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Dividend Taxation Revisited

This article first argues why independent taxation of corporate profits and dividend incomes has ill-effects on equity and efficiency and then considers the merits and drawbacks of tax alternatives. In the light of studies conducted in the US after the enactment of the 2003 legislation on dividends, it puts forward suggestions to address the problems with the Indian approach to dividend taxation.

Dividend Taxation Revisited

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experience offers useful lessons for framing policies in this regard. Basically there are three popular models for integration. These are (i) the deduction method; (ii) the imputation or tax credit method; and (iii) the exclusion method. Each has its merits and drawbacks. These are gone over briefly below.3 Table 1 brings out how the three models work.

(i) The deduction method: Under this method, dividends are allowed to be deducted in the computation of taxable corporate profits, just like salaries of employees, interest and lease payments, and taxed in the hands of the recipients. This clearly establishes neutrality between dividend payments and other deductible items of income and thereby between the choice of salaries and dividends as a form of labour compensation. Differential tax treatment of equity and debt financing and of incorporated and unincorporated enterprises is practically eliminated. There are however certain issues arising from the deduction method that need consideration.

One, unless capital gains are exempted from tax deduction of dividends from taxable corporate profits, it creates a bias against financing of investment with reinvested earnings. It also provides an inducement for companies to realise capital gains by stripping out profits as dividends. Two, dividend deduction benefits foreign shareholders equally as residents. A country may not like to extend such benefit unless there is reciprocal benefit for its citizens in other countries. Three, with a wider tax base of deductible items it may induce or enable companies to show losses for tax purposes, which otherwise would not be there. The tax system may encounter instability as transactions may be undertaken to shift losses to taxpaying units where they can be used readily. Multinational companies, in particular, may benefit as they may be able to shift more incomes to jurisdictions where losses occur. Very few countries follow the deduction method; only some apply a lower CT rate to distributed profits.

(ii) The imputation or tax credit method: Under this system a credit is provided to the shareholder against the tax payable on his/her income for the tax paid by the corporation. For this purpose the dividend received by a shareholder is grossed up by the tax paid by the company on its profits. Full or partial credit is allowed for the tax paid by the company against the tax payable on the grossed up dividend. This system too, like the deduction method, serves to bring neutrality between dividends and other items of deductible payments.

Under full integration, tax credit is allowed for the taxes actually paid by the company. This is the system followed in Australia. Sometimes the credit is allowed only for dividends paid out of taxable corporate profits. Several European countries follow this approach in the case of dividends paid out of foreignsource income. Under the full integration system a distribution or equalisation tax is sometimes levied on the corporation so that dividends qualifying for tax credit actually bear some taxation. Credit is allowed for such distribution taxes against the regular corporate income tax. Under partial integration, tax credit is allowed irrespective of the level of tax paid by the company.

