Meaning of expression ‘substantial part of business’ for Section 2(22)(e)

The meaning of the expression ‘substantial part of business’ for the purpose of Section 2(22)(e)

Introduction

Section 2(22)(e) of the Income Tax Act, 1961 will not be attracted if the company making the payment by way of loans or advances, have made such payment in the ordinary course of its business and lending of money is substantial part of the business such company.

What do you mean by “substantial part of business”?

COMMISSIONER OF INCOME TAX VERSUS PARLE PLASTICS LTD. AND OTHERS (Bombay HC)

Facts of the case

• The assessee had taken an unsecured loan from its sister concern AMPL and the loan amount of Rs. 2,18,60,949 was due and payable by the assessee to AMPL at the end of previous year ending 31-3-1997.
• Majority of the share capital of the assessee was held by two individuals namely R and Z. R held 54% share capital and Z held 20% share capital of the assessee.
• The same two persons were also the majority shareholders of AMPL. R held 53.33% of the share capital of AMPL and Z held 13.33% of the share capital of AMPL.
• In view of the fact that AMPL was a company in which public was not substantially interested and in view of the fact that the said two persons held majority of the share capital in the assessee company as well as in AMPL, the AO held that Rs. 2,18,60,949 which was a loan by AMPL to the assessee company, should be treated as a deemed dividend in its hands under section 2(22)(e) of the Act.

Contentions of the assessee

The assessee contended that the aforesaid loans would not be deemed as dividend under Section 2(22)(e) because granting of loans was substantial part of business of AMPL.

Contentions of the Department

• Objects Clause of AMPL does not contain lending of money as one of the main objects.
• Lending of money was not the main object, though it may be another object under the memorandum of association of AMPL.
• Though lending or advancing of money is in the usual course of business and may be an activity permitted by the memorandum of association of AMPL, the actual business of lending money was not the substantial part of the business of AMPL.
• In order to consider the activity of money lending as a substantial part of the business of the lending company (AMPL in this case), the business of moneylending must constitute more than 50 per cent of the business of lending company.

Findings of the High Court

• A plain reading of Clause (ii) of Section 2(22) of the Act shows that any advance or loan made by a company to a shareholder or a concern in which the shareholder has a substantial interest would not be regarded as a dividend if the two conditions are satisfied namely,that the loan or advance was made by the (lending) company in the ordinary course of its business and lending of money was a substantial part of the business of the (lending) company.
• Apart from the business of manufacture, supply and distribution of soft drinks and mineral water, AMPL was also engaged in the business of lending money.
• The money was lent by AMPL to the Assessee in usual course of business of the AMPL which included business of granting loans and advances. The first condition under Clause (ii) of Section 2(22) of the Act was satisfied.
• Therefore, it is important to ascertain the meaning of the word “substantial”, appearing in the expression “substantial part of the business”.
• Black’s Law Dictionary, Sixth Edition defines the word “substantial” as “of real worth and importance; of considerable value; valuable; belonging to substance; actually existing; real; not seeming or imaginary; not illusive; solid; true; veritable. Something worthwhile as distinguished from something without value or merely nominal.”
• As rightly observed in Stroud’s Judicial Dictionary, it is not possible to give any fixed definition of the word “substantial” in relation to “a substantial business of a company”.
• In our view, 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 really intended that more than 50 per cent of the business of the lending company must come from the business of lending, nothing prevented the legislature from using the expression “majority of business”. If the legislature at all intended that a particular minimum percentage of the business of a lending company should come from the business of lending, the legislature could have specifically provided for that percentage while drafting Clause (ii) of Section 2(22) of the Act.
• The legislature had deliberately used the word “substantial” instead of using the word “major” and instead of specifying any percentage of the business or profit to be coming from the lending business of the lending company for the purpose of Clause (ii) of Section 2(22) of the Act.
• 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.
• Various factors and circumstances would be required to be looked into while considering whether a part of the business of a company is its substantial business. Sometimes a portion which contributes substantial part of the turnover, though it contributes a relatively small portion of the profit, would be substantial part of the business. Similarly, a portion which relatively small as compared to the total turnover, but generates large, say more than 50 per cent of the total profit of the company would also be substantial part of its business. Percentage of turnover in relation to the whole as also the percentage of the profit in relation to the whole and sometimes even percentage of a manpower used for a particular part of business in relation to the total manpower or working force of the company would be required to be taken into consideration.
• Employees of a company are now called its “human resources” and, therefore, the percentage of “human resources” used by the company for carrying on a particular division of business may also be required to be taken into consideration while considering whether a particular business forms substantial part of its business. Undisputedly, the capital employed by a company for carrying on a particular division of its business as compared to the total capital employed by it would also be relevant while considering whether the part of the business of the company constitutes “substantial part of the business” of the company.

