Deemed Dividend- A detailed analysis of Section 2 (22) (e) and its legal implications

By: Megha Bhasin Section 2 (22) (e)- Scope and ambit of 2 (22) (e) which is pari materia with clause (e) of section 2(6A) of the Indian Incometax Act, 1922, was brought on to the statute book to bring within the tax net accumulated profits which are distributed by closely held companies to its shareholders in the form of loans/ advances. This clause seeks to suppress this mischief by creating a legal fiction whereby all such loans/ advances are deemed to be dividend. It is a well - settled legal principle that a legal fiction has to be carried to its logical conclusion within the framework of the purpose for which it is created.1Since this clause creates an artificial liability, it must be given a strict interpretation.2 The relevant extract of the provision is reproduced below:

(22) "dividend" includes ** ** **

(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) 26[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

Dividend- Meaning of Dividend in its ordinary connotation means the sum paid to or received by a shareholder proportionate to the dividend to his shareholding in a company out of the total sum distributed. Dividend distributed by a Company being a share of its profits declared as distributable among the shareholders, is not impressed with the character of the profits from which it reaches the hands of the shareholders 3

CIT v. PK Badiani (1970) 76 ITR 369 v. John(1990) 181 ITR 1 (Ker.); Tarulata v. CIT (1977) 108 ITR 345 (SC) 3 CIT v. Nalin Behari Lall Singha [1969] 74 ITR 849 (SC)
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The definition of dividend applies to all the provisions containing the term dividend in the Act.4. The definition as per this clause is an inclusive one implying that any receipt by a shareholder which is dividend under general law would be taxable as such under this Act, even if it falls outside the purview of this definition or is not attributable to the companys accumulated profit5. Now, the deemed dividend as comprehended by this clause, is not a dividend that arises out of distribution but dividend that arises out of payment. There is a distinction between distribution and payment. Distribution implies two acts namely diversion and delivery. Payment, however, implies something that is given and it need not have been first apportioned and then disbursed. The basic point of distinction between the two is that a loan ceases to be loan if it is not repayable, while a distributed dividend never entails a liability for repayment.6 On a bare perusal of the section it is clear that it brings to tax three types of payments. Firstly, any loans/ advances to shareholders. The question whether the transaction is genuine, mutual, open and current account has been considered by the Apex Court in Badin v. CIT7. This section was attracted where the shareholder was a company.8 Secondly, it includes any payment on behalf of a shareholder. Thirdly, it includes any payment for the individual benefit of a shareholder. A loan to a shareholder is deemed dividend irrespective of the purpose of the loan9. The fact that the loan is to be repaid during the same accounting year is immaterial10. Some judicial pronouncements The Delhi High Court, in a recent judgement in the case of CIT v. Shri Raj Kumar11, has distinguished between a loan and an advance. The relevant extract from the judgment is reproduced below:

If this purpose is kept in mind then, in our view, the word 'advance' has to be read in conjunction with the word 'loan'. Usually attributes of a loan are that it involves positive act of lending coupled with acceptance by the other side of the money as
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CIT v. Mysodet (P.) Ltd. (1999) 237 ITR 35 (SC)

Section 205 of The Companies Act, 1956 restricts the payment of dividend otherwise than out of profits of the year or any other undistributed profits; Bharat Insurance v. CIT 53 ITR 108 (SC) 6 Punjab Distilling Industries Ltd. V. CIT (1963) 48 ITR 288, 308 (Punj) affirmed by SC in (1965) 57 ITR 1 (SC) 7 105 ITR 642 (SC) 8 Sadhana Textile Mills v.CIT 188 ITR 318 9 CIT v. Ravindra D. Amin 208 ITR 815 10 Miss P. Sarada v. CIT 229 ITR 444 (SC); Smt. Tarulata Shyam v. CIT 108 ITR 345 (SC) 11 (2009) 181 Taxman 155

loan: it generally carries an interest and there is an obligation of re-payment. On the other hand, in its widest meaning the term 'advance' may or may not include lending. The word 'advance' if not found in the company of or in conjunction with a word 'loan' may or may not include the obligation of repayment. If it does then it would be a loan.

