Deemed Dividend – The Taxmen’s Arsenal

Introduction

“Deeming Provision” – deem things to be what they are not or changing some term to mean something more (or less) with the intent of conferring an advantage upon the taxman. Under the Income-tax Act, 1961 (‘the Act’) section 2(22)(e) is one such deeming provision that has been the focus of much litigation ever since its enactment.

As on 30th November, 2018, the number of companies registered under the Companies Act was around 18.28 Lakh. Out of this the total number of active companies are 11.27 Lakh (excluding the Companies that are closed, under liquidation, under dormant status or in the process of being struck-off) comprising 10.55 Lakh of private companies i.e. the Private Company accumulates to 93.6 percent of the total active companies in India. This is the area on which such deemed dividend strike its nail with its deeming provision.

Applicability

• The provision of deemed dividend is applicable on payments made by closely held companies;
• Closely held companies are those in which the public are not substantially interested, i.e. private companies;
• Payment is made by way of loans or advances;
• Payment is made to:
• a shareholder, being a person who is the beneficial owner of shares holding 10% or more of voting power; or
• any concern in which such shareholder is a member or a partner and in which he has a substantial interest; 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.

Exception: Dividend does not include:

1. 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;

2. any dividend paid by a company which is set off by the company against the whole or any part of any sum previously paid by it and treated as a dividend within the meaning of deemed dividend, to the extent to which it is so set off;

3. any payment made by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 77A of the Companies Act, 1956 (1 of 1956);

4. any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged company.

Such provision was introduced to bring an end to the practice of tax evasion being done by companies through routing of profits in form of loans and advance to avoid payment of dividend and tax thereon. Through Finance Act 2018 w.e.f. 1^st April 2018, such provision has been amended and now payments are liable to be taxed at the rate of 30 percent in the hands of the Company making such payments.

Let’s have a look at some cases:

Case A:

Company A gives loan to its shareholder holding more than 10% of shares in Company A. Whether section 2(22)(e) would be applicable?? YES

Case B:

Company A gives loan to another Company B in which its shareholder (having more than 10% stake in Company A) holds more than 20% of voting rights. Whether Company A needs to pay tax of 30% on such payment?? YES

Case C:

A subsidiary company advances a sum to its holding company. Whether deemed dividend provisions will hit?? YES or NO – This will depend upon the facts of the case, as if the advance is in nature of commercial or trade advance then the deeming provision will not be applicable.

Case D:

Advances made by a company to a sister concern and adjusted against the duesfor job work done by the sister concern. Whether section 2(22)(e) would apply?? NO, as this is under the nature of trade advance.

Case E:

Company A provides a loan to its shareholder holding more than 10% of voting right at an interest rate of 12% p.a. The shareholder has duly repaid such loan during the same year along with interest. Whether the Company have to pay tax at the rate of 30% on such loan?? YES or NO – Such transactions are under the grey area and will depend upon the facts of the case

From the above stated cases, it seems that such transactions are normally undertaken by every private company once in a year. What will be the repercussion of ignoring such transactions?? Let’s have a look.

Once Dividend Distribution Tax (‘DDT’) is applicable, the same must be paid within 14 days of giving loan to the shareholder. If the DDT is not paid to the government within the time frame, then:

1. Company would be deemed to be assessee in default as per section 201 of the Act;

2. Levy of interest at 1% for every month or part of a month, for delay;

3. Possible imprisonment under section 276B of the Act

Isn’t it harsh for genuine cases??

The provision was introduced to put an end to such transactions that were undertaken by Company to evade tax, however, later a lot of genuine cases also got covered under the provisions of deemed dividend. In this respect the Central Board of Direct taxes (CBDT) has issued a circular no.19/2017 dated 12th June, 2017 stating that commercial or trade advance shall not be covered under the definition of deemed dividend. Further, the provision of deemed dividend will not apply in case there is no accumulated profit or there is loss. However, still there are lots of grey areas that are yet to seek its correct path and are facing prolonged litigation.

Conclusion:

There are many transactions undertaken by the Company that get covered under the deeming provisions but are ignored/overlooked or neglected by the Company due to its nature. However, looking towards its effect and the current scenario of the department, one must properly apply his mind and kept in mind the intent of the legislature at the time of introducing the provision of deemed dividend before undertaking the transaction, as even the genuine cases are covered prima facie.