The concept of Deemed Dividend under the Income-tax Act, 1961(the Act) is not new. However, time and again many closely held company assessees and their controlling shareholders, to their surprise and dismay, realise very late the importance of this powerful taxing tool in the hands of the Assessing Officer.

Section 2 (22) of Income-tax Act, 1961 defines "dividend" and is the main section for taxation of Dividend. Unless a payment or distribution is covered by this definition, it can not be taxed as "dividend". Once an amount is covered as dividend it will be also considered as income as Section 2(24)(ii) of the Act includes 'dividend' within the definition of 'Income'.

Section 2(22) has 5 clauses (a), (b), (c), (d) and (e) which specify various types of distributions and payments as dividend. Clauses (a). (b), (c) and (d) mainly cover cases of distributions which entail release of assets or create liabilities. While clause (e) covers cases of payments by way of loans or advances and which is the clause mainly dealing with deemed dividend as it is commonly understood and has been dealt with in this article. In Kantilal Manilal v.CIT [1961] 41 ITR 275(SC) the Supreme court held that

Section 2(22) deals with various types of cases and creates a fiction by which certain receipts or parts thereof are treated as dividend for the purpose of levy of Income-tax .

In CIT v. Martin Burn Ltd.,(1982)136 ITR 805(cal) the Calcutta Highcourt held that Under section 2(22) certain amounts which are actually not distributed are also brought within the net of dividends. Therefore, that section must receive a strict interpretation.

Section 2(22)(e) has been held to be constitutionally valid in Navnitlal C. Javeri v. K.K.Sen, AAC [1965]56 ITR 198 (SC).

Section 2(22) starts with the words " Dividend includes ……….."Thus the definition of dividend is inclusive and not exhaustive.

Section 2(22)(e) is reproduced below:-

"any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) [made after the 31^st day of May, 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten percent of the voting power, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as said concern)] or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent to which the company in either case possesses accumulated profits;"

Let us now analyse the clause in detail.

Payment of any Sum.

Clauses (a),(b),(c) and (d) of section 2(22) use the word "distribution" while clause (e) uses the word "payment" which means amount may have been disbursed to one or two or more shareholders and not necessarily be distributed to all the shareholders.

Does it mean only payment by cash/cheque or will it cover loan in kind also? Whether a goods loan will be covered? In M.D. Jindal v. CIT [1986] 28 Taxman 509 (Cal.) it was held that Section 2(22)(e) is applicable even if a loan is given in kind. Thus a loan of goods or other assets will also be covered by the clause and it is not necessary that the loan or advance must be given in cash only.

Shareholder

The shareholder may be even a corporate entity. Loan given by a subsidiary company to a holding company wll be covered by clause (e).

Loan or advance

Section 269SS of IT Act specifies that ' for the purpose of this section,"loan or deposit" means 'loan or deposit of money'. A loan creates a relationship of a lender and a borrower.

• Can a bonafide loan given to a major shareholder for a short duration be covered by this section? In CIT v. Bhagwat Tewari [1979] 105 ITR 62 (Cal) it was held that a bonafide loan for a short duration is treated as dividend if all the conditions of section 2(22)(e) are satisfied.

• What is the position when a shareholder has a current account with the company? When a current account shows a debit balance of the shareholder in company's books, it will take character of a loan. Therefore, position after every entry will have to be ascertained.

• In order to attract the provisions of section 2(22)(e), the important consideration is that there should be loan/advance by a company to its shareholder. Every payment by a company to its shareholder may not be loan/advance. To be treated as loan every amount paid must make the company a creditor of the shareholder for that amount. If, however, at the time when payment is made, the company is already the debtor of the shareholder, the payment would be merely a repayment by the company towards its already existing debt. It would be a loan by the company only if the payment exceeds the amount of its already existing debt and that too only to the extent of the excess. If the shareholder has a current account with the company, the position as regards each debit will have to be considered individually, as it may or may not be a loan. In such case the debit balance of the shareholder with the company at any point of time cannot be taken to represent an advance/loan by the company; nor can the amount at the end of the previous year be alone taken as loan.CIT v. P.K. Badiani[1970] 76 ITR 369 (Bom.).

