By K. Sundararaj
On the pretext of safeguarding the minority shareholders interest, the Government has successfully introduced another tax, which is now within the corporate community widely known as “Deemed Dividends Tax”. The purpose of this article is to appraise the corporate tax payers as to the applicability and scope of this new tax.

Introduction of new dividend tax
Government in its budget proposals for the fiscal year 2007 declared that there will be an additional tax on companies, based on their distribution of corporate profits commencing from year of assessment 2007 / 2008. In order to give the legal effect to this proposal, Inland Revenue amendment Act No, 10 of 2007 amended the section 61 of the principal Inland Revenue Act, thereby introducing an additional income tax liability of 15 % on corporates, in case where such corporates have not declared dividends equal to at least 25% of their distributable profit. That additional tax liability will be calculated at 15%, on 1/3 of distributable profits, reduced by the dividends already declared pertaining to that financial year.

Accordingly you may realise that, this additional tax liability arises only in case where you have not distributed 25% of your distributable profits for the previous financial year by way of dividends before September 30, of the subsequent financial year. For an example, in case you do not distribute 25% of your distributable profit by way of dividends for the year of assessment 2006 / 07 before September 30, 2007, you will have to pay this additional income tax (Dividend tax) for the year of assessment 2007 / 2008.

Liability arisingon this rule is calculated as follows;
1/3 of Distributable profit for
the Y / A 2006 / 07 xxxxx
Less: Dividend distributed out
of such profits (Interim or
Final before Sept. 30 2007) (xxxx)
-------

Amount subject to deemed
dividend tax xxxxx
=====

Thereby additional Tax payable
would be = 15% of the above
Accordingly, also note that liability for any year of assessment is determined based on the distributable profit and dividend distributed for the previous year and such liability shall be paid before September 30, of that year of assessment. (i.e. for year of assessment 2007 / 08, September 30, 2007) Calculation of distributable profit
Inland Revenue Act, No. 10 of 2007 defines the word “Distributable Profit” as follows;

“The book profits of that company for that year of assessment, reduced by the aggregate of;

(a) the income tax payable for
that year of assessment

(b) the cost incurred by that company in that year of assessment in the acquisition of any land or any capital asset

(c) any notional profit computed on the basis of a revaluation of any capital asset and

Increased by the aggregate of the allowance for depreciation deducted in respect of such capital asset in calculating such book profits and any notional loss computed on the basis of a revaluation of any capital asset and included in such book profits.”
This definition will give rise to following issues;

a) Deductibility of capital investment
Capital Investment of a company is a part of capital assets of that company. Even though section 25 of the Inland Revenue Act, defines the world “Capital Assets” only to include depreciable assets such as plant, machinery, equipment, fixtures, buildings etc., that definition is applicable only to that section.

As per the Black’s Law dictionary “capital asset” is defined as “all properties held by a tax payer including stocks and bonds”. However trade receivables, stocks and properties held for resale are not part of capital assets. The Law Lexicon dictionary too gives a similar meaning to the word “Capital Assets”

In any event, distributable profit is an issue of liquidity. As such all long term investments including investments in subsidiaries and associates shall be allowed to be deducted, in determining the amount of distributable profits for the purpose of this section.

b)Adjustment for deferred tax
Book profit referred to in the above section, is the profit before tax and that is the reason why the section specifically allows you to deduct the income tax payable separately.

Accordingly, your deferred tax provision cannot be deducted in calculating the distributable profit. In the same way if you have identified a deferred tax asset in to your balance sheet by crediting such amount to profit and loss account that notional recognition of profit too shall not be considered in determining the distributable profits.

c) Valuation of short term investments
As per the above definition of distributable profit, what can be removed is only revaluation profit on capital assets (i.e. fixed assets and long term investments). Valuation profits on current assets identified in accordance with accounting standards cannot be removed in determining the distributable profit. Similarly valuation loss included in the profit on short term / current assets shall not be adjusted back in calculating the distributable profit.

d) Aggregation of book depreciation
The above definition states that “depreciation deducted in respect of such capital assets shall be added back”. It seams that, it refers only to the depreciation applicable for the assets acquired during the year. Accordingly what needed to be added back is only the depreciation charge on assets acquired during the year.
However, whether this is what the legislator wants is doubtful. As already mentioned, distributable profit is an issue of cash flow. As such the revenue authority should introduce necessary amendment to the Act, so that the total book depreciation is added back in arriving at distributable profits.