Final decision of the High Court

We do not find that the Tribunal has committed any error in coming to the conclusion that lending of money was a substantial part of the business of AMPL. The Tribunal has noted that 42 per cent of the total assets of AMPL as on 31st March, 1996 and 39 per cent of the total assets of AMPL as on 31st March, 1997 were deployed by it by way of total loans and advances. By no means, the deployment of about 40 per cent of the total assets into the business of lending could be regarded as an insignificant part of the business of AMPL. The Tribunal has also held that the income AMPL had received by way of interest of Rs. 1,08,18,036 while its total profit was Rs. 67,56,335. Excluding the income earned by AMPL by way of interest, the other business had resulted into net loss. In our view, the Tribunal has taken into consideration the relevant factors and has applied the correct tests to come to the conclusion that lending of money was substantial part of the business of the AMPL. Since lending of money was a substantial part of the business of AMPL, the money given by it by way of advance or loan to the Assessee could not be regarded as a dividend, as it has to be excluded from the definition of “dividend” by virtue of Clause (ii) of Section 2(22) of the Act.

TANUJ HOLDINGS (P.) LTD. VERSUS DEPUTY COMMISSIONER OF INCOME TAX, CC-1(2) (Kolkata – Trib.)

Facts of the case

• Assessee had received loan from a closely held company
• AO treated the said loan as deemed dividend under Section 2(22)(e)

Contentions of the assessee

The assessee contended that the said loan cannot be deemed as dividend under Section 2(22)(e) because the lending company was substantially engaged in the business of granting loans and advances

Contentions of the Department

• The ‘main business’ of loan granting company was Real Estate Development. Therefore the assessee cannot take the defense of the clause (ii) of Exclusion envisaged in Section 2(22)(e)

Findings of the ITAT

• The lending company deployed in granting loans in excess of 20% of Net Owned Funds. It would thus be evident that granting of inter corporate deposits was ordinary business of lending company and income derived from such activity was consistently assessed.
• The legislature in section 2(22) had consciously used the words ‘substantial part of the business’ in contradistinction to the words ‘main business’ or ‘principal business’.
• The expression ‘substantial part of the business’ is different and distinct from the words ‘principal business’ or ‘main business’ used in other places in the Act.
• Taking cue from provisions of section 2(22)(e) and section 2(32) of the Act, the courts and various benches of the tribunal have held that threshold of 20% can be safely applied to ascertain whether a particular business activity can be considered to be forming ‘substantial part of the business’. As per Section 2(32) of the Income Tax Act, 1961, “person who has a substantial interest in the company”, in relation to a company, means 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, carrying not less than twenty per cent of the voting power ;
• In the instant case, as already stated supra that the lending company had deployed more than 20% of its Net Owned Funds by way of granting of inter corporate deposits to the assessee and then it could be concluded that the substantial part of company’s business can be said to be granting loans, inter corporate deposits and advances and therefore clause (ii) of section 2(22)(e) of the Act becomes applicable in case of such company.
• The interest income earned on loans and inter corporate deposits by the lending company constituted substantial sources of income for the lending company. In these circumstances, an activity which was consistently carried on and which substantially contributed to the net profits of each year, could not be overlooked in deciding the question as to whether granting of loans and inter corporate deposits formed substantial part of the business of the lending company.
• More than 50% of paid up capital and reserves of the lending company were consistently deployed in the business of granting loans and inter corporate deposits for the purpose of earning interest income. Clause(ii) of section 2(22)(e) of the Act was clearly applicable and therefore any amount granted by the said company did not come within the mischief of section 2(22)(e) of the Act.

