In the modern era almost each business house has more than one company to which they call as group of companies. These closely held groups of companies enter into various transactions and do the funds movement to run the business smoothly. In this scenario it is very much important to pay the attention to provisions of income tax related to deemed dividend. Section 2(22)(e) of the income tax act defines deemed dividend. The provisions of section 2(22)(e) replicated below;
“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 concept of Deemed Dividend treats specified set of 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 shareholders have substantial interest. Any payment is made by way of loan or advance, the recipient of the loan or advance will be liable to be taxed on the received amount as a dividend, to the extent to which the company has accumulated profits, under the deeming provisions of section 2(22)(e) even though such loan or advance may have been given for genuine business need and even if the receiving company may have repaid the loan amount. Thus the section deems certain payments as dividend income which is not income under normal course of business. 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 and monitoring the payments. Many company which have surplus of funds and do not wish to pay the dividend distribution tax as per section 115O, but at the same time want to distribute the profits with the shareholders make arrangement like this. 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 provision.
Taxability of Deemed Dividend under section 2(22)(e)
The Deemed Dividend u/s 2(22)(e) is taxable in the hands of recipient i.e. the 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(34) of the Income Tax Act.
Following are the key points that one should understand with reference to the above:
What is Accumulated Profits?
The undistributed income, when accumulated from year to year, generates what is known as “accumulated profit” or “retained earnings”. Accumulated profits shall include all profits of the company till the date of distribution or payment referred to in sub-clause (e) of section 2(22).
How to be Computed Accumulated profits?
The term “accumulated profits” does not mean aggregate of assessed profits but it means commercial profits. If certain expenditures have been disallowed in the assessment proceedings but the expenditure had in fact been incurred, they should be bottom up from accumulated profits. In computing commercial profits, all the expenditures made and expenditure incurred for the purpose of business should be taken into account. The following are the list of items which are to be included or to be excluded while calculating the accumulated profits:
|Sl. No.||Items to be included||Items to be excluded|
|a)||Development rebate||Provision for taxation and dividend|
|b)||Refund of income-tax||Depreciation|
|c)||Development rebate reserve||Difference between depreciation calculated at the rate given under the IT Act and rate adopted in books|
|d)||General reserves||Balancing charge|
|e)||Capital gains chargeable to tax||Capital gains not chargeable to tax|
Who is Shareholder for the purpose of section 2(22)(e)?
Shareholder means any person who hold 10% or more voting power in that company.
What is concern?
Concern means i.e. HUF, partnership firm, LLP, 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.
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.
Effect of repayment of loan
What is the amount of deemed dividend?
The principle is that where loan given by the company exceeds the accumulated profits, deemed dividend would be limited to accumulated profits of the company and balance of loan amount would not be deemed dividend. Incase if the accumulated profits exceed the loan amount, entire loan amount would be considered as 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.
Now let us understand the provision by way of example:
The assessee held 20% shares of the closely held company. The accumulated profits were Rs. 5,000 while the assessee took loan of Rs. 20,000. 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).