A dividend, in common parlance, refers to a payment made to or received by a shareholder commensurate with his shareholding in a company out of the total amount of profit distributed. As per the Income Tax Act of 1961, dividend income received by shareholders is subject to taxation. However, certain transactions or distributions that resemble dividends but are not explicitly labelled as such are deemed to be dividends and are consequently treated as dividends for tax purposes, termed as “deemed dividends”. A deemed dividend is a concept in taxation that occurs when a company makes a distribution to its shareholders, but instead of being classified as a regular dividend, it is treated as if the shareholder received a loan from the company. This can happen in certain situations when a distribution is made in a way that resembles a loan or when there are specific tax rules that reclassify the distribution as a loan. In such cases, the deemed dividend is treated as a loan for tax purposes, wherein the shareholder may be subject to different tax treatment in comparison with a regular dividend. However, a deemed dividend is not an actual loan in the traditional sense but a tax classification based on specific circumstances.
The sub-clauses (a) to (e) of section 2 (22) of the Income-tax Act bring into the ambit of the dividend, any income which is treated as a dividend in an inclusive sense while envisaging 5 different deemed situations. The primary objective behind this is to curb attempts by closely-held companies and their shareholders to exploit loopholes to evade tax liabilities through transactions that mimic dividends.
Distribution entailing the release of assets of the company - Sec. 2 (22) (a)
Any payments made out of accumulated profits of concern, whether capitalised or not, if such allocations entail the discharge of all or any part of assets of the company to its shareholders. When these are distributed as dividends, the amount of the dividend is taken to be the market value of the property on the date on which the shareholders are authorised to accept the dividend. However, the bonus shares issued in lieu of dividend may be considered dividend only if it is accepted in cash.
Distribution not involving the release of assets of the company - Section 2 (22) (b):
Any distributions made by the company to its shareholders along the lines of debentures, debenture-stock, or deposit certificates in any form, whether with or without interest and any distribution of shares by way of bonus to its preference shareholders, to the extent to which the company holds accumulated profits, whether capitalised or not.
Distribution on liquidation - Section 2(22) (c):
Any amount distributed to the shareholders on account of the liquidation of a company, to the degree that such distribution is attributable to the company's accumulated profits immediately before its liquidation, whether capitalised or not. Unless the company possess accumulated profits prior to its liquidation, distribution by a liquidator by itself does not actuate taxability as dividend income.
Distribution on reduction of capital - Section 2(22) (d):
Any distribution made by a company to its shareholders on account of reduction of its capital, to the extent of accumulated profits held in its hand, which uprose after whether or not such accumulated gains have been capitalised, at the conclusion of the previous year ending next before the 1st day of April 1933.
Loan or advance to shareholder - Section 2(22) (e):
The following sorts of payments made by a firm are treated as dividends under this provision
Payment of any sum (whether forming a part of the assets of the company or otherwise) to a shareholder in the form of an advance or loan (including payment to companies in which those shareholders bear substantial interest).
Any settlement made on behalf of a shareholder
Any payment made for the particular advantage of a shareholder.
2(22)(e) does not hold in the case of commercial transactions.
Finance Act 2018 levied DDT (Dividend Distribution Tax) @ 30% u/s 115-0, on deemed dividends in the hands of the Payer Company. However, the recipient is also entitled to exemptions under section 10(34) with reference to the said deemed dividend. The following important ratios must be kept in mind while analysing any loan or advances granted by a company for a smooth sail through and to avoid DDT while considering the appositeness of the provisions of section 2(22)(e):
The concern should not be one in which the ‘Public holds substantial interest’. In other words, the applicability of this provision is confined to closely held companies.
The advance or loan is made to an equity shareholder who beneficially owns at least 10 per cent of the equity capital or to a concern in which he is a member/partner and is beneficially entitled to not less than 20% of the income of the concern;
Shareholding in the Lender Company and substantial interest in the Borrower Company must be examined in the act of disbursement of the loan.
The concern should possess accumulated profits at the time of making payment. Only to the extent of such earnings may the payment be deemed as a dividend.
DCIT (The Deputy Commissioner of Income-Tax) Vs Aaryavart Infrastructure Private Limited – dated: 18.07.2016 for Assessment years 2013-14 and 2014-15.
In an appeal filed against the order passed by the Commissioner of Income Tax (‘CIT’), wherein the non-reporting of the transaction in the tax audit report could be an error and had no implication on the fact of receipt of unsecured loans by the assessee from the party, the Ahmedabad Bench of the Income-tax Appellate Tribunal (ITAT) upheld the CIT order expunging the insertions made on account of deemed dividend. The bench ruled that the deeming fiction contemplated under section 2(22)(e) of the Income Tax Act 1961, solely applies to dividends and that its scope cannot be further expanded to cover non-shareholders as well.
