Circuit breaker . Dividend tax change: Who gains, who loses

The Union Budget for 2020-21 was not too liberal with its giveaways. But one giveaway that has received mixed reviews from its recipients is the proposal to abolish the Dividend Distribution Tax (DDT). While the government claims that this change will result in tax foregone of ₹25,000 crore, big stock market investors are ruing the sharp spike in their tax outgo.

The paradox is explained by the fact that, while some categories of equity investors will get to enjoy lower tax incidence on dividend receipts after the DDT abolition, others will end up paying through their nose.

Under the current tax regime (until March 31, 2020), companies distributing dividends are liable to pay tax at an effective rate of 20.56 per cent directly to the government from their surpluses. Effectively, out of every ₹100 in distributable profits, companies had to cough up ₹20.56 as tax, with only ₹79.44 left for distribution to shareholders.

While this makes the government’s job of collecting taxes easy, it results in all the shareholders of a company suffering a uniform tax rate on their dividends, irrespective of whether they are humble salary-earners or the Birlas, Ambanis and Jhunjhunwalas of investing.

The abolition of the DDT puts an end to this broad-brush treatment, by requiring all equity investors to treat their dividend receipts as income and pay taxes on it at their applicable slab rates, as per the classical system of dividend taxation that is widely prevalent globally. While this change enables companies to share their entire distributable profits with shareholders, its impact on dividend receivers is uneven.

Winners and losers

There seem to be four distinct sets of gainers from the abolition of the DDT. One, retail investors with a total income of upto ₹10 lakh a year no longer need to suffer the flat 20.56 per cent imposition on their dividend receipts when their own slab rates are much lower. Two, domestic mutual funds/asset managers who enjoy pass-through status and pay no tax can pocket larger dividend incomes from their portfolios, as they will no longer suffer the indirect incidence of the DDT.

Three, Foreign Portfolio Investors (FPIs) structured as corporates can now pay tax on dividends earned in India at either 20 per cent or lower rates, specified in tax treaties inked by their home countries. These rates can be as low as 5 per cent in some cases.

Four, multinationals and foreign companies that receive dividends from their Indian subsidiaries will also enjoy a regime similar to corporate FPIs. As an added sweetener, many of them can now claim credit for taxes paid on dividends received in India when assessed for corporate tax back home. This set-off wasn’t available with the DDT.

The losers fall into four categories too. One, individual investors in stocks whose income exceeds ₹10 lakh a year will shell out an effective tax of 31.2 per cent on their dividends, instead of a flat 20.56 per cent under the DDT. Those whose income tops ₹50 lakh, ₹1 crore and ₹2 crore will now find the hefty super-rich surcharges taking a big bite out of their dividend income too. For them, this will mean parting with an effective tax of 34.3 per cent, 35.8 per cent and 39 per cent, respectively, on dividend income. High net-worth equity investors with income of over ₹5 crore a year will now pay an eye-watering 42.74 per cent tax on their dividend receipts.

Which brings us to the second category; most big-name promoters of India Inc, who are likely to fall in this ₹5 crore category, will have to pay up the 42.74 per cent effective tax on dividends.

Three, insurance companies and other corporate investors in shares, who do not enjoy a pass-through status like mutual funds, may see a dent to their incomes from paying tax on dividends at the corporate tax rate. However, this blow has been somewhat softened by the Budget restoring Section 80M benefits, which allows companies to net out the dividends they distribute to their shareholders from the dividend income they receive, while paying corporate tax.

Four, NRI investors and FPIs structured as non-corporates will not reap the benefit of the 20 per cent tax rate on dividends enjoyed by other foreign investors, and may need to pay taxes at their slab rates.

Who’ll pay more

The uneven impact of the DDT abolition, as detailed above, suggests that there’s going to be an active tug-of-war between different classes of shareholders from the next fiscal, with each faction trying to alter the dividend policies of India Inc to its benefit.

Some quick number-crunching on 1,752 NSE-listed companies last fiscal (FY19), based on the Capitaline database, showed that only 938 of them paid out a dividend last year, with the payout aggregating to about ₹2 lakh crore. Of this, promoters (Indian and foreign) took home the lion’s share of about ₹1 lakh crore in dividends, FPIs pocketed about ₹37,000 crore, domestic mutual funds earned ₹16,000 crore, insurers ₹11,500 crore. Larger retail investors (holding over ₹1 lakh nominal value of shares) earned about ₹3,300 crore, while smaller retail investors pocketed ₹12,200 crore (the rest went to NRIs, corporate bodies, etc).

But big picture apart, whether individual companies will distribute more of their DDT savings, or simply sit on them, will depend on their ownership pattern and the clout that different categories of shareholders exercise on their dividend polices.

Based on where their promoters stand, two large classes of companies are quite likely to see their dividend payouts go up sharply — public sector undertakings (PSUs) and MNCs (including companies with foreign promoters). In the case of PSUs, given that their largest shareholder (the government) isn’t liable to income tax, it is very likely that it will insist on all the savings from the DDT abolition being paid out as dividends. PSU stocks, some of which are already high-dividend yield, may have reason to up their payouts further in future. Given that dividends are the key route through which local arms of MNCs/foreign companies share their profits with their parents, they are also likely to raise their payouts in the future.

Of the 938 dividend payers last year, there were 58 PSUs and 108 companies were with MNCs or foreign parents. Despite their small numbers, these two sets of firms made up nearly 49 per cent of the dividend pool, with PSUs distributing about ₹64,500 crore and foreign-owned companies paying ₹34,000 crore.

Of the companies with Indian promoters, 288 are widely held with promoter holdings of less than 50 per cent. These paid out ₹56,638 crore as dividends last year. In these companies, institutional investors may have sufficient clout to keep up the current dividend rates.

However, the promoter-dominated faction of India Inc, which accounts for 484 companies of the 938 and paid ₹54,500 crore in dividends last fiscal, may very well skimp on dividends and explore buybacks from next fiscal. This faction, though, makes up just 28 per cent of the dividend pool. Therefore, overall, the abolition of the DDT is likely to improve the attractiveness of Indian markets to foreign investors and domestic retail investors, from a dividend yield perspective. But the super-rich taxation on dividends flowing back to India Inc’s promoters, who are the primary risk-takers in the economy, may also mean less cash flows and appetite for investing in new ventures/projects from domestic entrepreneurs.

COMMENT NOW