Dividend income, partnership firms two ways to reduce income tax liability

Mumbai-based M K Rajendran (name changed on request), director at a leading private bank, has been calling his chartered accountant regularly since July 5 to find out if there are any avenues for reducing his tax liability after the Budget imposed a super-rich tax. Most tax experts and chartered accountants say their high-net-worth clients are rattled.

For people in the income bracket of Rs 2-5 crore, the Budget imposed a surcharge of 25 per cent, pushing their effective tax rate to slightly above 38 per cent. On those earning above Rs 5 crore, it imposed a surcharge of 37 per cent, pushing their tax rate to slightly above 42 per cent. Finance Minister Nirmala Sitharaman has said only 5,000 people will be impacted by this tax, and it will raise only Rs 12,000 crore.

Tax experts say there aren’t many options for the super rich to escape this tax liability. One way is to convert their business into a partnership or limited liability partnership (LLP). The tax rate for them is 30 per cent and their surcharge rate is 12 per cent. “After the LLP has paid its tax, whatever the partners receive is not taxable,” says Ashok Shah, senior partner, NA Shah Associates.

However, forming a partnership or LLP may not be feasible for everyone. A professional, such as a lawyer or a doctor, who has been running her practice as an individual, will have to acquire one or more partners and turn into a partnership. Those running proprietary firms or consultancies will have to do the same.

“The partners should also contribute to the business and not exist only on paper, as structures should not be set up just for tax avoidance,” says Gautam Nayak, partner, CNK & Associates LLP. Those running an active business or a factory may find conversion to a partnership or LLP difficult. One reason for this, for instance, could be that the licence to do business or contract received from the government may be in the individual’s name.    

Another option is to get more income in the form of dividend, as only amounts over Rs 10 lakh attract taxation. Once companies have paid a dividend distribution tax (DDT) at the rate of 15 per cent (plus surcharge and cess), it becomes tax-free in the hands of the recipient. Only if the dividend exceeds Rs 10 lakh does it become taxable. Even then the tax rate is only 10 per cent.

“An unlisted company’s promoter, who has nominated herself a director in it, may keep her salary below the threshold, and take money out of the business by declaring dividend,” says Arvind A Rao, financial planner, and founder, Arvind Rao & Associates. Another advantage of this route is that the promoter can decide the timing of payouts. “So long as the money is kept in the company it is not taxable. Thus, a person can defer his tax liability,” says Nayak.

This option is, however, not feasible for highly-paid directors of listed companies (who are not promoters), who may not be able to influence the payouts.  

Apart from individuals, trusts will also have to pay the higher surcharge now. Several wealthy individuals have set up trusts for estate or succession planning, or have invested through vehicles set up as trusts. “Now that these trusts will be taxed at a higher rate, there may be some merit in rethinking such consolidation,” says George Mitra, managing director and chief executive officer, Avendus Wealth Management. In other words, those forming trusts may consider splitting their assets into more than one such entity to reduce income from each.

On the investment side, some individuals’ income may be crossing the threshold level of Rs 2 crore or Rs 5 crore because of their investment income (and not salary income). “They may consider investing in tax-free bonds to reduce their tax liability,” says Vikas Srivastava, partner, L&L Partners.

Alternative Investment Funds (AIFs) that have been structured as trusts will also be hit by the higher surcharge rates. “These AIFs’ returns will be reduced because of the additional tax,” says Mitra. Even individuals who are not ultra-HNIs but have invested in such AIFs will earn less.

Mitra suggests that in future investors look not just at the type of investment, but also at the nature of the investment vehicle.