The Finance Minister presented her second Union Budget before the Indian Parliament which aimed to boost income and enhance purchasing power. In the longest budget speech FM said that the tax proposals in this budget introduce further reforms to stimulate growth, simplify tax structure, bring ease of compliance, and reduce litigations. Amongst the various direct tax proposal contained in the Finance Bill, 2020 ('Finance Bill') a key corporate tax amendment proposed to be brought in by this Finance Bill relates to shifting back the incidence of taxation on dividend income in the hands of investor by abolishing the scheme of Dividend Distribution Tax ('DDT'). In the ensuing paragraphs, an attempt is made to elucidate these proposals and undertake an impact analysis of the abolishment of DDT on various stakeholders.
Existing DDT Regime
Under the existing regime, in addition to the income-tax chargeable in respect of the total income of a domestic company, any amount declared, distributed or paid by way of dividend is chargeable to additional income-tax at the rate of 15 per cent on gross basis plus applicable surcharge and cess (effective tax rate of 20.56%).
Similarly, specified companies and Mutual Funds are liable to pay additional income-tax at the specified rate on dividend income distributed by them to its unit holders.
The tax so paid by the company /mutual funds (DDT) is treated as the final payment of tax on dividend and further such income is exempt in the hands of the investors.
The incidence of tax is, thus, on the domestic company/mutual fund and not on the investor.
Further vide Finance Act 2016, as per the provisions of section 115BBDA of the Income Tax Act, 1961 (the 'Act'), over and above the DDT paid by the domestic company declaring dividend, resident non-corporate shareholder is required to pay tax at the rate of 10% plus applicable surcharge and cess (maximum marginal rate of 14.25%) in respect of dividend exceeding Rs. 10 lacs.
Proposals in relation to abolishment of DDT
With a view to reduce the tax burden of a large class of investors (who are liable to pay tax less than the rate of DDT on dividend income) and to increase attractiveness of the Indian equity market, the Finance Bill proposes to make the following amendments with effect from April 1, 2020
- Adopt the classical system of dividend taxation under which the companies would not be required to pay DDT on dividend declared after April 1, 2020 and the dividend shall be taxed only in the hands of the investors at the applicable rate;
- With respect to tax on dividend income as per the provisions of section 115BBDA of the Act, the same would not be applicable to dividend declared after April 1, 2020;
- Deduction can be claimed under section 57 of the Act on account of interest expense, capped at 20% of the dividend income;
- Further the domestic companies/mutual funds would be required to undertake withholding tax at the rate of 10% under section 194/194K of the Act in respect of such dividend income exceeding Rs. 5000;
- To remove cascading effect, set off will be allowed for dividend distributed by the domestic company one month prior to the due date of filing of return as per the provisions of section 80M of the Act.
Even the Direct Tax Code Panel led by the then CBDT member Mr. Akhilesh Ranjan, in its report to the Finance Minister, recommended abolition of DDT. Also, no other country in the world has DDT regime.
Legislative History of Dividend Taxation
Tax Impact in the hands of company distributing dividend and investors pre and post amendment
In view of the above amendments proposed to be brought in by the Finance Bill, we have summarised below tax impact in the hands of the domestic company distributing dividend and in the hands of the shareholders pre and post amendment below:
|Dividend distributed by:
||DDT on company distributing dividend1 (pre-amendment)
||Tax liability in the hands of investors2 (post amendment)
|Money market mutual fund / Liquid fund
|Equity oriented mutual fund
With shifting of tax incidence, the foreign investors can claim benefit of the lower tax rate on dividend income, prescribed under the Double Tax Avoidance Agreement (DTAA) entered into by India with its home country, which could be ranging from 5% to 15%. This benefit would be subject to anti abused provisions of the IT Act as also the principal purpose envisaged by Article 7 of the Multilateral Instrument (MLI) which counteract the abuse of DTAA. Additionally, the foreign investor would be required to furnish the requisite documents (viz. Tax residency certificate, No PE declaration, Form 10F).