The five instances of dividend enumerated by this section in clauses (a) to (e) are cases of distribution or payment out of, or to the extent of accumulated profits of the company (Explanation 2). The deemed dividend under this sub-clause is not restricted to profits proportionate to the shareholding of the assessee in the capital but it extends to the entire accumulated profits.12 Accumulated profits means profits in a commercial sense. The expression includes tax-free profits like agricultural income, general reserve, development rebate reserve, credit balance and initial depreciation but not normal depreciation nor provision for taxation and dividends. In the case of Giridhardas v. CIT, the Bombay High Court has held that accumulated profits referred to profits out of which distribution was actually made. Any notional income of the company on which the company had been assessed but had not reached the companys hands and which was not available for distribution among shareholders could not be taken into account for the purposes of this clause. Deemed dividends assessed in the hands of the various shareholders in the past assessment years should be deducted from the surplus while determining the 'accumulated profits' in the hands of the company.13 If the accumulated profits are capitalised, they cannot be taken into account for the purposes of this sub-clause.14 It is germane to distinguish between the provisions stated in Clause (24) (iv) and (22) (e). The former applies to a person who has substantial interest in the company whereas the latter applies to a shareholder who has substantial interest in the company. It is evident that a person should be a shareholder15 in order to attract the provisions of this sub-clause. There have been many judicial pronouncements which re-enforce this point. The latest one being the ruling by ITAT Mumbai Bench in the case of Interventional Technologies, wherein it was held that deemed dividend cannot be taxed in the hands of non-shareholders. The Rajasthan High Court in the case of Hotel Hill Top 16and ITAT Mumbai Special Bench in the case of Bhaumik Colour (P)
CIT v. Mayur Madhukant Mehta 85 ITR 230; CIT v. Bhagwat Tewari 105 ITR 62; CIT v. Aratidevi 11 ITR 277 13 CIT v. G. Narsimhan (Decd) through LRs (1999) 236 ITR 327 (SC) 14P.K. Badiani v. CIT 105 ITR 642, 650-651 (SC) 15 CIT v. Mittal 219 ITR 420; Secs. 153 and 206 of Companies Act 1956, dividends can only be received by registered shareholders and not by beneficial owner of shares. 16 (2009) 313 ITR 116 (Raj.)
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Ltd 17have also held that 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 non- shareholder. Some glaring lacunae There arise many practical difficulties in the working of this provision. With the statute silent on certain critical aspects of this deeming provision, it is the assessee who is at sea while the Assessing Officers tend to press this legal fiction beyond its true limits, making it a powerful taxing tool for the Revenue. Where the assessee is a proprietary concern, the assessee is also MD and holds 65% equity in a private limited company. This company gives trade advances to the assessee for customised manufacture of equipment for its clients and the assessee shows certain 'advances from customers' in its balance-sheet. The AO treats the same as deemed dividend. This issue was resolved by the Delhi High Court in the case of CIT v. Shri Raj Kumar wherein it was held the word 'advance' which appears in the company of the word 'loan' only means that it carries with it an obligation of repayment. Trade advances which are in the nature of money transacted to give effect to a commercial transactions would not fall within the ambit of the provisions of Section 2(22) (e) of the Act. Another glaring lacuna in the provision is regarding Inter Corporate Deposits. A recent judgement by the ITAT Mumbai Bench 18 has held that Intercorporate deposits are not deemed dividend under section 2 (22) (e) of the Income Tax Act. It is clear that there is a distinction between deposits vis-a-vis loans/advances. Section 2 (22) (e) enacts a deeming fiction whereby the scope and ambit of the word dividend has been enlarged to bring within its sweep certain payments made by a company as per the situations enumerated in the section. Such a deeming fiction would not be given a wider meaning than what it purports to do. The requisite condition for invoking section 2 (22) (e) of the Act is that payment must be by way of loan or advances. Another grey area pertains to loans given to sister concerns which are not shareholders. The ITAT Bangalore, in the case of Salarpuria Properties 19has held that such loans cannot be brought to tax under 2 (22) (e) as deemed

Seamist Properties (P.) Ltd. 95 TTJ 201 (Mum.) (dividend income can be taxed only in the hands of a shareholder) 18 Bombay Oil Industries v. Dy. CIT 19 Dy. CIT v. Salarpuria Properties Pvt. Ltd. (IT Appeal Nos. 1123 to 1125 (Bang.) of 2008, dated 27-2-2009)
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dividend. In yet another case, the AAR(Authority for Advance Rulings)20 has held that a proposed loan by a company to its financial arm based outside India is not to be treated as deemed dividend to the extent of accumulated profits. Still another ambiguity relating to this sub-clause is as to whether there is a loan to a shareholder assessable as dividend under this sub-clause or is it to be treated as distribution of dividend for the purpose of Section 104. The answer to this problem can be found in a judgement given by the Calcutta High Court in Moore Avenue Properties (P) Ltd. V. CIT21 which says that there would be no further application of Section 104, basing it on the established proposition that legal fictions have to be carried to their logical conclusions. Conclusion There are some glaring lacunae in the provisions for deemed dividend under the Income Tax Act, 1961 as have been discussed hereinabove. A legislative amendment is long overdue considering the fact that this section has not been amended since the Finance Act, 1987 and there is also a pressing need for a CBDT clarification on this legal fiction which has continued to baffle the assessee, lawyers and the judiciary time and again.

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Madura Coats Private limited, In re (2005) 145 Taxman 366 (1966) 59 ITR 466 (Cal.)