UNDERSTANDING DEEMED DIVIDEND — SECTION 2(22)(e)
Rajnish K Vohra
JCIT (TDS), Ahmedabad
• Section 2(22)(e) of the IT Act’1961 deals with the issue of “deemed dividend.”
• Provisions of Section 2(22)(e) are as under:
(e) 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 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 profits.
The then Finance Minister while describing the purpose of insertion of clause (e) to Section 6(A) in the 1922 Act stated that it is being done to bring within the tax net monies paid by the closely held companies to their principal shareholder in the guise of loan and advances to avoid payment of tax. Therefore, if the said background is kept in mind, it is clear that provisions of Section 2(22)(e) of 1961 Act, which is pari materia with Section 2(6A)(e) of 1922 Act, plainly seeks to bring within the tax net accumulated profits which are distributed by closely held companies to its shareholder in the form of loans. The purpose being that persons who manage such closely held companies should not arrange their affairs in a manner that they assist the shareholder in avoiding the payment of taxes by having these companies pay or distribute, what would legitimately be dividend in the hands of the shareholder, money in the form of an advance or loan.
2. From the above it is clear that provisions of Section 2(22)(e) are applicable to all the corporate entities in which public is not substantially interested i.e. closely held companies only. Section 2(22)(e) of the Income Tax Act deals with the issue of “Deemed Dividend”. Nomenclature of this section connotes that this section has been brought on statue as “Deeming Fiction”. It means that the income termed as dividend is actually not dividend distributed by a closely held company but the amount paid is still treated as dividend and hence the term “Deemed Dividend”.
3. Analogous provision of deemed dividend was there in Section 2 of the Income Tax Act’1922 in the form of Section 2(6A) (e). Therefore, it may be seen that the provisions of Section 2(22)(e) are preceded by Section 2(6A)(e) of the old act. The legislative intent to bring this provision in the statue related to taxation of any advance or loan to a share holder, being a person who is the beneficial owner of shares holding not less than 10% of voting power, in a closely held company, as deemed dividend in the hands of shareholder. Shareholder for the purpose of Section 2(22)(e) means being a person who is the beneficial owner of shares (not being shares entitled to a fix rate of dividend whether with or without a right to participate in profits). It means only equity shareholder who has substantial interest in a company in which public is not substantially interested has to have substantial interest in the lending company i.e. 10% or more of voting power. As far as voting power is concerned, in a case where individual is a shareholder not only in his individual capacity but also a shareholder in the capacity of a ‘Karta’ of HUF, then the voting power computation would include the total voting power in both the capacities. Similarly, if an individual is a shareholder (Major) in his individual capacity and also hold voting power on behalf of a minor shareholder, then also the total voting power would be taken into account.
4. The fiction of deemed dividend is not restricted to a beneficial owner of shares only, but is extended to any concern also, in which such share holder is a member or a partner and in which he has a substantial interest. Substantial interest means, that person is entitled to not less than 20% of the income of such concern.
5. In order to attract the provisions of Section 2(22)(e), the important consideration is that, there should be loan/advance by a company to is shareholder. Every amount paid must make the company a creditor of the shareholder of that amount. But at the same time, every payment by company to its shareholder may not be a loan/advance and thereby fall within the ambit of Section 2(22)(e) i.e. “Deemed Dividend.”
6. The scope of Section 2(22)(e) widened as a result of amendment made by Finance Act’1987, i.e. w.e.f. A.Y. 1998-99. If any payment is made after 31/05/1987, by a closely held company, of any sum by way of advance or loan to a shareholder, who is beneficial owner of shares holding not less than 10% of voting power or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest, then such loan/advance will be treated as “Deemed Dividend” in the hands of such shareholder/concern. Besides, only a loan/advance can be deemed to be dividend and that too only to the extent that the company has on the date of the payment “accumulated profits”. Thus, from the above, it is abundantly clear that following conditions must be satisfied,
a. The company must be a company in which public are not substantially interested i.e. a closely held company. It means that the company which is paying loan/advance should be a closely held company but the company which is receiving such loans/advances can be a public company or a listed company on the stock exchange.
b. The borrower must be a shareholder having a substantial interest in the company on the date on which loan/advance is given. (Not less than 10% of voting power).
c. Loan advanced by company can be deemed to be dividend only to the extent the company possesses accumulated profits on the date of loan/advance being given.
d. The loan must not have been advanced by company in the ordinary course of its business.
e. Loan/advance given to a concern, in which share holder has substantial interest (entitled to 20% or more of the income of such concern).
f. Loans and advances given during the year i.e. year under consideration can only be taken into account for the purpose of deemed dividend and loans and advances given in earlier years should not be added to the loans and advances of year under consideration.
g. Further, as per the provisions of Section 194, TDS under Section 194 is required to be deducted by the company, even when the loans and advances given to a shareholder is being treated as deemed dividend in the hands of shareholder. However, the provisions of Section 194 are restricted to registered shareholder of the company. The AO should refer the matter to the AO of TDS section in this regard.
h. The loan or advance mentioned in Section 2(22)(e) includes any deposit including Inter Corporate Deposit (ICD).
i. As far as the addition to be made on account of deemed dividend under Section 2(22)(e) is concerned, the same can be made in the course of assessment proceedings of search cases under Section 153A of the IT Act also.
