A new approach
Rather than abolishing DDT, dividend deductibility by treating dividends the same as interest would yield better results that would allow it to be termed as a ‘true’ corporate tax reform
DDT has been abolished and the dividend is back to being taxed in the hands of the recipient. But the system is as flawed as before. Taxation of dividends is a mess almost everywhere in the world with open double-taxation. Many countries have a 'classical system' where both corporate profits and dividends are fully taxable. Most countries have a 'modified classical system' where corporate profits are fully taxed but dividends get a preferential (lower) rate. For ensuring single taxation, countries like Singapore exempt dividends completely. Others, like Australia and New Zealand use 'dividend imputation' where the dividend is taxable but shareholders receive tax credits for taxes paid by the company. A simple and elegant solution for India would be the 'Corporate deduction system' where dividends can be claimed as expenditure by the company. Amongst OECD countries, this is only used by Latvia as of now.
In India, earlier, a Dividend Distribution Tax of 15 per cent on grossed-up dividends had to be paid by the company and dividends beyond Rs 10 lakh annually were taxable at 10 per cent in hands of the recipient. Thus, the effective rate for the recipient was 15 per cent up to Rs 10 lakh and 25 per cent beyond that (cess and surcharge are ignored for simplicity's sake). Now, dividend is taxable at the applicable slab rates. If a shareholder falling in the highest tax bracket receives dividends, he faces a burden of 57 per cent (considering corporate tax at 25.17 per cent and personal tax at 42.74 per cent). Double taxation just became doubly painful. In an interaction between the Finance Minister and industry representatives on Friday, Motilal Oswal asked the Finance Minister about the fairness of 57 per cent. Nirmala Sitharaman had a simple question – What's the solution and would you prefer the old system?
The solution would be to make dividends tax-deductible in the hands of the company. But dividends are not deducted from profits as per accounting norms. So why should taxation be different? Profits are a more useful tool for measuring the performance of a company than retained earnings. So it makes sense not to deduct dividends while preparing income statements. But dividends can still be deductible for tax purposes. Accounting profits and taxable profits have anyway, always been two different things.
There is an argument that dividends are discretionary and voluntary, so they cannot be treated as a business expense. But dividends are not discretionary for the company. The shareholders can instruct the company to pay any portion of its profits as dividend and the company will have to comply. As such, the transaction of paying dividends is a purely business transaction.
More importantly, though, are the practical effects of taxing profits as well as dividends. There are two major ones. It makes debt cheaper than it actually is and it incentivises non-corporate forms of business.
The inequity in equity
Unlike dividends, interest is a business expenditure. This creates a perverse incentive for the use of debt. The decision of a company on whether to use equity or debt should be purely commercial. It should be based on prevailing economic conditions, interest rates and risk appetites of various participants. But income tax plays spoilsport.
Companies are taking more debt than they can sustain just because it is unnaturally cheap. This is a major reason for the NPA crisis that India is facing. The Economist has held distorted taxation to be at least partly responsible for the 2008 crisis.
In a crisis, equity bends while debt breaks. Unlike interest, the dividends paid to equity holders can be cut if things go wrong, without triggering a default. But our tax system introduces an equity penalty that creates pervasive crises out of localised hiccups
Limitations of limited liability
Taxation of distributed profits is unique to companies. Share of profits from partnerships and HUFs are exempt. Since a sole proprietorship is not a distinct entity from the individual running it, the question of taxing distribution of profits does not arise. This creates an unfair disadvantage for companies. But the government should be encouraging companies if at all a distinction has to be made. Companies are mandatorily audited. Others have to do so only if they cross threshold limits. Companies have to follow Schedule III and accounting standards. They have to conduct statutory meetings with written decisions. The slew of compliances under the Companies Act ultimately make it much easier to collect accurate revenue from companies, as compared to other forms of entities. Companies have to deduct TDS on payments to non-corporate taxpayers. This improves the tax compliance of those entities.
Another problem is the cascading effect where dividends are taxed again and again as they pass-through companies. While relief is available under the newly inserted section 80M, it is half-hearted because dividend tax will continue to cascade in certain cases.
The best solution would be to give dividends the same treatment as interest. The company would claim dividend as a deduction while calculating taxable profits. The tax rate for companies can be increased to 30 per cent plus surcharges to bring it on par with the individual tax rates. Since there is no double taxation, companies should pay a tax equal to or near the highest marginal rate.
This system would have several advantages. First, interest and dividends will be treated evenly. Second, the company form of business will no longer be disadvantageous. Third, there will be a major relief for low-income group shareholders as they will pay tax at lower rates or may even be exempt. Rich promoters and shareholders will continue paying at the highest rates. Fourth, dividends to foreign companies will be taxed at 40 per cent, the rate applicable to them. While India will get the revenue, full credit for this tax will be available in their home countries. So there will be no additional burden on them. Fifth, dividends will not be deducted from 'book profits' for calculating Minimum Alternate Tax. So companies claiming plenty of deductions would have to pay more. Dividend deductibility and not the abolition of DDT would thus be the true corporate tax reform.
The author is a Chartered Accountant and Company Secretary with expertise in corporate affairs and taxation, currently working at ITC Limited. Views expressed are strictly personal