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December 2012

GAP in GAAP Accounting for Dividend Distribution Tax

By Dolphy D’Souza
Chartered Accountant
Reading Time 10 mins
Introduction to Dividend Distribution Tax (DDT)

Prior to 1st June 1997, companies used to pay dividend to their shareholders after withholding tax at prescribed rates. This was the “classic” withholding tax where shareholders were required to include dividend received as part of their income. They were allowed to use tax withheld by the company against tax payable on their own income. Collection of tax from individual shareholders in this manner was cumbersome and involved a lot of paper work. In case of levy of tax on individual shareholders, tax rate varied depending on class of shareholders. For example, corporate shareholders and shareholders in high income group paid tax at a higher rate, whereas shareholders in low income group paid tax at a lower rate or did not pay any tax at all. Also, certain shareholders may not comply with tax law in spirit, resulting in a loss of revenue to the government.

The government realised that it may be easier and faster to collect tax at a single point, i.e. from the company. It, therefore, introduced the concept of Dividend Distribution Tax (DDT). Under DDT, each company distributing dividend is required to pay DDT at the stated rate (currently 15% basic) to the government. Consequently, dividend income has been made tax free in the hands of the shareholders.

DDT paid by the company in this manner, is treated as the final payment of tax in respect of dividend and no further credit, therefore, can be claimed either by the company or by the recipient of the dividend. However, DDT is not required to be paid by the ultimate parent on distribution of profits arising from dividend income earned by it from its subsidiaries (section 115-O). Such exemption is not available for dividend income earned from investment in associates/joint ventures or other companies. Also, no exemption is available to a parent which is a subsidiary of another company.

DDT is applicable irrespective of whether dividend is paid out of retained earnings or from current income. DDT is payable even if no income-tax is payable on the total income; for example, a company that is exempt from tax in respect of its entire income still has to pay DDT, or a company pays DDT even if distribution was out of capital; though those instances may be rare.

Accounting for DDT under Indian GAAP in standalone financial statements

The accounting for DDT under Indian GAAP is prescribed by the “Guidance Note on Accounting for Corporate Dividend Tax”. As per this Guidance Note, DDT is presented separately in the P&L, below the line. This guidance was provided prior to revised Schedule VI. Under revised Schedule VI, DDT is adjusted directly in Reserves & Surplus, under the caption P&L Surplus. The guidance note justifies the presentation of DDT below the line as follows – “The liability in respect of DDT arises only if the profits are distributed as dividends, whereas the normal income-tax liability arises on the earnings of the taxable profits. Since DDT liability relates to distribution of profits as dividends which are disclosed below the line, it is appropriate that the liability in respect of DDT should also be disclosed below the line as a separate item. It is felt that such a disclosure would give a proper picture regarding payments involved with reference to dividends.”

Accounting for DDT under IFRS in stand alone financial statements

It is highly debatable under IFRS, whether DDT in the standalone financial statements is a below the line or above the line adjustment. In other words, is DDT an income tax charge to be debited to P&L or is it a transaction cost of distributing dividend to shareholders, and hence, is a P&L appropriation or Reserves & Surplus adjustment.

The argument supporting a P&L charge under IFRS is as follows:

1 Paragraph 52A and 52B of IAS 12 Income Taxes clearly treats DDT as an additional income tax to be charged to the P&L A/c.

52A – In some jurisdictions, income taxes are payable at a higher or lower rate, if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In some other jurisdictions, income taxes may be refundable or payable if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In these circumstances, current and deferred tax assets and liabilities are measured at the tax rate applicable to undistributed profits.

52B – In the circumstances described in paragraph 52A, the income tax consequences of dividends are recognised when a liability to pay the dividend is recognised. The income tax consequences of dividends are more directly linked to past transactions or events than to distributions to owners. Therefore, the income tax consequences of dividends are recognised in profit or loss for the period as required by paragraph 58, except to the extent that the income tax consequences of dividends arise from the circumstances described in paragraph 58(a) and (b).

2 Paragraph 65A of IAS 12 states as follows – “When an entity pays dividends to its shareholders, it may be required to pay a portion of the dividends to taxation authorities on behalf of shareholders. In many jurisdictions, this amount is referred to as a withholding tax. Such an amount paid or payable to taxation authorities is charged to equity as a part of the dividends.” Some may argue that DDT is not paid on behalf of the shareholders, because they do not get any credit for it. The shareholders do not get the credit for the tax paid by the entity on dividend distribution. The obligation to pay tax is on the entity and not on the recipient. Further, there is no principalagency relationship between the paying entity and the recipient. In other words, the tax is on the entity and on the profits made by the entity.

