Income Tax

Deemed Dividend under Income Tax Act- Meaning, Taxability & Case Laws

Dividend refers to the return earned by the shareholder for investing in a company by purchasing its shares. It can be a reward, cash, etc., that a company provides to its shareholders. It can be issued in different forms. The company’s dividend is decided by the board of directors of such a company and warrants the shareholders’ approval. Hence, a dividend is some part of the profit that the company provides to its shareholders. However, there is another category which is known as Deemed Dividends. The Income Tax Act contains various provisions relating to it. This article will discuss the meaning, taxability, and certain case laws relating to deemed dividend under Income Tax Act.

What is deemed dividend?

The deemed dividend is an asset given to a shareholder who enjoys a significant share in the company. In simple words, a specific amount loaned or given in advance to a shareholder with a significant share in the company is termed a Deemed Dividend.

As per Section 2(22) (e) of the Income Tax Act, such payments are considered to be deemed dividend when a closely held company provides-

• Loan to a shareholder with a significant interest in the company, which means one that has a minimum of 10% of the voting power. Notably, the shares that an investor has must not qualify to obtain a fixed rate of dividend;
• Loan or an advance to the company or a business wherein the shareholder is a member and where he enjoys a substantial stake;
• An advance or a loan to the shareholder for their gain;
•  Loan to a shareholder for the benefit of the director of the company;
• A loan or an advance to the parent company;

Note– The advancement of the aforesaid loans or advances must be made during the year under consideration, and the loan amount or the advances should come only from the company’s accumulated profits. Moreover, the companies providing such loans should not be listed on the stock exchange.

Exceptions to Deemed Dividend

There are certain transactions that may appear to be part of the deemed dividend under Income Tax but are not treated as deemed dividends. Such transactions are termed as exceptions to the deemed dividend.

Following are the types of transactions which are a few exceptions in this regard: –

• Loan or an advance provided to a shareholder from the share premium account of the company;
• Money lending company offering loans under the natural course of the business;
• Loans extended to the shareholders that are adjusted later upon declaring the dividends;
• In a case where the company granting loans is trading publicly and has significant interest from the public;
• Loans extended to shareholders having or holding less than 10% of voting rights in a company;
• The payment made by the company to buy back its shares;
• Transactions acting as an inter-corporate deposit;
• Loans were provided during previous years, not in the current year.

Implications of Deemed Dividend under the Income Tax Act

Before 2018, companies that paid deemed dividends did not pay any Dividend Distribution Tax on those payments. In Budget 2018, an amendment was introduced to Section 115-O of the Income Tax Act. It mandated the companies to pay Dividend Distribution Tax at the rate of 30% with an applicable surcharge and cess on transactions carried out after April 1, 2018.

This amendment was introduced owing to the fact that the taxability of deemed dividends in the hands of the recipient made tax collection from the shareholder arduous.

Due to this, the shareholder does not have to pay taxes on such receipts.

In the 2021 Budget, the liability to pay tax on dividends was transferred to the shareholders. The companies are no longer liable to pay the Dividend Distribution Tax while providing dividends to the shareholders.

Taxability of Deemed Dividend under the Income Tax Act

As per Section 194 of the IT Act, which applies to distributed dividends, declared dividends, or dividends paid on or after April 1, 2020, an Indian entity is required to deduct tax at the rate of 10% from the dividends given to the resident shareholders or investors in the case where the total distributed dividend amount or the dividend paid to a shareholder in the financial year is more than 5000 rupees.

The government had reduced the TDS rate for dividend distribution as a covid-19 relief measure. However, no TDS could be deducted from the dividend amount that is paid or payable, or that is due to the insurance entities such as the Life Insurance Corporation, General Insurance Corporation, or other insurers pertaining to any shares held or owned by them.

However, in the case where the dividend is provided to a non-resident or a foreign company, then the tax has to be withheld as per the applicable DTAA under Section 195 of the IT Act 1961.

Section 10(34) exempting stockholders from dividend income stands repealed from AY 2021-22. It shall no longer be applicable to taxpayers. Resultantly, the dividends distributed after the financial year 2020-2021 will be taxable in the hands of the shareholders. This shall also include the dividends paid during the year 2020-21.

Moreover, the applicability of Section 115BBDA, which imposes a tax on the payment of dividends in excess of 10 lakh rupees, is not relevant because the entire pay-out amount shall be taxable in the hands of the investors in accordance with their tax rates.

