Foundation — The residuary head and the taxation of dividend income

Every large railway station has four numbered counters where you claim specific things: tickets, reservations, parcels, catering complaints. And then there is a fifth room at the end of the platform marked LOST PROPERTY.

The first four heads of income are the numbered counters — salary, house property, business or profession, capital gains. Each takes only what belongs to it.

The lost property office takes everything else — but only on two conditions, and both matter.

First, the item must actually belong to someone. Rubbish is thrown away, not stored. Likewise the Act says "any income WHICH IS NOT EXEMPT FROM TAX" — exempt income never enters any head at all.

Second, it must not belong at one of the four counters. A ticket complaint goes to the ticket counter, not here.

But the lost property office at this station has one unusual rule: certain items are sent here ALWAYS, even if another counter could have taken them. Dividend, interest on investment securities, forfeited advance money, deemed income under section 56(2), and specified sums from a business trust — these come here by name, not by default.

That is why the Act says the head catches what fits nowhere else, "HOWEVER, there are certain incomes that are ALWAYS taxable under the head income from other sources." Two limbs, not one.

A promoter owns a private company in Surat. He knows a dividend will be taxed at his slab rate, so he devises alternatives.

"I will not declare a dividend. I will take a loan from my own company instead." — Section 2(22)(e): a loan or advance by a CLOSELY HELD company to its shareholder out of accumulated profits is a deemed dividend.

"Then I will have the company give me debentures instead of cash." — Clause (b): distribution of debentures, debenture-stock or deposit certificates out of accumulated profits is a deemed dividend.

"Then I will reduce the capital and take the money out that way." — Clause (d): distribution on reduction of capital out of accumulated profits.

"Then I will wind the company up and take the assets." — Clause (c): distribution on liquidation out of accumulated profits.

"Then I will have the company buy back my shares." — Clause (f), and from 1 October 2024 the proceeds are taxed as dividend in his hands.

Every door he tries has the same phrase written above it: ACCUMULATED PROFITS. The Act is not interested in the label on the transaction. If the company's accumulated profits are reaching the shareholder, it is a dividend, whatever it is called.

At a large wedding in Jaipur, the host used to pay a single lump sum to the caterer covering every guest's meal. Rich uncle or student nephew, the host paid the same amount per head, and no guest paid anything at the table.

That was Dividend Distribution Tax. The company paid, at a flat rate, and shareholders were exempt. A pensioner with Rs 2 lakh of income and a promoter in the top bracket bore exactly the same burden on the same dividend, because neither of them saw the bill.

From AY 2021-22 the arrangement changed. The host stopped paying; each guest now settles his own plate at his own rate. The workbook: after abolition of DDT by the Finance Act 2020, dividend is taxable in the hands of such shareholder or unit-holders under the head income from other sources and will be taxable AT APPLICABLE SLAB RATE OF THE SHAREHOLDER.

The consequence for advice is immediate and practical. The same dividend-paying share is now a better holding for a low-slab investor and a worse one for a high-slab investor than it was before. A retired client in the nil or 5 per cent slab may now keep almost the whole dividend; a client at 30 per cent keeps far less than he used to.

Nothing about the company changed. Only who pays the caterer.

Imagine selling a second-hand car for Rs 10 lakh that you bought for Rs 4 lakh. You would naturally expect to be taxed on the Rs 6 lakh profit.

Now imagine a rule that says: you are taxed on the full Rs 10 lakh as income, and your Rs 4 lakh cost is handed to you on a separate slip which you may use only against future car sales.

That is precisely what happens to buy back proceeds from 1 October 2024. The workbook: buy back proceeds received by shareholder shall be taxed as DIVIDEND under the head income from other sources. NO DEDUCTION FOR EXPENSES shall be available. And: the COST OF ACQUISITION of shares which are bought back will be treated as a CAPITAL LOSS in the hands of the shareholder and will be eligible for set-off as per the applicable provisions.

One transaction, split across two heads — the money taxed under other sources, the cost parked under capital gains.

And the slip may go unused. A capital loss can only meet a capital gain; it cannot touch the dividend it arose from, nor salary, nor anything else. A shareholder can pay tax on Rs 10 lakh at 30 per cent while holding a Rs 4 lakh loss he has no gains to absorb.

