This article is written by Rohit Maheshwary, pursuing a Diploma in Business Laws for In House Counsels from lawsikho.com.
Table of Contents
Introduction
The Hon’ble Finance Minister, Ms. Nirmala Sitharaman presented the Union Budget 2020-21. The Budget seeks to amend various provisions of Income Tax Act, 1961 (‘Act’) for the development of our economy. This article discusses one such reform brought by the Union Budget 2020-21, that is, abolition of the Dividend Distribution Tax (‘DDT’).
Section 123 of Companies Act, 2013 and (Declaration and Payment of Dividend) Rules, 2014governs the law relating to dividend declared, distributed or paid by the Companies. The dividend as distributed will attract tax liability as per the provisions of Income Tax Act. However, an important question to be answered is: Who faces the liability of tax burden – the company or the investors receiving the dividends.
History of dividend distribution tax
The DDT regime mandated the companies distributing the dividend to face the erroneous tax liability. However, the “classical system of dividend tax” which existed before 1997 mandated the shareholders or the investors receiving the dividend to pay the tax liability arising from such a transaction. The enactment of Finance Act, 1997 shifted the classical system of dividend tax system to DDT regime and hence, the burden of discharging the tax liability shifted to the company distributing the dividend.[i] The shareholders were then absolved from tax liability and thereby exempted to pay any tax on dividend received from the company.[ii]
The classical system of dividend tax caused various hurdles in collection of tax since there were a large number of shareholders from which the tax needed to be collected and this was an administrative setback. The canon of economy which requires the cost incurred on tax collection to be low in comparison to the actual tax collected was not served in this case of the classical system of dividend tax.
The erroneous nature of the DDT can be seen from the fact that India is the only country to enact such a scheme as other countries tax the shareholders receiving the dividend. It was also expected that such reform will be challenged before the court of law after receiving criticism from the stakeholders. The Supreme Court in Union of India v. M/s. Tata Tea Co. Ltd.[iii]held that the scheme of the DDT is constitutional and opined that the DDT is an “additional income-tax on dividend” and the word dividend falls within the definition of income as provided under Section 2(24) of the Act.[iv]
The rationale furnished by Ms. Nirmala Sitharaman to abolish the DDT is to bring foreign investment in India and provide relief to small retail shareholders. The next part of this article discusses the impact of abolition of the DDT on various stakeholders.
Impact on foreign investment
The DDT had a huge impact on foreign investors since; they had to face the brunt of huge tax liability. The foreign investors were denied to claim any tax credit paid in the form of the DDT while filing tax return in his or her home country. For example, XYZ Ltd distributes INR 100 as dividend to its foreign equity investors based in the USA. Now, the DDT will be levied on XYZ at the rate of 20.56% and thus, the foreign investor will receive INR 79 (round off) after tax deduction. Now, the foreign investor will not get any exemption on the DDT paid by the XYZ Ltd and in return, the foreign investor will have to pay tax in the USA. Hence, if the USA levies 10% as per the Double Tax Avoidance Agreement entered between India and USA, then the foreign investor will pay tax of INR 7.9 and he or she will get INR 71 (round off) in his pocket.
This is nothing but a blatant instance of “double taxation”. The DDT does not qualify for the tax credit under the Double Tax Avoidance Agreement entered by India with other countries. This also increases the burden on the foreign shareholder as he or she needs to pay tax twice – once, in India in the form of the DDT and once, in his or her home country.
Every prudent and rationale investor will seek to maximize profit and expect a good return on his investment. The DDT hinders this expectation of the foreign investor and makes India a bad investment destination. To remedy this, Ms. Nirmala Sitharaman abolished the DDT stating that the “non-availability of credit of DDT to most of the foreign investors in their home country results in the reduction of the rate of return on equity capital for them.”[v]
The abolition of the DDT will benefit the foreign equity investor. The Finance Act, 2020 has charged 20% withholding tax on the dividend distributed by the domestic company to the non-resident foreign investor.[vi] Further, the foreign shareholders will be eligible for the tax credit as claimed under the Double Tax Avoidance Agreement.
