Section 2(22)(e) Deemed Dividend - Everything you need to know

Introduction

Section 2(22)(e) of Income Tax Act,1961 has been one the most helpful provision for checking the evasion of Income Tax. It has been introduced in the Finance Act, 1955 and this had created a vibration in the economy and tax laws because for the first time the Loans & Advances to shareholders are treated as Income for Shareholders. There had been a question of Constitutional Validity of this provision which has been in favor of revenue in the case of Navnitlal C. Jhaveri v K K  Sen, AAC [1965] 56 ITR 198 (SC).

Why the Section 2(22)(e) introduced??

In a case held at Delhi High Court CIT v. Raj Kumar (2009) 181 Taxmann 155 the following para were written which explains the reasons very well:

“Section 2(22)(e) of the Income Tax Act, 1961 plainly seeks to bring within the tax net accumulated profits which are distributed by closely held companies to its shareholders 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 shareholders in avoiding the payment of taxes by having companies pay or distribute, what would legitimately be dividend in the hands of shareholders, money in the form of advance or loan.”

Extract from Section 2(22)..

 “(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) ⁹⁷[made after the 31st day of May, 1987, by way of advance⁹⁸ or loan to a shareholder⁹⁸, 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 profits⁹⁹ ;……..” there are some exception which does not be included in definition of dividend.

Scope of Deemed Dividend

From a Bird View of the provision we could bifurcate the clause into the following 5 Checkpoints.

A.      Nature of Payments 

B.      Types of Company

C.      Persons to be Charged of

D.      Amount

E.       Point of Charging

A.      Nature of Payments :-

·         Providing Loans and Advances for or on behalf of Individual benefits of such Shareholder. Except when Loan or advance is granted in the ordinary course of its business and    lending of money is a substantial part of the company’s business.

·         Loan or Advances can be with Interest or without interest.

·         A notional payment by way of book entries will not be included it has been clarified in G.R. Govinda Rajolu Naidu v CIT (1973) 90 ITR 13 (Mad). Where the Court has given the emphasis on outgoing or flow of money from the company to the shareholder.

·         Early payments of any future Liability which is not yet due is define as Advances in - CIT v Srinivasan (K.) (1963) 50 ITR 788 (Mad) 

·         To Elaborate into the term “Advances” Delhi High Court applied the rule of construction of noscitur a sociis, which lead to a result that the advances which are obligated to repayments are only covered in Section 2(22)(e) for example Advances for Supplies to give them a commercial transactions are not covered in this provision. This is still not a settled matter and Courts has given some contraventional views.

·         Some of the Case Laws are as Follows :

o   ACIT v Harsad V. Doshi (2011) 49 DTR 181 (Trib) (Chennai), Imprest Balance by Directors are not covered in definition of Advances.

o   M.D. Jindal v. CIT [1986] 28 Taxman 509 (Cal.), Advances in kind are also covered under the Provision.

·         Payments on behalf of or for the individual benefit of such shareholder

o   In the Case of CIT v. L. Alagusundaram Chettiar[1977] 109 ITR 508 (Mad.), Company gives Loan to employee and employee gives loan to assesse on the same date, held liable to deemed dividend.

·         Exception of Clause (ii) of Section 2(22) had made it Loans and Advances in case of Ordinary course of Business which has a substantial part of business, out of this provision, but still in depth there is a need to understand these terms.

o   In the case of Jhamu V. Sughend v DCIT (2006) 284 ITR (AT) 82 (Mum) court has relied upon the de facto of the Situation in case and relied that no license of finance is required to prove the Ordinary Course of Business as Lending Business.

o   In the case of CIT v V.S. Sivasubramaniam (1998) 231 ITR 656 (Mad) Madras High Court has ruled that ‘Ordinary course of business’ shall mean that the loan or advance should be given to such shareholder at the same rate and terms as it is given to other borrowers.

o   To substantially is required to be checked on case to case basis no test rules had been ruled yet.

