Taxation of dividends – Change of hands!

The Union Budget 2020 (‘Budget 2020’) was presented by the Honorable Finance Minister on 1 February 2020. All had set their eyes to witness what this Budget would unveil for reviving Indian economy.

At the introduction of the speech, the Honorable FM mentioned that the existing Government wishes to open up vistas for a vibrant and dynamic economy. With a view to giving impetus to foreign investments into India, one of the key amendments proposed is the abolition of Dividend Distribution Tax (‘DDT’). DDT is currently payable by domestic companies / mutual funds on the dividend declared, distributed or paid by them. Once this amendment becomes law, there would be a shift in taxation into the hands of the shareholders / recipient of dividend income. The shareholders would then be required to pay tax on the dividend income at applicable rates.

DDT was primarily introduced with the intention of easing out the collection of tax on dividend at a single point (i.e. at a distributing company level), rather than collecting it from various shareholders. DDT enabled not only ease of collection of tax but would also avoid leakage of tax and reduce tax compliance burden for the shareholders.

At present, domestic companies are liable to pay DDT at 15 per cent (plus applicable surcharge and cess) of the aggregate dividend declared, distributed or paid. The effective DDT rate after considering surcharge and education cess, currently stands at 20.56 per cent. Such payment of DDT is treated as the final payment of tax in respect of such dividend paid to non-residents. However, in most cases involving foreign investors, credit for DDT is not available in their home countries, which ultimately results in a reduction of rate of return on equity capital.

Under the extant provisions of the Income-tax Act, 1961 (‘the Act’), the resident shareholder (other than domestic companies, fund specified under Explanation to section 115BBDA of the Act and trust registered under section 12A or section 12AA of the Act) is required to pay tax at 10 percent (plus applicable surcharge and cess) on dividend income exceeding INR 1 million.

In view thereof, there had been representations from foreign investors seeking abolition of the DDT, to enhance foreign direct investments into India.

I. Proposed amendment related to tax on dividends

• The government proposes to take the bold step of obliterating DDT and shifting the burden of tax on dividends from the domestic companies to the recipient shareholders.
• Withholding tax is proposed to be done under section 194 (for resident recipients at 10 percent) or section 195 of the Act / tax treaty rates (for non-resident recipients at the rate applicable).
• Further, the shareholders would be allowed to claim deduction of only interest expenses, if any, subject to a cap of 20 per cent of the dividend income.
• In case of multi-layered structure of companies, the cascading effect of tax on dividend is proposed to be removed by re-introduction of deduction under section 80M. Deduction would be lower of dividend received from another domestic company or dividend paid by the recipient domestic company. However, current deduction available in respect of dividend received from foreign subsidiary for the purpose of computation of DDT, shall not be available for the purpose of section 80M.

II. Impact of proposed amendment in respect of dividend distributed by domestic companies

The key impact of the above amendments proposed to the Act in respect of dividend distributed by domestic companies are as under:

III. Effect of removal of DDT (in a nut shell) is enumerated as under:

1. Foreign investors

Obliteration of DDT regime shall be beneficial for the foreign investors as it will minimize tax cost of investment in India and credit of such tax cost would be available in home country. However, in respect of foreign investors being discretionary trust and AOP, rate of tax applicable may be the maximum marginal rate, which shall be substantially higher than tax rate for foreign companies, unless treaty benefits are available.

2. Domestic investors

• In case of domestic companies, tax cost will be at 30 percent* or at applicable rates, as the case may be, as compared to 20.56 percent under the DDT regime.
• In case of domestic individual investors having dividend income less than INR 10 lakhs,

– Total income lower than INR 10 lakhs – Obliteration of DDT is beneficial;

– Total income between 10 lakhs and 12.5 lakhs – Obliteration of DDT would have no impact;

– Total income above 12.5 lakhs – Obliteration of DDT may be detrimental.

• In case of domestic individual investors having dividend income more than INR 10 lakhs,

–  Total income between 10 lakhs and 15 lakhs – Obliteration of DDT is beneficial;

–  Total income between 15 lakhs to 50 lakhs – Obliteration of DDT would have no substantial impact;

–  Total income above 50 lakhs – Obliteration of DDT may be detrimental.

3. Other aspects

• Due to abolition of DDT and consequent savings in tax cost, likely declaration / distribution of higher rate of dividend by domestic companies
• The controversy of section 14A disallowance in respect of dividend income, shall not arise going forward.
• Compliance of TDS returns for dividend payment may get cumbersome in case of listed companies distributing dividend.

The above amendments are a welcome step for foreign investors. It is earnestly hoped by the Honourable Finance Minister and the ruling Government that this proposed move will boost foreign investments into India due to the applicability of the lower beneficial rates prescribed under the tax treaties for foreign investors (instead of the higher prevailing rate of DDT) and the future availability of foreign tax credit in relation to tax on dividends paid by them in India. However, on the flip side, the amendment could also deter the sentiments of the domestic individual shareholders. Possibly, abolishing DDT coupled with elimination of long term capital gains tax on transfer of listed shares (which was introduced vide Finance Act 2018) would have made a more positive impact from the eyes of domestic investor. Was it all a shade too less to help the situation, or was it just sufficient? Will this prove to be a game changer or will it be seen as a disappointing anti-climax? Well, only time shall unfold all of this.

(Authored by Ashesh Safi – Partner, Kripa Ray – Manager and Karan Vakharia – Deputy Manager at Deloitte Haskins & Sells LLP, Mumbai. The views expressed are strictly personal)