7. The explanation 1 & 2 appended to Section 2(22)(e) defines accumulated profits and states that it will include all the profits i.e. commercial profits. The apex court in the case of P.K. Badiani (1976) 105 ITR 642 has held that the term “Profits” appearing in Section 2(6a)(e) of Indian Income Tax Act’1922, which corresponds to Section 2(22)(e) of the 1961 Act, means profits in the commercial sense, i.e. profits made by company in the usual and true sense of the term. It has also been held that development rebate reserves created out of the company’s profits constitute a part of the accumulated profits of a company. In view of this judgment it is clear that all the reserves created by company would form a part of accumulated profits for the purpose of Section 2(22)(e). Accumulated profit for the purpose of this section is required to be calculated till the date of payment of each loan/advance. This is in accordance with the decision of the supreme court in the case of Tarulata Shyam vs. CIT (1977) 108 ITR 345(SC). Further, any repayment of loan/advance during the same year after the advancement of the loan is not to be deducted from the accumulated profits. Moreover, in the case of NCK Sons Exports (P) Ltd. vs. ITO (2006) 102 ITD 311 (MUM), it was held that, there is no ambiguity in the definition of “accumulated profits given in explanation 1 and 2 of Section 2(22)(e) and for the purpose of this section the accumulated profits include all profits of the company upto the date of distribution or payment referred to in sub clause (e). Explanation 2 of Section 2(22)(e) very clearly says that accumulated profit referred to in sub clause (e) shall include all profits of the company upto the date of distribution or payment. Meaning thereby, in case the date of payment falls within the year under consideration then the whole year profit will be taken into account to compute the profit upto the date of payment i.e. if payment is made after 200 days from the beginning of the financial year then the profit of the year till the date of payment would be 200/365* Profit of the year.
As far as a closely held company, being a builder and following project completion method is concerned, accumulated profit has to be determined till the date of payment of advance/loan.
8. Explanation 3 appended to Section 2(22)(e) defines concern and it means a HUF, or a firm or an AOP or BOI or a company. Explanation 3 also defines substantial interest in a concern other than a company means beneficially entitled to not less than 20% of the income of such concern. In fact Bombay High Court in the case of Sadhna Textile Mills (p) Ltd. vs. CIT(1991) 188 ITR 318 has dealt with question of holding and subsidiary companies and has held that section 2(22)(e) applies to a holding company and a subsidiary company. Therefore, High Court in this case has held that loan given by subsidiary company to the holding company would fall within the ambit of Section 2(22)(e).
9. As far as the issue of giving loan/advance to a firm is concerned, the same was decided by Delhi High Court in the case of CIT vs. National Travel Services (2012) 347 ITR 305, wherein, it was held that for the purpose of Section 2(22)(e), partnership firm is to be treated as the shareholder and it is not necessary that firm has to be a registered shareholder. In this case the loan was given to partnership firm and partnership firm was not the registered shareholder of the company, but the partners of the firm were registered shareholders.
10. It is a moot question as to whether the expression, “being a person as a beneficial owner of shares qualifies the word shareholder:” i.e. whether to attract the provisions of Section 2(22)(e), the person to whom the loan or advance is made should be a shareholder as well as beneficial owner. In the above mentioned case of CIT vs. National Travel Services, Delhi High Court concluded that the beneficial owner may not be a registered shareholder or vice versa. However, Allahabad High Court in the case of CIT vs. Rajkumar Singh and company (2007) 295 ITR 9 held that conditions stipulated in Section 2(22)(e) were not satisfied where a firm was not shareholder of a company which gave the loan and the partners of the firm were shareholder in the books of company. This judgment was rendered following Supreme Court judgment in the case of C.P. Sarathy Mudaliar’s case (1972) 83 ITR 170, wherein, in Supreme Court held that only loan advanced to Shareholder could be deemed dividend under Section 2(6)(A)(e) of the old Act. However, Delhi High Court in the case of National Travels Services (supra) elaborately analyzed this issue and concluded that in case it is accepted that firm not being a legal entity cannot become a shareholder of a company and in case loan has been advanced to a firm whose partners are shareholders, then it would frustrate the provisions of Section 2(22)(e), and will lead to absurd results. Therefore, loan received by a firm, whose partners are registered shareholders of the company which advanced the loan, would fall within the ambit of Section 2(22)(e).
11. The next issue relates to loan and advances given by closely held company to its shareholders per se and in which circumstances it will fall within the ambit of Section 2(22)(e) of the IT Act’1961. Only two exclusions have been provided in the section itself. First, if the company is in the business of money lending and secondly if the payment is made in ordinary course of business. A company can be held to be in the business of money lending only when it has license from RBI or company is an NBFC.
