In recent months, there has been widespread discussion about the tax burden on individuals. However, tax collection remains indispensable as a key source of government revenue. Despite being one of the fastest growing economies, India has a bleak income tax return filing rate of 2.89%. Consequently, to bridge the revenue gap, the government escalates the burden on honest taxpayers. Such has been the case for Indian shareholders, who end up paying almost 50% of the dividend income in tax. The scenario is linked to practices resulting from double taxation, once as corporate tax and later as personal tax levied on shareholder’s income. The result of this process yields unwanted results like low tax collection and lower investment in domestic companies. The malice of double taxation in dividend distribution needs to be cured with a modern-day solution that aligns not only with the needs of investors but also makes room for fostering economic growth. The article examines the issue of double taxation in dividend income, provides insights from global economies and proposes a framework, inspired by the input tax credit system under GST, which will help redefine the current system to a better and more efficient dividend tax collection system.
Current Indian Framework for Dividend Taxation
The Indian taxation framework for dividend income has gone through two phases. Prior to 2020, under Section 115O of Income Tax Act, 1961 required companies to pay dividend distribution tax (“DDT”), a tax to be paid by companies on the dividend income before its distribution among the shareholder. Introduced by the Finance Act of 1997, the companies were obligated to pay DDT of 17.65% of the income tax obligations on the profit. Post-distribution of taxes, the shareholders were exempted from any taxation on dividend income.
However, as a part of policy change, the government attempted to reduce tax burdens and align with international best practices. In the Financial Year 2020-2021 the government abolished the DDT system, thereby invalidating Section 115O of Income Tax Act, 1961. Consequently, the tax burden for dividend distributed by the companies was shifted to the shareholder, which would be levied based on tax slabs. While prima facie it posed as a bold initiative of the government towards reduction of tax on dividend income, nonetheless, the shareholders pay almost 50% of the dividend income to the government as tax, which undermines the intended benefits. Section 115O, in its interpretation, included the dividend distribution tax as an additional tax to the income tax. Therefore, even after the abolishment of the DDT, the companies were still liable to pay the corporate tax on the profit generated.
Impact of Corporate and Individual Tax on Shareholders
In India, before the dividend income gets into the pocket of shareholders it undergoes a phased taxation process. In the first phase, the Income Tax Act, 1961 under Section 115BAA, makes provision for 22% tax on the total income of the domestic companies, which includes profit and dividends among other things specified under Section 2(24) of the Income Tax Act, 1961, earned during the previous assessment year.
The corporate tax also includes surcharges and cess. These are additional taxes levied by the government for generating funds to ensure adequate health, and education and arrange welfare programs for the needy. The surcharges vary as per provisions provided by the Finance Act passed by the government on an annual basis. As per Section 2(3) and Section 2(11) of Finance Act, 2024, made provision for domestic companies to pay an additional 10% surcharge on income tax and a 4% cess of income tax and surcharge combined, making it an effective tax of 25.17%.
In the second phase of taxation, after payment of corporate tax, the individuals have to pay personal tax, on incomes earned, relative to the income slabs as mentioned under Section 115BAC of the Income Tax Act, 1961. For instance, in the financial year 2024-25, a resident earning an income of more than INR 15 lakhs is subject to 30% of tax. In addition to this, as per Section 2(12) of the Finance Act, 2024, the individuals were mandated to a 4% cess, summing to a total of 31.2%. For incomes more than one crore, Section 2(3)(a)(ii) of the Finance Act, 2024, provides for an additional 15% surcharge, raising the tax rate to 35.88% of the income earned.
On combining the corporate tax with income tax, the total tax charged on the dividend becomes nearly 48.51%, which is a substantial chunk of dividend income. Despite the elimination of the Double Tax Distribution system, this cascading tax system results in double taxation resulting in a disproportionate effect on the resident shareholder, who has to pay such elevated tax rates.
Global Practice for Dividend Taxation
The problem of double taxation on dividends introduces challenges like erosion of profit and inefficient business strategies where companies tend to retain profits, leading to overall economic inefficiency. The United States of America is also facing a similar issue where due to the effect of cascading taxation, first by payment of corporate tax on the profits by companies and then on an individual level the tax rates causing a similar effect as observed in India. However, some countries have been successful in executing effective solutions to the problem. For instance, Australia follows an imputation system, where the burden of taxation on a company’s profits gets shifted to its shareholders. The imputation system involves the use of franking credits. Based on the taxation paid by the company, full or partially franked dividend credits are issued to the shareholder. These frank credits attached to the dividend help in setting off the tax to be paid by shareholders on their dividend income, thereby preventing double taxation of dividends. Likewise, Canada employs the Dividend gross-up and Dividend tax credit mechanism, which provides a dividend tax credit. The credit is deducted from the tax owed by a shareholder on a dividend income. Singapore came up with a one-tier tax system, where the companies had to pay taxes on dividends once along with the corporate tax. Post this, the shareholders are freed of further tax implications on the dividend income, except in the case of dividends from co-operatives, Real Estate Investment Trusts and foreign-sourced income.
GST-Inspired Framework for Dividend Taxation
Connecting the valuable insights that follow from global practices, India’s own GST framework presents a compelling model to address the lacunas in dividend taxation. The implementation of the Goods & Service Tax introduced an input tax credit system that precisely eliminated the cascading effect arising out of the overlapping collection of tax for the same commodity at multiple stages, where goods were being taxed at production and distribution stages. The input tax credit system, defined under Section 2(63) of the CGST Act, 2017 makes provision for the seller to offset the tax paid on purchase with the tax collected at time of sale. This ensures that the tax is levied on value added rather than being burdened by the tax on a repeated basis. A framework taking inspiration from the principles of input tax credit can offer a suitable solution to mitigate the current problem and make dividend taxation simple and equitable.
Under the proposed framework, the government can, taking inspiration from the GST model, use technology to develop a centralised system for managing and recording the corporate tax paid by the companies, based on which the shareholders shall receive tax credit certificates. The certificate will be a reflection of the dividend being already charged under the corporate tax and will allow the shareholder to offset their tax liabilities on the income generated from the dividend. For instance, if a company pays 25.17%, as corporate tax, and a resident shareholder earning more than 15 lakhs pays 31.2%, the same shareholder shall be obligated to pay tax worth only 6.03% to avoid double taxation. This will ensure that taxation is charged on income only once, thereby boosting the net income of shareholders. The framework shall help serve two-fold purposes: first, it will help fix tax evasion which is prevalent in India, one reason for which is the high tax charged by the government. Secondly, this shall ensure that there are more investments and confidence among shareholders. With smart and strategic use of technology, the government can increase efficiency in tax collection and limit any faults and miscalculations.
Conclusion
To conclude, the GST-inspired framework offers a pragmatic and effective solution to pursue a better taxation framework for dividends. Taking valuable insights from the approaches followed by other global economies and leveraging the input tax credit system under the GST framework, the government can assure shareholders of an equitable method of taxing dividends by eliminating the effect of double taxation. The tax credit certificate system not only brings transparency but also lowers the tax burden, making the Indian market investor-friendly. Such a proactive and technology-driven approach will align with India’s economic objective of being a global investment hub.
This blog is written by Anjnay Bansal and Arjun Kapur, Second year and Fourth Year B.A., LL.B. (Hons.) Student respectively, at MNLU, Mumbai