Dividends - To Tax or Relax ?

The Finance Budget of the Union Government for the financial year 2020-21 was recently presented by the Finance Minister (FM). One of the key points in the budget is that the dividend to be paid by companies will no more be subject to tax, hitherto known as the dividend distribution tax (DDT). The shareholders receiving the dividends will now be subject to income tax at the respective marginal rates, applicable to them. Previously, companies were subject to DDT but their shareholders, receiving the dividends, were exempt from paying any tax on them.

This announcement has stirred some debate about the desirability of the change. 

Alternative Arguments

There are broadly three sets of view on this issue:

A) Dividend should be exempt from tax in the hands of both the companies as well as shareholders. The main argument, here, is that the cash used for dividend is sourced out of the profits of a company, which has already been taxed once. Hence DDT or tax on dividend in the hands of a shareholder amounts to double taxation.

B) Dividend should be subject to tax, but in the hands of shareholders only. This argument emphasizes the principle that differential tax rates, based on the nature of the taxable entity, anyways apply to all kinds of income. So the changed rule will ensure that dividend income is also treated as any other income in the hands of the shareholders and taxed as such.

C) Dividend should be subject to tax at source, i.e., in the form of DDT. The underlying logic is that the dividend belongs to all shareholders. So the taxation on dividend should be equitable and not be influenced by who is the shareholder of a company.

Each of the above arguments has some merit. Taxation, including that on dividends, is a policy matter. Policies are always about choices and trade-offs between multiple objectives.

The FM has explicitly chosen the option (B) over the erstwhile prevailing option (C).She has completely ignored the option (A) which also used to prevail at some earlier time. So, the question remains whether there is a significant merit in the argument under option (A) over (B). 

Fundamental Principles

Let us evaluate option (A) on the basic principles of fairness to, and rights of, various stakeholders.

The profit before interest and tax (PBIT) of a company (say X) is the surplus available to it, for distribution between the debtholders (D), the government (G), and the equity shareholders (E). The nature of the contract between a company and the three aforesaid stakeholders is different. 

Fact 1:

Fundamentally, X, as a going concern, owes :

A) A fixed amount to D, which cannot be changed unilaterally by either party.

B) An amount to G, determined solely by G without the need for the consent of X.

C) An amount to E, which should be approved by E. X, represented by the Board and the Management, may propose or influence the amount but, in theory, E has the right to decide on the amount. While, in practice, the power of E is often undermined, that is not the pertinent issue here.

Fact 2:

Another relevant fact is that the allocation of EBIT to E can be done only after paying off D and G. 

Considering the above two facts, it is clear that the government does have the full right to allocate to itself any amount of the surplus after the company has paid off the debtholders. Government can do so through its sovereign right on taxes charged as per constitutional procedures. The amount asked for, by the government, is its prerogative. The channels of taxation like DDT or taxing in the hands of shareholders, are just semantics of structuring the tax process and do not take away from the right of the government. 

In the light of the above, those arguing in favour of (A) need to be more explicit about their objection to the recent change in rule. There is no merit in the the arguments like the government cannot tax E twice and D only once. These are only issues of process, and not principle. Government can charge any amount of tax from any stakeholder, as allowed constitutionally.

The more effective argument under (A) could be of fairness between stakeholders, beyond their contractual rights. This calls upon the government to be fair while exercising its right to tax the various stakeholders. One set of shareholders, i.e., individuals covered under the highest tax bracket, will now be subject to a higher rate of tax than another set, i.e., foreign investors or mutual funds. This merits a discussion. The problem, of course, could be that the government may actually be quite fine with this situation of differential taxation without necessarily admitting the same.

Government needs to communicate

An important point on this issue is the manner in which the government has managed the communication with stakeholders. There has hardly been any public statement by the FM or the Finance Ministry officials on the thought process behind the change in rule.

While the government has the absolute right to tax, it needs to state its intended objectives, and the trade-offs involved in its decision.

In the absence of proper communication, various commentators would likely continue to espouse their own versions of desirable policy. There is even a risk of influential opinion makers leading the public opinion in a biased manner, to the benefit themseves.