Final decision of the ITAT

No addition could be made in the hands of the assessee towards deemed dividend because substantial part of the business of the lending company is granting of loans, advances and inter-corporate deposit in the ordinary course of business

COMMISSIONER OF INCOME TAX, KOL.-III VERSUS SHREE BALAJI GLASS MANUFACTURING (P) LTD (Calcutta HC)

Facts of the case

• The assessee borrowed a sum of Rs.1,12,50,000/- from Pushpak Commercial Finance Pvt. Ltd. and a sum of Rs.1,79,50,000/- from Anjani Highrise Pvt. Ltd.
• Part of the aforesaid amounts representing share premium and accumulated profits were treated as deemed dividend by the AO under Section 2(22)(e)

Contentions of the assessee

• The assessee contended that lending of money formed substantial part of the business of the company, Pushpak Commercial Finance Pvt Ltd.
• Section 2(22)(e) cannot be invoked.
• The assessee has sought to draw strength from Section (32) of Section 2 which defines the expression person who has substantial interest in the company to mean in which a person who is the beneficial owner of the equity shares not less than 20% of the voting power. Strength has also been drawn on behalf of the assessee from clause (b) of Explanation 3 to Section 2(22) which lays down that a person shall be deemed to have a substantial interest in a concern other than a company if he is at any time during the previous year beneficially entitled to not less than 20% of the income of such concern.

Contentions of the Department

• In the case of Pushpak Commercial Finance Pvt. Ltd. less than 51% of application of funds is towards money lending.

Findings of the High Court

• Fund utilization to the extent of 34.98% has been made towards money lending activity by the said concern.
• Section 2(22)(e) does not define or lay down a percentage for the word “substantial” used there.
• The learned Tribunal was of the opinion that utilization of 34.98% of the total funds in the business of money lending constitutes a substantial part of the business of the company.

Final decision of the High Court

The High Court upheld the Order of ITAT who concluded that granting of loans and advances was substantial part of the business of the lending company

COMMISSIONER OF INCOME TAX, MUMBAI V. JAYANT H. MODI (Bombay HC)

Facts of the case

• Assessee received certain loans from company ‘J’ in which he was holding more than 10% shares.
• The AO held that loan amount to extent of accumulated profit of company would be taxed as deemed dividend under section 2(22)(e) in hands of assessee.

Contentions of the assessee

• Section 2(22)(e) cannot be invoked because of the applicability clause (ii) of Exclusion given in Section 2(22)(e) i.e. lending business is substantial part of the business
• The main object of the company ‘J’ was to carry on business as share and stock brokers but its memorandum of association allowed the company to carry on business inter alia of lending or advancing money.

Contentions of the Department

• Money lending was not a substantial part of the business of the company ‘J’ from whom loan was obtained by assessee
• The company ‘J’ was advancing money only to one entity, namely, M/s. Sonal investment. Rest of the sums were advanced to the employees of company ‘J’, therefore, the exclusionary clause was not applicable and reliance placed on the judgment of this Court in the case of CIT v. Parle Plastics Ltd. [2011] 332 ITR 63/196 Taxman 62/[2010] 8 taxmann.com 155 was entirely misplaced.

Findings of the High Court

• The Tribunal also referred to the assessment order in the case of the company ‘J’ for the year under consideration, namely 2006-07, wherein the nature of the business of that company was indicated as finance. The company continued in the business of short-term finance of idle funds.
• During the year under consideration, the company ‘J’ earned interest income on the loans and advances so granted to the tune of Rs. 9,16,088/- which constituted about 70% of its total business income amounting to Rs. 13,04,088/-.
• The maximum amount of loan advanced by the company during the year under consideration was to the tune of Rs. 95,45,000/-. That constituted 32% of the total funds available with the said company.

Final decision of the High Court

• Lending of money is substantial part of the business of the company ‘J’
• The addition made by the AO and sustained by the Commissioner was not valid and legal
• Tribunal’s order is correct and reliance placed by it on the Division Bench judgment of this Court is not misplaced.

INCOME TAX OFFICER, WARD-4(2), AHMEDABAD V. KRISHNONICS LTD. (AHMEDABAD TRIBUNAL)

Facts of the case

• Assessee had taken a loan of Rs. 37,77,474 from another company styled M/s. Indulal Dahyabhai Investment Pvt. Ltd.
• One of the Directors namely Shri Shashank I. Shah was holding 50 equity shares of M/s. Indutal Dahyabhai Investment Pvt. Ltd. out of total equity share capital of 410.
• Shri Shashank I. Shah was holding 686210 shares of the assessee company out of total paid-up equity capital 2137080.
• AO proposed to invoke the provisions of section 2 (22) (e) of the Act with respect to loan of Rs. 37,77,474 taken by the assessee.

