Understanding Classical System of Taxing Dividends in the hands of Recipients

1. Introduction

Amid this unprecedented health emergency like situation, caused due to the unfortunate COVID-19 outbreak, it has become essential for all of us to remain safe within the confines of our homes, and in order to facilitate and encourage such confinement in our homes, the DD National has started the re-broadcasting of the classical epic of the 1987-88, "the Ramayana", which has again become so popular among the masses, that the TRP of the Doordarshan Channel has again increased manifolds.

Similarly, the Finance Act 2020 has re-introduced the classical system of taxing dividend income in the hands of recipient shareholders or unit holders as was prevailing uptill AY 1998-99. However, unlike the Ramayana, this classical system of taxing dividend incomes in the hands of the recipients, may not be popular among the masses now, especially when a common man has become so habitual of the norm of receiving tax-free dividend income.

Uptill the AY 2020-21, a domestic company was liable to pay the Dividend Distribution Tax (DDT) under section 115-O of the Income Tax Act, on any dividend distributed by it to the shareholders. Consequently, shareholders were exempt from paying tax on such dividend income by virtue of section 10(34).

However, when a resident shareholder (other than a domestic company, educational institute or hospitals as referred to in clauses (iv) to (via) of Section 10(23C) or a trust registered under section 12A/12AA) was in receipt of dividend from the domestic company in excess of Rs. 10 lakhs, such excess dividend was taxable under section 115BBDA at the rate of 10% plus applicable surcharge and health & education cess. This additional tax under Section 115BBDA was levied on all types of dividends except deemed dividend as referred to in Section 2(22)(e), i.e., loans or advance to the shareholders.

The existing provisions concerning the levy of tax on dividend income were resulting in taxation at four levels viz.

(a) firstly, as regular corporate income tax on corporate profits;
(b) secondly, as DDT in the hands of corporate entities;
(c) thirdly, as tax on dividends in the hands of recipients u/s 115BBDA, if the dividend income exceeds Rs. 10,00,000/- p.a.;
(d) fourthly, as disallowance u/s 14A w.r.t. dividend income.

Thus, there was an urgent and dire need to eliminate this unjustified cascading of taxes and the scrapping of DDT in the hands of corporate entities.

Accordingly, the Finance Act 2020 has re-introduced the classical system of taxing dividend income in the hands of recipient shareholders or unit holders at their respective applicable slab rates and the domestic companies or mutual funds are not required to pay any DDT on such dividend income, w.e.f. AY 2021-22, i.e. w.e.f. 1.4.2020.

Therefore, the dividend income received by the recipient shareholders or unit holders, on or after 1.4.2020, shall be taxable in their hands at their respective applicable slab rates of income tax, and the domestic companies or the mutual funds distributing such dividend income shall not be liable to pay any DDT on such dividend income.

However, to avoid double taxation, the Finance Act 2020 has also provided that the dividend income received by the recipient shareholders or unit holders on or after 1.4.2020, on which the DDT has already been paid by the domestic companies or mutual funds, or tax u/s 115BBDA has been paid by the recipient shareholders, on or before 31.3.2020, shall not be taxable in the hands of the recipient shareholders or unit holders.

