Income Tax Taxation

Abolition of Dividend Distribution Tax and impact of its Taxability in the Hands of the Recipient

With a view to decrease compliance burden on issuing companies w.r.t. tax deduction certificates and to ease the collection of taxes, the DDT system was introduced to promote the collection of taxes at a single place. Way back in 1997, the concept of dividend distribution tax was launched in India, and it was levied at a flat rate of 7.5% to make tax collection more efficient. Currently, the incidence of dividend tax is on companies, which is levied @ 15% on the distribution of profits to shareholders.

The scrapping of Section 115O of the Income Tax Act is propounded in the budget in order to put the classical system of taxing dividends back into place. Budget 2020-21 has proposed the abolition of dividend distribution tax, to be effective from 1^st April 2020. Accordingly, from the financial year 2020-21, the dividend income from shares and mutual funds shall be taxed only in the hands of the recipient. 

Insertion of the classical dividend taxation system

Prior to the abolition of dividend distribution tax, earnings distributed by a domestic company weren’t counted in the total taxable income of an assessee. But now, dividends will form part of the taxable income of an assessee under the head “income from other sources”. Also, income distributed by a registered mutual fund shall be made taxable in the hands of the unitholders.

The new dividend tax regime is claimed to be a fairer system of taxation as it will eliminate tax inequalities among different taxpayers. A single rate for taxing dividends is regarded as unrighteous since it results in favoring taxpayers falling under higher tax brackets and works against those falling under lower brackets.

A new provision (Section 194K) is proposed to be inserted in the Income Tax Act stating that domestic companies must deduct TDS @ 10% if the amount of dividend distributed to an investor exceeds Rs. 5,000 during a financial year. The taxpayers, while filing their income tax returns, may avail the credit of such TDS levied by companies.

Impacts of abolition of dividend distribution tax

At present, DDT is required to be paid by companies on the circulation of dividend to their shareholders at the grossed-up rate of 17.65 percent plus applicable surcharge and cess, which effectively comes to 20.56%. This tax is in addition to the corporate tax payable by the company on its annual profits. Moreover, non-corporate resident assessees are liable to pay tax @ 10% plus surcharge and cess, if their dividend receipts exceeded Rs. 10 lakh during the relevant financial year.

Akin to DDT on shares, dividend tax on income from debt mutual funds is 25% for individuals/HUF and 30% for corporate assessees. The effective tax rates after grossing up and adding applicable surcharge/cess come to 38.33 percent and 49.92 percent respectively.

Considering these high dividend taxes, it is contented by the Finance Department that the new mechanism shall foster the growth of investments in debt mutual funds. This is evident from the fact that most of the individuals will end up paying lower tax on their dividend income from debt mutual funds in comparison to what they were subjected to pay earlier.

With the abolition of dividend distribution tax, low-income earners will be encouraged to invest in the capital market. The reason being that individuals with total income up to Rs. 5 lakh will not have to pay tax on dividend income as against 20.56 percent paid by them indirectly. Earlier, shareholders used to receive net amount of dividends after the deduction of 20.56% DDT by issuing companies. In simple words, low-income earners will save a hefty amount of tax since the issuing company will no longer deduct DDT @ 20.56% and, thus, shareholders will receive higher dividends on which nil tax will be paid as per their applicable slabs.

Also, under the new tax regime, persons having income between Rs. 5 – 7.5 lakh and those having income between Rs. 7.5 – 10 lakh would fall under the tax bracket of 10 percent and 15 percent respectively. The scrapping of the dividend distribution tax would prove beneficial to all these taxpayers. It is so because the tax to be paid by them on dividend income would be way lesser than what they were paying previously on an indirect basis through 20.56% DDT.   

In nutshell, with the abolition of dividend distribution tax, the net receipts after taxes will increase in the hands of the taxpayers. While the effect will be neutral for recipients falling in the tax bracket of 20%, those under a 30% tax bracket will have to suffer more tax.

Removal of dividend distribution tax to benefit Foreign Investors

On account of the removal of DDT liability, the corporate houses may pay higher dividends as they will have more surplus funds for disposal.

Non-resident or foreign residents will also gain from the new regime of dividend taxation. By following the old system, non-residents were being taxed at a higher rate than the treaty rate together with the possibility of no tax credit in their home country.

The DDT system was majorly criticized because foreign investors received no credit for the dividend tax paid by Indian companies. When dividends get taxed in the hands of the foreign equity investors, DTAA will become applicable, and the rate of tax would be determined depending on their shareholding and residence.

Since a mechanism of withholding of taxes will become effective unlike the present DDT system, foreign equity investors will get the credit of dividend tax paid in India, at the time of filing returns in their home countries. Further, non-residents will also be allowed to apply for a certificate for lower withholding tax in case the relevant tax treaty provides for a lower withholding tax. With this, the attractiveness of the Indian market will get significantly enhanced.

Takeaway

Dividend distribution tax is proposed to be shifted from companies to individuals so that it can address the issues of inequity in dividend taxation and offer relief to non-residents. The move shall make dividend income derived from shares/mutual funds to be taxable in the hands of the shareholders at their corresponding personal tax rates.

Also, Read: Old vs. New Tax Rates – Whether a taxpayer should choose the new tax regime for FY 2020-21?