Much has already been said about Budget 2020, which has had mixed reactions from experts as well as the financial markets. After crashing more than 1.5% on Budget Day, the markets have since gained as much as 5% in the two weeks since.
From the perspective of the stock markets, the alternative simple income-tax structure, continuance of LTCG, and the potential listing of LIC were the main talking points. Compared to these, the removal of Dividend Distribution Tax (DDT) & its impact went relatively less discussed. But this change can actually have significant impact on your dividend income from the new financial year – so let’s see what has happened & how it impacts you.
Under the new regime starting 1st April 2020, companies that provide dividends to shareholders won’t have to pay the associated Dividend Distribution Tax (DDT).
Instead, dividends will be taxed at the hands of the investor based on their income-tax bracket.
The Government promptly declared that this policy change will benefit all taxpayers, and there seemed to be a positive sentiment amongst most in general. This move will certainly benefit the companies that pay dividends – after all, they won’t have to pay the DDT.
But will this really benefit the end investors, who receive dividends, and who will now have to pay tax on it?
To some extent, this benefit will depend on the tax-bracket of the ultimate investor. Many argue that if you’re currently under the 20% tax-slab, then the abolition of DDT will benefit you, since the effective DDT would’ve been higher. But in reality, this move is more likely to harm most investors who receive dividend income.
This is primarily because abolition of DDT doesn’t mean the company passes on the saved taxes (i.e. more money) in the form of more dividends to shareholders.
Let’s see how & why.
1. No mandate to increase dividends
Even though companies have had to pay DDT for many years now, the dividend announced to shareholders/market has always been net of tax. Shareholders wouldn’t have ever known and/or cared about the tax paid by the company.
Now the company will be saving on these taxes when paying dividends – but they have no mandate to pass on this benefit to the shareholders. Moreover, listed companies tend to only increase dividends when they’re sure they can maintain it. That’s because the negative impact (i.e. stock price decrease) due to reduction in dividends is invariably more than the positive sentiment (i.e. stock price increase) when an increase in dividend is announced. Increasing dividends once, after all, sets expectations that it’ll continue.
Given that most investors are already used to the net-of-tax announced dividends, companies have little incentive, and no mandate, to pass on this benefit to their shareholders.
Now, if the company doesn’t increase dividends – or increases it by a marginal amount – then, this will prove to be costlier for most investors, even if they’re in the 5-10% tax-bracket. For example, let’s assume Company A announced & paid ₹10 in dividends last year. Most investors would expect the same dividend this year – and if the company pays out the same amount this year, then the end investor will now have a burden. Assuming they’re in the 20% bracket, they’d effectively now only get ₹8 and have to pay ₹2 in taxes.
So by how much should a company increase their dividends for you to effectively receive the same amount?
Continuing from the previous example, the company would have to increase the dividends by 25% to ₹12.5 for you to receive the same level of dividend income. Then, the gross dividend you receive is ₹12.5, the tax you pay will 20% of ₹12.5 = ₹2.5, and the net dividend income you finally have is still ₹10.
In case you’re in the 30% bracket, the dividend amount should increase by ₹10/(1-30%) = ₹14.29. Or a dividend increase of approx 43%.
Now, how likely do you think it is that firms will increase their dividend payouts by this much, especially when they’re not required to? Personally, I expect only a handful of companies of a few kind (discussed below) to do so. In the absence of that, it’s the end investor who will now bear the additional burden.
PS: To learn more about the signalling effects of dividends on the market, read this post I’d written earlier.
2. Promoters are in the highest tax-slab
Another reason why many companies may choose not to increase their dividends is because almost all company promoters fall under the highest 30% tax-bracket. Usually, promoters are not only amongst the largest shareholders of the firm, but also involved in the management/Board – thus deciding how much dividends to pay any year, if at all.
Now, most promoters are in the 30% tax slab – and assuming they earn more than ₹2 crores, they have to pay surcharge which makes their effective tax rate even higher at 39% or 42.74%. As such, they’d have maximum liability if they choose to use the firm’s excess capital to pay out dividends. Many would certainly prefer to avoid that personal tax burden by instead preferring to use these funds to grow the company instead, and thus earn capital gains as the company growth translates to increased stock price.
One argument here is that Public Sector Undertakings (PSUs) – like Indian Oil, ONGC, PNB, etc. – are likely to increase their dividends.
That’s because the largest shareholder of most PSUs is the Government – which doesn’t have to pay any tax.
I agree this will most likely happen. In fact, even MNCs which have parent companies as large shareholders in the Indian listings, are also likely to increase this assuming they’re subject to lower dividend taxes in their home country. A recent story in The Hind Business Line stated that “Of the 938 dividend payers last year, there were 58 PSUs and 108 companies were with MNCs or foreign parents. Despite their small numbers, these two sets of firms made up nearly 49% of the dividend pool.”
PS: The dividend pool refers to the total amount of dividends paid out.
As such, investors in PSUs are likely to be winners with this policy change & can also expect increase in dividend payouts since their largest shareholder is usually the Govt., which is likely to push them for this. Another winner is the debt mutual fund investor, since debt MFs were earlier subject to a very high DDT of 29.12%. But for shareholders of most domestic companies, this benefit is not likely to accrue. As discussed, most companies (and their management/promoters) aren’t required or incentivised to pass on this benefit to their shareholders.
Which is why if you’re the kind of investor who looks to earn additional dividend income, it’s a good idea to keep a track of whether your invested companies are passing on this benefit to you, or not. On that note, one of my favourite smallcases is the Dividend Aristocrats smallcase – which only invests in companies that have a history of consistently increasing dividends. Take a look, and see if it helps you with your investment objectives.
PS: DDT has also been removed from dividends given by Equity MFs – but if you’re such an investor, please remember that dividends distributed by equity MFs aren’t really “dividends”. Instead, they are more akin to systematic withdrawals of your own invested capital. Read Everything you need to know about Mutual Fund Dividends to learn more.
This article was also published on Moneycontrol.com on 2nd March 2020.