• Whether an overdraft taken by a major shareholder from the company will be covered as deemed dividend? An overdraft taken by a shareholder from the company is treated as loan and taxable as dividend if conditions of section 2(22)(e) are satisfied—CIT v. K..Srinivasan [1963] 50 ITR 788 (Mad.).

• What will be the position when a major shareholder misappropriated some amount from the company? Amount misappropriated by the director cannot be treated as deemed dividend in his hands since in such a case there is no lending or advancing by the company. It cannot be said that in such a case the company has paid anything and unless there is an actual payment by the company as a loan or advance to the assessee, it cannot be treated as dividend under section 2(22)(e). CIT v. G. Venkataraman [1975] 101 ITR 673 (Mad.)

• If a loan is repaid before the end of the previous year, the section will be attracted? Yes, even if a loan is repaid before the end of the previous year the section will be attracted. In Tarulata Shyam v. CIT [1977] 108 ITR 345 (SC) the Supreme court held that under section 2(22) the liability to tax attaches to any amount taken as loan by the shareholder from a controlled company to the extent it possesses accumulated profits at the moment the loan is borrowed and it is immaterial whether the loan is repaid before the end of the accounting year.

• Whether Book debts will be covered by "loans and advances"? Where the assessee-shareholder, having business of his own, was transacting business with the company and the account of the assessee in the company always showed a debit balance, it was held that the said debit balance would amount to a loan from the company to the assessee. CIT v. Jamnadas Khimji Kothari [1973] ITR 105 (Bom.)

• Every sale of goods on credit does not amount to a transaction of loan. A loan contracted no doubt creates a debt but there may be a debt without contracting a loan. Bombay Steam Navigation Company P. Ltd. v. CIT(1965) 56 ITR 52(SC)

• Whether Security deposit to a major shareholder for use of premises will be covered under clause(e)? Genuine security deposit without any element of loan may not be considered as a loan.

• Whether loans or advance to relatives of a major shareholder will be covered? Loans to relatives of substantial shareholders are not covered as loans or advances to the shareholder. However such loans or advances may be covered as" payment on behalf of or for the individual benefit" of the shareholder.

Clause (ii) to section 2(22) provides that "dividend" does not include any advance or loan made to a shareholder [or the said concern] by a company in the ordinary course of business, where the lending of money is a substantial part of the business of the company;

If a majority of a company's assets and income are from money-lending business, it will be proper to assume that lending of money is a substantial part of the company's business.

In Walchand & co. Ltd. V. CIT,(1975)100 ITR 598(Bom) it was held that the onus to prove these facts lies on the assessee.

Clause (iii) to section 2(22) provides that "dividend" does not include any dividend paid by a company which is set off by the company against the whole or any part of any sum previously paid by it and treated as a dividend within the meaning of sub-clause (e),to the extent to which it is set off.

This clause gives some relief to the assessee by way of avoiding double taxation as well as brings in some scope for Scope for tax-planning. Thus, if a loan is already treated as a dividend it may make sense to declare dividend and adjust the outstanding loan amount against the dividend declared. No tax will be payable by shareholder on such dividend declared.

However, if the loan has been repaid by the shareholder and nothing is due by the shareholder against the loan referred in section 2(22)(e), then no set-off would be possible. Also if the sum due by the assessee is on account of some other payments not covered by section 2(22)(e), then set-off will not be possible.

It appears that liability to pay tax on distributed profits u/s 115-O can not arise in a case where a dividend paid by a company is set-off by the company as mentioned above, since the amount itself is not to be treated as a dividend . EEEEeee xplanation to section115Q may be referred to for this purpose.

