Beware of tax trap while giving loan to shareholders

  Deemed dividend covered under section 2(22)(e) plays pivotal role in complicate business structure of holding & subsidiary companies along with closely held companies. Any transaction including inter corporate deposits, loans and advances with closely held companies shall be closely scrutinized. Beware of tax trap while giving loan to shareholders!! Provision of section 2(22)(e) provides: any payment by a company, not being a company in which the public are substantially interested, of any sum, 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.  

Company in which public is substantially interested includes:

• A company owned by the Government or the RBI or more than forty per cent of the shares are owned by Government or the RBI or a corporation owned by the RBI.
• A company registered under section 25 of the Companies Act, 1956.
• A company not having share capital and declared by the Board to be such company.
• Mutual Benefit Finance Company – business of acceptance of deposits from members and notified by the Central Government u/s 620of the Companies Act, 1956.
• A company, whose more than 50% Equity Shares (not being Preference Shares) held by one or more Co-operative Societies throughout the previous year.
• A company not being a Private Company as defined in the Companies Act, 1956, whose Equity Shares were listed on the 31 March of the previous year in a Recognised Stock Exchange.
• A ‘Government Company’ not being a ‘Private Company’ (both terms being defined in the Companies Act, 1956).

    We shall understand the above mentioned section in details:  

Why deemed dividend?

Earlier this section, for the purpose of tax planning, closely held companies used to distribute their profit to shareholders in form of loans or advances. To curtail this custom and to bring within the tax net accumulated profits which are distributed by closely held companies to its shareholders in the form of loans, concept of deemed dividend was introduced.  

Loan or Advance is given by a closely held company:

(i)                 To any shareholder who is a beneficial owner of 10% or more of Voting power of the Company (but the shares shall not be entitled to a fixed rate of dividend, whether with or without a right to participate in profits); Or (ii)               To a concern including HUF, Firm, AOP or BOI, Company in which such shareholder is a partner or a member; AND has substantial interest (when entitled to 20% or more of the income of such concern). (iii)             To a concern i.e. Company on behalf of, or for the individual benefit, of any such 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. Note: loan given by subsidiary to its holding company shall be considered as deemed dividend subject to conditions of section 2(22)(e).  

Effect of repayment of loan

As soon as loan is advanced to shareholder by closely held company from accumulated profits statutory fiction under section 2(22)(e) becomes operative and such loan is deemed to be dividend. It is to be noted that such loan does not cease to be deemed dividend on account of any subsequent event. Even if the loan is repaid by the shareholder in the same previous year, the statutory fiction arising at the time of giving loan by the company does not cease to be operative. Such a loan would be taxed as deemed dividend even if repaid in the same previous year.  

Dividend does not include:

(i)                 a distribution made in accordance with sub-clause (c) or sub-clause (d) in respect of any share issued for full cash consideration, where the holder of the share is not entitled in the event of liquidation to participate in the surplus assets ; (ia)       a distribution made in accordance with sub-clause (c) or sub-clause (d) in so far as such distribution is attributable to the capitalized profits of the company representing bonus shares allotted to its equity shareholders; (ii)               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 ; (iii)             any dividend paid by a company which is set off by the company against the whole or any part of any sum previously paid by it and treated as a dividend within the meaning of sub-clause (e), to the extent to which it is so set off; (iv)              any payment made by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 77A 1 of the Companies Act, 1956 (1 of 1956); (v)                any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged company (whether or not there is a reduction of capital in the demerged company).  

Quantum of deemed dividend

If the loan given by the company exceeds the accumulated profits, deemed dividend would be to the extent of accumulated profits and balance of loan amount would not be deemed dividend. If the accumulated profits exceed the loan amount, entire loan amount would be 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.  

Taxability:

Deemed Dividend u/s 2(22)(e) is not exempt u/s 10(34) of the Income Tax Act. Deemed Dividend u/s 2(22)(e) is taxable in the hands of shareholder u/s 56 of the Income Tax Act and it is not taxable in the hands of company.   It is taxed under the head “Income from Other Source” and taxed as income chargeable to tax at normal slab rates in case of individuals & HUF’s.  

Deduction of Tax at Source u/s 194:

The principal officer of an ‘Indian Company or a foreign Company which has made arrangement for payment of dividends in India’ is liable to deduct income tax u/s 194 at the rate in force, before making any payment of any sum deemed to be dividend u/s 2(22)(e) of the IT  Act, 1961.  

Deemed Dividend in the hands of a Non-Resident Shareholder:

Section 2(22)(e) does not distinguish between a Resident or Non-resident shareholders. Section 9(1)(iv) provides that “any dividend paid by an Indian company outside India” is ‘Income deemed to accrue or arise in India’. Therefore, Deemed Dividend u/s 2(22)(e) is subject to tax in India in the hands of a non-resident shareholder subject to DTAA relief.  

Deemed Dividend in case of Loan or Advance by a Foreign Company to a Resident Shareholder:

Section 2(22)(e) does not distinguish between an Indian or a Foreign Company. Sum paid by a Foreign Company to a resident shareholder has been held as deemed dividend. _________________________________________________________________________________