Background

In the backdrop of slowdown in the Indian economy, there were huge expectations from Union Budget 2020. Capital markets and corporates were expecting a slew of measures which included removal of Dividend Distribution Tax (DDT), changes in long term capital gains, an increase in tax exemption slabs for individuals, etc.

The Union Budget 2020 was announced on 1 February 2020 and the removal of DDT was one of the significant announcements made.

Current Tax Regime for Dividends

Under the current regime, the corporates are required to pay a DDT of 20.56% over and above the corporate tax paid before distributing the surplus to the shareholders. Further, such a dividend was also taxed in the hands of certain shareholders at 10% (plus applicable surcharge and education cess). This resulted in three-level taxation which was considered very draconian. Accordingly, there was a demand from the corporates and stakeholders to abolish DDT.

New Tax Regime for dividends

The Union Budget 2020 has now abolished the DDT and has restored the traditional taxation system of dividends whereby dividends would be taxed in the hands of the shareholders/investors. Further, the concessional rate of taxing dividends at 10% (plus applicable surcharge and education cess) and exemption of no tax on dividend up to INR 1 million has also been removed. This would mean that the dividends would now be taxed in the hands of shareholders/investors at the applicable rates.

Further, the Union Budget proposal also requires corporates declaring dividend to withhold taxes on dividend declared to the shareholder at 10% for resident and at applicable rates for non-residents. The provisions also provide that only interest expenditure would be allowed as a deduction from the income and the same would be restricted to maximum 20% of the income. The law provides for providing credit to companies receiving dividend which in turn are also declaring dividends out of the same amount subject to certain conditions.

However, no exemption is provided for Indian companies receiving dividends from a foreign subsidiary and then declaring the same to its shareholders. Earlier, for computation of DDT, the dividend received from foreign subsidiaries was required to be excluded.

Impact of amendment

These amendments would lead to taxation in the hands of shareholders at applicable tax rates. For example, these provisions would result in taxation of dividends at the maximum rate of 39% and 42.75% for high net worth individuals. In the case of foreign shareholders, the applicable tax rates would be either as per the Indian Income Tax Act or Tax Treaty, whichever is more beneficial.

Dividend Tax Rates for Non-Residents

Country As per the Income Tax Act As per Tax Treaty
Corporates Others (excluding LLP) Corporates All other cases
USA 21.84% 26%*/28.5%** 15% -If shareholding > 10% 25%
Singapore 21.84% 26%*/28.5%** 10% - If shareholding > 25% 15%
Mauritius 21.84% 26%*/28.5%** 5% - If shareholding > 10% 15%
UAE 21.84% 26%*/28.5%** 10% 10%
Netherlands 21.84% 26%*/28.5%** 10% 10%
Germany 21.84% 26%*/28.5%** 10% 10%
Hong Kong 21.84% 26%*/28.5%** 5% 5%

*Assuming total income is more than INR 20 million and less than INR 50 million

**Assuming total income is more than INR 50 million

Based on the above, it is evident that all taxpayers would pay tax at different rates on dividend income. Further, for non-residents, it becomes imperative to ensure that they are eligible to claim tax treaty benefits in order to avail beneficial tax rates provided under the Treaty. Also, participation exemption (i.e., a lower rate of dividend tax applies only if the shareholding is above a threshold) provided in various treaties is available to corporate shareholders only, and for other shareholders, the higher rates would be applicable.

Also, from a Foreign Portfolio Investors (FPI) perspective, the participation exemption would never be available as FPI’s are not allowed to invest more than 10% in a single security. This would result in FPI paying taxes in the range of 5% to 25% on dividend income earned in India. Further, in cases of funds set-up in countries like Mauritius, UAE, Singapore, the foreign dividend is exempt and hence the tax credit may not be available, leading it to become a tax cost. From an FPI perspective, Hong Kong may become an attractive jurisdiction as it provides for a tax of only 5% on dividends.

Furthermore, to claim tax treaty benefits, the foreign shareholder/FPI would be required to file a tax return in India. This may result in additional compliance requirements for foreign companies in India even though they are only earning income from dividends in India.

Also, locally, most of the Alternate Investment Funds are structured as a Trust and they would be liable to pay tax on dividends at the rate of 42.75%.

It would be important to note that enhanced surcharge on the super-rich, which was introduced in the last budget was made inapplicable to capital gains income through the ordinance passed recently. However, dividends would not get the same advantage in the absence of any specific provisions.

On the positive side, with the removal of DDT, corporates would have an additional surplus and the overall quantum of dividends declared should be much higher than declared in past. Also, taxation of dividends in the hands of shareholders results in an equitable tax system as the rich would pay higher tax and the poor would pay lower tax depending on the total income of each taxpayer. Earlier, rich and poor both were indirectly paying taxes at the same rate through DDT. Also, DDT was creating a challenge for many foreign companies/taxpayers to claim a tax credit in their home country.

Another important aspect of this proposal is allowing of only interest expense against the dividend income and that too restricted up to 20% of income. Earlier, since the dividend was considered as exempt income, no deduction was allowed. Logically, with dividends becoming taxable, expenses therefrom should be allowed. The current provision to allow only interest expense up to 20% is unfair. For example, if dividend income is INR 3 lakhs (for a yield of 3% on, say, investment in equity shares of INR 100 lacs), and the said INR 100 Lacs are funded by INR 50 lacs of borrowings at 10%, then the interest deduction will be only INR 60,000 (and not INR 5 Lacs). This seems to be unfair proposition and would discourage funding of investments through borrowings as the same would be highly tax inefficient.

Further, on reading the fine print of the provisions, it appears that there can be a situation where the company declares its dividend before 31 March 2020, but an individual, who receives the same after 1 April 2020, would suffer old dividend distribution tax by the company as well as full dividend taxation in his/her hands. Hopefully, this anomaly would be corrected; otherwise, companies will avoid declaring dividends in the final two weeks of the financial year.

Dividend Tax vs Buy Back Tax

It is essential to note that currently, buy-back tax is applicable in the hands of the Indian company at a rate of 23.296% on distributed income (i.e. Buyback price less the amount received by the company while issuing shares).

In comparison to the same, the promoters of the Indian company may end up paying 42.75% tax on dividend income. Accordingly, the company’s option of buy-back of shares may become more attractive than the option of dividends from the perspective of the promoters of the Indian company. Furthermore, the buy-back would have to be carried out in compliance with the provisions of the Indian Companies Act.

Dividend tax is the new reality and investors would have to brace themselves to comply with the law of the land. Also, it would be interesting to analyze whether this tax would result in more buy-backs by the companies or if corporates need to re-examine the option of Limited Liability Partnership structure as there is no repatriation tax on the same.