Understanding Deemed Dividend u/s 2(22)(e) of the Income Tax Act

Introduction to Deemed Dividend

The concept of "deemed dividend" under the Income Tax Act, 1961, is an anti-avoidance measure designed to prevent companies from distributing profits to shareholders in the guise of loans or otherwise to avoid tax liabilities. Section 2(22) broadly defines what constitutes a dividend, and within this section, clause (e) specifically addresses deemed dividends. This provision targets closely held companies, where there is a significant risk of profit distribution without declaring actual dividends, thus evading the applicable Dividend Distribution Tax (DDT).

Provisions of Section 2(22)(e)

Section 2(22)(e) deems certain loans or advances made by a company to its shareholders or to concerns in which such shareholders have a substantial interest as dividends. The provision applies if the following conditions are met:

1. Nature of the Company: The company making the loan or advance must be a closely held company, i.e., a company in which the public is not substantially interested.

2. Recipient: The loan or advance must be made to:

   • A shareholder who holds at least 10% of the voting power in the company, or

   • A concern in which such a shareholder has a substantial interest (holding at least 20% of the income or share of profit of the concern).

3. Availability of Accumulated Profits: The loan or advance is deemed to be a dividend only to the extent of the company’s accumulated profits.

The intent behind this provision is to tax the distribution of profits to shareholders in the form of loans or advances that would otherwise escape the normal taxation mechanism applicable to dividends.

Taxation of Deemed Dividend (Revised)

Deemed dividends under Section 2(22)(e) are taxed as "Income from Other Sources" directly in the hands of the recipient shareholder. This differs from regular dividends, which were previously subject to Dividend Distribution Tax (DDT) and exempt in the hands of shareholders until April 1, 2020. Following the abolition of DDT, all dividends, including deemed dividends, are now taxed at the applicable income tax rates of the recipient.

• Tax Rate: The recipient`s applicable income tax slab rate is applied to the deemed dividend amount.

• TDS Applicability: The company making the loan or advance is required to deduct TDS at 10% under Section 194 of the Income Tax Act on the amount of the deemed dividend.

This change ensures that all dividend income, whether regular or deemed, is uniformly taxed in the hands of the shareholder.

Calculation of Accumulated Profits

Accumulated profits are critical in determining the extent to which a loan or advance can be considered a deemed dividend. The term "accumulated profits" includes:

1. Current Year’s Profits: Profits up to the date of the loan or advance in the current financial year.

2. Previous Years’ Profits: Unutilized profits from prior financial years that have not been capitalized or distributed.

3. Exclusions: Accumulated profits do not include unrealized revaluation reserves or provisions for depreciation.

Example of Deemed Dividend Calculation Considering Accumulated Profits

Scenario:

Let`s consider a closely held company, XYZ Pvt. Ltd., with the following financials:

• Accumulated Profits (including current year’s profit up to the date of transaction): Rs.10,00,000

• Loan/Advance given to Mr. A (a shareholder holding 15% of the voting power): Rs.12,00,000

• No other loans/advances or distributions during the year.

Calculation:

According to Section 2(22)(e), the deemed dividend will be limited to the amount of accumulated profits available with the company.

• Accumulated Profits Available: Rs.10,00,000

• Loan Amount: Rs.12,00,000

The deemed dividend will be the lower of the two, which in this case is Rs.10,00,000. This amount will be taxed as income in the hands of Mr. A.

Tax Implication:

• TDS by XYZ Pvt. Ltd.: 10% of Rs.10,00,000 = Rs.1,00,000 (under Section 194).

• Tax in the Hands of Mr. A: The deemed dividend of Rs.10,00,000 will be taxed according to Mr. A’s applicable income tax slab rate.

In this example, even though Mr. A received a loan of Rs.12,00,000, the deemed dividend is restricted to the accumulated profits of Rs.10,00,000. The excess Rs.2,00,000 loan would not be treated as a deemed dividend under this provision.

Judicial Interpretations

Several judicial pronouncements have further clarified the scope and application of Section 2(22)(e):

CIT v. Urmila Ramesh [1998] 75 TAXLOK.COM (IT) 086 (SC), (1998) 230 ITR 422 (SC):
The Supreme Court held that "accumulated profits" for the purpose of Section 2(22)(e) of the Income-tax Act include not only the profits accumulated in past years but also the current profits up to the date of distribution or liquidation. This broadened the understanding of "accumulated profits" to include any profit earned during the year up to the relevant date.

P. K. Badiani v. CIT [1976] 15 TAXLOK.COM (IT) 653 (SC), (1976) 105 ITR 642 (SC):
The Supreme Court clarified that capitalized profits, which are not available for distribution as dividends, do not form part of "accumulated profits" under Section 2(22)(e). The Court emphasized that only profits that are available for distribution as dividends should be considered when determining "accumulated profits."

CIT v. Ashokbhai Chimanbhai [1964] 8 TAXLOK.COM (IT) 540 (SC), (1965) 56 ITR 42 (SC):
The Supreme Court held that "profits" should be interpreted in its commercial sense, meaning the profits as determined by commercial accounting practices, subject to necessary adjustments for tax purposes. This decision highlighted the importance of using commercial accounting standards to define "profits" in the context of taxation.

CIT v. Mangesh J. Sanzgiri (1995) 213 ITR 188 (Bom):
The Bombay High Court held that the term "accumulated profits" in Section 2(22)(e) should be interpreted to mean the profits accumulated up to the date of payment of the loan or advance, rather than the profits accumulated up to the end of the previous financial year. This interpretation ensures that the most current profit figures are considered when applying the provisions of Section 2(22)(e).

Practical Considerations

• Documentation: Companies must maintain clear documentation to substantiate the nature of loans or advances, particularly to establish that these are for business purposes and not for the benefit of shareholders.

• Tax Planning: Shareholders and companies should be aware of the potential tax implications of intra-group loans and advances and plan their transactions accordingly to avoid unintended tax liabilities.

Conclusion

Section 2(22)(e) serves as a critical tool for the tax authorities to prevent the evasion of dividend taxation by closely held companies. By treating certain loans and advances as deemed dividends, the provision ensures that profits are appropriately taxed in the hands of shareholders. Understanding the intricacies of this section, especially the concept of accumulated profits, is essential for tax professionals to navigate the complexities of corporate tax planning and compliance effectively.