Critical issues in respect of deemed dividend

The provisions of section 2(22)(e) of the Income-tax Act, 1961 create a fiction whereby amounts which are paid otherwise than as dividend, are deemed to be dividend. Therefore, this clause must be given a strict interpretation.

In order to attract the provisions of section 2(22)(e) of the Act, four conditions need to be fulfilled: (i) the assessee should be a shareholder of the company ; (ii) the company should be a closely held company in which the public are not substantially interested ; (iii) there must be payment by way of advance or loan to a shareholder or any payment by the company on behalf of or for the individual benefit of the shareholder ; and (iv) there must be accumulated profits in the hands of the company up to the date of such payment.

To attract the first limb of section 2(22)(e), the payment must be to a person who is a registered holder of shares. The word ?shareholder? in section 2(22)(e) is followed by the following words ?being a person who is the beneficial owner of shares?. This expression only qualifies the word ?shareholder? and does not in any way alter the position that the shareholder has to be a registered shareholder. If a person is a registered shareholder but not the beneficial shareholder then the provisions of section 2(22)(e) will not apply. Similarly if a person is a beneficial shareholder but not a registered shareholder then too the first limb of section 2(22)(e) will not apply.

The new category of payment which was considered as dividend introduced by the Finance Act, 1987, with effect from April 1, 1988, by the second limb of section 2(22)(e) is payment ?to any concern in which such shareholder is a member or a partner and in which he has a substantial interest?. The expression ?such shareholder? in the provision refers to the shareholder referred to in the earlier part of section 2(22)(e), namely, a registered and a beneficial holder of shares holding at least 10% voting power. The very same person must also be a member or a partner in the concern holding substantial interest in the concern.

The intention behind enacting the provisions of section 2(22)(e) arose from that fact that closely held companies which are controlled by a group of members, would not distribute such profit as dividend because the dividend income would become taxable in the hands of the shareholders. Instead, companies distribute them as loans or advances to the shareholder or to a concern in which such shareholder has a substantial interest or make any payment on behalf of or for the individual benefit of such shareholder. In such an event, by the deeming provisions such payment by the company is treated as dividend. The provisions contemplate a charge to tax in the hands of the shareholder and not in the hands of a non-shareholder, viz., the concern.

The definition of dividend under section 2(22)(e) of the Act is an inclusive definition which enlarges the meaning of the term ?dividend? according to its ordinary and natural meaning to include even a loan or advance. The ordinary and natural meaning of the term dividend would be a share in profits to an investor in the share capital of a limited company. If the definition of ?dividend? is extended to a loan or advance to a non-shareholder the ordinary and natural meaning of the word dividend is taken away. Deemed dividend under section 2(22)(e) of the Act can be assessed only in the hands of a shareholder of the lender company and not in the hands of any other person.

In C.I.T. v. Hotel Hilltop (313 I.T.R. 116), the assessee-firm constituted of two partners ran a hotel business. It entered into an agreement with a private limited company formed by the two partners with their close relations under which the management of the firm?s hotel was to be handed over to the company. The assessee-firm received a sum of Rs. 10 lakhs as advance against security. The assessee-firm filed its return of income for the assessment year 1991-92, declaring an income of Rs. 72,000 disclosing the amount received from the company as an advance against security. The Assessing Officer made an addition to the income of the assessee treating the amount as deemed dividend under section 2(22)(e) of the Act. The Commissioner (Appeals) deleted the addition on the ground that the firm was not a shareholder of the company. The Tribunal confirmed the deletion.

On appeal, the Rajasthan High Court held that the assessee was not shown to be the shareholder of the company and the two individuals who were partners of the firm were the majority shareholders of the company. Therefore, the security advanced by the company to the assessee could not be deemed to be dividend as the assessee was not a shareholder in the company. The amount was paid by the company to the assessee on behalf of the individuals.

This provision was considered by a Special Bench of the Income-tax Appellant Tribunal in Bhaumik Colour P. Ltd. v. C.I.T. (I.T.A. No. 5030/Mum/04). In this case the assessee-company took an interest bearing loan of Rs. 9 lakhs from a company (UPPL). The company had a common shareholder, a trust, which held 20 per cent. of the shares in the assessee-company and ten per cent. of the shares in UPPL.

The Assessing Officer was of the view that the transaction was covered by the second limb of the provisions of section 2(22)(e) of the Act. On appeal by the assessee the Commissioner (Appeals) deleted the addition.

The Tribunal, in view of a conflict of opinion among Benches, referred the matter to a Special Bench which held that the three trustees of the trust owned shares in UPPL and the assessee-company was only as a legal and registered owner for and on behalf of five beneficiaries of the trust who were different individuals. The three trustees were, therefore, not beneficial owners of the shares.

Therefore, the provisions of section 2(22)(e) would not be applicable at all to the case of the assessee-company. Deemed dividend could be assessed only in the hands of the person, who is a shareholder of the lender company and not in the hands of a person other than a shareholder, i.e., the concern.

The aforesaid decisions throw considerable light on critical issues pertaining to the fictional concept of deemed dividend.