distribution Tax (DDT) was first introduced vide Finance Act 1997 as a means to simplify the taxation of dividends. Over time, it underwent several modifications before being abolished in 2020, transferring the tax burden directly to shareholders in a bid to improve transparency and align with international practices.
After the abolition of the Dividend Distribution Tax (DDT) w.e.f. Financial Year (FY) 2020-21, now dividends are taxed in the hands of resident individual shareholders as per the tax slabs applicable to them. For these taxpayers whose total taxable income exceeds Rs 10 lakhs in old tax regime or Rs 15 lakhs in new tax regime, the effective marginal tax rate is 31.2% which progressively increases to 35.88% where such income exceeds Rs. 1 crore. This coupled with the corporate tax rate of 25.17% results in an effective cumulative tax of 48.51%. This happens because firstly, the company pays tax on the profit earned at 25.17% (22% plus 10% surcharge plus cess 4%). Thereafter, the dividends are declared from the profit amount left after tax. On the dividend amount received by the individual resident shareholders, again the tax is levied at the tax slab rates applicable to them say at 31.2% (30% plus cess at 4%).
On the other hand, the effective tax rate paid by non-residents is substantially lower when compared with effective tax paid by the resident individuals. As per income tax laws, non-residents are liable to pay flat tax on dividends at 20% which coupled with cess of 4% results in an effective tax rate of 20.8%. The surcharge is applicable if total income (including dividends) exceeds Rs 50 lakh in a financial year. This flat 20% tax rate gets further lowered by Double Tax Avoidance Agreements (DTAA) to 5%-15% in most cases. However, in comparison resident taxpayers with their incomes in highest tax bracket of 30% pays tax at 31.2% (including cess at 4% excluding surcharge).
3.0 Illustrative Example
To understand this, here is an example. Suppose a company earns profit of Rs 100. On this profit, tax of Rs 25.17 is paid by the company which leaves Rs 74.83 for dividend distribution. On the dividend received by shareholders, they will pay tax at 31.2% (30% plus 4% cess), if the taxable income exceeds Rs 10 lakh in old tax regime or Rs 15 lakh in new tax regime. This double taxation leads to effective tax rate of 48.51% as follows:
| Figures in Rs. | |||||
| Description | Amount | Tax Rate (%) – RI | Tax Amount (RI) | Tax Rate (%) – NR | Tax amount (NR) |
| Profit of the company and corporate tax | 100 | 25.17% | 25.17 | 25.17% | 25.17 |
| Dividends (100-25.17) | 74.83 | 31.2% | 23.34 | 20.80% | 15.56
(74.83 * 20.8%) |
| Total tax | 48.51 | 40.73 | |||
| RI – Resident Indian
NR – Non-Resident |
|||||
The effective tax rate of 48.51% is significantly high and places a substantial burden on resident individual shareholders. This elevated rate, resulting from the dual taxation of dividends—first at the corporate level and again at the individual level—leads to a situation where a large portion of a company’s profits is eroded before reaching the shareholders.
In case of partnership firms and Limited Liability Partnership (LLP), the present effective tax rate is 34.94% since there is no further tax on the partners on their share of profit. Only in case of resident individuals or companies, the effective tax rate is the highest and almost equivalent to 50%.
Such a high tax rate not only discourages dividend distribution but also impacts the overall attractiveness of equity investments in India, potentially driving investors towards alternatives with lower tax implications. This reinforces the need for a rationalised approach to dividend taxation to ensure a more competitive and investor-friendly tax regime.
4.0 Issues arising from Dual Taxation of Dividends
Such dual taxation can result in a significant portion of the profits being eroded, reducing the amount available for distribution to shareholders and potentially impacting investment decisions.
Further, the current system of double taxation of dividends presents several issues:
- Economic Efficiency: Double taxation distorts investment decisions as it incentivizes companies to retain earnings rather than distribute them as dividends.
- Decline in Investment: Investors may prefer capital gains over dividends due to lower tax implications, affecting the flow of funds into the equity market.
- Complexity: Compliance with multiple layers of taxation increases administrative burden and compliance costs for companies and investors alike.
- Impact on Retail Investors and SMEs: Retail investors, particularly those reliant on dividend income for regular cash flow, bear a disproportionately higher tax burden under the current regime. Similarly, SMEs, which often distribute dividends to maintain shareholder confidence, face challenges in retaining capital for growth due to the high effective tax rate.
- International Competitiveness: In countries like the United States, qualified dividends are taxed at preferential rates ranging from 0% to 20%, depending on income levels. The UK provides a tax-free dividend allowance, while developing nations like Indonesia and Thailand impose a 10% dividend tax rate, with Vietnam levies a rate of 5%.
Thus, in a globalized economy, countries with lower tax burdens on dividends may attract more foreign investment compared to those with higher effective tax rates due to double taxation.
5.0 Need for Rationalisation
To address the aforementioned challenges, rationalisation of the tax treatment of dividends is crucial. There is an imminent need for restricting the dividend taxation for resident investors to 15% (excluding surcharge and cess) which can result in an effective tax rate of 17.94% (assuming surcharge of 15% and cess of 4%).
Rationalising the dividend taxation for resident shareholders could lead to an increase in retail investor participation in the equity markets and a significant boost to dividend-paying companies valuations.
Lowering tax rates on dividends for residents can encourage companies to distribute profits while still ensuring an adequate revenue stream for the government. Further, streamlining tax laws and reducing compliance burdens can aligns with the government’s vision of fostering a business-friendly environment under initiatives like Make in India and Ease of doing business and improve investor sentiment. The government is anticipated to consider this highly beneficial measure in the forthcoming Union Budget, scheduled to be presented on 1st February, 2025.
6.0 Conclusion
In conclusion, the issue of double taxation of dividends is a complex one that requires careful consideration and reform. While the abolition of DDT was a step forward, further rationalisation through reduction in tax rates, and simplification of regulations can create a more conducive environment for investment and economic growth. By addressing these concerns, India can enhance its competitiveness in the global market and promote a healthier investment climate domestically.
Author Bio
very interesting facts about the double taxation on dividend.
thanks