Double Taxation or Over-Taxation
The Classical System of taxing companies and its shareholders results in over taxation and NOT double taxation. The reason behind this is explained as follows:
When entities are different, however the same income is taxed more than once.
When the same entity discharges a tax liability on the same income twice.
A Company is a separate legal entity from its shareholders. Under S.2 (7) of the Income Tax Act, all entities can be shareholders. For example, sometimes Companies themselves are shareholders in other companies and draw Inter Corporate Dividends from the other. In another example, Dividend Distribution Tax is paid on the profits of a Company, which are distributed as dividends. And, the shareholder pays a tax of 10% on dividend income if the income so earned i.e. via dividends exceeds Rupees 10 Lakhs. Therefore, the same income i.e. the company’s profits gets taxed first in the hands of the company itself and then in the hands of the shareholder. Since the company and its shareholders are two different entities, therefore this is called ‘over-taxation.’
The System of Partial Integration
The System of Partial Integration is a form of reducing the above over-taxation. It may different forms. There are three forms where as a tax-legislator, as policy makers, we can reduce this problem. Different countries follow different forms of Partial Integration.
1. Dividend Exemption
When P. Chidambaram was the Finance Minister, he introduced this Exemption on Dividends income. Pursuant to this, when the dividend reaches the hands of a shareholder, it is completely exempt from any tax liability.
However, this caused a loss of revenue to the Government. Consequently, a new tax by the name of Dividend Distribution Tax was levied. This was to be paid on the distribution of dividend.
During the year 2017, under the goal of ‘redistribution of income’ if an individual derived an income of above Rupees 10 lakhs from dividends, then such individual was subject to a tax liability.
Dividend Distribution tax needs to be abolished because for example, a Company decides to give Rupees 150 as dividends to its shareholders. Now because of DDT, 15% of this Rupees 150 will be paid as Dividend Distribution Tax. This causes a fall in the profits of the Company, which lowers the cash flow of the company and ultimately the income earned via dividend income goes down for the shareholder.
2. Dividend Deduction
Under this method companies do the following:
a. Calculate their income
b. Prepare Profit Loss Account
c. Prepare Balance Sheet
d. Make the payment of Dividends to Shareholders as ‘expense’
e. This causes a reduction in net profit
f. This causes the income to reduce
g. Consequently, their tax liability falls.
3. Split Rate System
Under this method, the following changes are proposed:
a. Lower rate of tax for distributed profits
b. Increase rates of tax for retained profits
c. Profits distributed as dividends will be higher
d. Consequently, the tax liability shall fall.