Why Budget 2020 may reduce your dividend income

New dividend regime

Under the new regime starting April 1, 2020, companies that provide dividends to shareholders won't have to pay the associated Dividend Distribution Tax (DDT). Instead, dividends will be taxed in the hands of investors 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 DDT.

But will this really benefit the end-investors, who receive dividends and will now have to pay tax on them?

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 per cent 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.

No mandate to increase dividends

Even though companies have had to pay DDT for many years now, the dividend announced to shareholders 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 them. That's because the negative impact (i.e., stock price decrease) due to a reduction in dividends is invariably more than the positive sentiment (i.e., stock price increase) when an increase in dividend is announced.

Given that most investors are already used to net-of-tax announced dividends, companies have little incentive, and no mandate, to pass on this benefit to their shareholders.

Now, if a company doesn't increase dividends – or increases it by a marginal amount – it will prove to be costlier for most investors, even if they're in the 5-10 per cent tax-bracket. For example, let's assume Company A announced and paid Rs 10 in dividends last year.

If the company pays out the same amount this year, the end-investors will now have a burden. Assuming they're in the 20 per cent bracket, they'd effectively only get Rs 8 now and have to pay Rs 2 in taxes.

So by how much should a company increase its dividends for them to effectively receive the same amount?

Continuing from the previous example, the company would have to increase dividends by 25 per cent to Rs 12.5 for you to receive the same level of dividend income. Then, the gross dividend you receive is Rs 12.5, the tax you pay will be 20 per cent of Rs 12.5, which is Rs 2.5, and the net dividend income you finally have is still Rs 10.

In case you're in the 30 per cent bracket, the dividend amount should increase to Rs 14.29. Or a dividend increase of approximately 43 per cent.

Will firms increase their dividend payouts by this much, especially when they're not required to? To put this in perspective, the average increase in dividends paid by Nifty-50 companies over the last five years has been 16.58 per cent.

Only a handful of companies may increase dividends by an amount greater than the resulting tax burden for most shareholders.

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 in the highest 30 per cent tax-bracket. Usually, promoters are not only amongst the largest shareholders of the firm, but are also involved in the management/Board, thus deciding how much dividends to pay during any year, if at all.

Assuming that promoters earn more than Rs 2 crores, they have to pay a surcharge that makes their effective tax rate even higher at 39 per cent or 42.74 per cent. 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 using these funds to grow the company instead, and thus earn capital gains as the company growth translates to increased stock price.

One opposing view here is that Public Sector Undertakings (PSUs) such as Indian Oil, ONGC and PNB 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 that have parent companies as large shareholders in the Indian listings, are also likely to hike payouts assuming they're subject to lower dividend taxes in their home countries.

Of the 1800-odd companies listed on the NSE, only 938 paid dividends last year, amounting to a total of about Rs 2 lakh crores. Of these dividend-paying companies, PSUs (58) and MNCs (108) comprised less than 18 per cent. Yet, these two groups still made up nearly 49 per cent (approximately Rs 1 lakh crore) of the total dividend pool.

Conclusion

As such, investors in PSUs are likely to be winners with this policy change and can also expect increase in dividend payouts since their largest shareholder is usually the Government, 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 per cent. But for shareholders of most domestic companies, this benefit is not likely to accrue since the 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 track of whether the companies you have invested in are passing on this benefit to you or not.

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." They are akin to systematic withdrawals of your own invested capital.

(The writer is AVP at smallcase Technologies Pvt. Ltd.)