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October 10, 2020

Deemed dividend is to be assessed in the hands of the shareholder and not in the hands of the firm

by CA Shivam Jaiswal in Income Tax

Deemed dividend is to be assessed in the hands of the shareholder and not in the hands of the firm

Dividend basically refers to a reward, cash or otherwise, that a company gives to its shareholders. Dividends can be issued in various forms, such as cash payment, stocks or any other form. However, it is not obligatory for a company to pay dividend. Dividend is usually a part of the profit that the company shares with its shareholders. 

The dividend is the amount received by an investor, whether it’s an individual or HUF, on account of holding shares in a company. In simple words, it is the distribution of profits of the company to its shareholders.

According to Section 2(22)(e) of the Income Tax Act, when a company in which the public are not substantially interested, extends a loan or an advance to:

  • any of its shareholders who has more than 10% voting power in the company or
  • to any concern in which such shareholder is substantially interested or
  • for the individual benefit of such shareholder or
  • on behalf of such shareholder

to the extent the company has accumulated profits, such payment would be deemed as a dividend under Section 2(22)(e).

A company in which public is not substantially interested is otherwise called a closely held company. In case of deemed dividend under section 2(22)(e), the tax is charged at the rate of 30%.

Let us refer to the case of CIT Vs. T. Abdul Wahid & Co. (Madras High Court), appeal was admitted to decide whether the ITAT was right in holding that the deemed dividend under Section 2(22)(e) was to be assessed in the hands of the shareholder and not in the hands of the firm?

Facts of the Case

  • The assessee filed the return of income and an order was passed under Section 143(3) assessing the said income.
  • The assessment was reopened by issuance of notice under Section 148 (notice for income escaping assessment). The reason being that a sum of Rs.2 Crores was shown as unsecured loan obtained from M/s Abdul Wahid Tanneries Pvt Ltd by the assessee firm.
  • One of the partners of the assessee firm, Mr T Rafeeq Ahmed, was also a shareholder in the company holding 26.25% shares.
  • Therefore, it was stated that the shareholder of the company had substantial interest in the firm and consequently, the concept of deemed dividend under Section 2(22)(e) would apply.
  • The assessee objected to the reopening and filed written submissions. However, the assessing officer (AO) confirmed the proposal in the notice under Section 148 and completed the assessment under Section 143(3) read with Section 147.

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Appeal to Commissioner of Income Tax (Appeals) [CIT(A)] and Income Tax Appellate Tribunal (ITAT)

  • Aggrieved by the order of the AO, the assessee preferred an appeal before the CIT(A), who dismissed the appeal.
  • Challenging the same, the assessee filed an appeal before the ITAT, which was allowed by the ITAT. Aggrieved by the order of the ITAT, Revenue filed an appeal before the High Court (HC).

Submissions before the High Court (HC) by Appellant

  • It was submitted by the Revenue that the assessee firm had shown Rs 2 Crores as unsecured loan obtained from the company during the year and one of the partner of the assessee firm was having 35% stake in the assessee firm and he was also a major shareholder in the company holding 26.25% shares and therefore, the partner was substantially interested in the firm.
  • The company was having accumulated profit of Rs.3,90,02,578.
  • The assessee themselves claimed that the said amount as unsecured loan and auditor had also certified in the balance sheet as unsecured loan.
  • The payment for the purposes of Section 2(22)(e) need not be cash payments and journal entries were also sufficient.
  • Such loan or advance had to be treated as dividend to the extent of accumulated profits (excluding capitalized profit).
  • Further, loan or advance may be given directly to shareholder or it may be given for the benefit of shareholder or on behalf of shareholder.
  • Thus, it was submitted that the AO had rightly treated the loan as deemed dividend under Section 2(22)(e).
  • It is further submitted that before the CIT(A), the assessee stated that he was purchasing finished leather from the company for manufacture of shoe and shoe uppers and the assessee firm had to pay a sum to the company towards the supply of leather.
  • Further, to maintain working capital ratio for the purpose of retaining existing working capital facility from the bank, Rs 2 crores was transferred from the sundry creditors for trade running account of the company, as deferred liability, which was shown under the balance sheet under the head of “unsecured loan”, since the amount was payable after one year, otherwise, the assessee firm should have declared the same under ‘current liability’ payable within a day.
  • It is also submitted that this reasoning was rightly not accepted by the CIT[A]. However, without considering the factual and the legal position, the ITAT erroneously reversed the orders passed by the assessing authority as confirmed by the CIT(A).

Submissions before the High Court (HC) by the Respondents

  • The respondent submitted that the fundamental error committed by the AO and CIT(A) is on facts because the amount of Rs 2 Crores paid to the assessee firm was neither a loan nor an advance, but a deferred liability.
  • The assessee firm was not a beneficial shareholder or a registered shareholder.
  • The shareholder was a partner of the assessee firm and the shares held by him in the Private Limited Company was in his individual capacity and therefore, the firm was not a beneficial owner.
  • In the balance sheet of the respondent, nowhere did the amount of Rs 2 crores appear in the Investment section.
  • Therefore, the AO and CIT[A] erred in holding that it is an investment in the name of the assessee.
  • Respondent referred to the circular issued by the Central Board of Direct Taxes dated 12.06.2017, wherein it was stated that trade advances, which were in the nature of commercial transactions would not fall within the ambit of word “advance” in Section 2(22)(e).

Observations of the High Court (HC)

  • Section 2(22)(e), which defined dividend was an inclusive definition, included any payment by a company (not being a company in which the public were substantially interested), of any sum by way of advance or loan, to a shareholder, being a person, who was the beneficial owner of shares holding not less than 10% of the voting power, or to any concern in which such shareholder was a member or a partner and in which he had a substantial interest 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 possessed accumulated profits.
  • The said provision would stand attracted when a payment was made by a company, in which public were not substantially interested by way of advance or loan to a shareholder, being a person who was the beneficial owner of the shares.
  • In this case, it was clear that the payment was made to the assessee, a partnership firm.
  • The partnership firm was not a shareholder in the company.
  • The records placed before the AO clearly showed the nature of transaction between the firm and the company and it was neither a loan nor an advance, but a deferred liability.
  • These facts were noted by the AO. In such circumstances, HC was of the view that the ITAT had rightly reversed the order passed by the CIT(A).
  • HC found no grounds to interfere with the order passed by the ITAT and accordingly, dismissed the present appeal and answered the substantial question of law against the Revenue.

In conclusion, deemed dividend under Section 2(22)(e) is to be assessed in the hands of the shareholder and not in the hands of the firm.

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