DEEMED DIVIDEND CAN NOT BE TAXED IN THE HANDS OF A LOAN RECIPIENT COMPANY LINKED BY A COMMON SHAREHOLDER
By Subash Agarwal, Advocate
Dividend in common parlance means the amount paid to a shareholder by a company in proportion to his shareholding in that company. However, section 2(22) of the Income Tax Act provides the inclusive definition of dividend and imparts much wider connotation to the term dividend. For example, as per section 2(22)(e), even loans given to a shareholder (under certain circumstances) are treated as dividend though under the common law, a loan which is repayable to the lender cannot be said to be dividend. Dividends are generally exempt from tax as per section 10(34) in the hands of recipients but the domestic companies declaring, distributing or paying dividend are liable to pay additional income tax at the rate of 15% on dividends declared/ paid. However, as per section 115Q, “deemed dividend” u/s 2(22)(e) is not subjected to tax in the hands of the company concerned but the same is chargeable to tax in the hands of recipients as “Income from other sources”.
2. Relevant provisions concerning “deemed dividend”
Clause (e) of section 2(22) provides as under-
“(22) dividend includes-
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;
This provision further provides six exclusions out of which two are directly related to clause (e) of section 2(22). These two exclusions are set out as under-
“But dividend does not include-
------ ------ -----
(ii) 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;
(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;
------ ------ -----”
The three “Explanations” appended to the provision, which provide definitions/certain clarifications to the expression used in the provision are also stated below for the sake of clarity-
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 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.
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;
3. Section 2(22)(e) made easy
A cursory glance at the provisions stated above shows their cumbersome nature. Attempt is made to simplify the same.
As per the provision of section 2(22)(e), following types of payments are treated as “dividend” to the extent of accumulated profits-
(i) Loan to a shareholder or payment on behalf of or for the benefit of a shareholder.
(ii) Loan or advance to a concern.
4. Case(ii) scenario discussed
Here we are concerned with case(ii) scenario.
(a) Conditions to be satisfied in case (ii) are as under-
Loan or advance given to a concern(may be HUF/ firm/ company/ AOP/BOI) is treated as a deemed dividend u/s 2(22)(e) if the following conditions are satisfied-
(a) loan or advance is given by a company in which the public are not substantially interested;
(b) loan or advance is given after May, 31, 1987;
(c) the company should possess accumulated profits (excluding capitalized profit) at the time it makes payment of loan or advance; and
(d) loan or advance is given to a concern (i.e. a Hindu Undivided Family or a Firm or an Association of Persons or a Body of Individuals or a Company) in which a shareholder (which is a registered shareholder as well as beneficially holding at least 10 percent equity share capital) of the company (giving loan or advance) has substantial interest.
A person shall be deemed to have a substantial interest in a concern, if he is at any time during the previous year, beneficially entitled to at least 20% of income of such concern (if such concern is a company, then he should beneficially hold at least 20 percent equity share capital of the company).
(b) A perusal of the above provision r.w. explanation 3 reveals that the following types of payments by a company are deemed as dividend by way of deeming fiction though in common parlance of the term such payments are not in the nature of ‘dividend’-
(i) payments by way of advance or loan to a shareholder (holding 10% or more of the voting power).
(ii) Payments by way of advance or loan to a concern / company in which such shareholder (i.e. who holds 10% or more of voting power of the lender company) also holds 20% or more shares (of the loan recipient company).
It may , however, be noted that in case (ii) scenario, the loan recipient company is not a shareholder of the loan giver company. There is only an indirect linkage through common shareholder.
(c) The provision merely states that the payments of the above mentioned nature by a company are deemed to be “dividend”. It is silent as to in whose hands, “such payments” will be treated as dividend.
(d) Section 2(22)(e) falls under the “Definitions” provisions of the Act and merely defines the term “dividend”. Clause (e) of the provisions deems certain payments to be in the nature of “dividend”. The provision nowhere, and rightly so being a “definition provision”, states in whose hands the payments in question are to be treated as “income”.
