Union Budget 2020: Dividend Taxation- Reopens old wounds!

Elimination of dividend distribution tax and returning to the classical system of dividend taxation was the one of the key highlights of this Union Budget 2020. We will discuss the proposed scheme of the taxation and impact thereon forthwith:

The Need:

The old system had created a hurdle and DDT was considered as extra cost for flowing the funds between corporate groups. The move was the latest in a series of steps from Prime Minister Narendra Modi’s government to prop up the growth from the lowest in six years. Over recent months, Government have slashed corporate taxes, rolled back a levy on global funds, injected $10 billion into struggling state banks, and eased foreign direct investment rules.

Old v/s New regime:

The “Old wounds”

In proposed regime, only interest expenses up to 20% of dividend income is deductible against the dividend income. This may lead to the genuine hardship, for instance, if someone has borrowed money to invest in capital market then he/she may not be able actual interest expense against the dividend income. In this way, 80% dividend income will be taxable regardless of your actual interest expense.

Now, someone may argue that doing investment in the capital market is the regular business activity and hence it should be taxable as business income and consequently, whole interest expense and other expenses incurred to earn the said dividend income may be allowed. Past judicial rulings support this preposition, few of it are listed below:

Hon’ble Supreme Court in case of Western States Trading Co. (P.) Ltd. V CIT (1971) 80 ITR 21 (SC), held that,

Dividends are included in the meaning of income under sub-section (1A) of section 12 (of the Indian Income Tax Act, 1922, similar to Section 56(2)(i) of Income Tax Act, 1961) which is the residuary head. Applying the principles adverted to before, the amount of dividends would form a part of the income from the business of the assessee if the shares were a part of the assessee’s trading assets and the assessee would be entitled to a set-off as claimed against the loss from its business incurred during the previous years.

Similarly, in case of CIT v. Excellent Commercial Enterprises and Investments Ltd. (1980) 147 Taxman 558 (Delhi), held that,

Once it is held that the shares held by the assessee as a stock-in-trade and the income whether directly or incidentally from holding of such shares as stock-in-trade, would be business income, then it cannot be said that the dividend income would fall as an income from other sources as contemplated under section 56 of the Act and that set-off of under section 72 of the Act in a subsequent year would not be permissible.

Further, in case of CIT v. Ramnath Goenka (2003) 259 ITR 26, held that,

As held by the Apex Court in the case of Western States Trading Co. (P.) Ltd. v. CIT [1970] 80 ITR 21, the amount of dividend would form part of the income from the business of the assessee if the shares were a part of the assessee trading asset even when the dividend received on those shares had been computed as being part of the assessee’s income under the head ‘Other sources’. The Apex Court in very clear terms approved the view that had been taken by the High Courts consistently that ‘business loss carried forward from earlier years can be set off against the dividend income derived from the shares held as stock-in-trade.’

Further, Hon’ble Gujarat High Court shares  in the case of ACIT v. Laxmi Agents (P.) Ltd. (1980) 125 ITR 277 (Gujarat), went one step ahead and held that, dividend income would be taxed under “Income from other Sources”, but interest expenses incurred for purchase of shares need to be allowed as business expense under Section 36(1)(iii).

Fact of the case:

The assessee was a private limited company carrying on managing agency business. The income of the assessee comprised of (1) managing agency business, (2) income from trading in shares, and (3) income from other sources, i.e., dividends. It was found that during the relevant assessment year, the assessee paid interest on the borrowings made by it for the purpose of purchasing the shares of its managed company. The assessee claimed this payment of interest as deduction from its business income.

Held that,

As regards the question as to whether income from dividend was assessable under the head ‘business income’, even though the assessee had purchased the shares of the managed company for the purpose of its business of managing agency, the income received from the dividends must be classified under the specific head provided for the same.

As sub-section (2) of section 56 specifically provides that dividend income shall be chargeable to tax under the head ‘Income from other sources’, therefore, the income arising out of the share investment should be charged under the head ‘other sources’ as dividend as laid down in section 56.

The question came up for consideration was whether of interest on amounts borrowed for share investment should be allowed as business expenditure. It is true that, in ordinary course, according to general principles applicable to this question, expenditure incurred for earning income falling under a particular head should be deducted only under that head. But this general principle has to be read subject to the special provisions contained in section 36(1)(iii) as regards deduction of interest.

Further, the principal is to be worked out only for the limited purpose of computing total income of an assessee. The main requirement of section 36(1)(iii) is that the interest amount which is sought to be deducted in computing business income under section 28 should be in respect of capital which is borrowed ‘for the purpose of business’.

Even though an item of income falls under a specific head, in spite of the fact that item is earned for the purpose of business, for purpose other than the computation of income, the commercial character of that income can be taken into account.

In the instant case, the commercial character of the income was helpful in determining whether the borrowing on which the interest was paid for the purpose of business. The assessee invested in shares of the managed company with a view to protect its managing agency business and hence the main object of this investment was not to earn dividend, and if the borrowing were required to enable the assessee to purchase these shares, it must follow that the interest was paid on the capital borrowed for the purpose of business and it was immaterial how that borrowed capital was applied because all that clause (iii) of section 36(1) requires is that borrowings, on which interest is paid, should be for purpose of business. Therefore, the Tribunal was right in holding that though the income from dividend had to be assessed under a separate head, payment of interest by the assessee on amounts borrowed for purposes of investments must be allowed as business expenditure, and not as expenditure incurred for earning dividends.

The Fun fact:

Further, till date we were contending that investment in shares were made out of interest free funds (as dividend income were exempt) to save ourselves from disallowance of Section 14A r.w.s 36(1)(iii), now we need to eat our words and prove that investment in shares were made out of the interest bearing funds.