Hamza Textiles: salary versus dividend as a profit-extraction route
Hamza Textiles (Pvt) Limited is owned equally by two shareholder-directors. Each already draws a salary of Rs 6 million a year, taxed at a 35% marginal rate in their hands. The company now wants to move a further Rs 20 million of value to the two directors and is choosing between (a) additional salary, deductible for the company and taxed at 35% in the directors' hands, and (b) a dividend, paid out of after-tax profit with 15% withholding deducted at source, which is a final tax for individuals. The corporate tax rate is 29%. Ignore all other taxes, credits and surcharges. The directors want the route that delivers the most after-tax cash for each rupee of profit the company has to earn.
1. Compare the two routes on a common basis and recommend one, showing your workings.
Read the worked answer
Compare per Rs 100 of profit before tax generated by the company.
Route A – Additional salary
- Profit before tax 100.00; salary deductible, so corporate tax = 0.
- Director receives 100 − 35% personal tax = Rs 65.00.
- Total tax = Rs 35.00.
Route B – Dividend
- Profit before tax 100.00; corporate tax at 29% = 29.00; distributable = 71.00.
- Withholding at 15% (final tax) = 10.65; director receives 71.00 − 10.65 = Rs 60.35.
- Total tax = 29.00 + 10.65 = Rs 39.65.
Conclusion: salary delivers Rs 65.00 per Rs 100 of pre-tax profit against Rs 60.35 for a dividend, so salary is the cheaper route by about Rs 4.65 per Rs 100, i.e. roughly Rs 0.93 million on the Rs 20 million being extracted. The Rs 20 million figures reconcile to this: salary gives Rs 13.0 million in hand (20 × 65%), while a dividend of Rs 20 million requires Rs 28.17 million of pre-tax profit (20 ÷ 0.71) and leaves Rs 17.0 million gross, Rs 14.45 million in hand. Note that the result is driven entirely by the relative rates, not by the amount.
2. At what marginal personal tax rate would the recommendation reverse, and what non-tax constraints must be checked before either route is used?
Read the worked answer
Break-even personal rate. Salary is better while (1 − t) > 0.71 × 0.85 = 0.6035, i.e. while t < 39.65%. Above a marginal rate of about 39.65%, the dividend route wins:
- At t = 39.65%: salary gives 60.35 per 100; dividend gives 60.35 per 100 - indifferent.
- At t = 45%: salary gives 55.0; dividend gives 60.35 - dividend better.
So the recommendation is sensitive to the directors' total income: if the additional salary pushes them into a higher slab (or a surcharge applies), redo the comparison at the marginal rate actually suffered, including the surcharge threshold.
Non-tax constraints
- Services and reasonableness. Directors' remuneration must be for services actually rendered and approved under the company's constitution/board or shareholder resolution. A salary fixed above market for a passive shareholder invites disallowance as excessive, converting it into a constructive dividend with worse consequences.
- Distributable profits. A dividend needs realised profits available for distribution; check the accumulated position, not just the current year.
- Withholding mechanics. Salary is subject to withholding by the company as an agent; failure to deduct and deposit makes the company an assessee in default regardless of the directors' own tax position.
- Timing and rate change. The final-tax character of dividend withholding fixes the cost; a change in the corporate rate changes the comparison.
- Documentation. Board minutes, payroll records and a dividend voucher are the audit trail the tax authority will ask for.
3. The directors propose instead to pay Rs 20 million as a 'management fee' to a partnership firm owned by their spouses, which has no employees. Comment.
Read the worked answer
Substance over form. The label does not determine tax treatment. The questions are whether services were actually rendered to the company, whether the amount is arm's length, and whether the arrangement has a purpose other than tax avoidance.
Analysis
- If no services exist, the payment is not an expense incurred wholly and exclusively for the business: it would be disallowed and treated in substance as an application of profit (a distribution to the directors' connected persons).
- Payments to connected persons are commonly subject to specific anti-avoidance provisions and to transfer-pricing/arm's-length rules; a no-employee firm charging Rs 20 million is unlikely to survive scrutiny.
- Withholding obligations still apply to the fee, and the partnership's own tax position is separate; a mismatch creates double taxation and penalties.
- Company law also bites: benefits to directors or their relatives may need disclosure and approval, and a sham arrangement exposes the directors to breach-of-duty claims.
Recommendation: reject the structure. If genuine services are being provided, document the scope, benchmark the fee to market, obtain approvals and apply withholding. If the objective is simply extracting cash, the salary/dividend comparison above is the defensible route.