Impact on retail shareholder
The DDT was a setback to small retail shareholders since; the rate of the DDT (20.56%) was high as compared to the traditional tax slab (5% or 10%). For instance, a shareholder named ABC comes within the tax bracket of 5% in the assessment year. Now, a Company XYZ Ltd distributes a dividend of INR 100 to ABC. The company XYZ Ltd will have to discharge tax liability of INR 20.56 and the remaining amount of INR 79 will be paid to ABC. Hence, the DDT regime caused INR 21 (round off) to be deducted as total tax liability. On the contrary, the classical system of dividend tax requires ABC to pay INR 5 as tax on dividend of INR 100. Thus, the classical system of dividend tax comes as a huge relief for small retail shareholders who come within 5 to 10% of the income tax bracket.
It has also been suggested that the tax on dividend must be levied slab wise.[vii] The abolition of the DDT is intended to protect the tax burdened shareholders who are paying a higher tax disguised as the DDT in comparison to lower tax liable to be paid under the lower tax rates.[viii]
On the contrary, abolition of the DDT will be detrimental to the interest of high net worth individuals coming within the 20% or 30% tax bracket. The high net worth individual’s tax liability (30%) will be high as compared to the DDT (20.56%). This will now compel the high net worth individuals to restructure their ownership in the company or try to avoid their tax liability.
Impact on REITs and InvITs
The stipulation to pioneer Real Estate Investment Trusts (REITs) and the Infrastructure Investment Trusts (InvIT) has been a long-standing one. They were allowed years back but did not gather attention due to blurred tax treatment. However, the present government was swift to launch the REIT structure in India as soon as it came to power in 2015.
REITs and InvITs are innovative mutual funds that pool in assets to raise funds from unitholders. The existing structure exempted tax liability on dividends from REITs/ InvITs. However, the proposed conventional method of taxing under Budget 2020 is also applicable on REITs and InvITs. While nothing fluctuates for trusts, unit holders of InvITs and REITs are no longer off the hook. They will now disburse tax on the dividend income as per appropriate income tax rate.
Industry officials have referred to this decision as a “roll-back” which creates an ironic situation because the government decided to support InvIts/ REITs by providing tax stability to long- term infrastructure investors. This will produce a considerable heartburn for active investors as well as for potential investments, for the mere reason that such investments have been planned with a certain tax impact in mind. Moreover, the current situation of the real estate sector with challenges such as the fall of IL & FS has left a huge black mark on the sector. In such a scenario, the proposed tax on unit holders is unwelcoming.
Conclusion
The abolition of the DDT will not only impact the small retail shareholder or the foreign equity investor, but this will also impact various stakeholders. The abolition of the DDT will have a huge impact on the Mutual Fund industry, Real Estate Investment Trusts (REITs), corporate governance, etc.
The DDT can be viewed as a classical instance of taxing a non-income based transaction. The dividend is an income for shareholders, but yet the tax liability is on the company paying the dividend and not otherwise. However, the DDT has faced the test of judicial reasoning in the case of Tata Tea Co, but the Union Budget 2020-21 has repealed the scheme of the DDT and replaced it with withholding tax as present prior to 1997.
The abolition of the DDT will open the gate for foreign investment in India and this can be a huge boost for the Indian economy. The falling Indian economy gets a ray of hope in the form of expected foreign investment.
The Union Budget 2020-21 did not take into the canons of economy and how the cost of tax collection will be minimized. The collection of dividend tax from a large number of shareholders must not be costly for the authorities and it need not create administrative setbacks.
References
[i] The Finance Act, No. 26, Acts of Parliament, 1997, sec. 40.
[ii] The Finance Act, No. 26, Acts of Parliament, 1997, sec. 3. See: The Income Tax Act, No. 43, Acts of Parliament, 1961, sec. 10(34).
[iii] Union of India & Ors. v. M/s. Tata Tea Co. Ltd & Anr, (2017) 10 SCC 764
[iv] Id.
[v] Budget Speech, 2020-21.
[vi] The Finance Act, No. 12, Acts of Parliament, 2020, Schedule I, Part II, 1(b)(i)(L).
[vii] Nilesh Shah, Is hike in dividend tax justified?, THE ECONOMIC TIMES (Mar. 05, 2007), https://economictimes.indiatimes.com/is-hike-in-dividend-tax-justified/articleshow/1722893.cms?from=mdr.
[viii] Memorandum, The Finance Bill, 2020, Income Tax Department, https://www.incometaxindia.gov.in/budgets%20and%20bills/2020/memo.pdf.
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