Are You a Shareholder? Here’s What You Must Know About Deemed Dividends

Whether receipt of Loan from a Company can be taxable as Dividend? Sounds astonishing, right? Let's see what the Income-tax Act has to say..

Dividends traditionally have been taxable either in the hands of the company in form of Dividend Distribution Tax (DDT) and now in the hands of shareholders after the abolishment of DDT. Typically, to avoid paying such tax many privately held companies resorted to providing loans or advances to shareholders or to any concern/ entity in which such shareholder(s) had substantial interest. Thus, loans were commonly used to channel funds by the promoters from cash-rich entities to another entity / business which required a fund raise / capital infusion.

In order to curb such practices and tax such situations, the concept of deemed dividend was introduced in Income-tax Act.

Below are the scenarios when a loan provided by a private company be considered as deemed dividend:

• A shareholder holds equity shares in the private company holding at least 10% of the voting power;

• The private company provides loan to such shareholder or to an entity/ concern in which the above shareholder has beneficial interest of at least 20% or more;

• The private company has positive reserve/ profitability balance at the time of giving loan.

Let's understand this with the help of an example:

Suppose Mr. A holds equity shares carrying 10% voting power in ABC Pvt. Ltd, a private company. Also, Mr. A is a partner in a partnership firm named PQR Partnership Firm having a 20% share in profits of the firm. The company ABC Pvt Ltd has a positive reserve/ profitability balance as per its last audited balance sheet.

In these facts, if the company ABC Pvt Ltd gives a loan to either Mr. A or the partnership firm PQR in which Mr. A has substantial interest (i.e. at least 20% beneficial share), the said loan shall be considered as dividend in the hands of Mr. A.

Whether a shareholder is liable to tax even though a loan is provided to another entity in which the shareholder has substantial interest?

The answer is Yes. If we understand this with the help of the above example, in the case where a loan is provided by ABC Pvt Ltd to PQR partnership, the loan shall be taxable as dividend in the hands of Mr. A, being the shareholder of ABC Pvt Ltd.

Are there any other instances where any other transaction shall be taxable as dividend in the hands of shareholders?
Yes, in the case of a shareholder having shareholding of 10% or more in a private company and such private company makes payment on behalf of or for the individual benefit of such shareholder. In such an instance also, even though no actual dividend is paid by the company, the same shall be taxable as dividend.

Does this tax arise even if the loan transaction is squared off immediately or in near future?

Yes, the dividend tax triggers as soon as the loan / advance is made. Subsequent settlement / repayment of loan/ advance is no remedy.

Are trade receivable / payables also covered?

No, receivables or payables arising out of genuine business transactions are outside the scope of deemed dividend. The onus of proving the genuineness of such transactions shall be on the company/ shareholder.

What kind of reserves are covered?

In layman terms reserves means commercial profits earned by the entity. Capital reserves / securities premium is generally out of the ambit of accumulated reserves to be considered for determining deemed dividend. This position has emanated out of judicial precedents. The nature of the reserve hence needs to be reviewed case by case.

Where deemed dividend tax is already applied on reserves, would actual DDT again apply on subsequent declaration of dividend by the company?

Such treatment would lead to double taxation. There have been judicial precedents wherein courts have ruled that same reserves cannot be subjected to dividend tax twice.

Most of the questions dealt above have been a matter of litigation and judicial interpretation. The authors suggest adopting abundant caution while channelling funds with group entities in the form of loans or advances. Apart from tax laws, there are also restrictions provided under Company Law. A holistic analysis should be undertaken to identify other modes of funding options considering the four corners of laws.