The authors are students at School of Law, Christ (Deemed to be University), Bengaluru.
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 shift in tax policy- induced the managers to pay higher dividends and therefore bridging the rift between shareholder’s and managements’ interests.
Impact of COVID-19
At this juncture, an important question arises- if this is always the case? If it is always right for a person to assume that the company has a good corporate governance mechanism if the dividend is distributed? The answer is in ‘negative’. Undoubtedly, there are other factors on which fate of corporate governance depends but even with the dividend distribution factor, there is an exception.
This exception is categorized under the head “unforeseen event or happening” such as sudden economic crisis, abrupt negative circumstances, etc. For example, the ongoing lockdown in the country and around the globe due to the pandemic (COVID-19) has left everything at a standstill. In such circumstances, a company which proposed to distribute dividend at an earlier stage would not be able to distribute them. Now, can it be concluded that the company does not have good corporate governance standards in place? After the outbreak of the novel COVID-19, it will not be feasible for the companies to distribute their surplus profits. The capital will be preserved by the company to absorb the losses incurred during the pandemic and thus creating a safety valve for the company.
The authors would like to highlight the state of affairs in the year 1974, wherein the legislature enacted The Companies (Temporary Restrictions on Dividends) Act to restrict certain companies to pay dividends in the interest of national economic development. The authors believe that this law might be re-enacted to fight the present situation. Recently, RBI Governor- Mr. Shaktikanta Das while addressing the press on April 17th, 2020 barred banks from paying out dividends to reserve capital.
Authors are of the view that dividend distribution can be considered as an apparent attribute to know the corporate governance principles of a company except in certain circumstances as mentioned above. To sum up, this relationship between dividends and corporate governance, authors would like to wrap up in the words of John D. Rockefeller- “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
[i] ShreyaRao, The Indian Equalisation Levy: Inelegant But Not Unexpected, 25 Nls Bus L. Rev. 25, 27 (2016).
[ii] Jensen, Michael C, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.”,76 American Eco Rev. 323-329 (1986).
[iv] UmakanthVarottil, A Cautionary Tale of the Transplant Effect in Indian Corporate Governance, 21 Nat’l L. Sch. India Rev. 1, 16 (2009).
[v] Randall Morck& Bernard Yeung, Dividend Taxation and Corporate Governance, 19 The Journal of Economic Perspective.163, 170 (2005).
[vi] Id at 178.