B.      Types of Companies:-

Only Loans and Advances from Closed held companies are covered in this provision and there is no distinguish between Indian and Foreign Company has been done in the provision which make this section applicable on Foreign Companies also but still subjected to DTAA. In define the term closed held no elaboration has been given in the Act but in general context it means in which public is not a substantially interested. Section 2(18) defines “Company which is having substantially public interest “which is as follows:

a.       Government Companies (40% or more by Government / RBI).

b.      Company u/s 25 of Companies Act, 1956

c.       Not Having Share Capital and declared by the Board to be such company.

d.      Mutual Benefit Finance Company

e.      Company >50% Equity Shares are with Co-operative Societies.

f.        Public Co. Listed on Recognized Stock Exchange.

f.

   Some of the proved Definition of Closely held companies are:

1.       Private Limited Company

2.       Public Limited Company not listed on Recognized Stock Exchange.

C.      Persons to be Charged of :-

·         Shareholder Having 10% or more voting power of Beneficial Interest in the company

·         Above person having a share with the fixed rate of Dividend i.e. Preferential Shares are not covered.

·         Loans and Advances Given to…

o   HUF, Firm, AOP, BOI, Company in which shareholder is a partner or Member and have substantial interest I.e. 20% or more of income of that concern belongs to shareholder.

o   Beneficiary Shareholder Only – The one who does not appear in Register of Members but have beneficial Interest.

·         If Payment is to a concern of which assesse is a shareholder

o   Only if Substantial Interest in the concern.

o   Explanation 3(b) to Section 2(22) defines Substantial Interest:-

§  Other than Company – beneficially entitled by not less than 20%

§  Company – beneficially had 20% or more.

o   Such a Loans & Advances would be added in the total income of Shareholder and not that concern.

§  This is a settled issue by the following judgments.

·         CIT v. Ankitech (P) Ltd. (2011) 11 taxmann.com 100 (Delhi)

·         CIT v. National Travel Services (2011) 202 Taxmann 327 (Delhi)

·         CIT v Universal Medical Pvt. Ltd. (2010) 190 Taxman 144 (Bom)

D.      Amount To Be Taxed:-

Amount of Advance or Accumulated Profits (Whichever is higher)

·         Accumulated Profits is a wide term and need to be defined in depth.

o   Supreme Court has ruled that Accumulated Profits should be seen in the light of commercial profits and not the assessed income, refer P.K. Badiani v. CIT (1976) 105 ITR 642 (SC)

o   Depreciation should be at the Rates of Income Tax Act,1961

o   Accumulated Profit Should be up to the date of Payment of Loans & Advances or say Distribution as per Expl. 2.

§  Supreme Court has been against this in the case of CIT v. Ashokbhai Chimanbhai (1965) 56 ITR 42 (SC) by ruling that “The profit accruing during the year cannot be considered as an accumulated profit for the purpose of section 2(22).

o   Accumulated Profit is to be see as a whole sum not the share of particular shareholder, this statement is supported by CIT v. Bhagwat Tewari (1975) 105 ITR 62 (Cal.)

·         Popular Judgments to define Accumulated Profits are as follows :

o   CIT v. MAIPO India Ltd. (2008) 24 SOT 42 (Delhi) - Security Premium should not be included.

o   S. Kumaraswami v.ITO [1961] 43 ITR 423 (Mad.) – Income From Exempt Sources are also Covered in Accumulated Profits.

o   CIT v V. Damodaran (1972) 85 ITR 59 (Ker.).  – Provision for Tax & Dividend are not to be included

·         No Income once added as deemed dividend would be added under this provision even if not adjusted in Books for Accounts, refer P. K. Badiani v. CIT (1976) 105 ITR 642 (SC)

E.       Point of Charging :-

As per Section 8(a) “Deemed Dividend” accrues in the ‘previous year’ in which the payment.

No Amount derived from Carry Forward of Loan could not be treated as Deemed Dividend. – Refer CIT, Panaji – Goa v. Parle Plastics Ltd. (2011) 196 Taxmann 62 (Bom.)

By Udit Mathur
CA Final Student
09993238124