Deemed Dividend U/s 2(22)(e)

1. Concept

The concept of deemed dividend postulates two factors, whether the payment is a loan or advance to a shareholder or a concern in which the shareholder is substantially interested and whether on the date of payment there is accumulated profit. Closely-held companies having accumulated profits in which substantial voting power lies in the hands of promoters may distribute accumulated profits as dividends to their shareholders. In such companies, it is for this group to decide whether the profits should be distributed or not. The declaration of dividends is entirely within the discretion of this group. Therefore, the Legislature realised that though funds are available with the company in the form of profits, the controlling group may not distribute this as dividends to the shareholders but adopt the device of parting with the profits by way of loan to its shareholders to avoid payment of tax on accumulated profits. The main reason for enacting Section 2(22)(e) of the Income-Tax Act, 1961 is to counter this device.

Sec 2(22)(e) read as follows, “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 31^st day of May, 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares holding not less than 10% of the voting power, or to any concern, in which such shareholder is a member or partner and in which he has a substantial interest (not less than 20% share in income), or any payment by any such company on behalf, or for the individual benefit, if any such shareholder, to the extent to which the company in either case possesses accumulated profits”

Section 2(22)(e) is deeming section which deemed any loan or advance by closely held company to a shareholder (not less than 10% shareholding) or concern in which the shareholder is substantially interested (not less than 20% interest) as dividend. Thus sec 2(22)(e) gets attracted in below circumstances:

1)      Payment by closely held company by way of loan or advance to a shareholder or to a concern in which the shareholder is substantially interested.

2)      Shareholder holding in the company should not be less than 10% or the interest in concern in which the shareholder is substantially interested be not less than 20%.

3)      Company possesses accumulated profits on the date of payment

4)      Deemed dividend is restricted to the extent of accumulated profits

The deemed dividend is taxable in the hands of shareholder under the head “income from other sources” and the company is required to deduct TDS at the applicable rate.

2. Exceptions

The following payments by a closely held company cannot be treated as deemed dividend in the hands of shareholder:

1)      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.

2)      Any subsequent dividend to the extent it is set off against any loan or advance (deemed as dividend under section 2(22)(e)] is not treated as dividend.

3)      If the shareholder doesn’t hold 10% or more holding in the company the advance cannot be deemed as dividend.

4)      If the interest of shareholder in the concern, to whom payment is made by the company, is less than 20% .

5)      If the loan or advance is given to set off any pre-existing liability then the advance cannot be deemed as dividend.

3. Landmark Judgements

1) Shareholder means registered shareholder and not beneficial owner - The word ‘shareholder’ as occurring of in section 2(6A) of the 1922 Act [corresponding to section 2(22) of the 1961 Act] refers to a registered shareholder and not to a beneficial owner. It is the former who is the ‘shareholder’ within the matrix and Scheme of company law, and not the latter - Rameshwarlal Sanwar­mal v. CIT [1980] 122 ITR 1 (SC)/CIT v. Shakuntala [1961] 43 ITR 352 (SC).

2) Where assessee was shareholder in a company doing only money-lending business, loan taken by assessee could not be treated as deemed dividend even though company had accumulated profits - CIT v. V.S. Sivesubramaniam [1997] 141 CTR (Mad.) 34.

3) Payment must be adjusted against accumulated profits - When a loan by a company to a shareholder in the manner set out in sec­tion 2(22)(e) is treated as a deemed dividend, it is to be treat­ed as payment out of accumulated profits of the company. Any legal fiction will have to be carried to its logical conclusion. If the payment under section 2(22)(e) is treated as a deemed dividend and is required to be so treated to the extent the company possesses accumulated profits, the logical conclusion is that this payment must be considered as adjusted against the company’s accumulated profits to the extent it is treated as deemed dividend while calculating accumulated profits of the company. Whenever accumulated profits of the company are required to be determined, such an adjustment will have to be made - CIT v. G. Narasimhan [1999] 102 Taxman 66/236 ITR 327 (SC).

4) Emphasis is on ‘possessing’ accumulated profits - Payments made by way of loan or advance to a shareholder or any payments made on behalf or for the benefit of a shareholder are to be treated as dividend in either case to the extent to which the company possesses accumulated profits. The emphasis in this connection must be on-the word ‘possesses’. If the company does not possess the amount, it cannot pay the same. A company can be said to have profits or to be possessed of profits when it actually possess the amount or is in its control - R. Dalmia v. CIT [1982] 133 ITR 169 (Delhi).

5) Mere creation of debtor-creditor relationship is not enough - There should be an actual cash advance or loan from the company to the assessee and the mere creation of a debtor and creditor relationship between the company and the assessee will not be enough. There should be an outgoing or flow of money from the company to the shareholder. The director or shareholder helping himself out of the money of the company cannot be treated as lending or advancing - CIT v. G. Venkataraman [1975] 101 ITR 673 (Mad.).

6) Fact of repayment of loan is not relevant - The Legislature has deliberately not made the subsistence of the loan or advance, or its being outstanding on the last date of the previous year relevant to the assessment year, a prerequisite for raising the statutory fiction. In other words, even if the loan or advance ceased to be outstanding at the end of the previous year, it can still be deemed as a ‘dividend’ if the other four conditions factually exist to the extent of the accumulated profits pos­sessed by the company.  - Smt. Tarulata Shyam v. CIT [1977] 108 ITR 345 (SC) [See also Miss P. Sarada v. CIT [1998] 96 Taxman 11 (SC)].

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CA Sandeep Soni