Dividend distribution in India

Thu, Nov 5, 2015

In Focus

Dividend taxation policy in India has been a dynamic one. Dividend taxation before the financial year 1958-59 was based on tax imputation method. Effectively, dividends were used to be taxed only once i.e. in the hands of shareholders only. However, the process of grossing up dividend income for shareholders was complicated due to various incentives provided to corporates in the tax system such as taxation
holiday, development rebates etc. One other disadvantage of this system was that the assessment of shareholders was to be done only after the assessment of the company. The single taxation on dividends at shareholder level was abolished in 1959-1960 and corporate earnings distributed as dividends were taxed twice i.e. first in the form of corporate taxes on earnings and then as dividend income taxed in the hands of shareholders. In financial year 1997-98, budget dividend distribution tax was proposed for the first time. The Finance act of 1997 amended the Income-Tax act 1991 and a 10 % tax was levied on corporate houses distributing dividends out of taxable profit. Consequently, dividend income received was exempted at the hands of the shareholders.

Though the core focus of government since independence has been to discourage dividend payouts, so as to encourage firms to invest the profits back into their existing or new businesses, the primary reason of such policy has been to boost Indian economy through investments. Alongside this policy, government has consistently taken steps to encourage retail investors’ participation in capital market by increasing tax exemption limits and by providing various rebates. Currently, tax system in India is biased towards companies not paying dividends and thus encouraging long term investments in securities. The capital gain tax in India is lesser than taxes on dividends. The long term capital gains on sales of shares and mutual funds are exempted under section 10 (38) of the Income tax act. Short term capital gain, however, are taxed at the rate of 15 % under section 111A.

In most countries dividends are taxed at the hands of investors. Until 1997, in India too, dividend income used to be taxed at the hands of shareholders. From the beginning Indian government has discouraged distribution of dividends in order to encourage firms to invest the profits in future investments so as to enhance growth of economy. In order to combat inflationary pressures in the economy and to generate sufficient resources for investments in the corporate sector, the government has consistently put restraints on dividend distribution. In the budget of financial year 1946-47, a very high tax (super-tax) on dividends above a datum line was introduced. The objective of very high taxes on dividends above a ceiling was to deter the distribution of large dividends and to encourage the plough back of profits into firm’s investments. The then finance minister proposed to reduce tax on the undistributed profits of companies by one anna (an anna is 1/16th of a rupee). A tax rate of 5 annas a rupee were levied on distributed profits while the tax on undistributed profits was reduced to 4 annas a rupee in the financial year 1948-49.

Currently, distribution of dividend attracts tax at source in the form of Dividend Distribution Tax (DDT), levied at the companies end. Thus, there is double taxation at corporate level if a corporate is paying dividend. Corporate tax on income is applicable to all companies but the DDT is levied on only those companies which are paying dividends.

However, unlike most of the countries where dividend income tax is applicable at the hands of investors, dividend income tax is exempted
at the hands of investors in India. Objective of exorbitant dividend payouts by companies and to encourage them for more investments through retained earnings. It also ensured that it doesn’t let any shareholder with huge stakes in a company, to go off without paying taxes
on their income.

Since 1997, DDT was introduced at the rate of 10% and this benefited those shareholders who were falling in higher than 10 % tax bracket. Opponents of DDT argue that due to DDT there is double taxation on firms i.e. firms are taxed twice on the same income in the
form of corporate taxes and DDT and therefore DDT is not good for firms and investors. The other argument is that, since DDT is applicable
at firm level, all the shareholders irrespective of their income category are taxed indirectly at the same rate of DDT. Whereas in the previous
tax scheme where dividend income was taxed at the hands of shareholders, shareholders having low amount of dividend income can claim deduction under section 80L, subject to a maximum ceiling. Thus, the low income investors falling under such ceiling get tax rebate and are encouraged to invest. It is difficult to determine whether the tax collection through DDT scheme is higher than the earlier tax regime. But, the introduction of DDT shifted the responsibility to pay dividends from individual investors to firms and therefore collection of tax on dividends have become more efficient.

However the pros and cons of DDT can be established only by answering two empirical questions. One, since DDT is a fixed tax applicable to all investors; and historically it has always been lower than the maximum income tax rate applicable on individual investors, there is need to find whether there is a lower effective taxation on average income earning investor in DDT regime. However, it is difficult to get such data because of large heterogeneity in incomes of investors and also, data is often lacking. Also, this question should be answered in a dynamic environment where we see frequent changes in DDT rates ranging from 10 % in 1997 to approx. 20 % in 2014. Second broad question is more from
policy point of view. DDT was introduced in order to encourage firms to use their earnings for future investments and to enhance growth. Also, during that time, the tax collection system was not so efficient. So DDT provided a way out for government to overcome these loopholes by indirectly taxing investors at the hands of firms. However, with time this loopholes in tax collection system has been greatly reduced through various banking and taxation reforms, along with use of Information technology in taxation. One needs to find out in which scheme (with DDT or without DDT but dividend income tax at hands of shareholders) government tax collection is higher. If the two are comparable figures then DDT scheme should be abolished because in DDT scheme, even the lower income group investors are taxed indirectly at the same rate as the very high income group investors. Though it is very difficult to get the data required for such a study.


Vikas Sangwan

PhD, IME Department, IIT Kanpur

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