Though widely followed, the tax credit method also has its drawbacks. Like the

Economic and Political Weekly April 7, 2007

Economic and Political WeeklyApril 7, 20071265deduction method it does not providerelief fromdouble taxation arising fromtaxation of capital gains accruing to cor-porate equities as a result of retention ofafter-tax profits. To get over this problem,the celebrated Carter Commission ofCanada (1966) while recommending fullintegration had suggested that in taxingcapital gains from equities a tax credit beallowed for the undistributed profits attrib-utable to each share. Given the constantlychanging ownership pattern of large cor-porations this is not a simple task. Notsurprisingly, the recommendation was notacted upon.Then again, if no credit is allowed unlessthe profits out of which the dividend isdistributed suffers taxation, the benefit ofinvestment credits or other tax preferencesextended to the corporation does not “flowthrough” to the shareholders. Whether ornot that should be allowed, involves aconscious policy decision.Imputation can be extended to non-residents by treaty if desired. Credit canbe allowed in respect of foreign sourceincomes also but countries are generallydisinclined to provide such benefit. Usuallythe matter is left to treaties to sort out.Whether to extend the benefit of tax creditto tax exempts again is a policy issue.(iii)The exclusion (full or partial exemp-tion) method: Double taxation of corporateincomes can be relieved simply by ex-empting, fully or partially, the dividendsreceived by shareholders. Alternatively,dividends can be taxed at a lower rate thanapplicable to other corporate source incomeslike salaries and interest. As noted earlier,the full exemption system is operating inIndia since 1997 almost continuously. Inthe US following the 2003 law dividendsare taxed at a concessional rate that worksout to roughly half the normal rate.It should be noted however that exemp-tion method achieves integration only fora single personal tax rate. The rate of taxapplicable to the company can be loweror higher than the rate at which the incomesof the taxpayer would normally be taxed.Tax exempts would also bear the corporatetax under this system unless the corporatetax is refunded to them by a specialdispensation.Another drawback of the exemptionmethod is that it does not integrate personaland corporate income taxes on capital gains.If the capital gains arising from reinvestedprofits of a company are to be exempted,in computing the gains on the sale or transferof the equities their cost basis would needto be raised to the extent they reflect thecorporation’s undistributed profits aftertax. Only the gains in excess of theenhanced cost should be subjected to tax.This was also recommended by the CarterCommission and seems to be on the agendaof the Bush administration.For a proper integration of personal andcorporate taxation, exemption of dividendsshould be permissible only when the dis-tribution is made out of taxed profits. Atax on dividend distribution as is nowapplied in India would seem to meet thisrequirement. But levied as it is at a flat ratethe DDT does not serve the purpose ofintegration. For taxpayers in the lowerincome brackets it imposes an extraburdenwhile for those in top brackets the systemfalls short of appropriate integration.Reviewing the three models of integra-tion, Mintz concludes: “The dividendexemption approach provides shareholderrelief on the simplest basis although it failsto achieve integration for all taxpayersfacing different tax rates. Further, similarto the credit method, if the exemption isprovided for only dividends received fromresident-based companies, the effect is toimpose a barrier to cross-border capitalflows” [Mintz op cit]. This lastobservationof Mintz brings to the fore another dimen-sion to the issue of relieving double taxa-tion of corporate incomes when dividendsare also taxed in the hands of recipients,viz, the impact on international capitalflows, an issue that is looming large in afast globalising world and has been instru-mental in inducing thinking about ways toharmonise capital income taxation in theEuropean Union [vide Cnossen (ed) 2000].Dividend Taxation Reforms in USAsbriefly mentioned earlier in a majorinitiative to reform the system of dividendtaxation the US Congress enacted a law,the Job Growth and Tax Relief Act(JGTRA) in 2003. Notwithstanding themisgivings of economists about the distor-tions and inequities created by taxation ofdividends in the hands of shareholders theUS had followed the classical system sincelong. No serious attempt was made tointegrate corporate and personal incometaxation. Dividends even when distributedout of taxed profits of a company weretaxed like other incomes in the handsofshareholders. Under the new law,dividends are still taxed as the income ofindividualshareholders but at a maximummarginalrate of 15 per cent as against thenormal maximum rate of 30 per cent. TheAct however retains a unique feature ofthe US dividend taxation system, viz,taxation of intercorporate dividends.4Howhas the change impacted on corporationsparticularly their cost of finance and fi-nancing decisions for new investments?And if there be any validity in the doubletaxation argument, why not eliminate thetax on dividends altogether?Going by the theory of dividend taxa-tion, there are three possible scenarios forthe effects of a dividend tax cut to workout. There is first “the tax irrelevancetheory” that says that the “marginal share-holder is a tax free entity or one whoignores or can offset incremental taxes andthe dividend tax reduction has no effecton equity values or firm behaviour”. The“traditional view” on the other hand holdsthat new share issues provide the marginalsource of equity finance and the tax cutworks through the firm’s user cost of capitaland thereby stimulates capital formation.Share prices rise in the short run buteventually come down as the marginalrevenue product of capital declines witha higher level of capital, offsetting thedividend tax reduction. Yet another view– the “new view” – holds that retainedearnings constitute the marginal source offunds; the dividend tax cut gets capitalisedin the firm’s share price leaving no invest-ment effect [Auerbach and Hassett 2006].An “event-study analysis” of the impactof eight event dates leading up to the 2003legislation based on data drawn from alarge panel of firms went against the taxirrelevance view and tended to confirm thenew view for firms that paid dividends.The study, however, felt that additionaltheory was needed particularly to explainthe behaviour of firms that do not paydividends [Auerbach and Hassett 2005].While the findings reject the tax irrel-evance view whether the tax cuts led toa stronger investment responses amongfirms that were more likely to have expe-rienced a reduction in their cost of capitalis not clear.If prima facie tax reduction had stimu-lated investment among a large section offirms then one might ask why not do awaywith dividend taxation altogether? A strongdefence of what the new law has done, viz,reducing but not totally abolishing thedividend tax has been put forward in a wellreasoned article by Randall Morck andBernard Yeung (2005). This (the 2003Act), they argue, “by substantially reduc-ing double taxation of dividends but not
