Juridical Conundrum revolving around the incidence of Dividend Distribution Tax

[Kunwar Singh]

Albert Einstein succinctly worded the main attribute of taxation law when he stated that ‘the most difficult thing in the work to understand is the income tax law’. The incomprehensibility has been further exacerbated by contrary rulings of the courts and tribunals which lead to the germination of nebulous statutory interpretation rather than clearing the air. One such tax issue that has been marred by litigation is the taxation of the dividend income of non-resident shareholders in India. There is no problem if it comes to the dividend income of the resident shareholders but controversy arises when it is about a non-resident shareholder. The dividend rates given in the Double Taxation Avoidance Agreements (DTAA) are generally more beneficial than the rates given in the domestic law. What happens when a company resident in India is a wholly-owned subsidiary of a non-resident company? Basically, this argument is premised on the confusion related to the incidence of taxation i.e. whether Dividend Distribution Tax (hereinafter referred to as ‘DDT’) is a tax on a shareholder or a company. Although many tribunal rulings have given varied interpretations, can the answer to this imbroglio be found if we see it from the perspective of financial policy jurisprudence? This new line of argumentation was propounded by Robert H. Litzenberger and James C. Van Horne of the Graduate School of Business, Stanford University in their seminal paper titled “Elimination of the Double Taxation of Dividends and Corporate Financial Policy”.^[1] Are there any comparative learnings that we can incorporate from the American regime to understand the essence of the argument? Before moving on to this, I believe it is apposite to know about the history and the judicial advertence of the dividend taxation.

History of Dividend Taxation

Dividend taxation in India has evolved over time to align with the government's economic and fiscal policies. Before India gained independence in 1947, dividend income was taxed under the Income Tax Act of 1922. Post-independence, dividend income was subject to double taxation. First, the company paying the dividend was taxed, and then the dividend income received by the shareholders was taxed again in their hands. This led to high effective tax rates on dividends. In 1997, the DDT was introduced, which mandated the company to pay the tax. This simplified the dividend taxation regime as it was difficult and cumbersome to collect tax from the shareholders. In 2020, the tax burden was again shifted to shareholders.

The nature of dividend tax has led to multiple judicial inquiries, primarily due to challenges linking DDT to shareholders receiving dividends. The Calcutta High Court ^[2] and Gauhati High Court ^[3] upheld the constitutional validity of DDT, rejecting challenges that a company paying the dividend should not be subjected to DDT when earning agricultural income. However, these decisions did not find that a dividend (subject to DDT) is the income of the company. The Bombay High Court in Godrej & Boyce declared that a company paying the dividend is chargeable to tax on its profits as a distinct taxable entity, not on behalf of the shareholder.^[4] However, this legal position was short-lived as the Supreme Court reversed the decision but never categorically laid down whether it was a tax on a shareholder or a company^.[5] Lately, the decisions of the Delhi ITAT ^[6] and Mumbai ITAT ^[7] has also left open the debate around the incidence of dividend taxation.

Relevant provisions applicable

Taxation of dividends paid by a domestic company is governed under the provisions of section 115 O of the Income Tax Act, 1961 which reads as under:

'(1) Notwithstanding anything contained in any other provision of this Act and subject to the provisions of this section, in addition to the income-tax chargeable in respect of the total income of a domestic company for any assessment year, any amount declared, distributed or paid by such company by way of dividends (whether interim or otherwise) on or after the 1st day of April, 2003, whether out of current or accumulated profits shall be charged to additional income-tax (hereafter referred to as tax on distributed profits) at the rate of fifteen per cent'

As regards the taxation of dividends paid by a domestic company to a resident, the above provisions are simple and clear in their applicability.

Comparative Learnings

The dividend taxation regime of the US makes a good study, as it is one of the very few countries, where corporate income is taxed twice. Corporate profits are taxed as corporate income, and when distributed to shareholders, they are also included in their taxable income. Henceforth, the incidence of dividend taxation is both on the company as well as on the individual shareholder. This further results in double taxation on return on equity investments in corporate activities. For example, if the statutory corporate tax rate is 34% and the personal tax rate is 33%, one dollar of corporate earnings is reduced by 34 cents in corporate profits taxes, leaving the corporation with 66 cents. If dividends are paid out, this amount is included in shareholders' taxable income and subject to a personal tax of 33%, leaving the shareholder with 44 cents. Despite the fact that there have been clarion calls by the US businesses to integrate corporate and personal income taxes in order to reduce the burden of double taxation, Congress finds no reason to tinker with the prevalent system. This is because of the two fundamental reasons given by the advocates of corporate income tax:

1. A shareholder and a company are two separate economic units. This rationale owes its genesis to a basic understanding of company law. Corporations are separate legal entities created by law, with the right to own property, sue, enter into contracts, and be sued. They are separate from their shareholders.
2. The companies consume services from the government in the form of more favorable taxes, incentive-linked production schemes, tax exemptions, tax holidays etc, hence liable to a levy.

