Deeming fiction – a fiction resorted to by parliament for defying the law of literal interpretation. Whether it be Central Excise Act, 1944 [concept of deemed manufacture u/s 2(f)(iii)] or Income Tax Act, 1961 [concept of deemed dividend u/s 2(22)(e)], the weapon of deemed concept is adopted either for plugging the loopholes in the Act, or to depart from the natural and ordinary meaning of a so called ‘revenue yielding’ term used in the Act so that the government is not deprived of the revenue from any alluring activity which cannot be other wise brought into the tax net in ordinary sense.
Everything said and done, whenever the law infuses the deemed concept in any provision of law, the same shall be subject to rule of strict construction.
Section 2(22)(e) is one such deeming provision which covers within its ambit the receipt of certain securities or money from a closely held company under certain situation and subject to fulfilment of certain conditions and subject to certain exceptions.
As per clause (e) of section 2(22), any payment made by a closely held company by way of loans or advance shall be deemed to be dividend taxable u/s 56 provided the following conditions are satisfied:
- Payment is made to a shareholder having substantial interest [i.e., holding >10%] of voting power in the company and is beneficial holder of equity shares; and/or
- Payment is made to a concern in which aforesaid substantial shareholder is a member or partner and in which he has substantial interest [i.e., holding or owning >20%]; and/or
- Payment is made on behalf of or for the individual benefit of such substantial shareholder; and
- The company must possess accumulated profits.
The exceptions to the same is discussed in later part of this article.
Now, lets discuss some intricate queries arising out of the aforesaid definition.
Q 1. What kinds of advances are covered within the scope of section 2(22)(e)?
It has been held by Rajasthan High Court in re CIT v. Raj Kumar (2009) 23 DTR (Del) 304 that the word ‘advance’ has to be read in conjunction with the word ‘loan’ i.e., a payment shall be construed as a loan or advance if it involves following attributes–
- Positive act of lending coupled with acceptance by the other side of the money as a loan;
- Generally carries interest
- Obligation of repayment is inherent.
Considering the rule of construction viz., noscitur a sociis and keeping in view the intent of introducing the provisions [i.e., to plug the evasion of tax by payment of dividends in the guise of loans & advances to the principal shareholders], any advance which does not carry with it the obligation of repayment cannot fall within the four corners of the deeming provision. Consequently, trade advances made in then ordinary course of business that are adjusted against supply of goods/services do not fall within the ambit of section 2(22)(e).
Q 2. In whose hands will the payment deemed to be dividend if the loans or advances are made to concern or person on behalf of or for the benefit of substantial shareholder?
It is general principle that a payment can be taxed as dividend only in the hands of a shareholder. The same cannot be taxed as such in the hands of a non shareholder. This view has been reiterated by Rajasthan High Court in re CIT v. Hotel Hilltop (2008) 217 CTR (Raj.) 527 wherein it was held that the essential requirement of section 2(22)(e) is that payment should be made on behalf of or for the individual benefit of substantial shareholder. Thus, the provision is intended to attract the liability of tax on the person on whose behalf or for whose benefit the amount is paid by the company.
In re CIT v. Bhaumik Colour P. Ltd (2009), the special bench of Mumbai tribunal held that the inclusive definition of section 2(22)(e) enlarges the scope of the term dividend by including loans & advances. The legal fiction created by the said section is operative only so long as the deemed dividend is taxed in the hands of the shareholder. If the legal fiction is extended to loans & advance to a non shareholder, the very term ‘dividend’ will lose its identity.
One of the exceptions to section 2(22)(e) is that dividend shall not include any dividend paid by the company which is set off by the company against the whole or any part of the sum previously paid by it and treated as dividend within the meaning of sub clause (e) to the extent it is so set off.
In the event of the payment of loan or advance by a company to a concern being treated as dividend and taxed in the hands of the concern then the benefit of set off cannot be allowed to the concern, because the concern can never receive dividend from the company which is only paid to the shareholder, who has substantial interest in the concern. The above provision, further, contemplate that deemed dividend be taxed in the hands of shareholder only.
Q 3. One of the exceptions to section 2(22)(e) is that dividend shall not include any loans or advance made to a shareholder or the said concern by the company in the ordinary course of its business, where lending money is substantial part of the business of the company. Elaborate?
The term ‘substantial’ appearing in the aforesaid exception is not defined. But the same is defined in explanation 3(b) to section 2(22)(e) as not less than 20% of the income of such concern. Following the judgement of supreme court in CIT v. Venkateshwara Hatcheries (237 ITR 174) wherein it was held that the definition in one section can be used for understanding the meaning of the word in another section if the context justifies it, it can be concluded the definition of term ‘substantial’ used in the aforesaid section means 20% or more of the income of a concern.
Thus, if the income from money lending is 20% or more of the total income of the closely held company and the turnover of the loan funds to total funds of the company is above 20%, any loans or advance made by the said company to its principal shareholder cannot be deemed to be dividend. The same was upheld by Delhi Tribunal in Mrs. Rekha Modi v. ITO (2007) (13 SOT 512) and the same was not further challenged by the revenue.
Further, in deciding whether the company is engaged in money lending business, factual position only for the relevant previous year in question has to be considered i.e., the year in which the loan or advance has been given to principal shareholder holding 10% or more of voting power. The same has been upheld in the aforesaid judgement of the tribunal.