How rational is relating tax to dividend payment?

The term 'dividend' in finance refers to distribution of profits by a company among its shareholders. The company may choose to pay cash to its shareholders out of profit earned by it during a year or profit previously earned but retained within the business. Alternatively it can choose to compensate the shareholders by issuance of fresh shares free of cost which is popularly known as 'bonus' share or stock dividend. Profit in accounting terms refers to the net profit after payment of tax and therefore, the dividend is paid out of the current or retained profit.
While the corporate income tax is paid by companies on the profit it earns, dividend is paid out of profit that remains after payment of tax. Therefore, corporate income tax is generally unrelated to dividend. However, there are some unusual provisions in our tax laws that relate income taxes to payment or non-payment of dividend. These provisions against any business prudence forces companies to declare dividend. Besides our tax law, there are other provisions in our SEC and Stock Exchange regulations that directly or indirectly induce companies to pay dividend. Bangladesh is perhaps the only country in terms of number of regulations that directly or indirectly influence a company's dividend decisions. Interestingly, some of them are not only peculiar but also against any business prudence and contrary to any business norms.
One of such inconsiderate policies provides for discriminating tax for not paying dividend below a threshold limit. First introduced by the then finance minister M Saifur Rahman in his 2002-3 budget which, as it currently exists, requires listed companies other than tobacco, telco and bank, insurance and NBFIs to pay at least 10 per cent dividend to avail 27.5 per cent corporate tax. If the companies fail to pay that minimum dividend, they will be under 37.5 per cent tax bracket clearly a punishing tax of 10 per cent. It is important to note here that the dividend in relation to the aforesaid provision refers to the cash dividend only. The Section 2(26) of the Income Tax Ordinance 1984 while defining dividend excludes stock dividend from the definition. tobacco, telco and bank, insurance and NBFIs are, however, subject to higher tax rates varying from 42.5 per cent and 45 per cent plus. Interestingly, their tax rates remain unchanged even if they do not pay dividend to their shareholders.    
There is another provision in the tax law that states that if any company fails to pay less than 15 per cent dividend either in the form of cash or stock, it will have to pay an additional 5.0 per cent tax on all of its 'undistributed profit'. Undistributed profit has been defined as profits that the company has earned and retained over the years.
Another provision, first introduced by late A M S Kibria in his 2000 budget, says that if the company pays more than 20 per cent dividend (which is again cash dividend) to its shareholders it will be entitled to 10 per cent rebate on its tax liability.
While the third provision, as mentioned above, merits justification, the other two provisions demand analysis from legal and business perspectives. Outwardly, these provisions might look to have been framed for a benign purpose to benefiting general shareholders. But an in-depth analysis would reveal that these are discriminatory, not conducive to business and in some cases, not legally sustainable.
IRRATIONAL AND UNFAVOURABLE: Having given this background, let us have a look at why such tax policies are irrational and unfavourable to business. The first relevant question in this context is whether the companies are bound to pay dividend if they earn profit or if they have enough accumulated profit on its balance sheet. Dividend, as we all know, is not a guaranteed payment. The essential difference between a shareholder and a lender is that lenders are entitled to earn a fixed amount on their investment irrespective of company's profit while the dividend is dependent firstly on availability of profit and secondly on decision of the management to pay or not to pay which is dependent on a number of variables. A number of factors are there that influence businesses' dividend decision. Important among those factors are the availability of profitable investment opportunities, cost of external finance, company's access to such finance and most importantly, availability of cash. Profit that a company earns can either be distributed to the extent of 100 per cent to its shareholders or  100 per cent can be retained for re-investment with in business or can choose a mix of the two. For company that has a profitable investment opportunity and the cost of raising external fund is high prudent, business decision will be to retain the profit rather than distributing it as dividend.
Secondly, the way the profit is determined in accounting does not necessary guarantee that the company will have enough cash to pay to its shareholders. A company, despite earning enough profit, may be suffering from cash shortages. The obvious alternative in such case would be issuance of bonus share which is nothing else but a permanent increase in the paid-up capital of the company and dilution of future earnings. This, therefore, requires a prudent business decision. By issuing bonus share, the company is dividing the same amount of assets among larger number of shares. As per financial hypothesis, in an efficient capital market, gain from owning higher number of shares is supposed to be offset by decline in the market price of shares in the long run.
