• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

T. C. A. Ramanujam

NO COUNTRY has debated the pros and cons of direct tax levies more intensively than the US. Steven R. Weisman has sketched the course of this debate over the past century and a half in his monumental work, The Great Tax Wars. In the US, there have always been two views on income-tax: Odious, vexatious, inquisitorial or unequal vis-à-vis all other taxes; or, alternatively, the most just and equitable. In his narrative on the history of income-tax in the US, Weisman records fierce battles over money and power that transformed the nation. Abraham Lincoln introduced federal income-tax to finance the Civil War. It was declared unconstitutional by the American Supreme Court in 1895. Theodore Roosvelt legitimised the levy through a Constitutional amendment in 1913. And today, fiscal policymakers are worried whether the tax cuts of the US President, Mr George W. Bush, will not shift the burden of paying for the anti-terror campaign to future generations.

In India, the tax reforms movement was ushered in by Dr Manmohan Singh in 1991. It embraced both direct and indirect taxes. Tariffs were scaled down to international levels and corporate and personal taxes made moderate. And in 1996 came the most sweeping change: Tax on dividends in the hands of shareholders was abolished and, instead, a 10 per cent tax was levied on companies on the distributed profits.

But the 2002 Budget has reverted to taxing dividends in the hands of shareholders. The Finance Minister, Mr Jaswant Singh, raised hopes of relief from dividend taxation soon after he took over. Task forces have been set up to identify areas of tax reform.

The equity issue

In their thesis `A Simple Solution to Stock Market Woes: Kill the Corporate Dividend Tax', three US-based finance Profs, Jeremy Sigel, Andrew Metrick and Pal Gompers, talk of corporate dividend tax as one of the most detrimental of taxes, and a reason for the decline in cash dividends over the past decade. This tax, according to them, was cause for the plummeting of stock markets. The Wall Street Journal (August 6, 2002) has suggested amendments to the Inland Revenue Code so as to make corporate dividends deductible in computing profits and for eliminating dividend tax at the personal level.

Whether one calls it interest or dividend, the fact remains that the payout by the corporation represents compensation for using investors' money. It can be argued that likes should be treated equally: Interest receipts are taxed as income and, therefore, it should follow that dividend receipts too are taxed at the personal level, with some consideration given to the risk undertaken. But what is the rationale for not deducting dividend payouts in computing the taxable profits of corporations? Just as interest payment on borrowed fund is deductible, should not dividend payout too be made deductible? Such a measure would lead to a transformation in corporate financial policy.

It will reduce the dependence on borrowed funds, which often pushes a company into bankruptcy. Companies will be encouraged to pay out as much of their earnings as dividends, because retained earning would be taxable. There will be no temptation to divert money to tax havens and offshore entities to gain tax advantage. Companies will not indulge in covering up their income as foreign earned or coming from Mauritius.

Till recently, Indian laws taxed undistributed profits; this was to discourage the formation of corporations for avoiding income-tax on the shareholder. The US even now levies a special tax on corporations that accumulate (rather than distribute as dividends) their earnings beyond the reasonable needs of their business. The accumulated earnings tax is imposed on accumulated taxable income, which is in addition to corporate income-tax.

There can be arguments against making dividend payouts deductible. There may be investors who do not like to receive taxable dividends. But such shareholders can opt for investing the dividends in reinvestment plans. Newly set up units may object on the ground that if they declare their entire earnings as dividends, they will be left with no retained earnings to invest in business. It should, however, be pointed out that such newly established companies do not make profits in the initial years. At any rate, they can pay out and again borrow from their shareholders and the market.

While these may make for equity, shareholders may prefer to get tax-free dividends. It has never been the case that dividends should go completely tax free, either in the hands of the company or the stakeholders. Small shareholder can always file declarations about their incomes and get the dividends without tax deduction at source.

US-based companies are experimenting with various types of dividends — such as, asset or property dividend (a portion of corporate property is paid to the shareholders instead of cash or stock), bond dividend (similar to what Hindustan Lever proposed last year), consent/constructive dividend, and so on.

One can rely on India's corporate houses to come up with novel and original ideas to please the shareholders once profits distributed as dividends are treated on a par with borrowed funds and made tax deductible. Such a measure will shake-up the stock market and stocks will start quoting based on the expected dividend payout rather than earnings per share. There will be no need for companies to window-dress their accounts. Even in the US, the payout ratio in respect of dividend to shareholders has fallen steeply from 55 per cent to 35 per cent in the past 30 years. Dividends lost their sheen and gave place to stock options, bonus shares and share buybacks. But making dividends deductible in computing taxable profits will radically alter the economic perspective of companies and restore equity in tax treatment. After all, the way a business is organised and the form in which it is funded should not result in different tax treatments.

The Centre may also gain by way of enhanced dividends from profit-making public sector undertakings and higher tax yields from individual shareholders receiving larger dividends.

The country has experimented with different types of corporate tax plans vis-à-vis dividend payouts. There was a time when dividends were grossed as in the UK. And till last year, there was a tax on corporate profits distributed as dividends, with exemption in the hands of shareholders. Now, it would be worthwhile to make dividend payouts tax deductible. This will make both borrowed funds and equity capital tax neutral.

Send this article to Friends by E-Mail
Comment on this article to BLFeedback@thehindu.co.in

Stories in this Section
Can PM walk the talk?

Copyright © 2002, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line