Dividend Income: Meaning, Types and Taxation

Dividend is the amount distributed to shareholders of a company. Companies use it as a mode to distribute the company’s profits to its shareholders. Mature companies with consistent earnings over the past few years pay dividends to their shareholders. Also, investor’s confidence in the company increases with regular dividend payments. Moreover, the share price of these companies tends to be higher. It is paid out per share in the form of cash or additional stock. Also, dividends are taxable in India.

What is a Dividend?

The dividends are the share of the company’s profits or retained earnings that it distributes to its shareholders. When a company generates profits and accumulates retained earnings, these earnings are either reinvested in the company or paid out to shareholders as dividends. Simply put, it is the reward the company pays its shareholders. The company’s board of directors decides dividend payout, and the approval of majority shareholders is also necessary. Moreover, the announcement about dividends may impact the company’s stock value.

Types of Dividends

The following are the various types of dividends that the company can pay to its shareholders – 

• Cash: This is the most common type of payment where the companies pay in the form of cash directly to the shareholders. The payment is made electronically, but sometimes in cash or cheque. 
• Stock: The company offers its shareholders new shares as dividends. Payment is on a pro-rata basis, i.e. each shareholder receives a dividend depending on the number of shares they hold. 
• Asset: The company may reward the shareholders in the form of physical assets, investment securities and real estate. However, offering dividends as assets is a rare practice. 
• Common Stocks: The profit distributed among the common stockholders of a company from the share of accumulated profits. Usually the law decides these dividends, payments are in cash when the company is liquidating.
• Preferred Dividend: The profit is distributed among the preferred shareholders of the company, which is fixed and paid out quarterly. Also, this type of dividend works more similarly to bonds. 
• Others: Options, warrants, shares in a new spin-out company, etc., are other types of dividend payments.

Cash Dividends

Depending on the frequency of declarations, the cash dividends can further be classified as – 

• Special Dividend: This type of dividend payment is usually on the company’s common stock. Its issue is under specific circumstances when the company has accumulated substantial profits over several years. Also, the company doesn’t require these profits for immediate needs as they are excess cash. 
• Liquidating Dividend: When the company goes out of profit and decides to liquidate its assets, it distributes the proceeds from the liquidation to the shareholders in the form of liquidating dividends. In some cases, liquidating dividends is when the company sells its portion of assets and distributes the proceeds to shareholders.  

How is Dividend Income Calculated?

The dividend income is calculated using the dividend payout ratio. The dividend payout ratio is the total amount of dividends in proportion to the net income of the company. The formula is –

Dividend Payout Ratio = Total Dividends Paid/Net Income or Profit.

Note: The dividend payout ratio is zero for companies that do not pay dividends and those that pay total net income as dividends. 

Alternatively, one can calculate the dividend payout ratio as 1 – Retention Ratio. 

Retention Ratio = (Earnings per share – Dividends per share) / Earnings per share. 

Where

EPS = Net income or Total earnings / Number of shares

This ratio helps determine the amount of money the company offers its shareholders. It is also helpful to calculate the amount that the company reinvests for expanding and improving its operations, paying off existing debt or building a cash reserve. Furthermore, it helps to assess the company’s sustainability. 

For instance, a company with a payout ratio of more than 100% indicates that it is paying more than what shareholders are earning. This practice will help the company to reduce its offering or stop it. On the other hand, a steady payout ratio signifies a strong financial position of the company. 

How do Dividends Work?

The dividend value is determined based on per share and is paid equally to all shareholders of the same class (common, preferred, etc.). Also, the Board of Directors approves the payment. Furthermore, after declaring the dividend, the payment is on a specific date, i.e., the payment date. The following are the steps to highlight how dividends work – 

• The publicly listed companies generate substantial retained earnings and profits.
• The company’s management decides whether to reinvest the retained earnings or distribute them to the shareholders. 
• Along with attaining major shareholder approval, the board members declare dividends on the company’s shares.
• The company announces the important dates relating to dividend declaration.
• The shareholders’ eligibility to receive dividends is also scrutinised. 
• Finally, the shareholders receive dividends on the payment date. 

Impact of Dividend on Share Price

Paying dividends to shareholders may not impact the company’s valuation. However, it may tend to lower the overall equity value of the company by the amount of the dividend payment. In simple words, upon dividend payment, it is debited from the accounting book permanently.

When the company declares a dividend, the stock prices undergo significant changes due to market conditions. The stock price may increase on the announcement approximately by the amount of dividend declared. Similarly, the price starts to decline by a similar amount on the ex-dividend date. 

For instance, a company trades at an INR 100 per share price and declares an INR 5 dividend on the announcement date. As the news becomes public, the share price may increase to INR 105. 

Suppose the stock trades at INR 106 one business day before the ex-dividend date. On the ex-dividend date, the price adjusts by INR 5 and begins trading at INR 101 at the start of the trading session of the ex-dividend date. This is because anyone buying on the ex-dividend date will not receive dividends. 

However, there is no guarantee, but the price is often adjusted by the dividend amount on the ex-dividend date. Moreover, investors must understand the impact of dividend declaration on stock prices and become familiar with important dividend dates.

Why Are Dividends Paid? 

Mature companies with stable earnings over several years pay out dividends to investors. They do this to attract investors and increase the value of their stock. Companies also pay dividends to reassure investors about the company’s financial health.

Companies pay dividends as investors see it as a positive sign of management’s expectations. Investors’ confidence often increases with regular dividend payments. It gives them a message about the company’s future prospects. Investors seeking regular income often opt for such companies. Hence, increasing the demand for that stock. Hence this also increases the share price of the company.

Check Out our article on Difference Between Value Stocks and Growth Stocks

How are Dividends Paid?

Dividends are payable to the investors in the form of cash or additional stock. Investors receive the amount in their bank account. Also, they are payable in the form of stock or asset (rarely).

Important Dates for Dividend

There are a few dates that are important for dividend payments.

• Announcement date: It is also known as the Declaration Date. The companies announce dividend payments on this date and approve the payment of dividends to their shareholders. Also, it mentions the date of dividend distribution, the size of dividend the company will disburse, how much the shareholder will receive and the record date. 
• Record date: The date on which the company makes a list of shareholders in their books who are eligible to receive the dividend. However, shareholders who are not registered on this date will not receive dividends. Furthermore, investors who purchase shares on the record date will not receive dividends because it takes T+2 days for stock delivery and to reflect in the book record. 
• Ex-dividend date: The date on which the dividend eligibility date expires. All investors buying the share on that day or after this day will not qualify for dividend payments. Therefore, this date is the deadline for prospective investors to receive dividends. Moreover, this date is also set on the stock exchange because the stock exchange gives the list of shareholders to the company. Investors who purchased on or after this date will not appear in the company book records and will not receive dividends. 
• Payment date: The date on which dividends credit to the shareholder’s accounts. This is the final step of dividend payment. 

Are Dividends Taxed as Income? 

Yes, dividends are taxable as income. This income is taxable as per the applicable income tax slab rate of the shareholder. Also, they are subject to a TDS of 10% in case the dividend receivable is greater than INR 5,000. For non-individual shareholders (Company, Firm, HUF, etc.), this income is subject to TDS without any limit.

Explore our article on Monthly Dividend Mutual Funds.

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