Dividend distribution tax (DDT) was introduced by the Finance Act 1997. From June 1, 1997, DDT burden shifted from shareholders to Indian firms. Tax was imposed on domestic companies against dividend declared, distributed/paid by them.

However, from April 1, 2002, to March 31, 2003, the law reverted to taxing shareholders again. The objective of introducing DDT was to encourage ploughing back of profits for re-investment and expansion. The tax sought to check administrative difficulties associated with deduction and claim of credit for taxes on dividends by individual shareholders.

Prior to the introduction of DDT, dividends were taxed in shareholders hands, whether individuals, or corporates, and certain tax concessions were offered to eliminate double taxation. Under the present tax regime, companies are required to pay DDT prior to distribution of dividends at 14.025% dividends are exempt from tax in shareholders hands.

What started out as an attempt to streamline taxation has resulted in tax inequities and double taxation for many stakeholders.

Dividend paying cos & shareholders

DDT is required to be paid as a percentage of profits set aside for distribution and only the residual amount is distributed as dividend to shareholders. DDT eats into the pool out of which dividends can be distributed and reduces the effective rate of dividend payout. The system does not consider situations where individual shareholders were taxed at different rate, or were not liable to tax in respect of such dividend income.

Indian holding companies

The erstwhile DDT system provided that dividend received by Indian firms was not taxed to the extent of dividend distributed by it. However, a similar provision has not been incorporated in the present system. This has resulted in cascading effect of taxation in cases of multiple layers of corporate structure and makes a holding firm structure inefficient from an Indian tax perspective.

For example Co A holds shares in Co B and Co B holds shares in Co C. If Co C declares dividends, it would pay DDT on the dividend paid to Co B. Further, if Co B declares a dividend out of the dividend income received from Co C, it would again be required to pay DDT on such dividend declared by it. This results in the dividend declared by Co C being subject to DDT twice once when Co C declares dividend and then again when Co B declares dividend out of such income.

Foreign investors

While dividends distributed/paid by an Indian entity are tax free in shareholders hands, including foreign, indirectly DDT has resulted in dividends being taxed at a rate higher than that envisaged under most tax treaties signed by India.

Largely, tax treaties provide for 10%, or less, for taxation of dividends, based on the quantum of equity held by the foreign investor, which is relatively lower than DDT rate of 14.025%. The impact to foreign investors arises, as withholding tax on dividends would have meant a foreign tax credit in their home country. However, DDT has resulted in loss of tax credits to foreign investors since DDT is not allowed as a tax credit against the home country taxes of foreign investors.

These anomalies must be resolved. Earlier, section 80M provided that where a firm declares dividend out of the dividend income it receives, such dividend income would be allowed as a deduction in computing its total income. A similar provision is needed for DDT to ensure that the same dividend is not subjected to dual DDT. To mitigate tax burden, DDT could be reduced in this Budget. This would benefit foreign investors, who are unable to claim tax credit, as explained above.

Globally, the practice of DDT is not widespread and South Africa seems to be the only country other than India that taxes a company for dividends declared/paid. Even there double taxation has been avoided.

JAIDEEP KULKARNI & ANISH SANGHVI
(Authors are with Ernst & Young)