Deemed dividend provisions not applicable – What do we understand by ordinary course of business and substantial part of business

Deemed dividend provisions not applicable – What do we understand by ordinary course of business and substantial part of business

A legal backdrop:

The concept of deemed dividend under Section 2(22)(e) of the Income-tax Act, 1961, (the Act) is applicable in respect of loan or advance given by a closely held company to its shareholder[1] or any concern in which such shareholder is a member or a partner holding substantial interest[2] or any payment made on behalf or for the individual benefit of the shareholder. The deemed dividend will be taxable in the hands of the recipient company, to the extent to hich the company possesses accumulated profits.

However, there is an exception to the above stated legal positions. As per section 2(22)(e)(ii) of the Act, any advance or loan made to a shareholder or the said concern by a company in the ordinary course of its business, where the lending of money is a substantial part of the business of the company shall not constitute dividend.

The term “substantial part of the business” is not defined in the Act. As there is no definition of what constitutes substantial part of business, the same is interpreted variedly and is a subject of continuous dispute between the taxpayer and the income tax authorities. Recently, this issue has been addressed by the Ahmedabad Bench of Income tax Appellate Tribunal in the case of Krishna Coil Cutters Pvt. Ltd[3] 

The Assessing Officer and JCIT (“AO”) held that the amount of loans received from the sister concern falls within the ambit of provisions of Section 2(22)(e) of the Act and accordingly, taxed the same as deemed dividend.

In appeal before the Commissioner of Income-tax (Appeals) (CIT(A)), following contentions are raised:  

 Contention of the Assessee Company:

• Lender company had given advances to the assessee company in the ordinary course of business. Every advance or loan to a shareholder is not liable to be taxed as deemed dividend as per section 2(22)(e) of the Act, but only gratuitous[4] loans advanced by the company to shareholders should be treated as deemed dividend. In this connection reliance was placed on the decision of the Calcutta High Court in the case of Pradipkumar Malhotra[5]. Assessee was paying interest @ 12% to lending company and as such the loan was not gratuitous in nature. The AO had nowhere held that the amount advanced by the lending company to the Assessee was a gratuitous payment.
• The AO had allowed interest payment as deduction while computing business income of the assessee. Also, at the same time the amount of loan received is taxed as deemed dividend. Such interest payment could not have been allowed by the AO while computing the business income as no one makes payment of interest on the amount of dividend income it earns.
• Lending Company was advancing funds to the Assessee on interest at market rate even when the Assessee was not its shareholder. Therefore, routine advance of funds for earning of interest income by the lending company in which the Assessee has become substantial shareholder cannot be dividend merely because recipient has subsequently acquired substantial holding in the share capital of lending company.
• The transaction is Inter Corporate Deposit (ICD) between the Lender Company and the Assessee and hence, it cannot be termed as loans and advances.
• Lending of money was substantial part of the business of the lending company and the same cannot be taxed as deemed dividend in view of the exception provided in clause (ii) of section 2(22)(e) of the Act.
• Exception to Section 2(22)(e) refers to substantial part of business and not substantial income. For determining substantial part of money lending business, reference should be made to ratio of deployment of funds in money lending activities to the total funds available and not to the income criteria as done by the AO. Reliance is placed on the decision of the Ahmedabad Tribunal in the case of ITO Vs. Krishnomics Ltd.[6]

 Accordingly, it was contended by the assessee that the loan received from the lender company is not taxable as deemed dividend.

 Contention of the Revenue (AO/JCIT):

• For money lending activity to constitute principal part of the business activity the ratio of funds deployed to the gross turnover should be 50% or more. In the present case the said ratio was 10.25% and therefore, it cannot be held that the lending company principal activity of business is money lending
• The AO contended while placing the reliance on the decision in the case of Krishnonics Ltd (referred supra) that one must see the main object of the lending company and deployment of funds of the payer company. This means that, if it is found that the payer company has money lending as its main object and funds deployed during the year are more than other funds deployed for carrying on other businesses, then the money given by the payer company cannot be treated as deemed dividend.
• The money lending business can be considered substantial if 20% of the income of the lending company comes from money lending business. Reliance was placed on the on the decision of Delhi Tribunal in the case of Rekha Modi[7]
• In the present case the ratio of gross interest income to the turnover of the lending company is 0.5% and ratio of gross interest to gross profit is 11.22%. Also, ratio of net interest income to net profit is less than 20% and therefore it can be said that money lending is not substantial part of business of the lending company
• With respect to deployment of funds as per balance sheet of the company, the percentage of total funds deployed in loans and advances i.e. investment activities accounted for 46.28% and since, it was less than 50%, it was contended that the principle activity of the lending company is not money lending activity. Reliance in this context was placed on the decision of Bombay High Court i in the case of Parle Plastics Ltd.[8] is not applicable.