The arguments supporting a below the line adjustment (also referred to as equity or P&L appropriation adjustment) are as follows:

1 IFRIC at its May 2009 meeting, considered an issue relating to classification of tonnage taxes. The IFRIC was of the view that IAS 12 applies to income taxes, which are defined as taxes based on taxable profit. Taking a cue from the IFRIC conclusion, it can be argued that DDT is not an income tax scoped in IAS 12. Firstly, a company may not have taxable profit or it may have incurred tax losses. If such a company declares dividend, it needs to pay DDT on dividend declared. This indicates DDT has nothing to do with the existence of taxable profits. Secondly, DDT was introduced in India, without a corresponding reduction in the applicable corporate tax rate. Thus, DDT has no interaction with other tax affairs of the company. Lastly, the government’s objective for introduction of DDT was not to levy differential tax on profits distributed by a company. Rather, its intention is to make tax collection process on dividends more efficient. DDT is payable only if dividends are distributed to shareholders and its introduction was coupled with abolition of tax payable on dividend. Thus, DDT is not in the nature of an income tax expense under IAS 12.

2 As per The Conceptual Framework for Financial Reporting, “expenses” do not include decreases in equity relating to distributions to equity participants. DDT liability arises only on distribution of dividend to shareholders. Thus it is in the nature of transaction cost directly related to transactions with shareholders in their capacity as shareholders and should be charged directly to equity.

3    Support for treating DDT as an equity adjustment can also be found in paragraph 109 of IAS 1 reproduced here – “Changes in an entity’s equity between the beginning and the end of the reporting period reflect the increase or decrease in its net assets during the period. Except for changes resulting from transactions with owners in their capacity as owners (such as equity contributions, reacquisitions of the entity’s own equity instruments and dividends) and transaction costs directly related to such transactions, the overall change in equity during a period represents the total amount of income and expense, including gains and losses, generated by the entity’s activities during that period.”

4    Support for treating DDT as an equity adjustment can also be found in paragraph 35 of IAS 32 reproduced here – “Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability, shall be recognised as income or expense in profit or loss. Distributions to holders of an equity instrument shall be debited by the entity directly to equity, net of any related income tax benefit. Transaction costs of an equity transaction shall be accounted for as a deduction from equity, net of any related income tax benefit.” It may be noted that this paragraph has now been amended to remove the reference to income-tax; and consequently to bring income-tax purely in the scope of IAS 12 only.

Although DDT is paid by the company, the economic substance is similar to the company withholding the tax and paying it on behalf of the shareholders. The shareholder has the entire dividend income exempt from tax, to reduce the administrative effort to track the flow from the company to the shareholder. In other words, DDT in substance is a type of with-holding tax borne by the shareholder that should be accounted as a deduction from equity.

Almost all companies in India that prepare IFRS financial statements treat DDT as an equity adjustment rather than as an income-tax charge.

Accounting for DDT in the consolidated financial statements (CFS) under IFRS & Indian GAAP

There is an interesting but very significant difference when it comes to presentation of DDT at the CFS level under IFRS. Consider an example, where a group comprises of a parent, a 100% subsidiary and the parents investment in a joint venture. The joint venture pays dividend to the parent and the corresponding DDT is paid to the government.

In the CFS, the group would account for its proportionate share of the DDT (paid by the joint venture) as an income -tax charge in the P&L account (and not as a P&L appropriation or equity adjustment). The reason for this treatment is that it is a cost of moving cash from one entity to another in a group. In the standalone accounts of the joint venture, when the dividends are paid to the ultimate shareholder (the parent company in this case) from the perspective of the joint venture, the DDT is reflected as an equity adjustment, and one of the arguments for doing so was that in substance, it is tax paid on behalf of shareholders. In the CFS, even if the DDT paid by the joint venture was on behalf of the parent, the parent does not get any tax credit for the same. In other words, at the group (CFS) level, there is ultimately a tax outflow, for which no tax credit is available. Hence, the same is charged to the P&L account as an income tax charge. In India, almost all companies preparing IFRS CFS, adopt this approach. However, strangely, this approach is not followed by most companies in the CFS prepared under Indian GAAP. This is perhaps done erroneously and due to lack of understanding of the standards, which needs to be rectified by appropriate intervention from the Institute of Chartered Accountants of India.

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