The important aspect while planning restructuring proposals is the applicability of deemed dividend provisions that was under the controversial route which is now put to rest with the latest ruling by the Apex Court. The muddle of taxability under deemed dividend as per section 2(22)(e) is now cleared by the latest ruling of the Apex Court and would be beneficial for assesses facing similar issues.
The term “dividend” is defined under the Companies Act, 2013 to include any interim dividend. The dictionary meaning of the term “dividend” is a sum of money paid regularly (typically annually) by a company to its shareholders out of its profits (or reserves).
Under the Income Tax Act, 1961 (ITA), dividend has been defined to include
(a) Any distribution by a company of accumulated profits, whether capitalized or not, if such distribution entails the release by the company to its shareholders of all or any part of the assets of the company;
(e) any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) [made after the 31st day of May, 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten per cent of the voting power, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern)] or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent to which the company in either case possesses accumulated profits.”
For computation of income of an assessee, any income earned as dividend by an assessee in the previous financial year shall be taxed under the head “Income from Other Sources” and will be taxed at normal applicable rates.
The word “deemed” is not used anywhere under section 2(22) of the ITA. The Apex Court has ruled in the case of Kantilal Manilal (1961) 41 ITR 275 that dividend may not be distributed in money; it may be distributed by delivery of property or right having monetary value.
With an intent to bring the net accumulated profits available for distribution by private companies to their shareholders in the form of loans within the ambit of tax, amendments were made in section 2 by the Finance Act, 1987. Circular No. 495, dated 22 September, 1987 states that the payments made by a company by way of loans or advances to a concern where a member or a partner of the concern holds 10% of voting power in the company and entitled to 20% beneficial interest of the income of such concern shall be taxed in the hands of the concern.
The Apex Court has upheld the constitutional validity of the provisions of section 2(22)(e) in the case of Navnit Lal C. Javeri (1965) (56 ITR 198). It was contended that the provisions are a piece of colourable legislation, as under the guise of imposing tax on income, tax has been imposed on loan. Further, it was contended that the shareholders of the company resorted to a device of borrowing from the company to remain outside the ambit of taxability. However, to prevent evasion of tax by shareholders of the controlled company, provisions were enacted under the Constitution of India. The constitutional validity of the provisions was challenged and it was held that deemed dividend provisions have been enacted to prevent the evasion of taxes by members resorting to other devices and enacting these provisions was constitutionally valid in the eyes of law.
Section 2(22)(e) being a deeming provision, should be construed strictly upon fulfillment of following:
Where any advance or loan is made by a private company:
i. To a shareholder holding 10% or more of the equity share capital of the company; or
ii. To any concern in which a shareholder holding 10% of the equity share capital of the company is a member or partner and holds substantial interest.
The different limbs analyzed in the different rulings refer to the same arguments that a company in which the public are not substantially interested and is controlled by a group of members would not distribute dividend to its shareholders despite available accumulated profits, as the same would be taxable in the hands of the shareholders as dividend. To counter this, instead of distributing accumulated profits as dividend, companies distributed them as loans and advances to shareholders or to concerns in which shareholders have substantial interest or make payment on behalf of shareholders. This is where the deeming provision comes into play and such payment falls within the ambit of taxation. However, the intention is to tax the shareholder and not the loan recipient.
The Apex Court had ruled in case of Gopal and Sons (HUF) that although the karta of the HUF was a registered shareholder and had a substantial interest in the HUF, advances received by the HUF from the company would be treated as deemed dividend under the provisions of section 2(22)(e) of ITA.
The ruling passed by the Bombay High Court in the case of Impact Containers Pvt Ltd., held that certain companies advanced money to assessee companies in which one director of the assessee was holding more than 10% equity shares, as the assessee itself was not a shareholder of those lending companies, the addition made by the assessing officer by invoking the provisions of section 2(22)(e) was not sustainable. A similar analogy was adopted in the case of Universal Medicare Pvt Ltd. (2010) 190 taxmann 144 (that approved the tribunal ruling in case of Bhaumik Color 313 ITR 146) that loans and advances to a concern in which the shareholder has substantial interest would not be liable to tax under the provisions of deemed dividend, as the loan recipient is not the shareholder and the deeming fiction is for taxing dividend in the hands of shareholders.
The Delhi High Court, in the case of Ankitech (P) Ltd., held that deemed dividend was not taxable in the hands of recipient concern, if such concern was not a shareholder of the lender company. It was contended, “the deeming provisions would apply to a case of loans or advances by a company to a concern in which its shareholder has substantial interest, is based on the presumption that the loans and advances would ultimately be made available to the shareholders of the company giving loan or advance. Further, the High Court ruled that if the intention of the Legislature was to tax such loan or advance as deemed dividend at the hands of “deeming shareholder,” the Legislature would have inserted deeming provision in respect of the shareholder as well, which has not happened in the given case.” Recently, the Apex Court has upheld the Delhi High Court ruling where deemed dividend would not be taxable in the hands of the loan recipient, if such concern were not a shareholder of the lender company.
With the above ruling, the Apex Court has cleared the muddle of taxability under deemed dividend as per section 2(22)(e) in the hands of the loan recipient, and this will be beneficial for assesses facing similar issues. Further, it has now put to rest this controversy and held that the tax authorities are open to take corrective measures by treating the dividend income in the hands of the shareholder and taxing them accordingly.
However, if there are two or more shareholders holding beneficial interest in both, the lender and borrower companies, the deemed dividend provisions would be attracted in the hands of which shareholder and to what extent?
Author: Falguni Shah, M&A Tax Partner, PwC India and Akshay Shenoy, Associate Director – M&A Tax, PwC India
The views expressed here are personal. Article includes inputs from Manish Gupta, Manager – M&A Tax, PwC India and Vaibhav Zaveri, Assistant Manager– M&A Tax, PwC India