2(22)(e) – A Long standing Dispute between Income Tax Department and Assessee:
Background of the Section:
It’s a regular practice between closely held group companies to transfer monies to meet their fund requirements (other than for regular business activities). In such cases, the lending company does not charge any interest on such funds transferred to other group companies.
Eg: H is the Holding Company having S1 and S2 Subsidiaries. S1 is a well settled company in respect of business having sufficient funds and sufficient accumulated profits whereas S2 Company is a newly formed company with new line of business.
Hence, S2 requires funds for meeting its set up and expansion. Whenever S2 company requires funds, S1 company used to fund its requirements without charging any interest because S1 is a sister concern.
It means the Holding Company is benefitting in indirect way by way of distribution of assets of S1 to its own subsidiary S2.
In order to bring these kind of transactions into tax bracket, the Income Tax Department makes best use of Section 2(22)(e).
What is Section 2(22)(e)?
As per Section 115O, any Domestic Company which declares, distributes or pays dividend (whichever is earliest) shall pay an additional income tax (tax on distributed profits) @ 15% on such dividend distributed.
The definition of dividend is prescribed in the Section 2(22) of the Income Tax Act, 1961.
As per Section 2(22), dividend includes –
a. Any distribution of accumulated profits whether capitalised or not if it entails release of any assets of the Company
b. Any distribution by a Company to its Preference Shareholders by way of a Bonus to the extent of accumulated profits whether capitalised or not.
c. Any distribution by a Company to its Shareholders at the time of liquidation to the extent it is attributable to accumulated profits whether capitalised or not.
d. Any distribution by a Company to its Shareholders on reduction of capital to the extent it is attributable to accumulated profits whether capitalised or not.
e. any payment by a company, not being a company in which the public are substantially interested, of any sum 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 per cent 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 the 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.
Sub-section (e) plays an important role while taxing any payments by a Company to any persons who have substantial interest in the Company.
Prerequisites to tax u/s 2(22)(e):
1. There should exist accumulated profits in the books of the lending Company. If no profits are available, the distribution of assets cannot be termed as dividends.
2. Funding should not be against regular business transactions i.e. for purchase of goods / services. CIT vs Creative Dyeing & Printing (P) Ltd.
3. Funding should be in the form of a Loan or Advance only.
4. Any subsequent dividend distributed to the extent it is set off against any loan or advance shall not be treated as dividend.
5. Payment shall be made to the following persons shall only be taxed as deemed dividend.
a. Payment is made to the shareholder holding beneficial interest in shares of not less than 10% of the voting power.
Eg: Mr. X holds 10% of voting power in Company A. Company A lends an amount of Rs. 10,000 to Mr. X. In this case, Rs. 10,000 is taxable in the hands of Mr. X as deemed dividend.
b. Payment is made to the concern in which the shareholder in (a) above is a member or partner or holds beneficial interest in shares of not less than 20% in voting power.
Eg: Mr. X also holds 20% in Company B and Company A makes a payment of Rs. 10,000 to Company B. In this case also, Rs. 10,000 is taxable in the hands of Mr. X as deemed dividend (explained later why it is taxable in the hands of Mr. X).
c. Payment is made on behalf of and for the benefit of shareholder in (a) above.
Definition of Loan and Advance – What to include and what not to include?
The sub-clause (e) says that the funding should be in the form of a Loan or Advance and it should not be in on account of regular business transactions.
Hence, the following would be excluded from taxation u/s 2(22)(e).
1. Loans given by a company which is a NBFC to the specified persons. Since the regular business activity of a NBFC is to lend and take loans and advances, these kinds of funding are not taxable. DCIT vs JK Credit and Finance Ltd.
2. Inter Corporate Deposits (ICDs) given by a company to the specified persons shall not be covered since the funding shall be in the form of Loan or advance. DCIT vs Bombay Oil Industries Ltd.
3. Monies given by a Company for specific purpose to the specified persons shall not be taxable like Security Deposit in case of premises taken for lease. ACIT vs Harshad V Doshi.
4. Monies given to a registered shareholder who is not a beneficial shareholder and given to a beneficial shareholder but not registered shareholder. Eg: Mr. X is a having a shareholding of 10% in Company A but the beneficial owner of such shares is Mr. Y. In this case, amounts lent by Company A to either Mr. X or Mr. Y is taxable as deemed dividend. DCIT vs Madhusudan Investment & Trading Co Pvt Ltd and CIT vs Standipack Pvt Ltd.
Taxable in whose hands?
The whole intention of this sub-section is to tax the shareholder since the dividend is to be taxed only in the hands of a shareholder. This was reiterated in many cases and all the appellate authorities confirmed that even though the transactions are between common interest companies, the deemed dividend shall be assessed in the hand of the shareholders only. CIT vs Ankitech Pvt Ltd, Mukul International Ltd, Active Securities Pvt Ltd, Magic International Pvt Ltd, etc.,
Why it is so critical to closely held Companies in purview of Income Tax?
Since majority of the closely held companies frequently transfer funds for purposes other than mentioned earlier, due care should be taken while remitting funds.
Hence, the Companies shall make funding either in the form of ICDs and shall be made to entities or persons who does not have common shareholding.