Twenty per cent dividend deduction cap

Dividend used to arrive tax-free in the investor's hands, because the company paid the tax. That ended when Dividend Distribution Tax was abolished.

Dividend is now taxed as income from other sources, at the investor's own slab rate.

So the natural next question is what costs can be set against it. The answer is narrow.

Only one kind of expense counts: interest paid on money borrowed to make the investment.

And even that is capped. The deduction cannot exceed 20% of the total dividend income for the year.

Nothing else is allowed. Not the commission paid to a banker. Not any other cost of collecting the dividend.

A non-resident gets less still. No expenditure at all may be deducted from dividend income.

The practical effect is easy to state. Borrow heavily to buy a dividend stock, and most of the interest you actually pay simply does not count.

The rule, stated the same way three times. Section 10.3.3 (mutual fund dividend), section 11.2.2 (equity dividend) and section 11.6.1 (equity mutual fund dividend) all say it: a resident is allowed a deduction of interest expenditure incurred to earn that dividend income, to the extent of 20% of the total dividend income. No further deduction shall be allowed for any other expenses, including commission or remuneration paid to a banker or any other person to realise such dividend. The chapter-10 summary note repeats it for specified and debt-oriented mutual funds.

The workbook's own worked example (Example 11, section 10.3.3). Mr A, resident in India, invests Rs 50 lakh in debt oriented mutual funds, receives Rs 5,00,000 of dividend, and pays Rs 1,50,000 of interest on money borrowed to make the investment.

Rs 50,000 of real interest cost is simply lost. That gap is the whole content of the term.

The non-resident position. Where the dividend is received by a non-resident person or a foreign company — including FPIs and non-resident Indian citizens — the dividend is taxable at special rates, and section 10.3.3 gives 20% for a non-resident from a mutual fund, subject to the DTAA. In such cases the assessee shall not be allowed to deduct any expenditure from such income. Further, deduction under Chapter VI-A, sections 80C to 80U, shall not be allowed from such income — the workbook adds "even under the old tax regime".

Note the coincidence of numbers that trips candidates: 20% is the deduction cap for a resident, and 20% is also the tax rate on a non-resident's dividend. They are unrelated figures.

The DTAA layer. Section 11.2.2 adds that dividend income is generally chargeable in the source country as well as the country of residence, with the residence country giving credit for tax paid in the source country. Under most of India's DTAAs, dividend is taxable in the source country in the hands of the beneficial owner at a rate ranging from 5% to 15% of the gross dividend, and the assessee is taxed under the Act or the DTAA, whichever is more beneficial.

The contrast that makes the cap visible — and it is in the same chapter. Section 10.2.1, on interest arising from bonds, allows the assessee to deduct all expenditure laid out wholly and exclusively to earn that interest and the commission or remuneration paid to a banker or any other person to realise it. So the very banker's commission that is expressly disallowed against dividend is expressly allowed against interest.

One place the workbook words it differently. Section 9.2 deals with buy back proceeds, which from 1 October 2024 are taxed as dividend under income from other sources. There the workbook says no deduction for expenses shall be available from such dividend while determining the income from other sources — without repeating the 20% interest allowance it states elsewhere for dividend. The workbook does not reconcile the two statements, so answer from the section a question is set in: the 20% interest allowance for ordinary dividend, and the flat no-deduction wording for buy back proceeds.

The first case below is the workbook's own Example 11, in section 10.3.3.

Case A — the workbook's figures. Mr A, resident, invests Rs 50,00,000 in debt oriented mutual funds, receives Rs 5,00,000 of dividend and pays Rs 1,50,000 of interest on borrowings.

Dividend                                  Rs 5,00,000
Interest actually paid                    Rs 1,50,000
Cap: 20% of Rs 5,00,000                   Rs 1,00,000   <- the binding number
Taxable dividend                          Rs 4,00,000
Interest cost disallowed                  Rs   50,000

At a 30% slab the tax is Rs 1,20,000. Had the whole Rs 1,50,000 been deductible, taxable dividend would have been Rs 3,50,000 and the tax Rs 1,05,000. The cap cost him Rs 15,000 of tax on Rs 50,000 of genuine, disallowed interest.

Case B — the same investor, less borrowing. Everything as above, but he borrowed less and paid only Rs 80,000 of interest.

Cap: 20% of Rs 5,00,000                   Rs 1,00,000
Interest actually paid                    Rs   80,000   <- now the binding number
Deduction allowed                         Rs   80,000
Taxable dividend                          Rs 4,20,000

The deduction is the lower of the actual interest and 20% of the dividend. Below the cap, the cap does nothing.

Case C — the same Rs 5,00,000 to a non-resident. No expenditure is deductible at all, and no deduction under sections 80C to 80U is available from this income.

Dividend                                  Rs 5,00,000
Deduction for the Rs 1,50,000 interest    Rs       Nil
Taxable dividend                          Rs 5,00,000
Tax at the special rate of 20%            Rs 1,00,000   (subject to the DTAA)

And the same money as bond interest instead. Suppose Mr A had earned Rs 5,00,000 of interest on bonds, paying the same Rs 1,50,000 of borrowing interest and Rs 12,000 of banker's commission to collect it.

Gross interest                            Rs 5,00,000
Less interest on borrowings               Rs 1,50,000   (no 20% cap)
Less collection charges / banker's commn  Rs   12,000   (expressly allowed here)
Taxable interest income                   Rs 3,38,000

The same Rs 5,00,000 of income and the same Rs 1,62,000 of costs produce a taxable figure of Rs 3,38,000 as interest and Rs 4,00,000 as dividend. Nothing changed but the head of income.

Chapter 10 (Taxation of Debt Products), section 10.3.3 Tax on dividend from Mutual Funds, states the rule and works Example 11 through it, and the chapter-end summary table repeats it as Note 2 for specified and debt-oriented funds. Chapter 11 (Taxation of Equity Products), section 11.2.2 Tax on dividend, states the same rule for equity dividend and adds the DTAA layer and the 5% to 15% source-country range; section 11.6.1 repeats it for equity mutual funds. Chapter 10, section 10.2.1, gives the deliberately wider deduction for interest on bonds that the cap should be read against. Chapter 9, section 9.2, gives the buy back wording.

Expect a computation exactly like Example 11 — dividend, interest paid, and the 20% test — and a question on whether a banker's commission is deductible against dividend, where the answer is no.

• The deduction is the LOWER of actual interest and 20% of the dividend. It is not a flat 20% allowance, and it is not the whole interest bill.
• 20% of the DIVIDEND, not 20% of the interest. Example 11 caps Rs 1,50,000 of interest at Rs 1,00,000 because the dividend was Rs 5,00,000.
• Only interest qualifies. A banker's commission or remuneration to realise the dividend is expressly disallowed — and expressly allowed against interest on bonds in the same chapter.
• A non-resident gets no deduction at all, and no Chapter VI-A deduction from the dividend either, even under the old tax regime.
• Two unrelated 20%s. 20% is the resident's deduction cap; 20% is also the special rate on a non-resident's mutual fund dividend. A question mixing them is testing whether you noticed.
• DTAA rates of 5% to 15% are source-country rates on the gross dividend under most of India's treaties, and the assessee is taxed under the Act or the treaty, whichever is more beneficial.
• Buy back proceeds are worded differently. Section 9.2 says no deduction for expenses is available from buy back proceeds taxed as dividend, and does not repeat the 20% interest allowance. The workbook leaves the two statements side by side without reconciling them.
• The cost of acquisition of bought-back shares is a capital loss, not an expense against the dividend. Section 9.2 treats it as a capital loss eligible for set-off under the applicable provisions.