Exemption may apply to subsidiaries lower down the corporate holding chain.

The finance ministry is considering a proposal to extend the tax exemption on inter-corporate dividends further down the chain of corporate subsidiaries in the upcoming Union Budget, a long-standing demand from India Inc.

The proposal is under consideration but a final decision has not been taken, said a senior government official. The move is expected to cost the exchequer less than Rs 3,500 crore a year, he added, an argument that has been made in favour of the proposal.

Current provisions allow exemption from paying dividend distribution tax (DDT) up to one layer. That means, a domestic holding company is exempt from paying DDT for the dividend it receives from its subsidiary. This exemption is not, however, permitted one step down that is, if the subsidiary company receives a dividend from its own subsidiary company which, in effect, creates a reverse cascade.

Overall, therefore, the one-step DDT exemption does not benefit many corporate groups, which tend to have multi-layered holding structures. At present, companies have to pay DDT at 15 per cent on dividend paid to shareholders, who are not taxed. With cess and other components, the effective rate comes to 16.99 per cent.

Industry lobby groups have argued for the re-introduction of Section 80M of the Income Tax Act (I-T), which was scrapped in 2004 after DDT was introduced. This section allowed the dividend received from another domestic subsidiary to be deducted from taxable income. For example, if company A receives a dividend of Rs 1 crore from its subsidiary B, this Rs 1 crore is exempt from calculating the taxable income for company A. The only condition is company A pays out a dividend of more than Rs 1 crore.

The one-step DDT exemption was introduced in last year's Budget following representations from industry representatives.

Industry bodies argue that a multi-layered corporate structure is essential for financial engineering. In addition, investment companies have been adversely impacted because of the one-step DDT structure, as it reduces their return on investment.

However, some officials in the finance ministry have argued that section 80M is not compatible with Section 115-O of the I-T Act that has provisions related to tax on dividends to shareholders.

If section 80M is reintroduced, then we will go back to the old system of taxing dividends in the hands of shareholders, said a senior revenue department official.