The Income Tax department has suggested a differential system for levying dividend distribution tax on companies in its list of pre-Budget suggestions to the Central Board of Direct Taxes.

The I-T department has said companies that have very high promoter holding often issue huge dividends to take advantage of the relatively low dividend distribution tax of 12.5 per cent.

The promoters of these companies, however, fix their annual salary and other perquisites at lower levels since the income tax rate is much higher at 33.6 per cent.

To plug this tax-avoidance strategy by several big companies I-T officials have suggested that instead of a flat rate dividend tax should be linked to the amount of payout based on the proportion of shareholding.

In other words, shareholders with a larger shareholding in the company should be taxed at a higher rate.

This would spare small shareholders whose annual dividend income is comparatively small from a higher tax rate, the I-T department has said.

Tax officials have also suggested restrictions on the use of carry-forward losses and depreciation in cases of demergers under section 72 of the Income Tax Act, 1961.

Officials have come across several cases of "fake" demergers to take advantage of the provision and set off gains against carry-forward losses to minimise taxes.

Since there are severe restrictions on the use of this provision for amalgamations, group companies often demerge the loss-making businesses of one of their loss-making companies and merge them with a profit-making company.

Thus, the profits of the company are set off against losses of the entity which is merged. There are currently no eligibility criteria for offsetting the losses of demergers against profits of other companies.

• Company promoters often pay themselves high dividends and understate income, says I-T department
• Dividend tax should be linked to the amount of payout based on the proportion of shareholding instead of a flat 12.5%
• Differential rates will protect small shareholders
• Restrictions on carry-forward losses to minimise incidence of "fake demergers"