The Hindu Business Line : DDT and closely-held companies

In terms of Section 115-O of the Income-Tax Act (I-T Act), Dividend Distribution Tax (DDT) is payable by every domestic company on the dividend distributed to the shareholders. This regime applies as much to closely-held companies as it does to widely-held ones.

In the private sector, a closely-held company is one whose shares are not listed in a recognised stock exchange as on the last date of the previous year. In other words, in the private sector, to make the grade as a widely-held company, a company’s equity shares must be listed in at least one of the recognised stock exchanges in India.

The term ‘dividend’ is defined in Section 2(22) that has five clauses (a) to (e). Normal dividends distributed, be they interim or year-end, are covered by clause (a) and they are exempt in the hands of the shareholders with the company paying DDT of 16.995 per cent, say, 17 per cent.

Loans, advances

Clause (e), which is unique to closely-held companies, targets loans and advance to shareholders having at least 10 per cent voting clout therein or to any concern in which such shareholder has a substantial interest in order to foil attempts at tax evasion by disguising dividends as loans or advances.

It is this clause that has been saved from the clutches of DDT and hence continues to be taxed in the hands of the beneficiaries of such loans and advances.

Closely-held companies must be vigilant not to extend loans or advances to dominant shareholders when it has accumulated profits because assuming they are taxable at the maximum marginal rate together with a surcharge of 10 per cent, they would have to fork out a 34 per cent tax, whereas they could have got away with a vicarious tax of 17 per cent DDT in the hands of the company.

To be sure, such deemed dividends are not exigible to DDT if such outstanding loans or advances are set off against one’s actual entitlement to dividend.

To wit, let us say a private limited company has got four shareholders with each having 25 per cent stake in the company and at the relevant point of time its accumulated profits were Rs 10 crore. Now if each one of them helps himself to a hefty Rs 1 crore loan, they would be required to pay 34 per cent tax on this.

Soon the company may at its Annual General Meeting (AGM) declare Rs 6 crore as dividend, thus entitling each one of them to Rs 1.5 crore but actually pay only Rs 50 lakh each after setting off the earlier loan of Rs 1 crore.

Damage done

But the damage has already been done because while now it has to pay DDT of 17 per cent only on Rs 2 crore, the shareholders have already coughed up Rs 34 lakh each.

The simple point is they could have minimised their overall tax bill by biding their time for actual dividend to be declared.

In the example on hand, had the entire cash been received as dividend and no part of it as loan, the DDT payable would have been 17 per cent of Rs 6 crore, that is, Rs 1.02 crore. But their indiscretion in taking loan has cost them and their company dearly — Rs 1.36 crore as normal tax on the loan of Rs 1 crore each aggregating to Rs 4 crore and DDT of Rs 34 lakh on Rs 2 crore of dividend paid after setting of Rs 4 crore resulting in an overall tax bill of Rs 1.70 crore. Thus their indiscretion has cost them Rs 68 lakh extra.

Profitable closely-held companies can liberally issue bonus shares to their shareholders.

Firstly, bonus shares distributed to equity shareholders are not treated as dividend and, hence, DDT is not payable. Nor are the shareholders liable to pay tax on bonus shares received.

While this advantage is common to both widely-held and closely-held companies, it has a special significance for the latter inasmuch as to the extent of issuance of bonus shares, the figure of accumulated profits come down.

In the example on hand, the closely-held company should not have allowed its accumulated profits to swell. Had it capitalised the profits by issuing bonus shares to its shareholders from time to time and extended loans to them at a time when there were no accumulated profits, it could have legitimately avoided DDT and its dominant shareholders could have avoided with equal legitimacy tax on deemed dividend.

Bonus shares

Closely-held companies would therefore do well to reward their shareholders largely with bonus shares instead of cash dividend and take care of their cash needs by extending loans to them at a time when there are no accumulated profits.

Such a liberal bonus share policy is simply unthinkable for a listed company which has to worry about the resultant dilution in EPS impacting the market quotations for its shares adversely but a closely-held company simply need not worry about such niceties because its shares are not listed, indeed cannot be listed, in the first place.

(The author is a Delhi-based chartered accountant. blfeedback@thehindu.co.in)

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