(e) A dividend is always taxed in the hands of a shareholder and not in the hands of a non-shareholder.
(f) The provision of section 2(22)(e) by a deeming fiction deems certain payments not in the nature of dividend. But there is no provision in the Act to tax dividend / deemed dividend in the hands of a non-shareholder. In fact, no legal fiction has been created in the Act to enlarge the meaning of shareholder so as to include “concerns / companies in which such shareholder also holds 20% or more shares or recipients of payments on behalf, or for the individual benefit, of any such shareholder” within the ambit of a shareholder for the purpose of taxing “deemed dividend”.
4. Judicial pronouncements
The above contentions find support from a catena of judicial pronouncements on the issue , which are discussed below-
i) In the case of Universa Medicare (P.) Ltd. 190 Taxman 144, (Bom.), it was held as under under the similar circumstances –
“ However, even on the second aspect which has weighed with the Tribunal, we are of the view that the construction which has been placed on the provisions of section 2(22)(e) is correct. Section 2(22)(e) defines the ambit of the expression 'dividend'. All payments by way of dividend have to be taxed in the hands of the recipient of the dividend namely the shareholder. The effect of section 2(22) is to provide an inclusive definition of the expression dividend. Clause (e) expands the nature of payments which can be classified as a dividend. Clause (e) of section 2(22) includes a payment made by the company in which the public is not substantially interested by way of an advance or loan to a shareholder or to any concern to which such shareholder is a member or partner, subject to the fulfillment of the requirements which are spelt out in the provision. Similarly, a payment made by a company on behalf, of for the individual benefit, of any such shareholder is treated by clause (e) to be included in the expression 'dividend'. Consequently, the effect of clause (e) of section 2(22) is to broaden the ambit of the expression 'dividend' by including certain payments which the company has made by way of a loan or advance or payments made on behalf of or for the individual benefit of a shareholder. The definition does not alter the legal position that dividend has to be taxed in the hands of the shareholder. Consequently in the present case the payment, even assuming that it was a dividend, would have to be taxed not in the hands of the assessee but in the hands of the shareholder. The Tribunal was, in the circumstances, justified in coming to the conclusion that, in any event, the payment could not be taxed in the hands of the assessee. We may in concluding note that the basis on which the assessee is sought to be taxed in the present case in respect of the amount of Rs. 32,00,000 is that there was a dividend under section 2(22)(e) and no other basis has been suggested in the order of the Assessing Officer.”
ii ) Hon’ble RAJASTHAN High Court in CIT vs Hotel Hilltop 3313 ITR 116 has held as under—
“ The more important aspect, being the requirement of Section 2(22)(e) is, that "the payment may be made to any concern, in which such shareholder is a member, or the partner, and in which he has substantial interest, or any payment by any such company, on behalf, or for the individual benefit of any such shareholder..." Thus, the substance of the requirement is, that the payment should be made on behalf of, or for the individual benefit of any such shareholder, obviously, the provision is intended to attract the liability of tax on the person, on whose behalf, or for whose individual benefit, the amount is paid by the company, whether to the shareholder, or to the concern firm. In which event, it would fall within the expression "deemed dividend". Obviously, income from dividend, is taxable as income from other sources, under Section 56 of the Act, and in the very nature of things, the income has to be, of the person earning the income. The assessee in the present case is not shown to be one of the persons, being shareholder. Of course the two individuals being Roop Kumar and Devendra Kumar, are the common persons, holding more than requisite amount of share holding, and are having requisite interest, in the firm, but then, thereby the deemed dividend would not be deemed dividend in the hands of the firm, rather it would obviously be deemed dividend in the hands of the individuals, on whose behalf, or on whose individual benefit, being such shareholder, the amount is paid by the company to the concern.
