Manish Kumar Agarwal, FCA
Now a days, in a modern organization , there will exist a complicate business structure of holding & subsidiary companies along with closely held companies. There will be routine flow of funds between these companies. It is very important to have the knowledge of provisions of deemed dividend under section 2(22)(e) of the Income tax act, 1961 before making any transaction with the closely held companies.
The provisos of section 2(22)(e) is reproduced below for your kind reference :
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) 93[made after the 31st day of May, 1987, by way of advance or loan to a shareholder94, 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 profits95 ;
but “dividend” does not include—
(i) a distribution made in accordance with sub-clause (c) or sub-clause (d) in respect of any share issued for full cash consideration, where the holder of the share is not entitled in the event of liquidation to participate in the surplus assets ;
96[(ia) a distribution made in accordance with sub-clause (c) or sub-clause (d) in so far as such distribution is attributable to the capitalised profits of the company representing bonus shares allotted to its equity shareholders after the 31st day of March, 1964, 97[and before the 1st day of April, 1965] ;]
(ii) any advance or loan made to a shareholder 98[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 ;
(iii) 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 sub-clause (e), to the extent to which it is so set off;
99[(iv) any payment made by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 77A 1 of the Companies Act, 1956 (1 of 1956);
(v) any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged company (whether or not there is a reduction of capital in the demerged company).]
Explanation 1.—The expression “accumulated profits”, wherever it occurs in this clause, shall not include capital gains arising before the 1st day of April, 1946, or after the 31st day of March, 1948, and before the 1st day of April, 1956.
Explanation 2.—The expression “accumulated profits” in sub-clauses (a), (b), (d) and (e), shall include all profits of the company up to the date of distribution or payment referred to in those sub-clauses, and in sub-clause (c) shall include all profits of the company up to the date of liquidation, 2[but shall not, where the liquidation is consequent on the compulsory acquisition of its undertaking by the Government or a corporation owned or controlled by the Government under any law for the time being in force, include any profits of the company prior to three successive previous years immediately preceding the previous year in which such acquisition took place].
3[Explanation 3.—For the purposes of this clause,—
(a) “concern” means a Hindu undivided family, or a firm or an association of persons or a body of individuals or a company ;
(b) 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 twenty per cent of the income of such concern ;]
The concept of Deemed Dividend is embedded in Section 2(22)(e) of the Income-tax Act, 1961 and was also embedded in section 2(6A)(e) of the Indian Income-tax Act, 1922. In nutshell, the concept envisages taxing certain payments made by closely held companies by way of loans or advances to certain shareholders of the company or to the concerns/companies in which they have substantial interest. Whenever any payment is made by way of loan or advance, the recipient of the loan or advance will be liable to be taxed on this amount as a dividend, to the extent to which the company has accumulated profits, under the deeming provisions of section 2(22)(e) although such loan or advance may have been given for genuine business purposes and even if the paying company may have received back the loan amount. Thus the section deems certain payments as dividend income which is not income under ordinary commercial parlance. Therefore, the name Deemed dividend.
The concept of deeming certain payments or loans or advances to substantial shareholders as income was introduced with the object of curbing tax evasion. Upto 31-5-1997 dividend was taxed in the hands of the recipient of the dividend. However many closely held companies never declared any dividend and accumulated profits in the company itself. Since no dividend was declared the same could not be taxed. However the companies did give loans or advances to substantial shareholders or to their concerns/companies who presumably enjoyed these funds but were not liable to pay any tax on the same as the amounts were loans or advances liable to be returned. These amounts of loans or advances are sought to be taxed as dividend by section 2(22)(e) of the Act by way of a deeming fiction..
Taxation of dividend under Income-tax Act, 1961 has undergone substantial changes in recent times. Effective from 1-6-1997 the scheme of taxation of dividend has been modified and is different from the old scheme . The essence of the old scheme was that the recipient of the dividend income was liable to pay the income-tax on the same, subject to certain exemptions. The new scheme essentially makes the dividend tax-free (section 10(33) of the Act) in the hands of the recipient (except cases covered under section 2(22(e)of the Act) and the dividend paying company has been made liable to pay tax on the amount of dividend declared , distributed or paid by it (Section 115-O of the Act). This tax is over and above the corporate income-tax which a company would normally pay. However there is no change in the scheme of taxation of Deemed Dividend contained in the section 2(22) (e) of the Act and such dividends are governed by the old scheme of taxation of dividend i.e. tax on deemed dividend is paid by the recipient and the paying company does not have to pay dividend tax but will be liable to deduct tax at source from such loans or advances/deemed dividend and pay the same to the Government.
