Tax must be paid on dividend unless rules change
Dividend represents a share of the company’s post-tax profit that is divided among its shareholders. In other words, once corporate tax has been paid on profit, the remaining earnings are distributed amongst shareholders as dividend. So far, so good. Then, this dividend is characterised as income in the hands of shareholders and taxed again! Simply put, this system of taxing the company as well as the shareholder has faced criticism on the grounds that it amounts to double taxation.
A simple parallel can be drawn to understand the challenge laid out above. You give your children their monthly pocket money out of the salary you receive, from which tax has already been deducted. And then the tax authorities show up at the front door to take some part of this pocket money as tax! Is this acceptable?
Faced with criticism and its own contradictions, the tax policy was amended in 1997 vide the Finance Act, 1997. The concept of dividend distribution tax (DDT) for the first time was introduced from June 1, 1997. This brought a radical change in the system of taxation of dividend. DDT is a separate and additional tax in addition to normal tax payable by the domestic company declaring, distributing or paying dividend out of post-tax profits to its shareholders.
DDT, being tax on the profit that is appropriated towards dividend, is mandatory even if no income tax is payable by the domestic company on its total income. The DDT scheme provides that dividend does not include specific situations, i.e., those covered within the ambit of section 2(22)(e) viz. loan or advance to a shareholder having substantial interest in the company. Items covered in section 2(22)(e) are taxed at the normal rates.
Recently, an amendment to the Finance Act, 2014 brought in the concept of applying the tax rate on the gross amount of dividend which is effective from October 1, 2014. This change results in increase in effective tax cost in the hands of the companies. The computation mechanism is contained in Union budget 2014.
While several changes were made to the provisions relating to DDT, including those that remove the cascading effect of dividend received from subsidiaries, no change has been made to address the question of double taxation as outlined right in the beginning.
In the above backdrop, it may be worth looking at the system of taxation of dividend in some oth-er countries.
In China, dividend is generally taxed at a flat rate of 20 per cent in the hands of the recipient. Having said that, resident individuals who receive dividend from Chinese listed companies have incentives based on their holding period. So if the listed shares are held for more than one year, dividend is taxed at 5 per cent, which results in 75 per cent of dividend income being exempt. This system appears to have been implemented to encourage individuals to invest in shares of listed companies in China. While the Chinese system does not address the challenge of double taxation as referred to earlier, it does provide some relief to individual taxpayers who hold the shares for a longer period of time.
In the US, qualified dividend (dividend paid by all domestic corporations and dividend paid by ‘qualified’ foreign corporations and corporations registered on the stock exchanges as listed by US tax law) received by individuals is taxed at the reduced rates. The shareholders need to meet the holding period requirement in order to get the benefit of reduced rate. Non-qualified dividend is subject to US federal income tax at the ordinary individual income tax rates.
The above illustrations — one of a developing country and another of a developed country — suggest that relief is available to investors who hold shares for a longer period. In the Indian context, where there is an attempt to widen the capital market and bring individual investors back, the government may consider providing incentives to individual investors who hold shares of Indian listed companies for a longer period of time.
Dividend received by Indian companies from offshore companies is taxable in the hands of the recipient. There is no participation exemption available. However, in order to incentivise repatriation of profits to India, a lower rate of 15 per cent applies on gross dividend received by an Indian company from its foreign subsidiary (‘specified foreign company’). Moreover, where the Indian company pays dividend to its shareholders from dividend received from its offshore subsidiary, there is no further DDT liability. This system helps in eliminating several layers of taxation.
While this is welcome, considering the need for Indian entrepreneurs to spread their wings across geographies, it is imperative that India considers the best international practice in this area and provides an incentive to Indian entrepreneurs. While a complete exemption would be welcome, a small tax of 5 per cent or so may not be a matter of significant concern to the Indian industry.
Thus, though the current system of taxation of dividend may appear to be unjustified as it results in double taxation, the rigour of the same could be reduced such that long-term individual investors have a lower tax cost and offshore dividend is either exempt or has a lower rate of tax.