An interesting issue that arises here is whether the deemed dividend (ie the loan or advance) should be taxed in the hands of the concern to whom the loan is given (borrowing concern) or in the hands of the shareholder (on account of whose common shareholding, the loan is considered as deemed dividend). The issue assumes particular importance, since this category of dividend is not exempt from tax.
One view is that the loan or advance is taxable as deemed dividend in the hands of the borrowing concern.
This is based on the rationale that under the relevant provisions of deemed dividend, it is the payment made to the related concern which is regarded as deemed dividend.
The Hyderabad Tribunal in the case of Hyderabad Chemical Products (72 ITD 323) has proceeded to tax the borrowing concern for the deemed dividend although there is no specific analysis on this aspect.
In fact, the CBDT circular no 495 dated September 22, 1987, giving explanatory notes when the provisions of deemed dividend were introduced in the Act indicates that such a loan is taxable as deemed dividend in the hands of the borrowing concern. The revenue authorities therefore would tend to take a view that such deemed dividend should be taxed in the hands of the borrowing concern and not the shareholder.
Another view is that the loan or advance ought to be taxed as deemed dividend in the hands of the shareholder (having a common shareholding) and not the borrowing concern. This view finds its justification from a well-established principle that dividend income is linked to shareholding.
Further, the legislative intent behind introducing such a deeming provision was to plug the loophole where shareholders who control closely held companies, avoid payment of tax by retaining and accumulating profits in the company itself and the company then provides loans or advances either to the shareholders or to a concern in which they have substantial interest, instead of distributing dividends. Dividend is generally a return or income on the investment by shareholders. However, taxation of dividend in the hands of the borrowing concern and not the shareholder leads to a situation where the borrowing concern, which has no shareholding is taxed in respect of the deemed dividend income instead of the shareholder.
Normally, it is always the shareholder who is taxed in respect of the dividend income and this is also true in all other situations where a payment is deemed to be taxed as dividend.
It is a well-settled principle that a deeming fiction should be carried to its logical conclusion and according to the purpose for which it has been enacted.
It may be possible to argue that the provisions of deemed dividend should not be extended further and interpreted to go beyond the legislative intent in creating it.
Accordingly, while the loan may be deemed through the fiction to be dividend, the fiction should not be extended further to regard such dividend to be the income of the borrowing concern which is not a shareholder.
In this context, recently the Mumbai Tribunal (in an unreported ruling) after an analysis has held that the objective of the tax provisions on deemed dividend is to tax the shareholders and that non-shareholders cannot be subject to tax on the deemed dividend income.
The Mumbai Tribunal held that deemed dividend cannot be taxed in the hands of the borrowing concern. The issue remains contentious and one hopes that the expert committee constituted by the CBDT for simplification of the tax laws brings clarification on this issue.
The writers are senior tax professionals with Ernst & Young