Section 2 (22) of Income-tax Act, 1961 defines “dividend” and is the main section for taxation of Dividend. Unless a payment or distribution is covered by this definition, it can not be taxed as “dividend”. Once an amount is covered as dividend it will be also considered as income as Section 2(24)(ii) of the Act includes ‘dividend’ within the definition of ‘Income’.
Section 2(22) has 5 clauses (a), (b), (c), (d) and (e) which specify various types of distributions and payments as dividend. Clauses (a). (b), (c) and (d) mainly cover cases of distributions which entail release of assets or create liabilities. While clause (e) covers cases of payments by way of loans or advances and which is the clause mainly dealing with deemed dividend as it is commonly understood and has been dealt with in this article.
Following points are to be understood with reference to the above:
Sub-clause (e) applies when distribution or payment referred to therein are connected with accumulated profits. The undistributed income, when accumulated from year to year, generates what is known as “accumulated profit”. Accumulated profits shall include all profits of the company till the date of distribution or payment referred to in sub-clause (e).
(ii) Current Profits
Current profits are included in “accumulated profits” in section 2(22)(e) of I.T. Act 1961. The expression “accumulated profits” was defined in the 1961 Act so as to include current profit upto date of distribution or payment.
(iii) Accumulated profits – How to be Computed
The phrase “accumulated profits” does not mean aggregate of assessed profits but commercial profits. If certain disbursements have been disallowed in the assessment proceedings but the expenditure had in fact been incurred, they should be excluded from accumulated profits. In computing commercial profits, all the disbursements made and expenditure incurred for the purpose of business should be taken into account. The following are the items which are to be included or to be excluded in computing accumulated profits:
|Sl. No.||Items to be excluded||Items to be included|
|a)||Provision for taxation and dividend||Development rebate|
|b)||Depreciation||Refund of income-tax|
|c)||Difference between depreciation calculated at the rate given under the IT Act and rate adopted in books||Development rebate reserve|
|d)||Balancing charge||General reserves|
|e)||Capital gains not chargeable to tax||Capital gains chargeable to tax|
[B] Advance Or Loan To A Shareholder By A Closely – Held Company
I) Who should be given loan or Advance
Loan or Advance is given by a closely held company (i.e. Private Limited Company) to-
(i) Shareholder holding 10% or more voting power in that company;
(ii) Concern i.e. HUF, Firm, AOP, BOI in which, Shareholder who holds 10% or more voting power in the company, also holds 20% or more of the income of that concern at any time during the previous year;
(iii) Concern i.e. Company in which, Shareholder who holds 10% or more voting power in the company, also holds 10% or more voting power of that concern at any time during the previous year.
II) Loan or Advance
The expression used in section 2(22)(e) is “advance or loan”. It ordinarily means payment of cash or transfer of goods for which accounting must be rendered by the recipient at some later date. Thus, there would be advance by the company when goods are transferred to shareholder. The expression “advances” also refers to something which is due to be paid to the shareholder but which is paid to him ahead of time when it is due to be paid.
The transaction of loan involves lending and delivery by one party and receipt by another party of sum of money upon express or implied agreement to repay it with or without interest.
III) Effect of repayment of loan
As soon as loan is advanced to shareholder by closely held company from accumulated profits statutory fiction under section 2(22)(e) becomes operative and such loan is deemed to be dividend. Such loan does not cease to be deemed dividend on account of any subsequent event. Even if the loan is repaid by the shareholder in the same previous year, the statutory fiction arising at the time of giving loan by the company does not cease to be operative. Such a loan would be taxed as deemed dividend even if repaid in the same previous year.
IV) Subsequently declared dividend set off against previously granted loan
Where a loan granted by the company is treated as dividend under section 2(22)(e) and the company subsequently declares regular dividends and sets it off against the said loan, the dividends so set off would not be treated as dividend in the hands of the shareholder.
