Deemed Dividend under Section 2(22)e of Income Tax

Dividend is the return(s) that a shareholder receives after purchasing a company’s shares. Tax is not levied on dividend for the recipient as companies pay Dividend Distribution Tax in the initial stage. However, dividend also includes deemed dividend under its confines.Deemed dividend is an income which refers as the same to dividend, though it is not distributed by a closely-held company. Deemed dividend tax falls under the Income Tax Act’s Section 2(22)e.As per Section 2(22)e, when a closely held company, gives a loan or extends an advance to the respective personnel:

• A shareholder who holds a minimum of 10 per cent of the voting rights, and is the beneficial owner of shares. However, it is important that the shares held are not entitled to a dividend rate’s fixed rate.
• When such shareholder is substantially interested towards any business concern.
• For such shareholder’s individual benefit.
• To a specific extent on behalf of such shareholder.

Till the company earns profits, payments like these are deemed as dividend under Section 2(22)e. However, other than the above-mentioned points, loans handed out by a subsidiary company to its parent company are also subjected to this section.Tax is levied on dividend income in the declaration/payment/distribution year. Recipients are not taxed for dividends as it receives income tax exemption . However, deemed dividends don’t receive that exemption. Shareholders do have to pay a nominal tax rate.Finance Bill (2018)’s draft has demanded that deemed dividend should be levied on dividend distribution tax at 30 per cent rate. It sought to levy this tax on closely-held companies as they generally hide dividend by making them look like loans or advances.There are few conditions which come into play while determining the tax on deemed dividend. Here are they:

• The paying company can’t be a company in which the public aren’t substantially interested, while the receiving company can be listed or public.
• The company loans or advances should not be in the business’ ordinary course.
• The company has to be assigned by the shareholder as their creditor.
• The accumulated profits of the company is the only consideration for deemed dividend. All the commercial profits of a company till the distribution/payment/liquidation date are considered as accumulated profits.

• When a money lending company gives a loan.
• When loans are extended to shareholders.

Before April 1, 2018, DDT was not levied on companies that paid deemed dividend on such payments. However, Budget 2018 changed it and mandated that such companies pay DDT at 30 per cent along with applicable surcharge and cess.

The term "dividend" describes the returns on an investor's investment in a corporation.Let's take an example where a firm is producing good net profit and wishes to disperse the earnings to its shareholders. The board of the company chooses to pay each shareholder a 3% return on their investment. Each share unit costs Rs. 100. Therefore, the shareholder receives Rs. 30 for each share, or what is known as a "Dividend."While the "deemed dividend" is actually a specific sum of money or asset lent to a shareholder with a sizeable stake in the company, for tax purposes, the sum qualifies as a " deemed dividend ." Only the company's accumulated profits should be used to fund any debt or advancement.The Income Tax Act's Section 2(22)e explains how some loans and advances that a firm makes to a shareholder are recognised as deemed dividends. The payment types listed below are those that this statute considers deemed dividends:

• Payments of loans or lending of assets to a shareholder who owns a significant stake in the company are deemed dividends and must only come from earnings that have accumulated.
• Loans from accumulated profits given to a parent business by a subsidiary company.
• Advances given to shareholders by the company to help them install equipment and plant that would allow them to execute an export order.
• The corporation will also count any personal payments given to shareholders as declared dividends.

Previously, businesses that distributed considered dividends did not have to pay DDT on those payments. Section 115-O was altered in Budget 2018 to take care of this. Such businesses were required to pay DDT at a rate of 30%, plus any applicable surcharges and taxes, for any transactions made on or after April 2018.The taxability of deemed dividends in the disposal of the receiver made it challenging to collect tax on them from the shareholder, which led to the introduction of this amendment. Therefore, the shareholder is exempt from paying taxes on such receipts.The cost of paying tax on dividends was shifted to the shareholders in Budget 2021. Dividend Distribution Tax is no longer required from businesses when paying dividends to shareholders.

There are a select few transactions that, despite having the characteristics of lending advances, are not recognised as presumed dividends.
Shareholders cannot treat loans and advances they receive from the share premium account as deemed dividends.Loans provided by businesses whose primary activity is lending money.
As a dividend is declared and disbursed, loans are modified.
The paying business cannot be the one in which the general public is genuinely engaged.
Loans given to stockholders who don't possess a significant stake in the business.

According to Section 2(22)e of the Income Tax Act, in the case of a closely held company (where the trading of the shares is not open to the public), there are certain circumstances where transactions equate to the distribution of dividends from the company to the shareholders.Such transactions will be taxed as though they are dividends distributed to the shareholders at 30% of the amount distributed plus cess and surcharge as applicable.A transaction is considered to be a deemed dividend if a closely held company extends a loan or an advance to:

1. Any shareholder who owns more than 10% of voting power in the company
2. Any company in which a shareholder has a substantial interest
3. For the individual benefit of a shareholder
4. On behalf of the shareholder to the extent of accumulated profits

There are some exceptions to this rule. A transaction will not be considered to be a deemed dividend if:

1. The loan given by the company is part of the ordinary course of the company’s business (money lending business).
2. The loan extended is subsequently adjusted against the dividend declared and distributed later.

For example, if a shareholder with 20% stock in a company borrows Rs. 1,00,000 from the company, it is deemed a dividend. Even if the shareholder repays the amount within the same financial year, the transaction will be considered a deemed dividend and income tax rules will apply.

Deemed dividend is taxed at 30% on the deemed dividend amount, and cess and surcharge are added to it to arrive at the final tax liability .Before 2018, deemed dividends were exempt from Income Tax. From April 2018 to April 2020, it was mandated that the companies deduct DDT (Dividend Distribution Tax) at the time of making payment to the shareholder, even for deemed dividends. However, after FY 21, the onus of paying tax on dividends is now shifted to the shareholders. Typically, dividend income is automatically shown in the pre-filled returns (through Annual Information Statement) of an individual if the company has submitted the required details.

Deemed dividends are eligible to be considered as dividends provided, they fulfil all the conditions. A loan or an advance given by a company to its shareholders is considered a deemed dividend except in the following cases:

1. Loans and advances are given out of the share premium account
2. Loans and advances are adjusted against dividends declared and distributed
3. The company’s business is money lending
4. The shareholder does not own more than 10% of the company
5. The company is a company in which the public is substantially interested, which means it is not a closely held company.

Between 2018 and 2020, deemed dividends were also eligible for DDT (Dividend Distribution Tax) at the rate of 30%.

Before a company declares dividends, the following points should be carefully considered.

• The rate of dividend they wish to declare cannot be more than the average rate of dividend declared in the immediately preceding 3 years. If the company has not declared a dividend in each of the three years, this rule can be ignored.
• The total amount of dividends distributed from accumulated profits cannot be more than one-tenth of the total paid-up share capital and free reserves as per the last audited financial statements.
• The amount drawn from the accumulated profits must first cover the losses, and then the balance can be used to declare dividends.
• The balance of reserves after dividend distribution should not be less than 15% of paid-up share capital as per the last audited financial statements.

1. TDS on dividend – there is no TDS that has to be deducted from dividends.
2. DDT (Dividend Distribution Tax) – Earlier, a DDT of 15% plus cess and surcharge had to be deducted by companies before distributing dividends to shareholders. However, after 2020, DDT has been abolished, and the shareholders are liable to pay tax on dividends. The dividend is added to their total taxable income at the time of filing their income returns .
3. Dividend declared by a loss-making company – if a loss-making company wishes to declare a dividend, they should consider the following points first:

Dividends can only be declared after the losses and depreciation carried forward from the previous are set off against the profit of the current year.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.