Taxation of dividends has seen several twists and turns over the years. In order to reduce cost of collection and curb tax evasion through non-reporting of dividends by shareholders, Government had introduced section 115-O in the Income-tax code through Finance Act, 1997. The section presently provides for 15% tax on dividends distributed by a domestic company. After considering grossing up, surcharge and cess, the effective rate of dividend distribution tax (‘DDT’) stands at approximately 20%. Such dividends are, however, exempt from tax in the hands of shareholders. In effect, every shareholder, irrespective of his effective tax rate, is indirectly taxed @ 20% in respect of dividend income.

Finance Bill, 2016 has introduced a concept of progressive taxation of dividends. Proposed section 115BBDA seeks to tax dividends in excess of INR 1 Million @ 10% (plus surcharge and cess) in the hands of individuals, HUFs, partnership firms and LLPs resident in India. HUFs, LLPs and partnership firms are included in the levy since share of profits distributed by them are not taxable in the hands of recipients. It should be noted that dividend income up to INR 999,999 is still not taxable and expenditure relating to earning dividend income (including portfolio management fees and other incidental expenses) would not be allowed as deduction. Further, companies (both domestic and foreign), trusts and non-residents are outside the purview of this tax. Naturally, this tax on dividends would not have any negative impact on FDI as non-residents are not covered in the levy.

The impact of this levy is explained in the following illustration:

Note – Finance Act, 2016 has increased rate of surcharge to 15% (from 12% till last year) for persons with total income exceeding INR 10 Million. Rate of cess remains unchanged @ 3%.

Presently, effective tax on dividends is 20%. However, Finance Minister believes that affluent people having higher dividend income should be taxed on such income at a higher rate so that vertical inequality can be eliminated. Further, a developing country like India cannot afford to tax active income earned through hard work at a higher rate and passive income at a lower rate. Assuming dividend yield @ 2.5%, INR 1.5 Million of dividend income entails shares worth INR 60 Million. While taxation of dividend leads to economic double taxation, non-taxation or preferential taxation of the same would lead to incentivizing passive income from capital at the cost of tax on active income from labour. Such incentive may not be desirable in a young demography like India’s with visible inequality in distribution of income. Further, if the same person had earned other passive income like rent, interest or royalty, such income would have been taxed at the maximum marginal rate of 35.535%. Therefore, preferential tax treatment on dividends may not be equitable.

Globally, except few countries like Singapore, Hong Kong and Brazil which allow tax exemption on dividends in the hands of shareholders, most countries tax dividends @ 15% to 35%. United States follows a progressive taxation regime for dividends (tax rate varies between 0% and 39.6%). The proposed section 115BBDA would be applicable on dividends declared / received in FY 2016-17. In order to dodge this additional tax, promoters of cash rich companies would rush to pay interim dividends in the month of March 2016. This is a fantastic year-end bonanza for shareholders. Instead of complaining about this tax, shareholders (read HNIs) should thank the Finance Minister for the windfall gain and get ready for the next holiday!