V) Exception where substantial part of business of the company is money – lending
Where the lending of money is a substantial part of the business of the company, “dividend” would not include any advance or loan made in the ordinary course of business to a shareholder or to the concern in which such shareholder has substantial interest.
[C] Quantum of deemed dividend
The principle is that where loan given by the company exceeds the accumulated profits, deemed dividend would be to the extent of accumulated profits and balance of loan amount would not be deemed dividend. If the accumulated profits exceed the loan amount, entire loan amount would be deemed dividend and not the amount proportionate to shareholder’s interest in the shareholding of the company. If there are no accumulated profits, there would not be any question of loan being treated as deemed profits.
The assessee held 25% shares of the closely held company. The accumulated profits were Rs. 4,000 while the assessee took loan of Rs. 29,000. Here, loan given by the company exceeds the accumulated profits. Thus, entire accumulated profits are to be taken into account under section 2(22)(e). And only 25% of Rs. 4,000 should not be regarded as deemed dividend under section 2(22) (e).
[D] Taxability of Deemed Dividend under section 2(22)(e)
Deemed Dividend u/s 2(22)(e) is taxable in the hands of shareholder u/s 56 of the Income Tax Act and it is not taxable in the hands of company.
Also Deemed Dividend u/s 2(22)(e) is not exempt u/s 10(33) of the Income Tax Act.
Now, lets discuss some intricate queries arising out of the aforesaid definition.
Q 1. What kinds of advances are covered within the scope of section 2(22)(e)?
It has been held by Rajasthan High Court in re CIT v. Raj Kumar (2009) 23 DTR (Del) 304 that the word ‘advance’ has to be read in conjunction with the word ‘loan’ i.e., a payment shall be construed as a loan or advance if it involves following attributes–
Considering the rule of construction viz., noscitur a sociis and keeping in view the intent of introducing the provisions [i.e., to plug the evasion of tax by payment of dividends in the guise of loans & advances to the principal shareholders], any advance which does not carry with it the obligation of repayment cannot fall within the four corners of the deeming provision. Consequently, trade advances made in then ordinary course of business that are adjusted against supply of goods/services do not fall within the ambit of section 2(22)(e).
Q 2. In whose hands will the payment deemed to be dividend if the loans or advances are made to concern or person on behalf of or for the benefit of substantial shareholder?
It is general principle that a payment can be taxed as dividend only in the hands of a shareholder. The same cannot be taxed as such in the hands of a non shareholder. This view has been reiterated by Rajasthan High Court in re CIT v. Hotel Hilltop (2008) 217 CTR (Raj.) 527 wherein it was held that the essential requirement of section 2(22)(e) is that payment should be made on behalf of or for the individual benefit of substantial shareholder. Thus, the provision is intended to attract the liability of tax on the person on whose behalf or for whose benefit the amount is paid by the company.
In re CIT v. Bhaumik Colour P. Ltd (2009), the special bench of Mumbai tribunal held that the inclusive definition of section 2(22)(e) enlarges the scope of the term dividend by including loans & advances. The legal fiction created by the said section is operative only so long as the deemed dividend is taxed in the hands of the shareholder. If the legal fiction is extended to loans & advance to a non shareholder, the very term ‘dividend’ will lose its identity.
One of the exceptions to section 2(22)(e) is that dividend shall not include any dividend paid by the company which is set off by the company against the whole or any part of the sum previously paid by it and treated as dividend within the meaning of sub clause (e) to the extent it is so set off.
In the event of the payment of loan or advance by a company to a concern being treated as dividend and taxed in the hands of the concern then the benefit of set off cannot be allowed to the concern, because the concern can never receive dividend from the company which is only paid to the shareholder, who has substantial interest in the concern. The above provision, further, contemplate that deemed dividend be taxed in the hands of shareholder only.
Q 3. One of the exceptions to section 2(22)(e) is that dividend shall not include any loans or advance made to a shareholder or the said concern by the company in the ordinary course of its business, where lending money is substantial part of the business of the company. Elaborate?