Thus, the significant requirement of Section 2(22)(e) is not shown to exist. The liability of tax, as deemed dividend, could be attracted in the hands of the individuals, being the shareholders, and not in the hands of the firm.”
iii) Recently, HIGH COURT OF DELHI in CIT v.Ankitech (P.) Ltd. 340 ITR 14 had occasion to deal with the same issue and has come to the following finding-
“ Further, it is an admitted case that under normal circumstances, such a loan or advance given to the shareholders or to a concern, would not qualify as dividend. It has been made so by legal fiction created under section 2(22)(e) of the Act. We have to keep in mind that this legal provision relates to 'dividend'. Thus, by a deeming provision, it is the definition of dividend which is enlarged. Legal fiction does not extend to 'shareholder'. When we keep in mind this aspect, the conclusion would be obvious, viz., loan or advance given under the conditions specified under section 2(22)(e) of the Act would also be treated as dividend. The fiction has to stop here and is not to be extended further for broadening the concept of shareholders by way of legal fiction. It is a common case that any company is supposed to distribute the profits in the form of dividend to its shareholders/members and such dividend cannot be given to non-members. The second category specified under section 2(22)(e) of the Act, viz., a concern (like the assessee herein), which is given the loan or advance is admittedly not a shareholder/member of the payer company. Therefore, under no circumstance, it could be treated as shareholder/member receiving dividend. If the intention of the Legislature was to tax such loan or advance as deemed dividend at the hands of 'deeming shareholder', then the Legislature would have inserted deeming provision in respect of shareholder as well, that has not happened. Most of the arguments of the learned counsels for the revenue would stand answered, once we look into the matter from this perspective.
In a case like this, the recipient would be a shareholder by way of deeming provision. It is not correct on the part of the revenue to argue that if this position is taken, then the income 'is not taxed at the hands of the recipient'. Such an argument based on the scheme of the Act as projected by the learned counsels for the revenue on the basis of sections 4, 5, 8, 14 and 56 of the Act would be of no avail. Simple answer to this argument is that such loan or advance, in the first place, is not an income. Such a loan or advance has to be returned by the recipient to the company, which has given the loan or advance.
Precisely, for this very reason, the Courts have held that if the amounts advanced are for business transactions between the parties, such payment would not fall within the deeming dividend under section 2(22)(e) of the Act.
Insofar as reliance upon Circular No. 495, dated 22-9-1997 issued by Central Board of Direct Taxes is concerned, we are inclined to agree with the observations of the Mumbai Bench decision in Bhaumik Colour (P.) Ltd.'s case (supra) that such observations are not binding on the Courts. Once it is found that such loan or advance cannot be treated as deemed dividend at the hands of such a concern which is not a shareholder, and that according to us is the correct legal position, such a circular would be of no avail.
No doubt, the legal fiction/deemed provision created by the Legislature has to be taken to 'logical conclusion' as held in Andaleeb Sehgal's case (supra). The revenue wants the deeming provision to be extended which is illogical and attempt is to create a real legal fiction, which is not created by the Legislature. We say at the cost of repetition that the definition of shareholder is not enlarged by any fiction.”