Contentions of the assessee

• The main business of M/s. Indulal Dahyabhai Investment Pvt. Ltd. was of money lending and giving of advances or to give credit on such terms and conditions as may be expedient.
• Reference was made to the Memorandum and Articles of Association of M/s. Indulal Dahyabhai Investment Pvt. Ltd.
• The assessee’s case was, therefore, to the effect that M/s. Indulal Dahyabhai Investment Pvt. Ltd. had given the loan in question to the assessee company during the course of its ordinary business of money lending and, therefore, the provisions of section 2(22)(e) were not applicable.
• The provisions of section 2 (22) (e) refers to the words “substantial part of business” and not to the words “main business” or “substantial business” or “main or substantial Income” and therefore, assessee’s one of the object, out of six main objects, admittedly being of money lending, the loan given to the assessee has to be accepted as having been given during the course of ordinary business by M/s. Indulal Dahyabhai Investment (P.) Ltd.
• So far as the question of finding out as to which part of the business was substantial part of business carried on by that company, one has to see only the main objects and deployment of funds.
• Considering this issue on the basis of quantum of income is not justified because it may happen many times that one may not earn any income from the source for which there is heavy investment and there can be so many reasons – one of the reasons may be that funds might have been deployed on the last day of the previous year.
• It is quite evident from the balance sheet of M/s. Indulal Dahyabhai Investment Pvt. Ltd. as on 31-3-1996, which was furnished before the CIT (A) as well as Assessing Officer, that the amount deployed during the course of money lending business is Rs. 37,77,474 (loan to the assessee) and Rs. 1,08,099 (Loan to M/s. Goyal Metallic Pvt. Ltd.) , whereas the investment in shares from which the assessee received dividend was only to the tune of Rs. 4,14,300. He therefore submitted that the deployment of funds during the course of money lending business being about ten times to the funds set apart for investment in shares, the money lending business of that company for assessment year 1996-97 was absolutely substantial one and therefore, the CIT (A) justified in deleting the addition under reference.

Contentions of the Department

• The dividend income earned by M/s. Indulal Dahyabhai Investment Pvt. Ltd. was Rs. 1,60,320 whereas income from interest on loans and advances was to the tune of Rs. 52,768 and therefore, the business of giving loans was not the main business.
• The object of giving loans and advances was only one of the six main objects.
• The Assessing Officer, therefore, rejected assessee’s explanation and invoked the provisions of section 2 (22) (e) of the Act.

Findings of the ITAT

• The provisions of section 2 (22) (e) (ii) refers to the words “Substantial part of the Business” and nowhere refers to the words “Substantial Income” which means that to find out as to whether a given case is covered by the provisions of section 2(22) (e) of the Act or not, income criteria from a particular source is not relevant.
• To find out substantial part of business of the lender company, one should consider the ‘objects’ and ‘deployment of the funds’ by the lender company because there can be cases where the company might have deployed more funds by way of loans during the course of business of money lending at the end of the previous year and may not have earned any interest or earned a small interest, but might have earned more dividend on investment having been made before the declaration of dividend on shares bringing dividend, even if the investment so made may be quite less as compared to money given by way of loan.
• If income criteria is taken into account, there will be absurd results.
• Discard such system to be adopted for finding out as to whether the money lending was substantial part of the business carried out by the lender company or not.
• If it is found that the lender company had money lending as its main objects or one of the main objects and the funds deployed during the course of money lending business were substantial when compared to the total of other funds deployed for carrying on the other business, then the amount given by such lender company to any other company will not attract the provisions of section 2 (22) (e) of the Act.
• We, after having gone through the memorandum and articles of association placed at Page 88 of assessee’s paper book and its balance sheet placed at Page 78 of assessee’s paper book have noticed that money lending was not only one of six main objects of the lender company, but the assessee was carrying on this business in preference to other business and at the same time had deployed funds to the extent of Rs. 37,77,475 by way of loan to the assessee and to the tune of Rs. 1,08,099 to Goyal Metallic Pvt. Ltd. out of total funds available at Rs. 44,56,304 as against the deployment of amount of Rs. 4,14,300 as investment in shares earning dividend.

Final decision of the ITAT

• Substantial part of the business carried on by M/s. Indulal Dahyabhai Investment (P.) Ltd. was that of money lending and consequential loan given to the assessee (on interest) was loan having been given during the course of money lending business. We, therefore, are of the opinion that assessee’s case was not covered by the provisions of section 2(22) (e) and the CIT (A) was quite justified in deleting the addition. The order of CIT (A), on this point, is therefore confirmed.