 Accordingly, the AO held that the funds received by the assessee from the lending company will be taxed as deemed dividend and the same is not covered by the exception to Section 2(22)(e) of the Act.

 Decision of the CIT (A)

• The assessee company’s memorandum of association (MOA) permitted the activities of lending money under incidental and ancillary clause to the main object and since it is covered by MOA, the contention of the AO that it forms part of the main object clause is not acceptable.
• The CIT(A) held that findings given by the Jt. CIT that since, the funds deployed in loans and advances is less than 50% of the total funds available with the lending company, , lending of money is not a substantial part of the business of the lending company is not correct. While holding so, the CIT(A) placed reliance on the decision of The Hon’ble Bombay High Court in the case of Parle Plastics Ltd. (supra) wherein the issue discussed is what can be considered to be the substantial part of the business. In this decision the Court has held that the phrase “substantial part” appearing in section 2(22) (e) does not mean “Principal Business” or such activity which constitutes more than 50% of the total activity or assets of the company.
• The CIT(A) placed reliance on the decision of Rekha Modi in holding that in order to ascertain as to whether money lending constitutes a substantial part of total business of lender company, the facts have to be considered in respect of the previous year relevant to the assessment year under consideration and not in relation to earlier years.
• Further, CIT(A) relying on the decision in the case of Krishnomics (referred supra) held that for determining substantial part of business, deployment of funds should be considered and not the income criteria.
• CIT(A) relying on the ruling in the case of Jayant H Modi[9] by Mumbai ITAT, wherein it was held that where the maximum funds deployed in lending activities was 32% of the total fund available with the company, it can be said that the company had lending money as substantial part of its business. In the present case the funds deployed by the assessee company was more than 32%.
• Additionally, the loans given to the Assessee by the lending company are not gratuitous loans and the Assessee is paying interest at the rate of 12%, being the prevalent market rate, to the lending company on which the lending company is paying taxes. Further, the lending company had also granted loan on interest to the Assessee in preceding years when the Assessee was not holding substantial interest in the lending company.

Based on the facts and judicial rulings, CIT(A) held that money lending is a substantial part of the business of the lender company and the loan to the Assessee has been advanced in the ordinary course of its business. Accordingly, such loan cannot be taxed as deemed dividend in the hands of the Assessee.

Decision of the Income-tax Appellate Tribunal (Ahmedabad) (“ITAT”)

• The ITAT relied on the decision of the Calcutta High Court in the case of Pradip Kumar Malhotra CIT (referred supra) wherein it was held that advances given by the lender was not for the individual benefit of the shareholder but for business purposes and therefore such transactions would not fall within the sweep of deeming fiction created as per section 2(22)(e) of the Act. Hence, ITAT concluded that this reason on a standalone basis is sufficient to exclude the applicability of Section 2(22)(e) of the Act on the money received by the Assessee.
• ITAT also held the money lent to the Assessee was received in the ordinary course of business for fulfilment of business supply through consolidated negotiation. ITAT observed that similar advance was obtained in the earlier years where the Assessee was not a shareholder in the lender company. ITAT further observed that the lender company was substantially engaged in money lending activity and even more, the lender company has charged interest on the loans advanced to the Assessee.
• ITAT held that in the facts stated above, the case of the Assessee is squarely covered by the decision of the Hon’ble Gujarat High Court in Pr. CIT v Mohan Bhagwatprasad Agrawal[10] & CIT Vs. Parle Plastics Ltd. (supra).
• ITAT also clarified that Section 2(22)(e) of the Act requires money so lent to be only ‘substantial part’ of business in contrast to the ‘principal business’ as wrongly assumed by the AO. Based on the same, it was concluded that, no addition could be made by way of deemed dividend in the case of the assessee as rightly held by the CIT(A).

SKP Comments:

This decision is a welcoming one and will bring certainty for the taxpayer on the applicability of the deeming provision and what constitute substantial part of the business of the company. Although, it is a fact specific exercise to examine the applicability in each case, but the clarity on how to determine substantial part of the business will be helpful to the taxpayers.

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[1] Shareholder who is the beneficial owner of such shares holding not less than ten per cent of the voting power

[2] A person shall be said to have substantial interest in a concern only when such person is beneficially entitled to not less than twenty per cent of the income of such concern.

[3] [TS-534-ITAT-2021(Ahd)]

[4] Gratuitous loan or advance means where the lender of the loan is not getting in return any advantage in respect of loan     provided.

[5] (2011)338 ITR 538(Cal)

[6] [2009] 308 ITR (AT) 8 (Ahd.)

[7] [2007] 13 SOT 512 (DELHI)

[8] (2011) 332 ITR 63 (Bombay)

[9] 56 SOT 84 (Mum)

[10] [2020] 115 taxmann.com 69 (Gujarat)

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The author is Anita Basrur, Partner Sudit K. Parekh & Co. LLP and she was assisted by Ms. Mital Patel, CA and Ms. Gurleen Kaur, CA.