Abolition of DDT- Tale of its Impact on Corporate Governance

[By Rohit Maheshwary and Shrutika Lakhotia] The authors are students at School of Law, Christ (Deemed to be University), Bengaluru. Introduction The Finance Act, 2020 has brought in some relief for the companies by swapping the Dividend Distribution Tax (“DDT”) with the classical system of dividend taxation and thus functioning as a raindrop in the drought. The Finance Minister, Ms. Nirmala Sitharaman, has closed the doors of the DDT while paving a way out for tax liability on the shareholders, thus following the relics of 1997. This means that the company distributing dividends will be exempted from paying tax on it and the burden to discharge the liability has been shifted in the hands of shareholders receiving the dividend. Before the enactment of the Finance Act, 2020, the DDT was provided under section 115-O of the Income Tax Act, 1961 (“Act”). It states that the amount declared, distributed, or paid by the company by way of dividends will be subjected to additional income-tax at the rate of fifteen percent. The government’s approach to tax a non-income based transaction has attracted a lot of criticism by various stakeholders in the past.[i]The DDT caused an excessive tax burden on the companies distributing the dividend since the effective tax rate amounted to 48.5% (inclusive of the corporate tax rate at 25%). The DDT has been referred to as the epitome of “double taxation” as well as “surrogate tax”. To clear the air, the Apex Court in the case of Union of India & Ors. v. M/s. Tata Tea Co. Ltd. has upheld the constitutionality of section 115-O of Act. Raison D’être to Abolish DDT The rationale purported by the government to bring this change in the dividend tax policy is worth mentioning. The government decided to abolish the DDT for the benefit of the small retail investor who had to face the brunt of high tax in the form of DDT levied at the rate of 20.56% in comparison to the tax levied at the rate of 5% or 10% on the income of the shareholders falling in the lower tax bracket. Further, the move to abolish the DDT is intended to welcome investments from the foreign shareholders since, the denial of the tax credit paid in the form of the DDT caused excessive tax burden on the foreign investors. This decision to abolish the DDT impacts, various stakeholders, in different ways. However, the present article analyses the impact of DDT abolishment on one of the most crucial aspects of company law jurisprudence- “Corporate Governance.” In 1994, the King Commission portrayed Corporate Governance minimally as “the system by which companies are directed and controlled.” Impact on Indian Corporate Governance Any corporate structure possesses a unique characteristic of separation between ownership and management. This structure efficiently functions on the well-established premise that the management works for the best interest of the company and the shareholders. However, this is not always true because sometimes the managers may prove to act otherwise and prioritize their self-interest. Having said this, it is pertinent to refer to the “Free Cash Flow Theory” as suggested by Jensen in 1986.[ii] The study conducted by Jensen in 1986 reveals that the companies having excess cash under the opportunistic management’s hand will invest in unprofitable projects. This tends to burden the shareholders with the cost and reduces the firm’s value.[iii] The presence of the “corporate insiders” in a company deepens the hole and aggravates this problem. Corporate insiders are the persons who tend to dominate the affairs of the company because they hold detailed knowledge of the working of the company.[iv] In practical terms, a corporate insider uses the excess cash for satisfying their personal needs and political agendas instead of investing in profitable projects.[v] One such instance can be drawing huge remuneration from the company. This also undermines the duty of the managers to act faithfully towards the owners of the company. Therefore, when the management or the corporate insiders do not offer to distribute the profits of the company in the form of dividends or otherwise amongst the shareholders, it results in the reduction of the rate of return on equity capital and decreasing the value of the firm. In the erstwhile DDT regime, the managers could escape from their actions of not distributing surplus cash to the investors by shifting the blame on the excessive tax burden on the company when a dividend is paid to its shareholders. This practice gives the managers an “excuse” to use the retained earnings for their benefits and thereby sabotaged the shareholders’ interest. With the abolition of the DDT, the seesaw of conflicting interests between the managers and the shareholders would balance out. One may examine the standards of corporate governance through the lens of dividends distributed by the company. The Jobs And Growth Tax Relief Reconciliation Act, 2003 This link between the dividend distributed and the corporate governance standards can also be witnessed by looking at America’s dividend tax policy of 2003. Unlike India, America always followed the classical system of dividend tax. However, the corporate behaviour in America changed with the enactment of The Jobs and Growth Tax Relief Reconciliation Act (“Tax Reform”), 2003. Before the enactment of the Tax Reforms, the dividend tax in the hands of the shareholders receiving dividends was levied at the rate of 35 percent whereas the Tax Reform provided huge relief for the shareholders by levying tax at the rate of 15 percent. One of the main considerations for the enactment of the Tax Reform was to enhance the corporate governance practice in the company.[vi] The Joint Economic Committee (2003) also supported the outlook that the reduced tax rate would result in good corporate governance since the distribution of dividends would attract a healthy appetite for investment in the company. Moreover, this would provide shareholders with a greater degree of control over the company’s resources. Another key aspect of the enactment of the Tax Reform was the increased dividend payouts by the company.[vii] Hence, the

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