Solvency test and dividend tax
In imposing the additional income tax on deemed dividends, through subsection 61 (1) (b) (ii) of Inland Revenue Act, the section also provides a proviso to the effect that, where any company has been restrained from distributing the whole or any part of its distributable profits, in order to comply with any requirement imposed by any other written law such part so restrained from being distributed shall be deemed to have been distributed, for the purpose of determining whether such company has distributed 25% of its distributable profits for that year of assessment.

This means that, even though the company has profits, if that company is restrained from distribution of dividend due to not satisfying the solvency test stipulated in Section 57 of the Companies Act, No. 7 of 2007, such company shall not be made liable for above additional dividend tax.

Distribution otherwise than by way of cash
Normally, companies distribute dividends in the form of money or of an order to pay money. This is known as cash dividend; however in rare circumstance companies may distribute dividends in some other forms too. Inland Revenue Act, defines the word “Dividend” not only to include distribution by way of money or of an order to pay money but also shares in any other company, debentures in that company or any other company.

Accordingly, the companies who are facing sever cash flow issues but still compelled to declare dividends as a result of this additional tax can use the above as a solution. For example they can declare dividends by way of a debenture of the same company where you allot debentures to the name of shareholder according to their dividend entitlement using the distributable profits.

Alternatively you can declare dividend together with a rights issue to the extent of the net dividends, where, if shareholder wants to exercise the rights, shareholder returns the dividend cheque to the company as his contribution towards the right.

Liquidity Vs forced distribution of dividends
The writer personally does not agree with Inland Revenue intervening with the taxpayer’s dividend policy. Pretext of safeguarding minority shareholders interest is not actually the reason behind the introduction of this tax. The Government simply needs to increase their tax revenue and this is only another mode of tax to the Government. If Government actually introduced this to safeguard the minority shareholders interest, it should have excluded the private closely held companies from this tax. Also it could have eliminated the subsidiaries of group companies from this additional tax.

Negative implications of this forced distribution are far grater than its positive impacts. While encouraging individuals or partnerships to become limited liability companies, by way of introducing a new Companies Act, Government has totally discouraged such individuals or partnerships through this additional tax. As a result of this new tax you will be better off to continue as individual or partnership entity rather than becoming a limited liability company, since your effective tax rate will be lower as a against a limited liability company. In any event encouraging consumption against investment is not a healthy or acceptable policy.

Also the introduction of this tax has a retrospective effect, since the calculation of distributable profit has been based on the previous years performance. Even though it was introduced from April 1, 2007, by making 2006 / 07 the base year for calculation of liability and by emphasizing that taxes shall be paid before September 30, 2007, the Government has effectively imposed the tax for the year of assessment 2006 / 07/. If this is a budgetary proposal for 2007 which shall be effective from April 1, 2007 then none can justify the reason as to why the tax payer is required to be burdened with an additional taxes based on the calculation for the year 2006 / 2007.

What should have happened is that rather than basing the calculation on the previous year it could have been based on the profits of the same year and dead line for declaration of dividend and payment of tax should have been made September 30, of subsequent year.(i.e. 2007 / 08 declaration of dividend and payment of additional tax in case where less then 25% dividend is declared should have been made before September 30, 2008) The writer feels that taxpayers have unreasonably been robbed of one additional year. It’s a clear indication of the status of discipline of our fiscal policy makers whose target is only the revenue. The writer is a Chartered Accountant and is a Tax Partner of Amerasekera & Co.