2. Section-wise Amendments in Finance Act 2020, concerning Taxability of Dividend Income

The Finance Act 2020 has provided to-

1. amend section 115-O providing for payment of DDT by domestic companies and mutual funds, to provide that dividend declared, distributed or paid after 1st April, 2003, but on or before 31st March, 2020, shall only be covered under the provision of this section, and dividend declared, distributed or paid on or after 1.4.2020, shall not be covered under this section.
2. amend clause (34) of section 10, providing for exemption of dividend income upto Rs. 10 lakhs in the hands of the recipients, to provide that the provision of this clause shall not apply to any income, by way of dividend, received on or after 1st April, 2020.
3. amend section 115R to provide that the income distributed on or before 31st March, 2020 shall only be covered under the provision of this section.
4. amend clause (35) of section 10 to provide that the provision of this clause shall not apply to any income, in respect of units, received on or after 1st April, 2020.
5. amend clause (23FC) of section 10 so that all dividends received or receivable by business trust from a special purpose vehicle is exempt income under this clause.
6. amend clause (23FD) of section 10 to exclude dividend income received by a unit holder from business trust from the exemption so that the dividend income is taxable in the hand of unit holder of the business trust.
7. amend sub-section (3) of section 115UA to delete reference to sub-clause (a) so that distributed income of the nature as referred to in clause (23FC) or clause (23FCA) of section 10 shall be deemed to be income of the unit holder and shall be charged to tax as income of the previous year. Thus, dividend income distributed by a special purpose vehicle to business trust would be taxed in the hands of unit holder.
8. remove reference of section 115-O dividend income in various sections like section 57, section 115A, section 115AC, section 115ACA, section 115AD and section 115C.
9. remove the opening line of clause (23D) of section 10, as mutual fund no longer required to pay additional tax.
10. insert new section 80M as it existed before it removal by the Finance Act, 2003 to remove the cascading affect, with a change that set off will be allowed only for dividend distributed by the company one month prior to the due date of filing of return, in place of due date of filing return earlier.
11. amend section 115BBDA which taxes dividend income in excess of ten lakh rupee in the hands of shareholder at ten per cent., to only dividend declared, distributed or paid by a domestic company on or before the 31st day of March, 2020.
12. amend section 57 to provide that no deduction shall be allowed from dividend income, or income in respect of units of mutual fund or specified company, other than deduction on account of interest expense and in any previous year such deduction shall not exceed twenty per cent. of the dividend income or income from units included in the total income for that year without deduction under section 57.
13. amend section 194 to include dividend for tax deduction. At the same time the rates of ten per cent. is proposed to be prescribed and threshold is proposed to be increased from Rs 2,500/- to Rs 5,000/- for dividend paid other than cash. Further, at present the mode of payment is given as "an account payee cheque or warrant". It is proposed to change this to any mode.
14. amend section 194LBA to provide for tax deduction by business trust on dividend income paid to unit holder, at the rate of ten per cent. for resident. For non-resident, it would be 5 per cent for interest and ten per cent. for dividend.
15. insert a new section 194K to provide that any person responsible for paying to a resident any income in respect of units of a Mutual Fund specified under clause (23D) of section 10 or units from the administrator of the specified undertaking or units from the specified company shall at the time of credit of such income to the account of the payee or at the time of payment thereof by any mode, whichever is earlier, deduct income-tax there on at the rate of ten per cent. It may also be provided for threshold limit of Rs 5,000/- so that income below this amount does not suffer tax deduction. It is also proposed to defined "Administrator", "specified company", as already defined in clause (35) of section 10. It is also proposed to define "specified undertaking" as in clause (i) of section 2 of the Unit Trust of India (Transfer of Undertaking and Repeal) Act, 2002. It is also proposed to provide that where any income is credited to any account like suspense account, in the books of account of the person liable to pay such income, the liability for tax deduction under this section would arise at that time.
16. amend section 195 to delete exemption provided to dividend referred to in section 115-O.
17. amend section 196A to revive its applicability on TDS on income in respect of units of a Mutual Fund. It is also proposed to substitute "of the Unit Trust of India" with "from the specified company defined in Explanation to clause (35) of section 10"and "in cash or by the issue of a cheque or draft or by any other mode" with "by any mode".
18. amend section 196C to remove exclusion provided to dividend under section 115-O. It is also proposed to substitute "in cash or by the issue of a cheque or draft or by any other mode" with "by any mode".
19. amend section 196D to remove exclusion provided to dividend under section 115-O. It is also proposed to substitute "in cash or by the issue of a cheque or draft or by any other mode" with "by any mode".

Amendments at clause (i) to (xii) above will take effect from 1st April, 2021 and will, accordingly, apply in relation to the AY 2021-22 and subsequent assessment years. Amendments at clause (xiii) to (xix) will take effect from 1st April, 2020.

3. Impact Analysis of Above Amendments in Finance Act 2020

3.1 Foreign investors

Removal of DDT regime shall be beneficial for the foreign investors as it will minimize tax cost of investment in India and credit of such tax cost would be available in their home country. However, in respect of foreign investors being discretionary trust and AOP, rate of tax applicable may be the maximum marginal rate, which shall be substantially higher than tax rate for foreign companies, unless treaty benefits are available.