By virtue of the case, learned Counsel stated that similar issues arose before the Tribunal in the case of Wonder Waves Entertainment Private Limited vs DCIT, in which the Tribunal, considering the decision of ITAT, Amritsar Bench, in the case of Sibia Healthcare Private Limited vs DCIT, had concluded the similar issue in favour of the assessee. The matter in question was whether the tax liability of deemed dividends regarded as such under Section 2(22)(e) is applicable to the persons who are not shareholders of the company which has disbursed loans and advances under the ambit of deemed dividends. The tribunal, while ruling in favour of the assessee, has held that applying the proposition of law to the facts of the present case, the assessee who had received advances from the said two concerns, was not a shareholder of these concerns therefore, even though the advances qualified as deemed dividend in terms of Section 2(22) (e) of the Act, they are not taxable in the hands of the assessee. As a result, non-shareholders may not be taxed on the deemed dividend.
Exclusions from deemed dividend
Any payments made to the shareholders in the event of liquidation [sub-clause (c)] or on reduction of share capital [sub-clause (d)] with reference to any share issued for full consideration, where the shareholder is not entitled to participate in the surplus assets in event of liquidation is not treated as a dividend. In other words, a payment to a preference shareholder as a result of a liquidation or reduction in capital is not considered a deemed dividend.
In cases where money lending is a substantial part of the business of a company, any advance or loan made to a shareholder or the concern by the company in the ordinary course of business is not taxable as dividend U/S 2(22) (e).
Any eventual dividend paid by the concern is not treated as a dividend for the purpose of taxation to the extent to which it is reinforced by the company against any loan or payment that has previously been classified as a dividend within the purview of sub-clause (e). However, if the dividend paid is not set off against the earlier deemed dividend, then such payment will be taxable.
As per the provisions of Section 77A of the Companies Act, 1956 any disbursement made by a company for buyback of its own shares cannot be treated as dividend. It is taxed under the purview of capital gains/loss to shareholders under section 46A.
In consonance with the demerger, the distribution of shares to the shareholders of the demerged concern (whether or not there is a diminution of capital in the resultant company) is not taxable under the definition of the dividend.
Inter-corporate deposits are not treated under the realm of ‘loans and advances’ and are therefore not taxed as deemed dividends.
When a company uses its accumulated profits for the maintenance of shareholders' assets, particularly those belonging to related parties, it can be considered as deemed dividend as per above mentioned provisions. Related-party transactions and corporate governance are the prominent concerns to be raised. Other implications are discussed below:
Deemed Dividend: If the maintenance expenses exceed the accumulated profits of the company, the excess amount may be treated as deemed dividends, subject to taxation as per the provisions of the Income Tax Act, 1961. This could result in additional tax liabilities for both the company and the shareholders.
Disallowance of Expenses: The Income Tax Act allows companies to claim deductions for expenses incurred for the purpose of business. However, if the maintenance work on shareholders' assets is not directly related to the company's business operations, tax authorities may disallow such expenses, leading to higher taxable income for the company.
Fiduciary Duty: The directors and officers of a company have a fiduciary duty to act in the best interests of the company and its shareholders. If the maintenance of shareholders' property is not directly related to the company's business or does not serve the company's interests, using accumulated profits for this purpose could potentially be considered a breach of fiduciary duty.
Corporate Purpose: Companies are generally incorporated for specific purposes outlined in their articles of incorporation or similar founding documents. If the maintenance of shareholders' property is not within the scope of the company's stated purpose, it may be challenging to justify the use of accumulated profits for that purpose.
Legal Restrictions: Laws and regulations regarding the use of accumulated profits can vary among jurisdictions. Some jurisdictions may impose restrictions on how a company can use its accumulated profits, requiring them to be used for specific purposes such as reinvestment in the business, distribution to shareholders, or repayment of debts. Using accumulated profits for purposes other than those allowed by law could lead to legal consequences.
Shareholder Agreements: If the maintenance of shareholders' property is allowed under a shareholder agreement or similar contractual arrangement, it may provide a legal basis for using the accumulated profits of the company. It is important to review any applicable agreements or contracts to determine the rights and obligations of the parties involved.
Independent Valuation: When maintenance work is undertaken on shareholders' assets, especially related parties, it is advisable to obtain an independent valuation to establish the fair value of the services rendered. This can help demonstrate that the transactions are conducted at arm's length and in the best interest of the company.
Documentation and Transparency: Maintaining proper documentation, including agreements, invoices, and supporting evidence, is crucial to substantiate the necessity and commerciality of the maintenance work. Transparently disclosing related-party transactions in the company's financial statements and complying with disclosure requirements can enhance transparency and minimize scrutiny.
Compliance with Corporate Governance Practices: Adhering to robust corporate governance practices, including having independent directors on the board, establishing a strong audit committee, and maintaining appropriate internal controls, can help strengthen the company's governance framework and ensure fair treatment of shareholders.
Reference:-  ITA No.2105/Ahd/2015