Understanding the Taxation of Dividends in India: From Dividend Distribution Tax to Recipient-Based Taxation

Special Provision for Deemed Dividends

Under Section 2(22)(e), certain payments made by companies, such as loans or advances to shareholders holding substantial interest (10% or more of voting power), were deemed as dividends and taxed at the rate of 30% in the hands of the recipient.

Exemption on Dividends and Additional Tax for High-Income Recipients

While dividends were exempt from tax in the hands of shareholders under Section 10(34) during the DDT regime, an additional tax at the rate of 10% was levied on dividends exceeding Rs.10 lakhs per annum under Section 115BBDA for individual, Hindu Undivided Family (HUF), and firm shareholders.

Abolition of DDT and Introduction of Recipient-Based Taxation

The Shift in Tax Policy

The Finance Act, 2020 marked a significant shift in the taxation of dividends by abolishing DDT. Effective from April 1, 2020, the responsibility of paying tax on dividends shifted from the company distributing the dividends to the shareholders receiving them.

Key Amendments:

1. Abolition of DDT: DDT was abolished, and the tax on dividend income was reverted to the classical system where the shareholders were taxed on their dividend income.

2. Taxation in the Hands of Recipients: Dividends received by shareholders (both resident and non-resident) became taxable in their hands at applicable income tax rates. For resident individuals, the tax rates depend on their income slabs, while for non-residents, the applicable rates are based on the relevant Double Taxation Avoidance Agreements (DTAA).

3. Withholding Tax: To facilitate the transition, companies paying dividends are required to withhold tax at source (TDS) under Section 194 at the rate of 10% for resident shareholders if the dividend exceeds Rs.5,000 in a financial year, and at a higher rate or as per DTAA under Section 195 for non-resident shareholders.

Impact and Rationale

The abolition of DDT was aimed at:

1. Equity and Fairness: Ensuring that the dividend income is taxed at the applicable rate of the individual shareholder, thereby promoting fairness in the tax system.

2. Relief for Corporates: Reducing the tax burden on companies, which could now distribute higher dividends to shareholders without the additional cost of DDT.

3. Alignment with Global Practices: Aligning India`s tax regime with international practices where dividends are generally taxed in the hands of recipients.

Deduction Under Section 80M

Introduction of Section 80M

To mitigate the cascading effect of dividend taxation in the hands of corporate shareholders, the Finance Act, 2020 introduced Section 80M into the Income Tax Act, 1961. This provision allows a deduction in respect of dividends received by a domestic company from another domestic company or a foreign company.

Provisions of Section 80M:

1. Deduction Eligibility: A domestic company can claim a deduction for the amount of dividends received from other domestic companies, foreign companies, or business trusts.

2. Conditions: The deduction is available only if the company receiving the dividend distributes the same (or part thereof) as a dividend to its shareholders before the due date of filing its return of income.

3. Quantum of Deduction: The deduction under Section 80M is limited to the amount of dividend distributed by the company before the due date of filing its return or the amount of dividend received, whichever is lower.

Rationale Behind Section 80M

The introduction of Section 80M was driven by the need to prevent the cascading effect of dividend taxation. Without this provision, dividends received by a company would be taxed in its hands and, if subsequently distributed to its shareholders, would again attract tax in their hands also. This cascading effect would lead to multiple layers of taxation on the same income.

Section 80M ensures that the dividend income flows through the corporate structure without being subjected to multiple layers of tax, thus maintaining a single point of taxation on dividend income. This promotes efficient capital allocation and encourages corporate entities to pass on the dividend income received to their shareholders.

Summary of Changes in Dividend Taxation

To summarize the changes brought by the Finance Act, 2020:

1. Abolition of DDT: DDT was abolished, and dividends are no longer taxed at the corporate level under Section 115-O.

2. Taxation in the Hands of Shareholders: Dividends are now taxable in the hands of the shareholders under the applicable income tax slabs.

3. Withholding Tax: Companies are required to deduct tax at source (TDS) under Section 194 at the rate of 10% for resident shareholders if the dividend exceeds Rs.5,000 in a financial year, and at the applicable rates under Section 195 or DTAA for non-resident shareholders.

4. Deemed Dividends: Deemed dividends under Section 2(22)(e) continue to be taxed at the rate of 30% in the hands of the recipient.

5. Section 80M: Provides a deduction for dividends received by a company if those dividends are redistributed to its shareholders before the due date of filing the return of income.

Conclusion

The transition from Dividend Distribution Tax to taxing dividends in the hands of recipients marks a significant reform in the Indian tax regime. This change has aligned India with global practices, ensured fairness in taxation, and relieved companies from the additional tax burden of DDT. The transition to taxing dividends in the hands of shareholders has been significantly bolstered by advancements in technology and improved reporting mechanisms. Modern financial technologies and robust reporting frameworks allow for more accurate tracking and reporting of dividend income. The implementation of SFT(s) where needed and comprehensive databases by the government ensures that dividend payments are transparently recorded and reported. This reduces the likelihood of dividend income escaping taxation. The introduction of Section 80M has further refined the system by mitigating the cascading effect of dividend taxation, thereby promoting an efficient and equitable tax environment for corporate entities and their shareholders.