The jurisprudence pivoted around the concept of public goods consumption and taxation providing more credence to the arguments mentioned above. The private sector's inability to provide public goods efficiently is due to their almost zero marginal cost and non-excludability, making it impossible to prevent those who do not pay for the goods from enjoying the benefits. In a free market economy, the government relies on the private sector to produce public goods and relies on tax revenues to pay for the cost of these goods. The fact that shareholders enjoy the benefits provided by public goods in no way detracts from the companies’ ability to enjoy the same benefits. Shareholders pay their share of the cost of public goods and companies also need to pay their share of the cost of the public goods they consume. Therefore, if we interpret Section 115-O through the prism of the American dividend regime, the only consequence would be that the DDT on a company resident in India is levied on its distributed profits and has no connection whatsoever with the shareholders. It is an independent corporate income tax. This further boils down to the interpretation that a non-resident shareholder would not be able to resort to the beneficial rates as contained in the bilateral tax treaties and the only rate applicable will be 15% as given in Section 115O of the Act.

Another aspect that favors DDT being a tax on a company and not on a shareholder is that it actually entails more benefits to the shareholders. Scholars against dividend taxation argue that dividend taxation reduces these benefits as it’s a tax on the distributed profits of the company which is also a non –non-deductible expenditure.  It has to be understood that taxes paid by residents and businesses equal the value they place on public services which means the more public services a company consumes, a proportional tax has to be paid. When a particular state or a local area wants to increase investment, they offer tax incentives to attract these businesses. These businesses are being subsidized for what they will normally do, which is a loss to society at large and a corresponding benefit to their shareholders. If a company chooses an inefficient location, it may produce fewer private goods and public goods due to the diverted subsidy. Conversely, if a company is subsidized to choose a site, it will normally have chosen it based on its merit, resulting in a subsidy at the expense of public goods, which will flow through to shareholders. Henceforth, it is the company that is paying the tax for the indirect benefits accruing to its shareholders.

This article is a bona fide attempt to introduce a new line of thought to look at the contentious issue of dividend taxation in India. In the complex landscape of taxation and finance, dividends stand as a compelling bridge between investment and income, providing investors with a steady stream of returns. Let us not forget that the world of tax is a realm of continuous transformation. Tax laws cannot be interpreted in a vacuum and readings of comparative jurisdictions might pave the way for some more clarity till the issue is further litigated in the constitutional courts. It is, therefore, paramount to stay informed and devise new ways to think about the issues.

References

[1]. Robert H. Litzenberger, James C. Van Horne, “Elimination of the Double Taxation of Dividends and Corporate Financial Policy” (1978) Journal of Finance Vol. 33 No. 3 < https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1978.tb02015.x> accessed on 21 October 2023

[2]. JAYSHREE TEA AND INDUSTRIES LTD AND ANOTHER VERSUS UNION OF INDIA AND OTHERS - 2001 (9) TMI 74 - CALCUTTA HIGH COURT

[3]. GEORGE WILLIAMSON (ASSAM) LIMITED AND ANOTHER VERSUS UNION OF INDIA AND OTHERS - 2007 (6) TMI 174 - GAUHATI HIGH COURT

[4]. GODREJ AND BOYCE MFG. CO. LTD. VERSUS DEPUTY COMMISSIONER OF INCOME-TAX AND ANOTHER - 2010 (8) TMI 77 - BOMBAY HIGH COURT

[5]. GODREJ & BOYCE MANUFACTURING COMPANY LIMITED VERSUS DY. COMMISSIONER OF INCOME-TAX & ANR. - 2017 (5) TMI 403 - SUPREME COURT

[6]. GIESECKE AND DEVRIENT [INDIA] PVT LTD VERSUS THE ADDL. C.I.T SPECIAL RANGE -04 NEW DELHI - 2020 (10) TMI 750 - ITAT DELHI

[7]. DEPUTY COMMISSIONER OF INCOME TAX CIRCLE 11 (3) (1) , MUMBAI VERSUS TOTAL OIL INDIA PVT LTD AND (VICE-VERSA) - 2021 (6) TMI 855 - ITAT MUMBAI