Summary: Section 2(22) of the Income-tax Act, 1961, defines dividends, including “deemed dividends” under sub-clause (e). This provision applies to payments made by a private company as loans or advances to shareholders holding 10% or more voting power or to entities where such shareholders have a substantial interest. These payments are treated as dividends to the extent of the company’s accumulated profits. Prior to the 2020 Finance Act amendment, companies paid Dividend Distribution Tax (DDT), but post-2020, the tax liability shifted to shareholders. Not all loans or advances fall under this provision. Courts have clarified that only those advances with repayment obligations qualify. For instance, trade advances made as part of regular business transactions are exempt. Judicial precedents, such as the Supreme Court’s ruling in Dwarka Prasad Aggarwal, have upheld this interpretation. Similarly, transactions like loans repaid within the same financial year or commercial arrangements between companies and directors, as seen in Suprabha Industries Ltd and Smt. Jamuna Vernekar cases, are not covered under Section 2(22)(e). Companies must ensure tax is withheld under Section 194 where deemed dividend provisions apply, as failure to do so can lead to penalties. Understanding these nuances is essential to avoid tax liabilities.
Introduction
Section 2(22) of the Income-tax Act, 1961 (the Act), deals with Dividends. Sub-clause (e) of section 2 sub-section (22) of the Act includes payments made by a private company by way of advance or loan to a shareholder who owns at least 10 per cent of the voting power or to any shareholder who has a substantial interest (20 per cent or more at any time during the relevant financial year) in the said concern or payment on behalf of a shareholder such payment would be deemed as dividend. The relevant extract of the sub-section is hereunder –
“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 such shareholder 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.”
Brief History
Prior to the amendment vide Finance Act 2020, the Company declaring dividends was required to pay tax on such amounts which were distributed as dividends under section 115-O of the Act and the recipients were exempt from tax under section 10(34) of the Act. However, Dividend Distribution Tax (DDT) was abolished with effect from 1 April 2020 and the incidence of taxability was passed to the recipient of such dividends.
Essentially, the legislature whilst explaining the rationale behind abolition of DDT under section 115-O of the Act clearly said that dividend is income in the hands of the shareholders and not in the hands of the company. Further, it also pertinent to note that the Legislature has also specified that the DDT was reintroduced vide Finance Act, 2003 merely for administrative convenience as it was easier for the Legislature to collect tax at a single point i.e., from the company on behalf of the shareholders.
Judicial Precedents
It is pertinent to note that not all advances or loans would fall under the ambit of the said clause. The word ‘advance’ used along with the word ‘loan’ means such advance that has an obligation of repayment. Therefore, trade advance, being in the nature of a commercial transaction, will not be covered within the ambit of the provision of section 2(22)(e) of the Act. The said position was also affirmed by the Hon’ble Supreme Court in the case of Principal Commissioner of Income-tax (Central) v. Dwarka Prasad Aggarwal[i].
Further and rightly so, the Hon’ble Calcutta High Court in case of Principal Commissioner of Income-tax v Suprabha Industries Ltd[ii] held that in case where an assessee had secured loan from its group company and repaid with interest during the same financial year, the provisions of section 2(22)(e) of the Act would be wholly inapplicable in the loan transaction and the question of deemed dividend arising therefrom does not arise. The said position was also upheld by Hon’ble Supreme Court[iii].
It is a settled legal position that where pursuant to family settlement, the individual parties to the family arrangement receive certain amount and assets from a company in which such individuals have substantial interest, provisions of section 2(22)(e) of the Act can’t not be applied to the amount so received.
There are many transactions between a company and directors of the company and not all fall within the ambit of 2(22)(e) of the Act, therefore, it would be pertinent for the Companies to ensure that the loans/ advances given to a director or Key Managerial Personnel are in the nature of commercial parlance. Reference in this regard is drawn in the case of Smt. Jamuna Vernekar v. Deputy Commissioner of Income-tax, Circle 12(5), Bangalore[iv] wherein the court held that advances received by a director of the company for construction of building on plot owned by him
and such advance was later adjusted towards security deposit and rent payable to director, it would be a commercial transaction and would be outside purview of section 2(22)(e) of the Act.
It would be apposite for the Indian company to withhold tax under section 194 of the Act where provisions of section 2(22)(e) of the Act are triggered. Failure to withhold tax by the Indian company, the Indian company could be liable to pay penalty of 100% of the withholding tax amount.
Conclusion
There is a fine line between the transactions that would fall under the ambit of section 2(22)(e) of the Act and that would fall outside the provisions of the said section. Therefore, the transactions/structuring that takes place between the company and the directors must be done in such a manner that the provisions of the said clause does not get triggered, where the same gets triggered one must ensure that necessary taxes have been withheld to ensure that there is no penalty implications and tax leakages.
[i] S.L.P. (CIVIL) NO(S). 28223 OF 2018
[ii] 136 taxmann.com 259
[iii] SLP (CIVIL) Diary No. 30687 of 2023
[iv] 432 ITR 146
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