I strongly believe that dividends should not be taxed for shareholders. In social media I’ve received a lot of criticism for this opinion, because an Azim Premji gets more than 500 crores of dividend on which he pays no tax, or some other such example. Let me explain why I think this is a silly thing to say.
But first, a point on outrage. I believe there are a lot of things wrong with this country. But we, as a mature people, must engage on each issue with earnest and depth, without the kind of knee jerk reaction that our media is very happy to treat us to. Big statements that oversimplify, or the "them versus us" arguments are usually just blank rhetoric. So just because someone made money, and because someone told you they didn’t pay tax on it, doesn’t mean it is a bad thing – the money that they have received is already post-tax, as I will show you, and if you did attempt to tax them, India’s taxes would not increase one bit and in fact we’ll not get quite as much.
Now, what are dividends?
A company earns a profit, of say Rs. 100, after accounting for wages, overheads, depreciation, interest and other legal expenditure incurred.
It must pay income tax on this money. Usually this rate is 30% (plus surcharges and cess), but if a company is a low tax entity or in an SEZ it will pay the minimum alternate tax (MAT) which is about 20%. Let’s just say it pays Rs. 25 as tax.
Of this, the company chooses to distribute Rs. 30 in dividends, and retain the remaining Rs. 45 for future use.
Current Situation, where DDT Applies
The company must pay 15% – or Rs. 4.5 – to the government as dividend distribution tax (DDT). Along with surcharges and cess, let’s say this amount is Rs. 5.
The government gets: Rs. 25 (income tax) + Rs. 5 (DDT + surcharges + cess) = Rs. 30.
The company keeps: Rs. 100 (profit) – Rs. 25 (income tax) – Rs.5 (DDT) – Rs. 30 (dividend) = Rs. 40.
The shareholders get: Rs. 30 (on which no further tax is levied). They also indirectly own the Rs. 40, but it stays with the company.
New Utopian Situation: No DDT, but dividends are taxed.
Let’s assume that for the purpose of answering the trolls, dividends are taxed in the hands of shareholders. Assume a 20% tax overall, to them as individuals, and no DDT. Then:
The company keeps: Rs. 100 (profit) – Rs. 25 (tax) minus Rs. 30 (dividend) = Rs. 45.
The shareholder gets: Rs. 30 (dividend) – Rs. 6 (20% tax) = Rs. 24.
The government gets: Rs. 25 (company income tax) + Rs. 6 (personal income tax). = Rs. 31.
Look at the two above equations. The government is not much better off in the utopian situation (just Rs. 1. But shareholders are substantially poorer, and the company gets to keep a little more money back.
Reality: What Will Happen.
People respond to incentives. So what is likely to happen? You are going to see a few things change.
There will be lower dividends. Consider that the company has already paid tax, then why distribute any more if it will only be taxed? Let the company own the money, and not pay it out. Like Apple has, or Microsoft for the longest time, in the US where dividends are taxed (though at a lower rate). It makes very little sense to pay dividends when you’re paying it out of post tax profits, if it simply means paying more tax.
Companies will use buybacks: One of the ways companies can create dividends is to offer a buyback program. To distribute say 40% of what it makes as a profit, a company can simply say it will buy back shares in a tender offer, giving everyone the right to participate and thus creating cash flow. This might not work when the share price is very high (bad use of cash).
Compensating management in other ways: Dividends are distributed among all shareholders. And promoters are happy to get their share today since dividends are not taxed. Should the government tax dividends, management will easily create promoter-owned companies and pay them fees or "royalty charges" which are very legal, even if they must be disclosed.
Expenses Versus Dividend
Why? Because such fees are tax-deductible. Consider the situation above (Rs. 100 profit) on which the government pays tax. If the promoter who owns 50% of the company wanted Rs. 15 of it, in the current situation he would offer Rs. 30 as dividend, where he would get Rs. 15.
But if dividends were taxed in his hands, at say 30%, he would have to offer a dividend of Rs. 45 (he would get Rs. 22.5, pay 30% of it as tax, and be left with Rs. 15). This is a 50% higher dividend that needs to be declared.
What has happened eventually is that the government has gotten a much larger share – first, the Rs. 25 as tax to the company, and then potentially another Rs. 15 (30% of the Rs. 45) as dividend tax, which adds up to a real tax of 40% of the company’s profit.
This is patently unfair, and instead, the promoter can choose to distribute money to himself in easier ways. Payment of a very high salary or benefits, and then, not paying much dividend (and thus keeping the money in what is effectively their own control) are quite likely consequences. While salaries are restricted (you can only pay directors a total of 11% of net profits), there is no limit if the directors provide services of a "professional nature" for which they are qualified.
A Real Situation
Indeed, look at what happens if the promoters manage to pay themselves about 10% more and cut dividends to zero.
New Net profit = Rs. 90.
Government gets: Rs. 22.5 (25% tax rate)
Shareholders get: Nothing, since there are no . (Promoters get a higher salary)
Company keeps: Rs. 67.5.
Look carefully and you find that the govt gets less (Rs. 22.5 versus Rs. 30). Shareholders get less since there are no dividends. The company keeps more money but that’s neither this way or that.
There is no rule that requires companies to pay dividends. To appease investors some may pay a small sum.
Counter-Arguments
Some tell me that dividends are "unearned" profits and must be taxed. Other examples of unearned profits are interest, rent etc.But look carefully and you will see that when a bank pays you interest, it deducts that interest from it’s profit as an expense. A company that pays you rent will deduct the rent as an expense. The profit you earn is taxed only in your hands. With a dividend, the profit is first taxed in the company’s hands, and you are given a part of what is left after such a tax. See the unfairness? If dividends are this way, then allow them as an expense for tax purposes, and that will still be okay.
Others tell me that the company and the shareholder are different entities. Any transfer of wealth between different entities must be taxed. But there are umpteen examples of where this is not true. In India you don’t tax inheritance. We don’t tax the receiver of insurance policy proceeds on death. We don’t tax gifts. These are all inter-entity transfers, and there is no tax. I assume this is acceptable to the detractors, since they don’t appeal against such laws. In principle, therefore, inter-entity transfer is not a rule that is strictly taxable under all circumstances. Now let’s go back to first principles: a shareholder owns a piece of a business, and if the company has paid taxes on a profit, the shareholder can be given his share post such tax; it should not be taxed once again in his hands.
Yet others say the game is unfair because the rich benefit hugely at the
cost of the government. Firstly I think that’s perfectly fine. I would rather have rich individuals than a rich government in India which squanders wealth by propping up banks or the likes of Air India. Secondly, as I said, if dividends were taxed, the government would actually receive lesser in tax, and the rich would still benefit hugely. Third, the principle of not taxing dividends is more fair; just because some people made money out of it doesn’t mean it’s bad, like it’s not bad that some of us get paid a salary even for those days that we spent too much time doing nothing. (Some people say they got rich by bribing the government. That is just strawman and again, is a different argument.)
Lastly, they say that America taxes dividends so that must be okay. But that’s being a lemming. Sometimes America does the wrong thing – a lot of people would agree here – and we needn’t follow. It’s as logical that Americans shouldn’t pay taxes on dividends received as much as it is for Indians.
My opinion is that this is a good debate but we need to build the concept of fairness into the laws we create. Double taxing profits when a company gives out dividends is unfair, illogical, and unproductive.