This is why the adviser's conversation must happen before the client tenders shares into a buy back, not after.

Three people in Kochi each hold an identical corporate debenture of the same company, same face value, same coupon.

The retired teacher holds it as an investment. Her interest is INCOME FROM OTHER SOURCES — the workbook says interest income from securities HELD AS AN INVESTMENT is always taxed here.

The bond dealer holds an identical debenture as stock-in-trade for resale. His interest and his profit are both BUSINESS INCOME, because the footnote to the computation table says interest on securities falls under other sources only if such income is NOT chargeable under the head profits and gains of business or profession.

And the teacher again, when she eventually sells the debenture rather than holding it to maturity, moves to a third head: if securities are held as an INVESTMENT, any profit arising from the sale of such securities is chargeable under the head CAPITAL GAINS.

So one instrument, and three possible heads depending on who holds it and why — and for the teacher, two heads from the same holding: interest under other sources, profit on sale under capital gains.

The Act never asks what the instrument is called. It asks in what capacity you hold it.

A milkman in Pune keeps his accounts one of two ways, and he must choose one and stick to it.

The mercantile ledger: he writes down each delivery on the day he delivers it, whether or not the customer has paid. At the end of March, his books show every litre supplied that year, including March's unpaid bills. Income on ACCRUAL.

The cash ledger: he writes down only what actually reaches his hand. March's deliveries, paid in April, appear in the next year. Income on RECEIPT.

Section 145 lets the taxpayer choose, and the workbook states the consequence plainly: income in the nature of interest on securities shall be computed in accordance with THE METHOD OF ACCOUNTING REGULARLY EMPLOYED BY THE ASSESSEE. If the assessee follows the MERCANTILE system, interest on securities is taxable ON ACCRUAL BASIS. If he follows the CASH system, it is taxable ON RECEIPT BASIS.

The word doing the work is REGULARLY. You cannot keep the mercantile ledger in a year when it suits you and the cash ledger in a year when it does not.

And notice how different this is from salary, which is taxed on due or receipt, whichever is EARLIER, with no choice at all. Interest on securities is one of the few places where the taxpayer's own accounting method decides the year of taxation.

A young man in Kanpur receives shares from three different friends during one financial year — worth Rs 20,000, Rs 18,000 and Rs 19,000. Each is comfortably under Rs 50,000, so he assumes each is exempt.

He has misread the provision. The workbook says no tax shall be charged if THE AGGREGATE amount of difference between the fair market value of properties received DURING THE YEAR and the amount of consideration paid, if any, DOES NOT EXCEED RS 50,000.

His aggregate is Rs 57,000. The threshold is breached.

And then comes the sting that catches almost everyone: once breached, THE WHOLE OF THE AGGREGATE fair market value shall be chargeable to tax. Not the Rs 7,000 of excess — the entire Rs 57,000.

This is a cliff, not a step. At Rs 50,000 he pays nothing; at Rs 50,001 he pays on the whole amount. Compare it with an ordinary exemption limit, where only the excess is taxed — that is a step. Section 56 gives you a cliff.

One more thing to hold: the threshold is tested per person per year in aggregate, not per gift and not per donor. Three small gifts from three friends are added together.

Look at the list of persons whose gifts escape tax and you will notice it reads like a traditional Indian wedding invitation — vertically deep and horizontally narrow.

Go up and it never stops: father and mother, grandfather and grandmother, great-grandfather and great-grandmother, and the spouse's grandparents and great-grandparents too. Go down and it is the same: son, daughter, grandson, granddaughter, great-grandson and great-granddaughter, with their spouses.

Go sideways and it stops almost immediately. Brother and sister and their spouses are in. Brother-in-law and sister-in-law and their spouses are in. Chacha, Tau, Bua, Mama and Mausi — with their spouses — are in.

And then the list simply stops, and the workbook names the three who are NOT relatives: step-brother or step-sister, nephew or niece, and cousins.

Pause on how strange that looks at first. Your father's brother (Chacha) is a relative, but HIS SON — your cousin — is not. Your brother is a relative, but HIS SON — your nephew — is not. The generation immediately below your uncles and beside you falls outside.

And note the asymmetry with step-relations: the Act accepts a step-father or step-mother and a stepchild, but expressly rejects a step-brother or step-sister.

Do not reason from what feels like family. Read the list.