12. In this regard, catena of judicial pronouncements reveal that normally all the loan/advances given by closely held company to its shareholder are treated as deemed dividend in the hands of shareholder. Ratio-decidendi of various cases decided in favor of revenue is as under:-
• P. Sarada Vs CIT(SC) 229 ITR 444: “The fact that loan or advance was ultimately adjusted at the end of the year against the credit balance of another shareholder will not alter the position. Account of another shareholder was not debited on various dates of withdrawals and hence it cannot be said that the assessee was paid money out of the funds lying to the credit of the other shareholder.”
• Tarulata Shyam & Ors. Vs CIT(SC) 108 ITR 345: “Loan advanced to a shareholder was re-paid within 23 days still deemed dividend under Section 2(22)(e)- If the assessee comes under the letter of law, he has to be taxed, however great the hardship may appear to the judicial mind to be.”
• Rajesh P. Ved Vs ACII (ITAT, Mum) 1 ITR (Trib) 275: “Accumulated profits means profits upto the date of payment of loan – subsequent repayment of loan not to be considered amount credited to wards remuneration of shareholder cannot be set off against the alleged loan considered as deemed dividend.”
• CIT Vs P.K. Abubucker (Mad) 259 ITR 507: “Advance to shareholder for building construction which will be later on taken on lease by company- As per the agreement, such advance to be set off against future rentstill deemed dividend arises and is taxable.”
• M.D. Jindal vs CIT(Cal) 164 ITR 28: Building material advanced to shareholder for construction advance to be set off against purchase consideration when the company buys some flats from assessee later on- value of advance in kind is also taxable as deemed dividend.”
• L. Alagusundaram Chettiar vs CIT(SC) 252 ITR 893: “Company advancing large amount to low-paid employee. Employee advancing loan to assessee, the Managing Director of the said company. Deemed dividend to be assessed in the hands of assessee.”
• CIT vs. T.P.S.H. Sokkalal (99) 236 ITR 981 (MAD): Shares held on behalf of minor children has to be included as the guardian can exercise voting power in respect of those shares in addition to shares held by guardian in his individual capacity.
13. The Assessing Officer has to give a finding of fact that loan/advance has been made during the year under consideration. Assessing Officer has to further describe the details of each and every date during the year along with amounts paid by closely held company to the shareholder on each date. These amounts have to be compared with accumulated profit on the day of advance and then it must be analyzed whether company giving loan/advance is in business of money lending or not and whether such loan is being given in ordinary course of business. Actual cash payment is not necessary, relationship of debtor and creditor is sufficient to invoke the provision of Section 2(22)(e) as held in the case of T. Sundaram Chattiar & ANR. vs. CIT(Mad) 49 ITR 287.
14. Action Points for the Assessing Officers:-
I. AO needs to go through the payments made by a closely held company i.e. analysis of balance sheet of the company.
II. Payment made to a person by the company should be beneficial owner of shares i.e. holding not less than 10% of the voting power or to any concern in which such shareholder is a member or partner. Holding of 10% voting power in a closely held company means holding not less than 10% of equity shares, either in individual capacity or in addition to voting power as a “Karta” of HUF or on behalf of a minor. Share holding pattern in the holding company is of utmost importance. Similarly, ascertaining the profit ratio in concern where shareholder is a member or partner to have substantial interest is also equally important.
III. It should be confirmed that company making payment of loan/advance is a closely held company and its shareholders holding 10% or more voting power should also hold substantial interest in such concern (Person who is entitled to not less than 20% of the income of such concern). The concern may be a firm or AOP/BOI or a company including a public limited/listed company.
IV. In case loans/advances including ICDs/Deposits etc are made to shareholders/concerns in which shareholders have substantial interest or made on behalf of shareholders, then investigation should be made to ascertain the incidence of “Deemed Dividend.”
V. The closely held company should have accumulated profits which includes reserves and also include proportionate profit, of the profit of the whole year.
VI. In no case quantum of “Deemed Dividend” under Section 2(22)(e) can exceed the amount of accumulated profits on the date of payment of loan/advance.
VII. Loan/advance paid during the year under consideration only, can be treated as “Deemed Dividend” and repayment made during the year should not be reduced from the loan/advance paid.
VIII. Any advance or loan given including a running account can be treated as “Deemed Dividend” except in a case where loan/advance made to a shareholder or the said concern by a company in the course of business of money lending.
IX. All the factual details i.e. shareholding pattern of closely held company status of recipient of loan/advance i.e. beneficial shareholder either in individual capacity or as a member/partner of a concern, quantum of accumulated profits should be clearly mentioned in the body of assessment order.
X. Assessing Officer of TDS wing should be intimated about “Deemed Dividend” as it entails TDS under Section 194 of the IT Act, regarding which action has to be taken by AO of TDS wing.