How promoters will end up paying higher tax on dividends?

Effective Fiscal Year 2020-21, dividends will be taxed in the hands of the shareholder at the peak marginal rate applicable.

Feb 23, 2020 09:02 IST India Infoline News Service

Budget 2020 made a number of important announcements, one of them being the abolition of dividend distribution tax (DDT). The Finance Minister’s argument was that the DDT was prima facie unfair because it levied the same rate of tax on the promoter and the small shareholder. DDT was not progressive in nature (as direct taxes are supposed to be). It was to rectify this anomaly that DDT was scraped in Union Budget 2020 after being in existence for more than 20 years. Effective Fiscal Year 2020-21, dividends will be taxed in the hands of the shareholder at the peak marginal rate applicable.
 
Taxing Dividends – Old approach versus New approach

In the old approach till fiscal 2019-20, dividends were taxed at 3 levels. Firstly, there was an opportunity loss because dividends are a post tax appropriation. Secondly, dividends were subject to DDT at 20.56% (including surcharge and cess) on the grossed dividend. Lastly, dividends above Rs10 lakhs per year were additionally taxed at 10% in the hands of the investor. This was specifically applicable to HNIs with large equity stakes and promoters.
 
In the new approach from fiscal 2020-21, the dividends will be taxed only at 2 levels. The opportunity loss on dividends will continue. However, there will be no DDT but the dividend income will be taxed at your peak marginal tax rate. If a retail investor falls in the 10% tax bracket, then the applicable rate of tax for dividend income will be 10.4% (10% tax + 4% cess). In the case of a company promoter earning more than Rs5cr as annual income, dividends will be taxed at the peak rate of 42.74% (30% tax + 37% surcharge + 4% cess). So, while small investors are likely to be happy with the new tax regime, HNIs and promoters are likely to be unhappy.
 
What would be the effective tax on dividends for promoters?

We can evaluate the impact of dividend tax shift on promoters by considering the case of company, X Ltd. Let us assume that the promoter, Mehul Shah, is a second generation businessman and his total annual income is well above the peak taxable limit of Rs5cr. Hence, he would be subjected to the highest level of tax and surcharge. How will his dividends be taxed?
 
The below example illustrates that promoters and large HNIs with substantial incomes will tend to pay higher rate of tax on dividend income. The dividend tax shield foregone is also considered as a cost to give you a clear picture of the opportunity cost of dividend income.
 

Particulars

FY20

FY21

Explanatory Notes

Profit Before Tax (X Ltd.)

100.00

100.00

Tax Rate (Tax + Surcharge + Cess)

25.17%

25.17%

Tax at 22%; Surcharge 10%; Cess at 4%

Tax Shield foregone (1)

25.17

25.17

Opportunity Cost of Dividend tax shields

Profit after Tax (X Ltd.)

74.83

74.83

Net profit of X Ltd. (100% dividend payout)

Dividend Distribution Tax

20.56%

0.00%

Surcharge and Cess is on Grossed Dividend

Actual DDT Cost (2)

15.38

-

DDT is scrapped in FY 21

Cash flow to Mehul Shah

59.45

74.83

Effective dividend flow before income tax

Income Tax Rate (Peak)

14.25%

42.74%

(37% surcharge and 4% cess applied)

Tax Paid by Mehul Shah (3)

8.47

31.98

Total Tax Cost to Mehul (1 + 2 + 3)

49.02

57.15

Effective Percentage tax payable

Net Cash flow to Mehul Shah

50.98

42.85

Effective Post Tax dividend income

It is evident that Mehul Shah, the promoter of X Ltd, will end up paying 813 basis points additional tax for the year on his dividend income. That will be true for all promoters and HNIs if their annual income is above Rs5cr per year as they would be subjected to 42.74% marginal tax. One of the reasons, promoters have been unhappy is that the effective tax rate on dividends has gone up from 49.02% to 57.15%.


Some challenges may emerge in the new dividend system

While taxing dividends in hands of investors is progressive, there are 3 challenges that remain.
  1. DDT was much easier to administer and collect since there were just a limited number of companies to administer. Taxing dividends in the hands of investors is more complex.
  2. The buyback tax was introduced to put them at par with dividends but this shift in tax system may again make buyback of shares more attractive than paying dividends.
  3. The new dividend tax system puts domestic companies at a disadvantage vis-à-vis MNCs, especially where the base country of the MNC is covered by tax treaty.
Taxing dividends may be unfair to the promoters and beneficial to small shareholders. But the real challenge will be in the implementation.

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