3.2 Domestic Investors

i) Domestic Companies

a) Before Amendment (uptill AY 2020-21)

The domestic companies paying dividends were required to pay Dividend Distribution Tax (DDT) at an effective rate of 20.56%.

However, no tax was payable on dividend income being received by domestic companies.

b) Post Amendment (w.e.f. AY 2021-22)

In case of domestic companies, receiving dividends, tax @ rate of 30% plus applicable surcharge in old corporate tax regime and tax @ 22%/15% plus applicable surcharge in the new corporate tax regime u/s 115BAA and 115BAB, shall be levied on the dividend income being received by them.

However, no DDT is payable by the domestic companies at the time of payment of dividends.

ii) Individual Investors

a) Before Amendment (uptill AY 2020-21)

Uptill AY 2020-21, dividend income up to Rs. 10 lakhs was exempt, in the hands of recipient shareholders and dividend income in excess of Rs 10 lakhs was taxable in the hands of recipient shareholders at a special rate of 10% u/s 115BBDA.

3.3 Case Study on Tax Liability on Dividend Income Before Amendment (uptill AY 2020-21)

(Amount in INR Lakhs)

*Personal Tax Rates under Old Regime have been Considered and surcharge and education cess have been ignored for simplicity & better understanding.

bb) After Amendment (w.e.f. AY 2021-22)

W.e.f. AY 2021-22, in case of domestic individual investors, receiving dividends, tax at their applicable slab rates shall be levied on dividend income being received by them. However, no special tax u/s 115BBDA would be levied.

3.4 Case Study on Tax Liability on Dividend Income After Amendment (w.e.f. AY 2021-22)

(Amount in INR Lakhs)

**Personal Tax Rates under Old Regime have been Considered and surcharge and education cess have been ignored for simplicity & better understanding.

3.5 Comparison between Pre & Post Amendment Scenario w.r.t. Taxability of Dividend Income in the Hands of Individual Recipient Shareholders

(Amount in INR Lakhs)

Conclusion: It is duly evident from above comparative analysis, that in the post amendment period w.e.f. AY 2021-22, since the dividend income being received by individual recipient shareholders, will not be considered as exempt income u/s 10(34), and will be considered as taxable income, thus, such dividend income will result in an increase in tax slab rates of individual recipient shareholders, and as such will result in more tax liability vis-à-vis the pre-amendment regime, even after taking into consideration the removal of special tax rate of 10% on dividend incomes in excess of Rs. 10 lakhs u/s 115BBDA.

4. Obligation of the Domestic Companies paying Dividend

The domestic companies shall not be liable to pay DDT on dividend distributed to shareholders on or after 01-04-2020. However, domestic companies shall be liable to deduct tax under Section 194. The Finance Act, 2020 has made amendments in Section 194 of the Income Tax Act.

As per the amended Section 194, which shall be applicable to dividend distributed, declared or paid on or after 01-04-2020, an Indian company shall deduct tax at the rate of 10% from dividend distributed to the resident shareholders if the aggregate amount of dividend distributed or paid during the financial year to a shareholder exceeds Rs. 5,000. However, no tax shall be required to be deducted from the dividend paid or payable to Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC) or any other insurer in respect of any shares owned by it or in which it has full beneficial interest.

TThe said amendment providing for deduction of TDS @ 10% u/s 194, on dividend income received by individuals and HUFs in excess of Rs. 5000, may create difficulties for such assessees, in the form of increased compliance burdens of filing their ITRs, in order to claim the refund of the TDS being deducted on their dividend incomes, if they are in the exempt slab of income tax.

Where the dividend is payable to a non-resident or a foreign company, the tax shall be deducted under Section 195 in accordance with the relevant Double Taxation Avoidance Agreements (DTAAs)./span>

4.1 Withholding Tax on Dividend Income as per DTAAs

The dividend income in the hands of foreign investors in Indian Domestic Companies shall be taxable in India as per the provisions of the Income Tax Act or as per relevant DTAA, whichever is more beneficial, to the assessee.

Dividend income is generally chargeable to tax in the source country as well as the country of residence of the assessee and, consequently, country of residence provides a credit of taxes paid by the assessee in the source country.

