Need for reform in direct tax provisions
A Standard Chartered report gives an insight into the key suggestions that the government could incorporate in the upcoming budget
In the current business environment, conglomerates are required to segregate various businesses in multiple subsidiaries which are controlled by various regulators such as the securities market regulator SEBI, the housing finance regulator NHB or the banking and payments authority RBI. Also, large companies which have business operations outside India, are expected to form separate companies for administrative and operational ease. This leads to multiple subsidiaries under a single holding company, like a Core Investment Company (CIC) or a similar holding company. The above organisational structure is required by regulation rather than by choice.
In this scheme of structure and given the above background, there is a need for reforms in some of the contentious direct taxes provisions like the dividend distribution tax payable under section 115-O and the disallowance of certain expenditure incurred in relation to tax exempt income under section 14A of the Income-Tax Act. There are certain critical issues in these areas that the finance minister can address in the forthcoming Union budget.
At present, companies pay taxes not only on their earnings but also on the dividend they pay to shareholders in the form of Dividend Distribution Tax (DDT). The problem that we are faced with is that the profits and the accumulated reserves out of which dividend is being paid are already taxed.
Dividend is mere distribution of income amongst shareholders out of a company’s current or past post-tax earnings. Since these earnings are already taxed, there is no case for making it subject to tax again in the hands of the shareholders. Abolishing DDT would put an end to the prevalent double taxation and also remove the bias against distributed profits and help ensure that the shareholders get a fair return on their equity investments.
It would also encourage many companies to distribute higher dividend encouraging the retail equity cult. Foreign investors, who see DDT as a disincentive for investing in our equities, would be encouraged as well. In sum, not only would it correct an anomaly, but it would also go a long way in reviving the overall market sentiment.
There is one more issue under the DDT provision. DDT-borne dividends received by a holding company from its subsidiary are to be excluded while calculating the DDT liability of the holding company. The intention behind this taxation as it stands in the present form, is understood to remove the cascading effect of DDT in a multi-tier structure. However, there is one uncertainty about applicability of a proviso in section 115-O (1A), the literal interpretation of which restricts applicability of deduction of DDT-borne dividend to only one upper level entity in a multi-tier structure and does not apply to multi-levels within the same structure. To achieve the desired objective of removing the cascading effect of DDT and for the purpose of clarification, there is a need that the above-referred proviso is to be done away with.
Another critical issue is disallowance under section 14A of the expenditure incurred in relation to tax exempt income. As per Justice R.V. Easwar Committee Report, around 15 per cent of tax litigations are attributed to determination of expenditure relating to exempt income. One common ground is attributing expenditure towards dividend income. As dividend declared by a company is exempt from taxation in the hands of shareholders, tax authorities frivolously resort to disallowance by apportioning part of expenditure towards earning of dividend income without appreciating the fact that effectively dividend income is already taxed in the hands of the company by way of DDT.
The so called disallowance of expenditure by apportioning it to dividend is unwarranted. In this backdrop, there is a need to exclude expenditure incurred in relation to dividend income from the purview of section 14A of the Act as well.
Alternatively, taking a cue from the CBDT circulars issued from time to time restricting the department from filing appeals up to prescribed monetary limits, suitable amendments can be made in the Act prescribing monetary limits of either exempt income earned or the expenditure incurred up to which the disallowances cannot be made by the tax department.
The above two measures can reduce substantial chunk of litigations and save the administrative time spent for both the industry as well as department and also free up valuable time of judiciary which can be devoted in other complex and vexed issues.

(The author is Group CFO, JM Financial)