Relief for stock market investors? Why double taxation of dividends should be removed in Budget 2024

After the abolition of dividend distribution tax (DDT) with effect from financial year (FY) 2020-21, dividends have been taxed in the hands of resident individual shareholders according to the tax slabs applicable to them. For taxpayers whose taxable income exceeds Rs 10 lakh in the old tax regime or Rs 15 lakh in the new tax regime, the effective marginal tax rate is 31.2%; this progressively increases to 35.88% when the income exceeds Rs 1 crore. This, coupled with the corporate tax rate of 25.17%, results in an effective cumulative tax of 48.51%.

How the total tax on dividend adds up

This happens because the company pays tax on the profit earned at 25.17% (22% plus 10% surcharge plus cess 4%). Thereafter, the dividends are declared from the profit amount left after tax. On the dividend amount received by the individual resident shareholders, the tax is levied at the tax slab rates applicable to them — at 31.2% (30% plus cess at 4%).

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Here is an example to understand this: Suppose a company earns a profit of Rs 100. On this profit, the company pays a tax of Rs 25.17. This leaves Rs 74.83 for dividend distribution. On the dividend received, shareholders will pay tax at 31.2% (30% plus 4% cess) if the taxable income exceeds Rs 10 lakh in the old tax regime or Rs 15 lakh in the new tax regime. This double taxation leads to an effective tax rate of 48.51%.

RI – Resident Indian
NR – Non-Resident
Figures in RsThe effective tax rate paid by non-residents is substantially lower when compared with the effective tax paid by resident individuals. According to income tax laws, non-residents are liable to pay a flat tax on dividends at 20% which, coupled with cess of 4%, results in an effective tax rate of 20.8%. The surcharge is applicable if total income (including dividends) exceeds Rs 50 lakh in a financial year. This flat 20% tax rate gets further lowered to 5%-15% by Double Tax Avoidance Agreements (DTAAs) in most cases. In comparison, resident taxpayers in the highest tax bracket of 30% pay tax at 31.2% (including cess at 4% excluding surcharge).

RI – Resident Indian
NR – Non-Resident
Figures in Rs

Before the Finance Act, 2020, abolished DDT, a company had to pay the tax at an effective rate of 17.65% on the amount of dividend; and the dividends were tax free in the hands of the shareholders. This made the effective tax rate 38.37% — much lower than the 48.51% mentioned above.

In the case of partnership firms and limited liability partnerships (LLPs), the present effective tax rate is 34.94% as there is no further tax on the partners on their share of profit. Only in case of resident individuals or companies, the effective tax rate is almost equivalent to 50%.

Issues arising from dual taxation of dividends

Such dual taxation can result in a significant portion of the profits being eroded, reducing the amount available for distribution to shareholders and potentially impacting investment decisions.

Further, the current system of double taxation of dividends presents several issues:

Economic Efficiency: Double taxation distorts investment decisions as it incentivises companies to retain earnings rather than distribute them as dividends.

Reduced Investment: Investors may prefer capital gains over dividends due to lower tax implications, affecting the flow of funds into the equity market.

Complexity: Compliance with multiple layers of taxation increases administrative burden and compliance costs for companies and investors alike.

International Competitiveness: In a globalised economy, countries with lower tax burdens on dividends may attract more foreign investment compared to those with higher effective tax rates due to double taxation.

Need for rationalisation

To address these challenges, rationalisation of the tax treatment of dividends is crucial. There is an imminent need to restrict dividend taxation for resident investors to 15% (excluding surcharge and cess). This can result in an effective tax rate of 19.5% (assuming surcharge of 25% and cess of 4%). Lowering tax rates on dividends for residents can encourage companies to distribute profits while ensuring an adequate revenue stream for the government. Further, streamlining tax laws and reducing compliance burdens can enhance ease of doing business and improve investor sentiment. While the interim budget 2024, which was a vote on account, did not make any changes in the tax structure, it is expected that the incumbent government can take up this extremely positive step in the upcoming full budget in July 2024.

Budget 2024 should consider reform in dividend taxation

In conclusion, the issue of double taxation of dividends is a complex one that requires careful consideration and reform. While the abolition of DDT was a step forward, further rationalisation through reduction in tax rates and simplification of regulations can create a more conducive environment for investment and economic growth. By addressing these concerns, India can enhance its competitiveness in the global market and promote a healthier investment climate domestically.