Thirdly, shareholders are the ultimately claimant of the profit earned by a company. If it is distributed among the shareholders this would mean that the individual shareholders are given the option to consume or spend the resources as it goes to their pocket. On the other hand, if the company despite earning enough cash chooses not to pay dividend and retains it within the business to plough it back it still remains in shareholders' ownership as an addition to their existing wealth. Given the capital market is efficient, such retention should be reflected in increase of market price of shares. A company that has profitable growth opportunity therefore may choose to retain the profit to plough it back at a rate higher than its cost of capital.
WHO SHOULD TAKE THE DIVIDEND DECISION? The very question, therefore, is who should take the dividend decision? Is it the company itself or should it be directed, influenced and compelled by the government policies? Payment or non-payment of dividend is absolutely a business decision. Law has given complete independence to the management to take dividend decision. It is the management vis-a-vis the board of directors of the company who makes the decision which is finally approved by the shareholders in the annual general meeting. To protect independence of the management, our Companies Act 1994 provides that even the shareholders can not approve higher dividend than what has been recommended by the board of directors although they may agree on a lower dividend. Throughout the world, the decision on dividend is considered to be an independent management decision of the concerned business. But the aforesaid provisions virtually interfere in the management's independence which also goes against the company law.
CONTRADICTORY DEFINITION OF DIVIDEND: The issue of contradictory definition of dividend in our tax law is also questionable. The Companies Act 1994 considers both cash and stock dividend as dividend. Similarly, the International Standard on Accounting that is followed in preparation of financial statement around the world including Bangladesh considers both stock and cash dividend as dividend. But the provision of the tax law in one case considers only cash dividend as dividend while in other case as mentioned above both cash and stock dividend are considered as dividend.
The tax provisions virtually make dividend to be a guaranteed payment which in real world is not the case. Moreover, the provisions are based on the assumption that the companies will make profit every year and years after years. This is because the law requires that if a listed company other than a banking or insurance company does not pay cash dividend or bonus share in any year it will have to pay 5.0 per cent additional tax on all of its 'undistributed profit' which is defined as 'accumulated profit including free reserves'. Can anyone think of how utopian such provision could be? Where will the money for dividend come from? The company's undistributed profit does not mean that it has idle cash lying in its vault. It is re-invested within the business. Will the company sell its assets to pay dividend? Otherwise, its only option will be to pay stock dividend which means permanent increase in capital and dilution of future earnings. Such dividend virtually gives no benefit to the shareholders in the long run.
It does not require much business knowledge to understand the fact that in business there is always the element of uncertainty. No one knows for sure that a businessman will be able to generate a constant amount of earnings in future days. But under the aforesaid rule if a company pays very good dividend every year and if in any particular year it fails to pay 15 per cent, it will have to pay 5 per cent tax on the cumulative earnings that it has retained over the years. This cannot be a sensible business policy. Are we trying to make dividend something like interest which is a fixed payment irrespective of level of earnings?
The tax provisions are also discriminatory in the sense that while some companies are punished for non-payment of dividend certain other companies are excluded from such punishment. If listed banks and insurance companies don't pay dividend to their shareholders, these are neither required to pay higher tax on profit than their standard rate nor do they need to pay any additional tax for such non-payment. Such discriminatory provision is not tenable in law.
The provision of charging additional tax on 'undistributed profit' is also against the canon of taxation in the sense that it amounts to double taxation of the same income. Any undistributed profit of a company is basically a tax-paid profit. Therefore, there cannot be further charging of tax on such profit.
These provisions were primarily driven by increased public pressure for revitalising of the stock market. The underlying hypothesis was that increased payment of dividend would make share attractive to the investors. In a country where risk-free rate of return is almost 12 per cent (through investment in FDR) how much dividend could the companies make attractive to the shareholders? The hypothesis that forcing dividend would encourage investment in capital market,  therefore, does not hold good. Moreover, many of the companies over the years have been forced to pay stock dividend to avoid penalising tax. Such indiscriminate issuance of the shares has made the capital structure of many of the companies disproportionate to their earning ability. Share prices of many of these companies have reached rock bottom level which virtually has gone against the interest of the shareholders.   
Arguments are often advanced that such tax policies were necessary for disciplining the unscrupulous company management that deprives the general shareholders of dividend despite earning profit. However, the way we cannot justify extra-judicial killing of even the criminals, in the similar fashion on the plea of disciplining the bad companies we cannot justify a generalised policy applicable to all which is irrational, unfriendly to business and lacks proper legal basis.  
Jamal Ahmed Choudhury, FCMA, is Secretary, the Institute of Cost and Management Accountants of Bangladesh. The opinion expressed here is of his own and does not necessarily relate to the organisation he is associated with.                 [email protected]