Money lending business is exception to deemed dividend provisions

Court :Bombay High Court

Citation : M/s Parle Plastics Ltd. (Taxpayer) [ITA No. 37 of 2002]

Brief : The issue before the HC relates to certain provisions in the Indian Tax Laws (ITL) that provide for taxability, as dividend, of certain advances or loans made by a company to another concern when the lender/borrower have a common shareholder with substantial interest (deemed dividend provisions). However, advance or loan is not treated as deemed dividend if it is made by the lending company in the ordinary course of its business and the lending of money is a substantial part of the company’s business.

The HC held that in order to constitute substantial part of the business, the lending of money need not be the major part i.e., more than 50% of the lending company’s business. In the facts of this case, loans and advances were more than 40% of the total assets and interest income was more than total profits of the lending company. The HC held that deemed dividend provisions were not applicable to the loan received by the Taxpayer from such a company.

Background-The ITL contains an expanded definition of dividend which, in addition to conventional dividend or distributions, includes payment of an advance or a loan made by a closely-held company to its shareholder or to a concern in which the shareholder has a substantial interest. However, if such an advance or loan is made by a company in the ordinary course of business where the lending of money is a substantial part of the company’s business, it is not treated as dividend (exception).

Facts

• The Taxpayer is engaged in the business of manufacture of plastic caps for bottles and supplied them to Lending Company (LCo) and others. It took loans from LCo and paid interest on it.
• LCo is engaged in the business of production, sale and distribution of soft drinks, aerated water and mineral water. In addition, LCo is also engaged in the business of lending money. Nearly 40% of total assets of LCo comprised loans and advances. Furthermore, interest income earned was more than the total profits of LCo.
• The Taxpayer and LCo have common shareholders which triggered applicability of deemed dividend provisions.
• The Tax Authority added loan balance appearing in the Taxpayer’s books as dividend to the Taxpayer’s income.
• On appeal by the Taxpayer, the first appellate authority held that only the loans which were received by the Taxpayer during the relevant tax year could be treated as deemed dividend.
• The Taxpayer further appealed to the Income Tax Appellate Tribunal (ITAT) which ruled in favor of the Taxpayer. It held that the Taxpayer’s case was covered by the exception as lending of money comprised substantial part of LCo’s business.
• The Tax Authority appealed to the HC against the ITAT’s ruling.

Tax Authority’s contentions

• All the prerequisites for applying deemed dividend provisions were satisfied in the Taxpayer’s case. The exception was not applicable since lending of money did not comprise substantial part of LCo’s business.
• In order to constitute substantial part, the lending of money should be a major part of the business of the company i.e., it should constitute more than 50% of the total business. In LCo’s case, the loans and advances comprised only about 40% of the LCo’s total assets. Hence, the loan advanced by LCo to the Taxpayer was covered by deemed dividend provisions and not saved by the exception.

Taxpayer’s contentions

• The Taxpayer is covered by the exception since lending of money comprised substantial part of LCo’s business.
• Since 40% of total assets of LCo comprised loans and advances and interest income earned was more than LCo’s total profits, lending of money did constitute substantial part of LCo’s business.

HC’s ruling

• Deemed dividend provisions were attracted in view of the common shareholder relationship. However, the said amount was saved by the exception since the amount was lent in the ordinary course of LCo’s business and lending of money comprised substantial part of LCo’s business.
• The Taxpayer’s business was complementary to LCo since the Taxpayer was a supplier of plastic caps to LCo. It is common for a manufacturer of a product to give some advance to the supplier of raw material or other parts used by the manufacturer in manufacturing its products. Such advances are commonly made in usual course of business.
• The expression ‘substantial part’ does not connote an idea of being the major part or the part that constitutes majority of the whole. If the Legislature had intended substantial part to mean more than 50% of the lending company’s business, it would have used the expression ‘majority of business’ or at least prescribed a specific minimum percentage of business. It is not possible to give any fixed definition of the word ‘substantial’ in relation to ‘a substantial business of a company’. Any business of a company which the company does not regard as small, trivial or inconsequential, as compared to the whole of the business, is substantial business.
• For ascertaining whether a part of the business is a substantial part of the overall business of the company, the proportion of the following factors of that part, as compared to the total business can be looked into:

o Turnover

o Profits

o Manpower or human resources

o Capital employed

• A part of business may comprise substantial part if its turnover is substantial even if its profit is relatively small or if its profit is substantial even though turnover is relatively small.
• Applying the above tests to the Taxpayer’s facts, lending of money can be regarded as substantial part of LCo’s business since 40% of the total assets comprised loans and advances and interest income earned was more than LCo’s total profits. Hence, the Taxpayer was covered by the exception and the loan advanced by LCo could not be treated as dividend in the Taxpayer’s hands.

Comments :-Since the term ‘substantial part of the business’ occurring in the exception is not defined in the ITL, there is an ambiguity as to when lending of money can be regarded as substantial part of a company’s business. This HC ruling provides useful guidance on this issue and sets out the parameters which need to be examined in each case. It also provides guidance that in order to constitute ‘substantial part’, it need not necessarily constitute more than 50% of the company’s total business. Since the proposed Direct Taxes Code 2010 contains identical provisions on deemed dividend and exception, the ratio of this ruling will be useful even after the Code comes into force.