Context

Budget 2020 abolished the Dividend Distribution Tax (DDT).

About

• Budget 2020 has proposed to make dividend income from shares and mutual funds taxable in the hands of recipients at the applicable income tax slab rates to the individual.
• Called the dividend Distribution Tax (DDT), it was hitherto levied on dividend income before distribution by the company or mutual fund house.
• Dividend distribution tax is the tax imposed by the Indian Government on Indian companies according to the dividend paid to a company's investors.
• Dividend is the return given by a company to its shareholders out of profits earned by the company in a particular year.
• Dividend constitutes income in the hands of the shareholders which ideally should be subject to income tax.
  • However, the income tax laws in India provide for an exemption of the dividend income received from Indian companies by the investors by levying DDT on the company paying the dividend.
• Previously, in addition to corporate tax, companies had to pay DDT at the time of distributing profits to its shareholders.
  • The effective DDT rate is 56 per cent.
  • Although the government recently reduced the effective corporate tax rate to 25.17/17.16 per cent, once DDT was factored in, the effective tax rate for corporates became 37.93 per cent.

Evolution of DDT

• System 1:Historically, the dividend was always taxable in the hands of shareholders.
• System 2:Concept of ‘DDT’ was for the first time was introduced by Finance Act, 1997.
  • Dividend that was subjected to DDT was made exempt in the hands of shareholders.
• System 3: Finance Act, 2002, replaced DDT with the earlier system of taxing dividends in the hands of the shareholder.
• System 4: DDT was then re-introduced vide Finance Act, 2003.
  • Several changes were made to provisions including those that remove the cascading effect of dividends received from subsidiaries, grossing up mechanism, changes in the rate of tax etc.
• System 5: In Finance Act, 2016 dividends earned in excess of Rs 10 lakh from domestic companies was made taxable in the hands of resident individuals, partnership firms, private Trusts, etc. at 10 per cent(plus surcharge and cess) on a gross basis.
  • The tax treaties entered by India with various countries, largely limit taxation on dividends in India at 10 per cent, and shareholder have the ability to claim credit in its country of residence for tax deducted in India.
• Problems: Since DDT was levied on the Indian company distributing dividend, it was believed that tax treaty provisions were ineffective.
  • Also, shareholders faced challenges in claiming credit for DDT in their home country, which typically resulted in high tax cost for foreign shareholders.
  • Though the existing system facilitated easy tax collection, it was viewed to be regressive in nature

Changes made in Budget 2020

• Budget 2020 proposes to abolish DDT. The proposal is to replace DDT with a classical system of taxation i.e. instead of levying DDT on companies; the tax should be levied in the hands of shareholders.
• This will put to an end to litigation related to the reduction in the rate of DDT.
• Foreign tax credit in respect of dividend would be available to non-resident shareholders much easier than when DDT was payable.
• The proposal suggests deduction has to be restricted to 20 percent of dividend income. No other deductions would be allowed.
  • Non-resident shareholders would be able to restrict the tax on the dividend to 5 per cent/10 per cent/15 per cent applying the beneficial tax treaty provisions.
  • The beneficial tax treaty provisions would be subject to anti-abuse provisions of the India income-tax law and provisions of Multilateral Instruments which is effective from 1 April 2020.

Conclusion

The earlier provisions levied a flat tax rate on distributed profits across the board, irrespective of the marginal rate at which the recipient is otherwise taxed. These provisions, therefore, were regressive. Removal of DDT is a welcome and much-expected move in line with recommendations of the Direct Tax Code Panel which will bring in vertical equity among taxpayers.