Payment on behalf of or for the individual benefit of

A benefit means some advantage to a person or something for the good of a person.

• A managing director of a company, whenever he needed money used to ask an employee to take a loan from the company and pass it on to him even without executing any pronote. Can he be said to have received any benefit? It was held that the loans made by the company to the employee fell in the category of "benefit" to the assessee managing director and were, therefore, assessable as deemed dividends in his hands—CIT v. L.Alagusundaram Chettiar [1977] 109 ITR 508 (Mad.).

• In one case, the assessee, having substantial interest in a company X, obtained from company Y two loans of Rs. 75,000 and Rs.2,00,000 on July 30, 1968 and September2, 1968, respectively. The question for consideration was whether these amounts could be treated as deemed dividend in the hands of the assessee under section 2(22)(e) on the ground that Y had made these loans to the assessee out of loans received by Y from X on the same dates.The Court held (in Nandlal Kanoria v. CIT [1980] 122 ITR 405 (Cal.)), that there was no loan given by X to the assessee. However, as the loan of Rs. 75,000 was given by Y to the assessee out of an equal amount received as loan from X on the same date, this amount was a payment by X for the benefit of the assessee and fell within the mischief of section 2(22)(e). The same could not be said of the loan of Rs. 2,00,000, as on the date of making that loan, Y had received loans not only from X but from another source also and the loan was made out of blended amount.

Of accumulated Profits.

• In P. K. Badiani v CIT(1976)105 ITR 642(SC) the Supreme court held that Accumulated profits mean commercial profits and not assessed income..It does not mean the aggregate of the assessed income arrived at after disallowing disbursements and expenditure in fact incurred..

• In Navnitlal C. Jhaveri v. CIT[1971]80 ITR 582(Bom) a question arose that while calculating accumulated profits depreciation as per books should be considered or as per IT Act? The Bombay High court held that while calculating accumulated profits an allowance for depreciation at the rates provided by the Income-tax Act itself has to be made by way of deduction.

This is an important saving grace and assessees can claim substantial deduction for Income-tax depreciation out of accumulated profits. This will also call for separate calculation for accumulated profits as per income-tax Act and the same may be different from the accumulated profits as per books of accounts.

• As the Accumulated profits have to be commercial profits, additions made by the ITO due to concealed income can be included in accumulated profits. However, by the same logic, additions made by the Income-tax officer on account of inadmissible expenses or disallowances can not be included in accumulated profits.

• Even loan obtained by the assessee-shareholder from a company from out of its Accumulated profits, which are exempt in the hands of the company as agricul tural income, is to be treated as deemed dividend in the hands of the assessee. S. Kumaraswami v.ITO [1961] 43 ITR 423 (Mad.)

• Whether balancing charge u/s 41(2)will form part of accumulated profits?.In CIT vs. Urmila Ramesh (1998) 230 ITR 422 the Supreme court held that the amount of balancing charge under section 41(2) of the Act, did not represent Accumulated profits.

• Whether capital gains can be included in Accumulated profits? Presently Capital gains are covered by the expression 'accumulated profits' except capital gains arising before the 1^st day of April, 1946, or after the 31^st day of March, 1948, and before the 1^st day of April, 1956. However, capital gains which are not taxable per se can not form part of Accumulated profits.Thus any distribution out of such non-taxable accumulated capital gains can not be treated to be taxable as deemed dividend. See CIT v. Mangesh J. Sanzgiri, (1979) 119 ITR 962(Bom). Thus capital gains on sale of agricultural land which is outside the purview of definition of "capital asset" as per section 2(14) of the Act should not form part of the Accumulated profits.

• Whether Revaluation reserves can be included in Accumulated profits? It appears that revaluation reserves can not be included in Accumulated profits as they are not in the nature of commercial profits as commonly understood and represent a mere book entry.

• Whether credit to Profit & Loss Account due to write-back of depreciation on account of change in method of depreciation will form part of accumulated profits?

