A dividend is a portion of a business firm’s profits distributed to the shareholders as a reward for their investment in the company. When a business entity makes profits and has sufficient reserves, it can decide to distribute part of those profits to its shareholders in the form of dividends. Normally, dividends are paid in cash; however, they can also be paid as bonus issues or in other forms, subject to the company’s policy and financial situation.
In India, payment and declaration of dividends are controlled by the Companies Act of 2013 as well as the directives issued by the regulatory authorities like SEBI on listed companies. A dividend may be interim, which is distributed by the Board of Directors within the financial year, or final, which is declared at the AGM with shareholder approval.
Dividends are an indicator of the financial strength and stability of a company that could help increase investor confidence. However, the company needs to ensure that the payment of dividends is made only from profits after meeting all obligations, such as taxes, depreciation, and reserve provisions. The procedure also has to comply with judicial timelines and procedural laws to protect the interests of the company as well as the shareholders.
What is a Dividend?
A dividend is a payment made by a firm to its shareholders from its retained earnings. It is the return on investment for shareholders and payment for their ownership of the firm. A dividend is normally declared when a firm has earned enough income and has a good financial position. The size and frequency of dividends depend on the profitability, cash flow, growth plans, and dividend policy of the company.
Dividends are also classified into two broad categories:
- Interim Dividend: This is issued by the Board of Directors within the financial year before final accounts approval.
- Final Dividend: This is recommended by the Board and requires shareholder approval at the Annual General Meeting (AGM), normally paid after closure of the financial year.
Dividends are usually paid in money, but may also be delivered as bonus shares or other property. In India, declaration and payment of dividends are controlled by the Companies Act 2013, while SEBI (Listing Obligations and Disclosure Requirements) Regulations are applicable to listed companies.
Dividends indicate a company’s profitability, liquidity, and responsiveness to shareholders, thus influencing investor sentiment and share price.
What is Dividend Distribution Tax?
Dividend Distribution Tax (DDT) was a tax levied on Indian corporations that distributed dividends to the shareholders. Added under Section 115-O of the Income Tax Act of 1961, DDT was a way to tax dividends at the level of the company before distribution among the shareholders. The main intention was to simplify taxation and minimize administrative efforts by holding companies accountable for paying tax.
In the DDT regime, the companies were required to bear an effective rate of taxation of around 20.56% (including surcharge and cess) on the aggregate of declared dividends. This was over and above the income tax the company had to bear on its earnings. Therefore, dividend income was actually taxed twice, once at the company level and again in the hands of the shareholders in case the dividend was above a certain limit.
But the DDT was done away with by the Finance Act of 2020 from April 1, 2020. Since then, the traditional system of taxation has resumed, where dividends are taxed only in the hands of the shareholders at the applicable income tax slab rates. Companies do not have to pay DDT, but deduct tax at source (TDS) before paying dividends.
The phase out of DDT was intended to make dividend taxation fairer and less of a burden for companies. It also placed the Indian taxation system on par with that of the world, which tends to tax dividend income only at the beneficiary level. The reform has improved transparency and is seen as being beneficial to investors, particularly foreign and small retail investors.
Who Paid the DDT?
Dividend Distribution Tax (DDT) was a tax levied on the corporation or mutual fund that distributed dividends to its shareholders, as opposed to on the shareholders. This tax was instituted in India under Section 115-O of the Income Tax Act of 1961 and existed until it was repealed by the Finance Act of 2020, with an implementation date of April 1, 2020.
When the dividend was within the period when DDT was relevant, it was the duty of the corporation or mutual fund that declared the dividend to pay the tax, exempting shareholders from paying the tax. This provided dividend income free of tax within a particular limit while at the same time imposing a further tax on the distributing entity. The system was also altered to increase transparency and fairness in taxation by transferring the burden of taxation to the recipient.
Who is Liable to Pay DDT?
According to the law, the domestic company or mutual fund that declared, distributed, or paid the dividend had to pay DDT to the central government. Shareholders received tax-free dividends up to a specific limit (₹10 lakh for individuals/HUFs), as they were treated as income that had already been taxed.
Entities falling within the ambit of this tax were:
- Domestic Corporations: All Indian corporations issuing dividends were required to pay DDT.
- Mutual Funds (Debt-oriented Schemes): Dividend-paying mutual funds on debt-oriented schemes were also liable for paying DDT.
When Was DDT Payable?
A mutual fund or domestic corporation was required to pay Dividend Distribution Tax (DDT) within 14 days after the payment, declaration, or distribution of the dividend, whichever happened first. This provision is contained in Section 115-O(3) of the Income Tax Act of 1961.
