Deemed Dividend Paid Out of Capital Profits Under Dividend Income tax Law in India

In India, the concept of 'deemed dividend' paid out of capital profits under the Income Tax Act, 1961 is an important aspect of the taxation of dividend income. This provision aims to ensure that shareholders do not evade tax by receiving profits in the form of loans, advances, or other non-dividend payments from closely-held companies.

Definition of Deemed Dividend

The term 'deemed dividend' refers to the certain payments or distributions made by a closely-held company to its shareholders. These payments are deemed to be a dividend and are therefore subject to taxation under the Income Tax Act, even if they are not specifically characterized as such by the company. The concept of deemed dividend is governed by Section 2(22)(e) of the Income Tax Act, 1961.

Scope of Section 2(22)(e)

Section 2(22)(e) of the Income Tax Act, 1961, defines deemed dividends as including the following payments or distributions:

  1. Any payment by a closely-held company to its shareholder, being a company, on account of advances or loans given to the shareholder or to a concern in which the shareholder is a partner or a proprietor.

  2. Any payment by a closely-held company to its shareholder, being a company, for the benefit of the shareholder's director or any concern in which such director has a substantial interest.

  3. Any payment by a closely-held company to a shareholder, being an individual, on account of advances or loans given to the shareholder or to a concern in which the shareholder has a substantial interest.

  4. Any payment by a closely-held company to a shareholder, being an individual, for the benefit of the shareholder or for the benefit of a specified relative of the shareholder.

Tax Implications of Deemed Dividend

When a payment or distribution falls within the ambit of deemed dividend under Section 2(22)(e), it is treated as a dividend for the purposes of tax assessment. As a result, such deemed dividends are subject to tax in the hands of the recipient shareholder, at the applicable tax rates for dividend income.

Moreover, deemed dividends are also subject to the provisions of the 'Income from Other Sources' under the Income Tax Act, and are included in the total income of the shareholder for the relevant assessment year.

Exceptions to the Scope of Section 2(22)(e)

It is important to note that Section 2(22)(e) contains certain exceptions, whereby certain payments or distributions are not treated as deemed dividends. These exceptions include:

  1. Any payment made in the ordinary course of business for the purchase of goods, services, or property from the recipient shareholder.

  2. Any payment made in the ordinary course of business for the genuine business transaction between the closely-held company and the recipient shareholder.

  3. Any advance or loan given by the closely-held company in the ordinary course of its business, where the lending of money is a substantial part of the company's business.

Impact of Recent Judicial Decisions

In recent years, there have been several judicial decisions that have interpreted and clarified the scope and applicability of Section 2(22)(e) in the context of deemed dividends. These decisions have provided valuable guidance on the interpretation of the provisions and have helped in resolving ambiguities in the law.

The Supreme Court of India, in various cases, has emphasized the importance of examining the commercial substance and business purpose of the transactions in determining whether a payment or distribution should be treated as a deemed dividend. The court has also reiterated that the provisions of Section 2(22)(e) should be interpreted in a manner that prevents tax evasion and abuse of the corporate structure by closely-held companies.

Compliance Requirements for Closely-Held Companies

Closely-held companies need to be mindful of the provisions of Section 2(22)(e) and ensure compliance with the tax implications of deemed dividends. It is important for such companies to maintain detailed records and documentation of any payments or distributions made to their shareholders, to establish the genuineness and bona fides of such transactions.

Furthermore, closely-held companies should seek professional tax advice and guidance to ensure that their transactions with shareholders are structured in a manner that is consistent with the provisions of the Income Tax Act, and do not attract adverse tax consequences.

Conclusion

The concept of 'deemed dividend' paid out of capital profits under the Income Tax Act, 1961, is a critical aspect of the taxation of dividend income in India. The provisions under Section 2(22)(e) are designed to prevent tax evasion and ensure that shareholders do not receive profits in the guise of loans or advances from closely-held companies.

It is essential for closely-held companies and their shareholders to understand the scope and implications of deemed dividends, and to ensure compliance with the provisions of the Income Tax Act. Professional tax advice and compliance assistance can play a crucial role in navigating the complexities of deemed dividend taxation and in mitigating the risk of adverse tax consequences.