The case against double taxation

There have been a few articles in Business Line, criticising the exemption for dividend income, calling for the taxation of dividends in the hands of shareholders, and, in effect, justifying the double taxation of dividends. Clearly, the counterview, i.e., the case against double taxation, needs to be put forth.

TWO-STAGE TAXATION

At present, companies pay tax at two stages: an income-tax when they earn profits, and a dividend distribution tax when they pay dividends. The dividend distribution tax replaced an earlier system, where dividends were taxed in the hands of shareholders.

Individuals may earn income through agents, partnerships, trusts or companies. In each of these cases, the agent, firm, trustee or company earns income for the ultimate benefit of the individuals concerned, and distributes it to them. In substance, there is no difference between a distribution made by a company, and that made by an agent, trustee or firm. Except in the case of companies, income-tax is levied at only one stage.

A system of double taxation of corporate profits creates distortions by materially altering the rewards from investment, as the final recipient of the income receives a lower amount than he would otherwise have received. The corporate form becomes relatively less attractive on account of double taxation. In law, a company and its members are different legal persons, but the economic reality is that a company is actually an association of persons, earning income for those persons, just as a partnership firm earns profits for its partners.

If the tax laws treat a company and its shareholders as two independent persons, it should logically follow that a company should be allowed a deduction for the dividends it pays to its shareholders. As between two different persons, dividends are a price for capital provided, just as interest is the price for moneys lent.

NATURE OF DIVIDENDS

The law, however, recognises that a dividend is a share in the profits of a company. The very word ‘dividend' refers to the dividing of a company's profits among its shareholders.

A shareholder “participates” in the profits of the company, and the dividend he receives is a share of those profits. The profits distributed are the same as the profits earned by the company. While the law does see a company as a separate person from its members, it clearly sees a dividend as a sharing of the same profits.

There is clearly double taxation of the same income, once when the profits are earned, and again when they are divided; and it cannot be said that this position is justified by the general law. The system of taxing corporate income therefore needs to be looked at afresh, so as to eliminate double taxation.

Earlier, India levied two separate taxes on both corporate and individual income: super-tax and income-tax. The super-tax originally eliminated double taxation by excluding dividends from the income of the company, in effect treating dividends as a price for capital provided.

REASONS FOR DOUBLE TAXATION

In the context of super-tax, double taxation was introduced to provide the Union with a separate revenue stream which was not divisible with the States. Under the Constitution, until 2000, taxes levied on the income of companies were not divisible with the States if no credit was given to the shareholders for the tax, i.e., where there was double taxation. This reason does not survive, since such a tax is now divisible with the States.

In the context of income-tax, double taxation was introduced on the grounds of simplicity and ease of administration. However, simplicity and administrative ease could have been achieved without introducing double taxation.

Double taxation of companies was also justified on account of the ‘benefit' of limited liability, but the benefit of limited liability to the members of a company usually creates a compensating disability for the creditors. Logically, then, any additional tax levied on account of double taxation should be shared out with the creditors. Hence, there is no justification for the double taxation of corporate income.

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