Economic and Political WeeklyApril 7, 20071266eliminating such taxation , strikes a usefulbalance between competing objectives”.The main strands of their argument are asfollows.While there has been some scepticismas to whether dividend tax cut induceslarger distribution of corporate profitsseveral studies report large and significantdividend increases following the 2003 re-forms. This is to be welcomed not onlybecause its corrective effect on the distor-tions stemming from double taxation ofcorporate incomes but also because of itshealthy influence on corporate governance.Noting that dividends serve to signal thehealth of a corporation and thus enable itto raise funds from the market and not relyonly on “free cash flow”, the authors goon to argue that the governance angleprovides a strong case for the kind ofreforms made by the 2003 Act.While welcoming the reduction of thedividend tax, the authors advance tworeasons for supporting the retention ofsome tax on dividends. One, continuingwith the tax on inter-corporate dividendsis wise; introduced in 1935 this has helpedto prevent “pyramiding” in the US corpo-rate structure unlike in other advancedcountries. Two, taxation of dividend in-come of individuals makes equities lessattractive to taxpaying individual investorsrelative to tax exempt institutional investorslike pension funds. Institutional investorscan undertake “the collective action”needed to keep corporate managers ontheir toes. Left to themselves, individualshareholders may not be in a position toexert the pressures on companies for goodgovernance that institutional investors can.In sum, the new law serves to mitigate theadverse effects of dividend taxation whilepreserving the link between dividends andcorporate governance. While the reformshave been by and large welcomed, they haveraised eyebrows about the likely impact oncross border capital flow by widening thegap between the tax regime of US andthose of other advanced countries.Indian ScenarioIntegration of personal and corporateand personal income taxation has notbeenunknown in India. In fact, the Indian IncomeTax Act 1922 provided for integration bygrossing up the dividend received by ashareholder by the tax paid by the com-pany before it was taxed in the hands ofthe recipient. This system was in operationfor over two decades but was given up in1959 as “grossing up” created problems.The effective rate of tax on companiestended to vary widely because of theintroduction of numerous concessions andrebates and assessments of shareholdersbecame problematic by being contingenton the information regarding the effectivetax rate on the profits out of which thedividend was distributed. Hence came theclassical system in the Indian corporatetax regime.However the possibility of doubletaxation bothered the policymakers all thetime. This was sought to be relieved byexempting dividend income of individualsand Hindu Undivided Families (HUFs)partially (under section 80L of the IncomeTax Act 1961). Inter-corporate dividendswere also partially exempted throughdeduction of a fraction of the dividendreceived by a company (60 per cent ingeneral ) from another company. Finallyin 1997 the present finance minister whoheaded the ministry at the time too ex-empted all dividends from taxation.5However this was coupled with the levyof a tax on distribution of dividend bycompanies at the rate of 10 per cent. Therate was raised to 20 per cent in 2000, butbrought down to 10 per cent in 2001 (“toprovide a boost to the capital market” itwas said). The year 2002 witnessed areversion to the system of taxation ofdividends at the shareholder level. In 2003this was reversed and the DDT was re-imposed at the rate of 12.5 per cent thistime. As noted at the outset, this year’sbudget has raised the DDT rate to 15 percent. Meanwhile in 2004 long-term capitalgains from listed equities were made taxfree and the same position continues. Whathas been the impact of these changes oncorporate financing and growth? Thatrequires a much more extensive studythancould be undertaken for this paper,though as may be seen the changes in theIndian dividend tax scenario in the last10years present almost a laboratory fortesting alternative hypotheses regardingcorporate and shareholder response totaxation.However a few observations maybe in order.– The Indian system of dividend exemp-tion achieves integration but at a huge costto equity, both vertical and horizontal, andalso to the exchequer. The tax on dividenddistribution seeks to mitigate the ill-effectsbut in a clumsy way. Clumsy, becausesince it is not a withholding tax to becredited to shareholders. In effect, the DDTtakes on the character of another imposton the corporate sector that discouragesdividend distribution. Assuming it falls onthe shareholders by reducing dividendpayout, all shareholders – no matter theirincome level – are treated equally,shareowners who belong to the no tax orlow tax category are penalised, while thosebelonging to the top brackets for whom themarginal rate is 30 per cent and more aretaxed lightly. Given that the pattern ofshareholding is highly skewed, the benefitof dividend exemption goes largely towealthy taxpayers. With appropriate inte-gration this cannot happen.– The double taxation argument in divi-dend taxation that is often advanced insupport of abolishing the tax on dividendsloses force in view of the fact that theeffective rate of tax suffered by companiesis much lower than the statutory rate.Reports appearing in the press from timeto time suggest that the effective rate isbelow 20 per cent as against a statutoryrate of 30 per cent or so. Many companiessuch as in the IT sector do not pay anycorporate tax at all. The dividends distri-buted out of their profits thus go untaxed,except for the DDT. By an amendmentmade in the Income Tax Act in 2005companies operating in the special eco-nomic zones will not be required to payany tax, not even the DDT.–While dividend distribution is subjectedto tax, in the absence of any tax on long-term capital gains on equities there is astrong incentive for retaining after taxprofits rather than distribution . This, asforcefully pointed out by Morck and YeungTable 2: Trends in Stock Prices,PE and Payout RatiosTrends inPE RatioPayout Ratio*DomesticGovern-PrivateIndicesmentSectorBSESectorSensex(Base:1978-79=100),Avg1993-941051.336.2116.626.51994-951537.341.2416.424.11995-961189.6199.9215.523.41996-971146.815.3414.328.71997-98381314.5017.328.41998-99329512.8624.627.61999-2000465919.7826.928.62000-01427023.8627.628.12001-02333216.552233.62002-03320614.5134.727.82003-04449216.032828.82004-05574116.5630.824.32005-06828016.98––* Dividend as percentage of profit-after tax of non-financial companies.Source: CMIE.
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