As an example, suppose that a company declared a dividend on April 1st and paid it out on April 10th. The DDT would have to be remitted by April 15th (14 days after the declaration date). The duty to pay the DDT was incurred upon the declaration of the dividend, even though the payment occurred later.
Failure to remit DDT in the scheduled period attracted a 1% per month or any fraction thereof interest charge under Section 115-P, together with potential penalties. The strict deadline made it possible for the government to collect taxes in a timely manner and highlighted the need for corporate bodies or mutual funds to comply with DDT requirements before distributing dividends to shareholders.
Rate of DDT
Section 115-O of the Income Tax Act, 1961, introduced a 15% Dividend Distribution Tax (DDT) on the aggregate of dividends distributed by domestic companies. But adding the surcharge (12%) and the health and education cess (4%), the net DDT rate worked out to nearly 20.56%. The net rate for dividends given by mutual funds, particularly debt-oriented mutual funds, fluctuated and was often higher. The tax was the burden of the company or mutual fund, not the shareholder. DDT was removed by the Finance Act 2020 w.e.f. April 1, 2020, dividends are taxed in the hands of the shareholders.
DDT On Mutual Funds
The Finance Act 2020 removed the dividend distribution tax (DDT) on debt-oriented mutual funds in India, with effect from April 1, 2020. In the old tax regime, mutual funds had to pay DDT before passing on dividends to unit holders. This wasn’t charged for equity-oriented mutual funds (those having exposure to equity greater than 65%), making debt funds less tax-efficient.
For residents and Hindu Undivided Families (HUFs), the DDT rate on debt mutual fund dividends was 25%, along with a surcharge of 12% and a 4% health and education cess, resulting in an effective rate of around 29.12%. For domestic companies, the basic rate was 30%, and this more than doubled the effective rate.
The burden of DDT cut down on the dividends for shareholders. Under the repeal, mutual funds no longer pay DDT, and dividends are taxed based on the corresponding income tax slab rates of shareholders, thus closely aligning the tax treatment of various types of investments.
Special Provisions On DDT
- Section 115-O(1A) provides an exemption for inter-corporate dividends: No DDT is levied on dividends obtained from a domestic corporation that is already taxed and distributed in the same financial year. This escape is to prevent cascading effects among group enterprises.
- Deemed dividend [Section 2(22)(e)]: Amounts paid by closely held companies to major shareholders, like loans, are treated as deemed dividends and taxed. They are charged in the receiver’s hands and are not subject to DDT.
- Mutual Funds (Section 115-R): DDT is applicable on debt-oriented mutual fund dividend distributions. Mutual funds, however, that have equity stakes of 65% or higher are exempted from this charge.
- Grossing Up Requirement (Post-2014): DDT is charged on the grossed-up sum of dividends, increasing the effective rate of tax. Businesses were subjected to an effective DDT rate of approximately 20.56 percent.
- No credits or deductions: Companies and shareholders cannot claim any credit, set-off, or deduction for DDT payments.
- Business Trusts Exemption: Dividends paid to REITs/InvITs are exempt from DDT.
- Interest on Delay (Section 115-P): 1% per month interest is charged if DDT is not paid within 14 days from the date of declaration, distribution, or payment.
These legislations are aimed at providing a balance in revenue receipt, avoiding duplications, and promoting equitable taxation.
Important Considerations
- Firm Liability: The Dividend Distribution Tax (DDT) was paid by the firm or mutual fund that declared and distributed dividends, and not by the shareholders.
- Effective Tax Rate: The effective tax rate is around 20.56%, including surcharges and cess, which is a huge tax on corporations.
- Grossing Up of Dividend: DDT was computed upon the grossed-up amount of dividends, leading to an increased tax charge.
- No Tax Credit: The shareholder and the corporation cannot take credit for the payment of DDT.
- Inter-Corporate Dividends: Dividends paid by domestic firms were exempt from DDT to prevent double taxation.
- TDS on Dividends: Companies need to deduct Tax Deducted at Source (TDS) on dividends in excess of ₹5,000 for each shareholder.
- Late Payment Interest: A 1% interest per month has to be paid if DDT is not paid within 14 days after the declaration or payment of dividends.
- DDT was withdrawn in April 2020 and dividends are taxed based on the income tax slabs of the shareholders.
Conclusion
The Dividend Distribution Tax (DDT) was a hefty tax charged on Indian firms and mutual funds before dividend distribution to ensure tax realization at the corporate level. Though it made the taxation process easier by requiring the firm to pay tax on dividends, it also caused double taxation, thus raising the tax burden. The phase-out of DDT in 2020 was a shift towards taxing shareholders’ dividends, promoting transparency, and equity. The shift brings India in line with international practices, benefiting investors by enabling taxation on the basis of individual incomes and enhancing investment attractiveness.
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