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Dividend tax must go

T. C. A. Ramanujam on why the coming Budget should remove or reduce tax on distributed profits

EQUITY and tax laws do not always go together. To add to this, Finance Ministers have often assumed that common sense is irrelevant to the administration and enforcement of tax laws. They have an array of advisors who bring out voluminous reports on what to tax and when, whom to encourage and how, and how to discourage and squeeze. The sum total of such advice appears in the form of the Budget speech.

Despite the clamour to discuss in advance the proposal contained in the Budget speech, no Finance Minister has ventured to do so. In respect of indirect taxes -- Customs and excise duties -- the element of secrecy may be warranted, as these take effect o n announcement. But as far as direct taxes go, the changes become effective only from April 1 or such other appointed date. Quite often, the announcements made in the Budget speech take the public unawares. There was a time when annual Budgets were looke d upon with trepidation. But in the past 10 years or so, Finance Ministers have attempted to present friendly Budgets, and credit must go to them for bringing down the direct tax rates substantially. Yet, it must be noted that Mr Yashwant Sinha was able to mobilise maximum tax revenues.

Corporate houses were overjoyed when Mr P. Chidambaram abolished the tax on dividends. Dividend taxation has been plaguing economies the world over. The fact that the joint-stock corporation is interposed cannot obliterate the unquestionable injustice in volved in the double taxation of corporate profits -- first in the hands of the company and then in the hands of the shareholder. The US chose to stick to this model of double taxation. In the UK, the imputation system is followed and dividends have to b e grossed up. This system was in vogue in India too till 1960. But the grossing-up principle was given up from 1960 onwards and the American model, imposing tax on both corporate houses and shareholders, was adopted.

The way business was organised had an impact on the level of taxation. Proprietary business, the partnership firm and the joint-stock corporation were dealt with separately by the tax code resulting in discrimination. The partnership firm was subjected t o tax on its profits and the partner was also taxed on his share of profits. This anachronism underwent a radical change in 1992 and the tax levy was confined to the profits of the partnership. The partner was left alone. Then came the clamour for a simi lar treatment for the shareholder.

Mr. Chidambaram saw some logic in the argument about double taxation of dividends. He, therefore, abolished the tax on dividends in the hands of shareholders. But at the same time, he brought in a 10 per cent tax on the distributed profits of companies. This was a unique experiment unparalleled in the fiscal system of any country. Investors were happy at the change, though in the bargain such of those small investors who were enjoying the limited tax exemption for dividend under Section 80 L of the Inco me-Tax (I-T) Act, 1961 came to realise later that the 10 per cent tax had deprived them of a larger share in the profits. Yet, the very thought that dividends are exempt and there was no need to fill up exemption application forms led to what the current Finance Minister is fond of referring to as ``the feel good factor''. The stock market reacted favourably to the change in the system of dividend taxation and companies were prepared to absorb the levy.

When the system was getting stabilised, Mr Sinha chose to listen to some faulty advice. He was told that interest income, compared to dividend income, was treated adversely in the tax code. Any person earning interest income is taxed at the rate applicab le to his total income, whereas a shareholder earning dividend goes scot-free. In fact, this line of thinking is wrong even conceptually. There can be no comparison between dividend income from a company and interest income from deposits in companies. In terest paid on deposits represents deductible tax expenditure and does not suffer tax in the hands of the company. This is not so of dividends, which are paid on profits that have already suffered tax. It was to avoid taxing twice the same amount in the hands of the shareholder that Section 10(33) was introduced in the Act.

Yet, in the last Budget, Mr Sinha chose to double the tax on distributed dividends from 10 per cent to 20 per cent on the specious plea that there should be parity in the tax treatment of income by way of dividend and income by way of interest. He made i t appear that the limiting of the tax to 20 per cent was itself a concession and it can even go up to 30 per cent. What a travesty of facts.

The stock market, which was booming in expectation of incentives for the capital market, suffered a jolt on February 28, 2000, with this announcement. The BSE Sensex, which was at an all-time high of 6150 on Valentine's day, fell sharply following the do ubling of tax on distributed dividends. The market has not recovered from the shock since. The imposition of the surcharge only added to the burden of corporate houses and reduced the distributable surplus for the shareholders. Companies made a beeline f or declaring and distributing dividends before June 1, 2000, the date from which the new levy become effective. It never occurred that there was a grievous inequity in the way the dividend tax operated.

Consider, for instance, the following: Company A receives dividends from Company B. The latter pays a 20 per cent tax on the profits distributed as dividends. Company A, after receiving the dividend from Company B, again distributes its profits as divide nd to its shareholders. Company A has to pay the 20 per cent tax. How did it not occur to the policy-makers that no fair juristic system would contemplate this sort of multiple taxation. One way out for the company could be to capitalise its profits and issue bonus shares.

Investors come to the capital market both for dividends and capital appreciation. The tax on distributed dividends has affected the sentiments of investors because, to the extent of that tax, the surplus available with the company is reduced. Initial pub lic offerings in the stock market have been reduced to nothing of late. The market itself has been in the throes of radical change, what with the provisions in the law enabling buyback of shares and the rules laid down by SEBI against insider trading.

There is yet another discrimination against the capital market, imposed by the tax code. Mutual funds have been recognised as reliable conduits for mobilising and channeling savings of investors into the capital market. They have their own stock market a nalysts whose wisdom can be tapped by individual investors who choose to invest their funds in the market through the medium of mutual funds. The mutual fund industry itself is in a nascent stage in India. Between debt oriented and equity oriented mutual funds, the tax code is biased towards the latter, giving it complete tax exemption. Debt-oriented funds have received a step-motherly treatment, bearing the brunt of the tax on distributed income.

Investors choose mutual funds only to avoid risk and get an assured return, which is possible only through the debt instrument. To satisfy the requirements of those investors who need a regular return, mutual funds invest in government bonds, resulting i n reduced monthly income for unit-holders. Also, the funds bore the burden of tax on the distributed income.

At a time when there is a crying need to develop the secondary market for debt instruments, this sort of tax discrimination against debt-oriented mutual funds means an almost exclusive dependence on long-term government bonds to the detriment of the bond s from the private sector. Only the Unit Trust of India has been able to survive and that too because the Government came to its rescue three years back with a massive infusion of over Rs 4,000 crore.

On the one hand, equity-oriented funds are exempted from the tax on distributed income but, on the other, the joint-stock companies on whom the mutual funds depend for earnings on their equities are saddled with a heavy burden of a 20 per cent tax on the distributed profits. The result has been that the mutual fund industry has practically collapsed in the past one year. Mr Sinha must own responsibility for this.

The Parthasarthy Shome Committee on Tax Policy and Tax Administrative Reforms appears to have recommended the abolition of the tax on distributed profits. This may not come through in Budget 2001. Given the choice, both corporate houses and small shareho lders may prefer to avail themselves of the benefits of Sections 80 M and 80 L which have been rendered infructous. The Government may argue that even a 10 per cent cut in the dividend tax rate will mean a revenue loss of Rs 1,500 crore. But there is exp ectation that though the dividend tax itself may not be abolished completely, the Finance Minister may at least bring it back to 10 per cent.

This move will provide a shot in the arm to the capital market. The Assocham has pointed out that this tax has severely affected capital-intensive infrastructure projects leading to closure and thus acting as a drag on the much-needed new investment in t he development of the country's infrastructure. Will Mr Sinha oblige?