When dividends are exempt from tax in the hands of the recipients, the question arises whether such exemption is available for deemed dividends as well.
T. C. A. Ramanujam
When the Government chose to end the debate about double taxation of dividends, the Income-Tax Act was amended and a specific provision was enacted in Section 10 of the Act to exempt dividends in the hands of shareholders from taxation. At the same time, to avoid loss of revenue because of this measure, Section 115-O was enacted, laying down that companies which distribute dividends will be liable to pay tax on the distributed portion of the dividends at the time of distribution.
Several anomalies were pointed out to show that in reality, double taxation was not avoided by this measure. One of the recipients may be a company and it may distribute dividends out of the share of dividends it receives. It will be liable for the additional dividend distribution tax. Government chose to ignore this anomaly.
Deemed dividends are taxed in the hands of shareholder —directors under Section 2 (22) of the Act. An artificial definition of ‘dividend’ is given for this purpose in Section 2(22). Section 2(22)(e) lays down that payment of any sum by a company by way of advance or loan to any shareholder holding more than 10 per cent of the shares of the company will be deemed to be dividends and not just loan or advance only, to the extent to which the company possessed accumulated profits.
This provision does not apply to companies in which the public are substantially interested. The device of slicing away a company’s profits by way of loans in order to avoid dividend taxation was sought to be checkmated by this provision. This sub-section has given rise to a lot of litigation and, generally, the Revenue has succeeded in taxing all such loans and advance as deemed dividends.
When dividends were exempted from taxation in the hands of the recipients, the question arose whether such exemption was available in respect of deemed dividends under Section 2(22)(e) of the Act. There was no authentic pronouncement on this issue. But, recently, this matter was looked at by the Mumbai Bench of the Appellate Tribunal in Kalyan M. Gupta vs Jt. Commissioner of Income-tax (293 ITR AT 249 Mumbai).
Kalyan Gupta case
Kalyan Gupta was a shareholder with more than 10 per cent interest in Om Shipping Agents (P) Ltd. He received a loan of Rs 73 lakh from the company. This was outstanding as on March 31, 1998. After hearing the assessee, the income-tax officer (ITO) added Rs 73 lakh as deemed dividend assessable under Section 2(22)(e).
It was pleaded that the amount was only a temporary borrowing and not in the nature of loan or advance. As this argument was not accepted, another submission was raised to the effect that the dividend exemption provision under Section 10 should be given effect in respect of the sum of Rs 73 lakh.
This provision came into effect from the assessment year 1998-99. What applies to dividend income should also apply to deemed dividend under Section 2(22)(e). The Bench examined Sections 115O, 115P and 115Q in Chapter XIID of the Act. It referred to the Explanation given in this chapter: “For the purposes of this Chapter, the expression “dividend” shall have the same meaning as is given to “dividend” in clause (22) of Section 2 but shall not include sub-clause (e) thereof.”
The loan or advance to the substantial shareholder is treated as deemed dividend under Section 2(22)(e). The Explanation at the end of Chapter XI B stipulates that the expression ‘dividends’ shall not include this type of deemed dividends comprising loans and advances. Thus, deemed dividend referred to in Section 2(22)(e) has been excluded from the ambit of Chapter XIIB. Tax is not levied on the company with regard to such deemed dividend. Consequently, the exemption provided under Section 10 is not applicable to “deemed dividend” referred to in Section 2(22)(e).
The above Ruling of the Tribunal has been criticised by tax jurists as being harsh. Section 2(22) covers various types of payments to substantial shareholders entailing release of assets or accumulated profits of the company. Sub-clause (e) entails hardship inasmuch as even repayments of earlier loans cannot be adjusted in the computation of deemed dividends. It is the gross amount of advance and not the net advance to the substantial shareholders that is brought to tax.
The interpretation placed by the Mumbai Bench of the Appellate Tribunal confirms to the strict meaning of the Explanation in Chapter XII B.
The Ruling clarifies doubts with regard to the exemption of ordinary dividends and taxation of deemed dividends.(The author is a former Chief Commissioner of Income-Tax.)