From the above, it is evident that the foreign investor would benefit from abolition of DDT as it would increase returns for foreign investors thereby making investment in Indian equity market more attractive. However, arguably, it tilts the scale against the domestic investors vis-a-vis the foreign investors. Thus, the Government should consider providing for the special rate of tax of 10% (as was prescribed under DDT regime by section 115BBDA of the Act) for taxation of dividend income in the hands of domestic investors. Such special rate would provide relief to large number of domestic investors and could give a major push to investment in the capital markets.
Impact on the top 5 countries investing in India
As per the latest data available in public domain4, the following are the major investing countries attracting highest FDI equity inflows in India and the tax rate on the dividend income earned by these foreign investors â€“
||Tax Rate on dividend income
||5% / 15%5
||10% / 15%6
By shifting the tax incidence from the company declaring the dividend to investors, the rate of tax on dividend income earned by the foreign investors would substantially reduce as reflected in table above since they can claim benefits under the DTAA between India and the foreign country. Further the credit for such tax on dividend paid in India would be available to the foreign investor in its home country subject to provisions of local laws and tax treatment of dividend income of shareholders home country.
Pending Litigation in respect of claiming refund of DDT
Foreign MNCs investing in India have been litigating the issue of the rate of DDT applicable on dividend declared by and which is receivable by such foreign companies from its subsidiaries / investee companies. Such foreign investors have contended before the appellate authorities that for all intents and purposes, the DDT is a tax on income (dividend income) and therefore the same should be capped at the rate of tax on Dividend Income specified in Article 10 of DTAAs concluded between India and investors' home country. To support its contention, reliance was placed on the legislative intention of introducing DDT as gathered from Memorandum explaining provisions of Finance Bills introducing DDT, wherein it is stated that the levy of DDT on companies was driven by administrative considerations and the levy of DDT, for all intents and purposes, is a charge on dividends.
Recently the Hon'ble Delhi Tribunal in the case of Maruti Suzuki India Ltd8 admitted an additional ground raised by the taxpayer requesting to restrict the levy of DDT on dividend distributed/paid to its non-resident investor to 10% in terms of the provisions of DTAA between India and Japan. In this regard, while deciding the rate of DDT on income distributed to non-resident investors, the key question is whether dividend is tax on dividend income of the shareholder albeit paid by the Company distributing the same or it is the tax on the domestic company.
The Hon'ble Supreme Court in the case of Union of India & Ors. vs. M/s. Tata Tea Co. Ltd. & Anr9. upheld the constitutional validity of section 115-O of the Act on the grounds that since DDT is defined to be an additional income-tax on dividend and the definition of 'income' as contained in the section 2(24) includes dividend, the imposition of DDT is clearly covered by Entry 82 of List I of the Seventh Schedule of the Constitution "taxes on income other than agricultural income."
On the other hand, the Hon'ble Apex Court in the case of Godrej & Boyce Manufacturing Co Ltd10 while deciding the case on applicability of section 14A of the Act, observed that DDT is in fact tax on the domestic company and not on the shareholder.
Considering the fact that exists conflicting legal interpretations on the nature of levy of DDT, it is pertinent to note how the law in respect of claim of refund of DDT paid by the domestic company on behalf of the non-resident investor progresses. Further the memorandum to the Finance Bill 2020 could pave way to the ongoing litigations in respect of rate of DDT on dividend distributed/paid to foreign investors as it spells out that the incidence of tax on the dividend should normally be on the investor and not on the domestic company since the same is an income in the hands of the investor and not in the hands of the domestic company .
Inter-corporate dividends- Deduction under section 80M
To prevent the cascading impact, the Finance bill proposes to re-introduce section 80M of the Act to provide for deduction in the hands of a domestic company in respect of dividend received by it from any other domestic company subject to the first mentioned domestic company declaring and distributing dividend to its shareholders, one month prior to the due date of filing return of income under section 139(1) of the Act.
Deduction in respect of inter corporate dividends under the proposed provisions of section 80M of the Act is allowed irrespective of any minimum shareholding requirement which in the existing DDT regime, domestic company was required to hold at least 51% of the equity share capital of the other company.
