When dividend distribution tax (DDT) was introduced more than 20 years ago, the markets were shocked. Over the years, markets have not only adjusted to it but actually created tremendous wealth over the years. In a way, it was a positive move. It dissuaded companies from paying out heavy dividends and coaxed them to reinvest in their business. This led to a capital investment driven rally in the new millennium and that ran all the way to 2008. In the Union Budget 2020, the DDT was abolished and replaced by the withholding tax that individual investors will have to pay on their dividend incomes. Here is how it actually works and here is how it will impact the markets.
How the DDT works currently and how it will work now?
In India, DDT is applicable to equity and to equity funds. Currently, companies are required to pay DDT on the dividend paid to its shareholders at the rate of 15% plus applicable surcharge and cess (effective tax rate for DDT is 20.56%) in addition to the tax payable by the company on its profits. This was resulting in a cascading effect of taxes on dividends. Firstly, dividends are a post tax appropriate. Secondly, there is DDT on dividends declared and lastly dividends of more than Rs.1 million per year are taxed at 10% in the hands of the investor. Now all that has changed and the investor will pay the peak rate of tax on the dividend income. In a way, that is fair because under DDT the promoter of the company and the small investor were virtually paying the same rate of tax. This scheme is more rational because an investor in the 5% tax bracket will now only pay tax at that rate on his dividend income. That makes this approach more progressive. But, how will it impact markets?
Impact of shift out of DDT into dividend tax
Post the budget 2020, from April 2020, all domestic companies and mutual funds declaring any dividend shall not be required to pay any DDT. The incidence of tax would get shifted from companies and mutual funds distributing the dividends to the investors who hold shares or MF units. Section 80M of the IT Act will be reintroduced to provide a deduction of dividend received from domestic company on further distributions by the domestic company receiving the dividend. In addition, there will also be TDS on dividends above a threshold where 10% TDS will be deducted before payment of dividends. In the case of NRIs the TDS will be 20% or applicable treaty rates.
Nirmala Sitharaman has underlined that the proposed changes will increase attractiveness of the Indian equity market and also provide the much needed relief to small and medium sized investors. The DDT approach was unfair as it resulted in an increase in tax burden for investors and especially those who are actually liable to pay tax less than the rate of DDT.
The real hit could be on the promoter groups who have high income levels of above Rs.5 crore per year. The amendment would negatively impact such promoters. In such cases, the dividends received will be now taxed at their peak rate of 42.74% (30% tax + 37% surcharge + 4% cess). This will hit Indian promoters using the individual, HUFs or trust structures. The irony is that when the loss of tax dividend shield is also added up, the effective rate of tax goes above 57% and is more than 10% higher than the old structure.
Bigger question pertains to REITS and INVITs
When the Mindspace REIT IPO was underplayed, the first signs of concerns over the impact of dividend tax on REITs and INVITs were visible. In the current context, REITs receiving dividend from the investee company (subject to conditions) are exempted from DDT and unit holders of such REITs are also not taxed. That is where the problem arises for REITs in the new budget. Budget 2020 has taken away the exemption in the hands of unit holders of such REITs and INVITs and now they would also be subject to tax. This would substantially reduce the effective yield for the REITs investors.
This could be a case of bad timing because India needs REIT and INVIT to succeed so that realty assets get monetized and liquidity problems are address. To that extent, this will be a major setback.
Will this encourage companies to pay rich dividends again?