It is important to understand how the dividend income arising from equities and mutual funds influences one’s income tax return. While dividends are a type of income, they are taxed in a unique manner that requires the taxpayers to familiarise themselves with the laws governing income tax. This knowledge not only helps to avoid violation of tax laws but also helps to minimise tax burden, which in turn improves the overall return on investment.
This article explains the taxation of dividend income and provides practical approaches to reducing the effects of taxation on such revenues.
Basics of Dividend Income and Its Taxation
Sources and Definition
A dividend typically represents a portion of profits that a company distributes to its shareholders. Investors receive dividends if they have stakes in mutual funds, ULIPs, or stocks. Dividends can originate from various sources:
According to Section 2(22) of the Income Tax Act, dividends must include these distributions.
Changes in Tax Regulations
The dividends received by shareholders from domestic companies were exempt from tax under Section 10(34) of the Act, up to the Assessment Year 2020-21. This exemption was subject to Section 115BBDA, which taxed dividends exceeding Rs. 10 lakh. During this period, the domestic company paid a Dividend Distribution Tax (DDT) under Section 115O. However, the Finance Act of 2020 abolished DDT, transitioning to a system where dividends are taxed in the hands of the investors at applicable income tax slab rates.
Now, dividends are reported under the ‘Income from other sources’ in the Income Tax Return (ITR) form. Taxpayers can claim a deduction of up to 20% of the gross dividend income for interest expenses incurred to earn such income. Moreover, a TDS of 10% applies to dividend income exceeding Rs. 5,000 annually, which can be adjusted against the total tax liability during ITR filing. Dividends from foreign companies are taxed upon receipt at the investor’s applicable rate or a flat rate of 20%, and mutual funds deduct a Dividend Distribution Tax before distributing dividends to investors.
How to Calculate Your Dividend Tax
Calculating the tax on dividend income has become crucial since the abolition of the Dividend Distribution Tax (DDT) by the Finance Act, 2020. Dividends are now taxed in the hands of investors, and the calculation depends on whether the dividends are treated as business income or income from other sources.
Impact of Income Tax Slabs on Dividends
Dividend tax will be computed according to the slab rates of income tax that was set for the investor. However, if the investor possesses shares with an intention of investment and not to run a business, the dividend income is subjected to taxation under the head ‘Income from Other Sources’ under the Income Tax law. The shareholders who have investment in business pay taxes to the received dividend by recognizing them under the head ‘Business Income.’
TDS Applicability and Thresholds
As per Section 194 of the statute, Tax Deducted at Source (TDS) of 10% is applicable on dividend payments exceeding INR 5,000 in a financial year. This rate applies unless the shareholder provides specific forms (like Form 15G or 15H for those whose income is below the taxable limit) to reduce or eliminate the deduction. For non-resident shareholders, TDS is deducted at 20% under Section 195, subject to any benefits available under double taxation avoidance agreements (DTAA).
Investors must account for these deductions in their income tax returns, and any excess TDS can be claimed as a refund. It is important for investors to keep track of the dividend income and the TDS deducted to ensure accurate reporting and compliance with the tax regulations.
Effective Ways to Reduce Tax on Dividend Income
Claiming Interest Expense Deductions
Investors can mitigate their tax liability on dividend income by claiming deductions for interest expenses. The Finance Act, 2020 allows taxpayers to deduct up to 20% of their dividend income as interest expenses incurred to earn such income. For instance, if an investor receives Rs 10,000 as dividends and incurs Rs 2,500 in interest expenses from a loan taken to invest in shares, they are eligible to claim up to Rs 2,000 (20% of Rs 10,000) as a deduction.
Utilising Double Taxation Agreements
Double taxation on dividends can occur when the same income is taxed in two different countries. To prevent this, investors can benefit from double taxation avoidance agreements (DTAA). These treaties between two countries ensure that income taxed in the source country will either be exempt or taxed at a reduced rate in the resident country. For dividends from foreign companies, investors can claim relief either as per the DTAA or under Section 91 if no such agreement exists, ensuring they do not pay tax twice on the same income. Investors should submit necessary documents like Form 10F and certificate of tax residency to avail themselves of treaty benefits, thus reducing their overall tax burden.
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