Loans as deemed dividend

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Granting inter-company loans is not uncommon in case of Indian companies. However, undertaking such transfer of funds carries with it income-tax implications, which should be kept in mind. The provisions of the Income-Tax Act, 1961 (the Act) lay down that in case a loan or advance is given by a closely held company to another concern where there is a common shareholder having a substantial interest, the loan or advance shall be taxable as deemed dividend, to the extent of accumulated profits of the concern granting the loan or advance.

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

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