Another unintentional fallout will be creation of significant tax arbitrage

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One of the most debated topics around the Union Budget 2020 has been the abolition of the dividend distribution tax (DDT). The government has proposed to remove the DDT and adopt the classical system wherein the dividend shall be taxed only in the hands of the recipients at their applicable rate and companies will no longer be required to pay DDT. The maximum deduction of expenses (interest, commission and other incidental expense) incurred for earning such dividend income has been capped at 20% under the proposed Section 57 of the Income Tax Act.

Fundamentally, dividend is received by the shareholders after the company pays the full tax and hence it amounts to double taxation. Comparably, partnership firms do not pay the same tax when the money is distributed to their partners. In that sense the companies have a major disadvantage.

While minority retail investors will clearly benefit from this change, it will also lead to several unintentional anomalies. Indian promoters and high net worth individuals (HNIs) will have to face a significant increase in the overall tax incidence to 57% (v/s 47% in FY20) on dividend income.

Total tax incidence on individuals for every INR100 of corporate profit earned and distributed as dividend:

The change also brings in a disparity between Indian and MNC promoters with respect to the tax rates applicable on dividend income. While Indian promoters will be liable to pay tax at 43%, corporate foreign promoters will be charged a tax of 22%, or even lower (5% in some cases) if they are located in a country where the tax treaty provides beneficial rates.

Another unintentional fallout will be the creation of significant tax arbitrage (in the hands of recipient) between the two popular ways in which a company returns money to its shareholders – dividend and share buyback. Share buybacks – like earlier – will be taxed at 23%, while dividend income will be taxed in the hands of promoters/HNIs at an effective rate of 43%. Thus, many companies might prefer buybacks over dividends to distribute profits. Many companies may in fact curtail the dividend itself.

Category III alternative investment funds (AIF) set up as a trust will be at a major disadvantage compared to Category I/II AIFs. This is because Category III AIFs do not have the pass-through status and will be taxed at a maximum marginal rate of 43%. Similarly, ULIP schemes may lose attractiveness compared to mutual funds as insurance companies are liable to pay tax on dividend income at 12%, while mutual funds enjoy specific exemption (u/s 10 (23d)) on such income.

I had brought the same to the attention to Hon Finance Minister who was kind enough to give a patient hearing. I request her again to look at the changes to even out such disparities and more importantly, cap the effective tax rates applicable on dividend income for Indian promoters/HNIs.

The author is managing director and CEO, Motilal Oswal Financial Services Ltd.