iv) The Hon’ble Kolkata Bench of ITAT in the case of DCIT v. Madhusudan Investment & Trading Co. (P.) Ltd. has dwelt upon the same issue and has held as under-
“Deemed dividend can be assessed only in the hands of a person who is a shareholder of the lender company and not in the hands of a person other than a shareholder. The provisions of s.2(22)(e) do not spell out as to whether the income has to be taxed in the hands of the shareholder or the concern (non-shareholder). The provisions are ambiguous. It is therefore necessary to examine the intention behind enacting the provisions of s.2(22)(e). The intention behind enacting provisions of s.2(22)(e) is that closely held companies (i.e., companies in which public are not substantially interested), which are controlled by a group of members, even though the company has accumulated profits would not distribute such profit as dividend because if so distributed the dividend income would become taxable in the hands of the shareholders. Instead of distributing accumulated profits as dividend, companies distribute them as loan or advances to shareholders or to concern in which such shareholders have substantial interest or make any payment on behalf of or for the individual benefit of such shareholder. In such an event, by the deeming provisions, such payment by the company is treated as dividend. The intention behind the provisions of s.2(22)(e) is to tax dividend in the hands of shareholder. The deeming provision as it applies to the case of loans or advances by a company to a concern in which its shareholder has substantial interest is based on the presumption that the loan or advances would ultimately be made available to the shareholders of the company giving the loan or advance. The intention of the legislature is therefore to tax dividend only in the hands of the shareholder and not in the hands of the concern. The basis of bringing in the amendment to s.2(22)(e) by the Finance Aft, 1987, w.e.f. 1st April, 1988 is to ensure that persons who control the affairs of a company as well as that of a firm can have the payment made to a concern from the company and the person who can control the affairs of the concern can draw the same from the concern instead of the company directly making payment to the shareholder as dividend. The source of power to control the affairs of the company and the concern is the basis on which these provisions have been made. It is therefore proper to construe those provisions as contemplating a charge to tax in the hands of the shareholder and not in the hands of a non-shareholder viz., concern. A loan or advance received by a concern is not in the nature of income. In other words there is a deemed accrual of income even under s.5(1)(b) in the hands of the shareholder only and not in the hands of the payee viz., non-shareholder (concern). Sec. 5(1)(a) contemplates that the receipt or deemed receipt should be in the nature of income. Therefore, the deeming fiction can be applied only in the hands of the shareholder and not the non - share-holder viz.,the concern. CBDT Circular No.495, dt. 22nd Sept., 1987, to the extent not benevolent is not binding. 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 as per s.2(22)(e)(iii) 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 provisions of sub-cl.(iii) of s.2(22)(e) also therefore contemplate deemed dividend being taxed in the hands of a shareholder only. Hence in our opinion provision of Section 2(22)(e) is not applicable to the present facts of the case.”
v) In Raj Kumar Singh& Co.’s case 295 ITR 9 (All.), it has been held as under-
Clause (e) of s. 2(22) of the Act as it existed clearly provided that if the loan is received by the shareholder, it is only then the said loan can be deemed to be dividend in his hand. In the present case, admittedly, the assessee-firm was not the shareholder of the company, M/s. Jai Prakash Associates (P) Ltd., and the partners of the firm were the shareholders in the books of the company, therefore, the loan advanced by the company to the firm cannot be deemed to be dividend inasmuch as loan was not to the shareholder but to the partnership firm which was not the shareholder in the books of the company. It is settled principle of law that the deeming provision has to be construed strictly.
vi) Recently the Hon’ble Madras High Court has adjudicated similar issue in the case of Commissioner of Income Tax vs. Printwave Services (P) Ltd 373 ITR 665 (Mad). The facts of the case alongwith the final decision is narrated hereunder-
The assessee-company, a private company, received a sum from its sister concern, another private company. The assessee-company showed the said sum as trade advance in its books of accounts. The assessee-company, on the same day, paid a sum, equivalent to the amount received from its sister concern, to one of its directors. The said director was holding 10% of the shareholding in the assessee-company and 44% of the shareholding in the assessee’s sister concern. Further, the amount paid by the assessee to the director was utilized by him for repayment of the housing loan. The A.O. stated that even though the amount received by the assessee-company from Front Line Printers, sister concern, was shown as trade advance, the same was effectively been utilized by the director, having substantial interest in the sister concern, towards repayment of the housing loan. The A.O. invoked the provisions of sec (22)(e) and added the sum received from the sister concern in the hands of the assessee-company stating the following:
“the use of nomenclature for the receipt of advance from Front Line Printers as ‘trade advance’ or ‘printing advance-cum-general advance’ is to divert the attention of the Assessing Officer and nothing but the loan received from the company. Therefore, the provision under section 2(22)(e) is attracted in this case.”
The High Court dismissed the appeal of the Revenue stating that the provisions of sec 2(22)(e) are applicable only when the payment is made to a person who is the beneficial owner of the shares holding not less than 10% 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. In the instant case, the assessee-company was neither a beneficial nor registered owner of the shareholdings in the sister company and thus the provisions of sec 2(22)(e) was not applicable on the assessee-company.