However, the beneficial provisions of section 80M of the Act do not extend to dividend income received by a domestic company from foreign companies thereby leading to double taxation in respect of such dividends i.e. in the hands of the domestic company and thereafter in the hands of the shareholders of such company.
Further in cases where dividend though received from a domestic company is not declared to the shareholders but ploughed back into business and declared after a few years, dividend income would again be taxed twice as deduction under section 80M of the Act would not be available to the domestic company declaring dividend.
Impact on book profits
The dividend income received by the domestic company would be considered for computing the book profit under the provisions of section 115JB of the Act, thereby leading to a double levy of tax in the hands of domestic company. In this regard, it is hoped that the government will issue necessary clarifications to remove cascading effect of tax on dividend income under the provisions of section 115JB of the Act in line with the relief provided under the normal tax provisions by virtue of section 80M of the Act.
Interplay between deduction under section 80M and Expenses in relation to dividend income
The abolishment of DDT proposed in the Finance Bill would finally bring end to the long-drawn litigation currently prevalent in respect of expenditure in relation to exempt (dividend) income disallowed by the tax authorities under section 14A of the Act on the premise that the dividend income would now be taxable in the hands of the investors.
Further, the Finance Bill has granted a pocket-sized relief to taxpayers by providing for deduction of interest expense (not exceeding 20% of dividend income) against the dividend income.
Considering that the disallowance under section 14A of the Act read with rule 8D of the Income Tax Rules, 1962 by using the formulatory approach sometimes exceeded the amount of dividend earned itself which in turn attracted litigation, it was expected that the government at least grant deduction of interest expenditure (specifically attributable to the earning of dividend income) equivalent to the dividend income.
Additionally, one may also need to consider that the deduction available under the provisions of section 80M of the Act are in respect of dividend income forming part of the gross total income of the domestic company. Hence, in cases where the domestic company has incurred any interest expenditure directly attributable to earning of dividend income, then the deduction available to the domestic company under this provision would only be in respect of net dividend income earned i.e. after reduction of interest expense (capped at 20% of the dividend income) as per the amended section 57 of the Act.
In a practical scenario, companies making investments in subsidiaries out of borrowed funds may be put to a disadvantageous position in many cases where interest on borrowed funds is generally higher than the 20% of dividend earned and at times even higher that the dividend earned from such investments. Therefore, restricting the claim of interest expenses to 20% of the dividend will adversely affect the computation of taxable income of such companies and in certain cases could result in incurring a corporate tax liability.
In summary, post abolishment of DDT the tax out go of Indian promotors/ investors who hold their companies/investments in their individual capacity would certainly go up. Thus, such promotors may re-visit the existing holding structures of the group and evaluate options to rejig their holding. Further companies would evaluate alternative ways to distribute profits to the investors i.e. by way of buyback of shares, dividend, etc. Needless to mention that providing for the special rate of tax of 10% (as was prescribed under DDT regime by section 115BBDA of the Act ) for taxation of dividend income in the hands of domestic investors as also removal of restriction on expense limit against dividend income would certainly bring cheers large number of domestic investors and could give a major push to investment in the capital markets.
1. The rates of additional income tax are calculated as per the provisions of section 115-O and 115R of the Act respectively after considering the surcharge @ 12% and health and education cess @ 4%
2. We have considered the maximum marginal rate of tax in respect to dividend income earned by resident individuals (inclusive of surcharge @ 37% and health and education cess @ 4%)
3. In addition to DDT, resident non-corporates are required to pay additional tax at the rate of 14.25% as per the provisions of section 115BBDA of the Act if the dividend received from domestic companies exceeds Rs. 10 lacs.
4. As per the FDI Statistics available at dipp.gov.in
5. 5% - if the beneficial owner is a company holding directly at least 10% of the capital of the company paying the dividends, 15% - in other cases
6. 10% - if the beneficial owner is a company which owns at least 25% of the shares of the company paying the dividends; 15% - in other cases
7. Arguably 5% by applying the most favoured nation clause as per the DTAA between India and Netherlands
8. ITA No. 961/DEL/2015 [A.Y 2010-11]
9. 398 ITR 260 (SC)
10.  394 ITR 449 (SC)