The term ‘substantial’ appearing in the aforesaid exception is not defined. But the same is defined in explanation 3(b) to section 2(22)(e) as not less than 20% of the income of such concern. Following the judgement of supreme court in CIT v. Venkateshwara Hatcheries (237 ITR 174) wherein it was held that the definition in one section can be used for understanding the meaning of the word in another section if the context justifies it, it can be concluded the definition of term ‘substantial’ used in the aforesaid section means 20% or more of the income of a concern.
Thus, if the income from money lending is 20% or more of the total income of the closely held company and the turnover of the loan funds to total funds of the company is above 20%, any loans or advance made by the said company to its principal shareholder cannot be deemed to be dividend. The same was upheld by Delhi Tribunal in Mrs. Rekha Modi v. ITO (2007) (13 SOT 512) and the same was not further challenged by the revenue.
Further, in deciding whether the company is engaged in money lending business, factual position only for the relevant previous year in question has to be considered i.e., the year in which the loan or advance has been given to principal shareholder holding 10% or more of voting power. The same has been upheld in the aforesaid judgement of the tribunal
Kalyan Gupta was a shareholder with more than 10 per cent interest in Om Shipping Agents (P) Ltd. He received a loan of Rs 73 lakh from the company. This was outstanding as on March 31, 1998. After hearing the assessee, the income-tax officer (ITO) added Rs 73 lakh as deemed dividend assessable under Section 2(22)(e).
It was pleaded that the amount was only a temporary borrowing and not in the nature of loan or advance. As this argument was not accepted, another submission was raised to the effect that the dividend exemption provision under Section 10 should be given effect in respect of the sum of Rs 73 lakh.
This provision came into effect from the assessment year 1998-99. What applies to dividend income should also apply to deemed dividend under Section 2(22)(e). The Bench examined Sections 115O, 115P and 115Q in Chapter XIID of the Act. It referred to the Explanation given in this chapter: “For the purposes of this Chapter, the expression “dividend” shall have the same meaning as is given to “dividend” in clause (22) of Section 2 but shall not include sub-clause (e) thereof.”
The loan or advance to the substantial shareholder is treated as deemed dividend under Section 2(22)(e). The Explanation at the end of Chapter XI B stipulates that the expression ‘dividends’ shall not include this type of deemed dividends comprising loans and advances. Thus, deemed dividend referred to in Section 2(22)(e) has been excluded from the ambit of Chapter XIIB. Tax is not levied on the company with regard to such deemed dividend. Consequently, the exemption provided under Section 10 is not applicable to “deemed dividend” referred to in Section 2(22)(e)
If a majority of a company’s assets and income are from money-lending business, it will be proper to assume that lending of money is a substantial part of the company’s business.
In Walchand & co. Ltd. V. CIT,(1975)100 ITR 598(Bom) it was held that the onus to prove these facts lies on the assessee. The same was also confirmed in the case of CIT v Creative dyeing & Printing (P) Limited 184 taxmann 483.
This clause gives some relief to the assessee by way of avoiding double taxation as well as brings in some scope for Scope for tax-planning. Thus, if a loan is already treated as a dividend it may make sense to declare dividend and adjust the outstanding loan amount against the dividend declared. No tax will be payable by shareholder on such dividend declared.
However, if the loan has been repaid by the shareholder and nothing is due by the shareholder against the loan referred in section 2(22)(e), then no set-off would be possible. Also if the sum due by the assessee is on account of some other payments not covered by section 2(22)(e), then set-off will not be possible.
The reason for allowing reduction of the accumulated profits to the extent of capitalisation of profits seems to be that to the extent of capitalisation, divisible profits i.e. profits available for distribution of dividend will reduce. A company can not distribute dividends out of capitalised profits i.e. capital. Thus if a closely held company wants to give loan or advance to a shareholder or his concern/company which are covered by this clause, it may first issue bonus shares (and thus capitalise the accumulated profits) and then grant such loan or advance. This is one sure way of escaping from the clutches of section 2(22)(e). However, it may involve expenses of filing fees and stamp-duty on increase of authorised share capital. Also a company may not want to increase its capital due to various other reasons.
I hope that above will be able to clarify your doubts in respect of deemed dividend to certain extent. Please write to email@example.com for any further clarification.