As per most of the DTAAs India has entered into with foreign countries, the dividend is taxable in the source country in the hands of the beneficial owner of shares at the rate ranging from 5% to 15% of the gross amount of the dividends./span>

4.2 Possibility of Dividend Stripping arising out of DTAA

In DTAA with countries like Canada, Denmark, Singapore, the dividend tax rate is further reduced where the dividend is payable to a company which holds specific percentage (generally 25%) of shares of the company paying the dividend. However, no minimum time limit has been prescribed in these DTAAs for which such shareholding should be maintained by the recipient company. Therefore, MNCs were often found misusing the provisions by increasing their shareholding in the company declaring immediately before declaration of the dividend and offloading the same after getting the dividend.

IIndia did not face this situation as dividend income was exempt from tax in the hands of the shareholders. However, after the proposed amendment, India too will face the risk of tax avoidance by the foreign company by artificially increasing the holding in the dividend declarant domestic company.

India is a signatory to the Multilateral Convention (MLI) which shall implement the measures recommended by the OECD to prevent Base Erosion and Profit Shifting. MLI is a binding international legal instrument which is envisaged with a view to swiftly implement the measures recommended by OECD to prevent Base Erosion and Profit Shifting in existing bilateral tax treaties in force. With respect to dividend income, Article 8 (Dividend Transfer Transactions) of MLI provides for a minimum period of 365 days for which a shareholder, receiving dividend income, has to maintain its shareholding in the company paying the dividend to get the benefit of the reduced tax rate on the dividend./span>

As the taxability of dividend is proposed to be shifted from companies to shareholders, the Government has proposed to introduce a new section 80M under the Act to remove the cascading effect where a domestic company receives a dividend from another domestic company. However, nothing has been prescribed where a domestic company receives dividend from a foreign company and further distribute the same to its shareholders. The taxability in such cases shall be as under:

5. Inter Corporate Dividend

a. Domestic Company receiving Dividend Income from another Domestic Company

As the taxability of dividend is proposed to be shifted from companies to shareholders, the Finance Act 2020 has re-introduced section 80M under the Act to remove the cascading effect where a domestic company receives a dividend from another domestic company.

Where a domestic company receives dividend from another domestic company, a new section 80M has been inserted. This provision removes the cascading effect by providing that inter-corporate dividend shall be reduced from total income of company receiving the dividend if same is further distributed to shareholders one month prior to the due date of filing of return.

b. Domestic Company receiving Dividend Income from a Foreign Company

In the Finance Act 2020, it has been provided that a domestic company receiving dividend income from a foreign company shall also be eligible for the benefit of deduction under the newly inserted section 80M of the Income Tax Act.

The taxability of the dividend income in such cases as per existing provisions under the Income Tax Act, was as under:

Dividend received by a domestic company from a foreign company, in which such domestic company has 26% or more equity shareholding, is taxable at a rate of 15%plus Surcharge and Health and Education Cess under Section 115BBD. Such tax shall be computed on a gross basis without allowing deduction for any expenditure.

Dividend received by a domestic company from a foreign company, in which equity shareholding of such domestic company is less than 26%, is taxable at normal tax rate. The domestic company can claim deduction for any expense incurred by it for the purposes of earning such dividend income.

6. Will the abolition of DDT really result in revenue forgone by the Exchequer?

The Hon’ble FM in her Budget Speech have mentioned that the abolition of Dividend Distribution Tax, will lead to estimated annual revenue forgone of Rs. 25,000 Crore.

However, in view of the fact that most of the big Indian corporate entities are promoter-run companies, and were distributing tax-free dividends to their promoter shareholders after paying DDT at an effective tax rate of 20.56%, and currently, after this amendment, the High Networth Individuals (HNIs) promoters of such companies may be subject to a maximum marginal rate of tax on their dividend incomes, this figure of estimated revenue foregone, appears to be doubtful.

Before parting, just wish to express my deep regards and gratitude to the makers and producers of the epic "the Ramayana", and the DD National, to provide our young generation with a wonderful opportunity of watching this magnificent and brilliant piece of art-work and to re-create the magic of the 1980s.