Therefore, the taxability of the dividend income and the rate of taxation shall be impacted by various factors, including the residential status of an investor and the category of the income, etc. Further, the terms and conditions of the DTAAs and the Multilateral Instruments shall be applicable in the case of a foreign shareholder or non-resident.

Deemed Dividend under Income Tax: Compliances

The compliance to be followed by the closely held company includes-

• Companies shall pay the dividend distribution tax as per Section 115-O of the Income Tax Act;
• The company’s officer paying the dividend is liable to deduct TDS under Section 194 of the Income Tax Act before making payments relating to the dividend. A company failing to deduct TDS shall be liable to a penalty under Section 271C (1) (a) of the amount equivalent to the tax amount supposed to be deducted.
• If the company declares a dividend and the dividend is set off against advances, then such a dividend that is set off against the advances will not be treated as a dividend.

The compliance to be followed by the taxpayers includes-

• Deemed dividends under the income tax act should be declared as income, and no special rate is levied on deemed dividends and is charged at normal income tax rates.

Case Laws on Deemed Dividends under Income Tax Act

Below we have discussed a few case laws relating to a deemed dividend under the income tax act.

CIT, Andhra Pradesh v CP Sarathy Mudaliar

In the case of CIT, Andhra Pradesh v CP Sarathy Mudaliar, the Apex Court was approached by the litigants to interpret the word dividend. The word dividend has been explained under the Income Tax Act^[1].

In the facts of the instant case, a company had provided a loan to HUF. The members of HUF were the company’s shareholders. Now the Court had to decide whether the loan advanced to HUF, not being a registered shareholder of the company, can be called a dividend.

The Court held that since the definition of dividend didn’t use the phrase, beneficial shareholder, it must be understood as only a registered shareholder. The Court observed that as the HUF is not and can’t be a registered shareholder of the company, the loan advanced to the HUF by the company cannot be termed as a dividend.

CIT v. Madhur Housing and Development Company

In this case, the Supreme Court, while dealing with a batch of appeals, held that the provisions of deemed dividends under the Income Tax Act won’t be attracted if the person availing the loan is not a shareholder of the lender company.

The Court upheld the ruling of the Delhi High Court in the case of Ankitech. It affirmed the Delhi High Court’s reasoning without sharing additional inputs. 

In the case of CIT v. Ankitech, the taxpayer company obtained some amount as advances from another company. The shareholders with a substantial interest in the taxpayer company also held voting power exceeding 10% in the other company. Considering that the shareholders holding a substantial interest in the taxpayer company also had a substantial interest in the other company, the tax authorities held that the amount of loans and advances shall be construed as deemed dividends.

On an appeal, this decision was reversed by the Income Tax Appellate Tribunal. The Tribunal also clarified that the dividends can be taxed in the hands of the shareholders having a substantial interest in the taxpayer company.

 The High Court noted that the legislature intended to tax deemed dividends in the hands of the shareholders of the lending company having substantial interest.

The tax authorities sought to rely on a circular dated September 22, 1997, which said that deemed dividends shall be taxed in the hands of the borrower. However, the Court rejected the claim.

It was held that deemed dividends could be taxed only in the hands of the shareholders of the lending company.

This decision of the High Court came to be upheld by the Hon’ble Supreme Court.

Commissioner of Income Tax & Anr v. N S Narendra

In this case, the Karnataka High Court held that the loan given to a shareholder to avail credit facility from the bank in the name of the shareholder cannot be treated as Deemed Dividend under Income Tax Act.

The bench observed that the loan wasn’t given to the assessee just because he was a shareholder but to avail loan from the bank for some business purposes.

Earlier, when this case went before the commissioner of income tax (appeals), it was held that the payments obtained by the assessee from the Company cannot be termed as deemed dividends because the payment was not for the benefit of the assessee.

The Income Tax Appellate Tribunal upheld these findings.

The High Court noted that the company derived benefits from the assessee. Hence, the loan was granted to the assessee. The Court affirmed the findings of the commissioner of income tax (appeals) and the Tribunal’s findings. The Court relied upon the decision of the Calcutta High Court in the case- Pradip Kumar Malhotra vs CIT.

Conclusion

Deemed dividends can be a productive idea for a closely held company to provide loans and advances to shareholders with substantial interest. To obtain deemed dividend, a person must understand the complex eligibility requirements and tax rules governing deemed dividend under the income tax act.

Read Our Article: Taxability of Dividend in Income Tax Returns