There is no legal bar to writeback of Depreciation.as per Department of Company Affair's view appearing in Company News and Notes, July 1 1963. However, since write-back of depreciation will be as per book-depreciation, while one needs to calculate Income-tax depreciation as per IT Act for the purpose of calculation of Accumulated profits, such writeback will not have any impact on Accumulated profits.

• Development Rebate Reserve and Investment Allowance Reserve will form part of Accumulated profits.

• Provision for tax and provision for dividend can not form part of Accumulated profits.CIT v V. Damodaran[1972]85 ITR 59(ker.).This is obvious because each of them represent a liability and is not in the nature of profits or reserves.

• In determining the Accumulated profits available for the purpose of section 2(22)(e), the amount treated as deemed dividend under section 2(22)(e) in past have to be excluded. CIT v. G. Narasimhan [1979] 118 ITR 60 (Mad)

Example -		Rs
a)	Accumulated profits	80,000
b)	Loan advanced to a major shareholder and treated as dividend	60,000
c)	Balance Accumulated profits a)-b)	20,000
d)	Loan repaid by shareholder	60,000
e)	Shareholder again borrows in the same year	70,000
f)	Second deemed dividend to the extent of balance Accumulated profits	20,000

Explanation 2 to section 2(22) provides that -- The expression "accumulated profits" in sub-clauses (a), (b), (d) and (e), shall include all profits of the company up to the date of distribution or payment referred to in those sub-clauses, and in sub-clause (c) shall include----------------

Thus it will be imperative for the company to calculate its profits and losses upto the date of payment of loan or advance and then calculate Accumulated profits (or losses).This date may be a date in between the two accounting years. In fact for every loan to such hareholder/concern the company may have to prepare profit and loss account upto that date.

Whether capitalised or not .

These words which are found in clauses (a) to (d) are not found in clause (e) of section 2(22) and, therefore, that provides some relief from the mischief of the section as well as provides some scope for planning .Thus it must be interpreted that to the extent of capitalisation of profits, accumulated profits would reduce for the purpose of this clause but not for other four clauses of section 2(22). What is capitalisation? It will ordinarily mean conversion of profits or reserves or income into capital as per Company's Articles of Association.

In P.K.Badiani v. CIT (1976)105 ITR 642 (SC) the Supreme court held that mere transferring of an amount from Profit & Loss account to the Development Reserve account or any other Reserve does not amount to capitalisation of profits.

Similarly a transfer to General Reserve will not amount to capitalisation.

The reason for allowing reduction of the accumulated profits to the extent of capitalisation of profits seems to be that to the extent of capitalisation, divisible profits i.e. profits available for distribution of dividend will reduce. A company can not distribute dividends out of capitalised profits i.e. capital. Thus if a closely held company wants to give loan or advance to a shareholder or his concern/company which are covered by this clause, it may first issue bonus shares (and thus capitalise the accumulated profits) and then grant such loan or advance. This is one sure way of escaping from the clutches of section 2(22)(e). However, it may involve expenses of filing fees and stamp-duty on increase of authorised share capital. Also a company may not want to increase its capital due to various other reasons.

Whether interest paid on loan which is treated as deemed dividend will be admissible as a deduction under section 57(iii)? Section 57(iii) allows a deduction for any expenditure (not being capital expenditure) laid out or expended wholly and exclusively for the purpose of making or earning such income. In Nandlal Kanoria v. CIT [1980] 122 ITR 405(Cal.) the Calcutta High court held that interest paid on loan treated as deemed dividend under section 2(22)(e) is not admissible as a deduction under section 57(iii
Whether deduction u/s 80-L or 80-M is available for deemed dividend? Deemed dividends, like normal dividends, are eligible for deductions under section 80L or section 80M . However, from the assessment year 1998-99, deductions under sections 80L and 80M are not available in view of amendment/omission of the relevant section.