Person with Substantial Interest in a Company Under Income Tax: An Indian Law Perspective

Understanding who constitutes a person with a substantial interest in a company is crucial under Indian Income Tax Law. This definition triggers various provisions, impacting tax liabilities and compliance requirements. This article delves into the definition, relevant legal provisions, implications, and related aspects under Indian law.

Defining "Person with Substantial Interest"

The term "person with a substantial interest" is defined under Section 2(32) of the Income Tax Act, 1961. It essentially refers to an individual who holds significant ownership and control within a company. The provision states:

"“person who has a substantial interest in the company”, in relation to a company, means 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, carrying not less than twenty per cent of the voting power;”

Therefore, a person is considered to have a substantial interest in a company if they:

  • Are the Beneficial Owner: This implies that the individual not only holds the shares legally but also enjoys the economic benefits derived from them. A nominee holding shares on behalf of someone else would not be considered the beneficial owner.
  • Hold Equity Shares (Not Preference Shares): The provision specifically excludes shares entitled to a fixed rate of dividend. This means only equity shareholders, who participate in the profits and losses of the company, are considered for this definition.
  • Possess at least 20% of Voting Power: The individual must have the right to exercise at least 20% of the total voting power in the company's decision-making processes. This voting power is typically linked to the number of equity shares held.

Key takeaways from this definition:

  • Beneficial Ownership is Paramount: Mere legal ownership without the right to enjoy the benefits is insufficient.
  • Focus on Equity Shares: Only equity shareholders are considered, excluding preference shareholders with a fixed dividend rate.
  • Threshold of 20% Voting Power: This is the critical benchmark for determining substantial interest. If the voting power is below 20%, the individual is not considered to have a substantial interest, regardless of the number of shares held.

Relevance of the Definition under Income Tax Act

The definition of "person with a substantial interest" is relevant in various sections of the Income Tax Act, impacting:

  1. Deemed Dividend (Section 2(22)(e)): This is arguably the most significant implication. Section 2(22)(e) deems certain payments made by a closely held company (a company in which the public is not substantially interested) to its shareholders as dividends, even if they are not declared as dividends. This is to prevent companies from distributing profits disguised as loans or advances to avoid dividend distribution tax (DDT), now dividend taxation in the hands of shareholders.

    • Conditions for Deemed Dividend: Section 2(22)(e) applies when a closely held company makes a loan or advance to:
      • A shareholder who is a person with a substantial interest in the company, OR
      • A concern in which such shareholder is a member or a partner and in which he has a substantial interest, OR
      • Any person on behalf of or for the individual benefit of such shareholder.
    • Extent of Deemed Dividend: The amount deemed as dividend is limited to the accumulated profits of the company.
    • Tax Implications: The amount deemed as dividend is taxable in the hands of the shareholder at the applicable income tax rates.

  2. Transfer Pricing Regulations (Section 92): While not a direct trigger, the definition can be relevant in determining whether associated enterprises exist for the purposes of transfer pricing regulations. If a person with a substantial interest in one company also controls or has a substantial interest in another company, these companies may be considered associated enterprises. This then subjects their international transactions to transfer pricing scrutiny.

  3. Tax Audit (Section 44AB): While not directly linked, the auditor needs to verify and report details related to transactions with persons having substantial interest, particularly when dealing with closely held companies.

  4. General Anti-Avoidance Rule (GAAR) (Chapter X-A): In cases where tax avoidance is suspected, the definition might be considered in conjunction with other factors to determine whether a transaction is designed to obtain a tax benefit.

Companies in Which the Public are Substantially Interested

It is important to distinguish between closely held companies and companies in which the public are substantially interested. The definition of "company in which the public are substantially interested" is provided in Section 2(18) of the Income Tax Act. These are companies where a large portion of the shares are held by the general public. Examples include:

  • Companies listed on a recognized stock exchange in India.
  • Companies where the government or a statutory corporation holds a certain percentage of shares.
  • Mutual benefit finance companies.

The key distinction is that Section 2(22)(e), which deals with deemed dividends, primarily targets closely held companies. Payments made to shareholders with a substantial interest in a company where the public are substantially interested generally do not fall under the ambit of Section 2(22)(e). This is because these companies are generally assumed to have a broader shareholder base and less scope for manipulating profit distribution through disguised loans.

Determining Beneficial Ownership

The determination of beneficial ownership is crucial. The Act requires the beneficial owner to be the one who ultimately enjoys the benefits of the shares. Several factors are considered:

  • Control over Voting Rights: Who ultimately decides how the shares are voted?
  • Right to Dividends: Who receives the dividends from the shares?
  • Power to Transfer Shares: Who has the power to sell or otherwise transfer the shares?
  • Economic Substance: The economic substance of the arrangement is given more weight than the legal form.

If an individual exercises control over these aspects, they are likely to be considered the beneficial owner, even if the shares are registered in someone else's name.

Implications of Deemed Dividend under Section 2(22)(e)

As mentioned earlier, the deemed dividend provision under Section 2(22)(e) is a critical implication. Let's explore it further:

  • Preventing Tax Avoidance: The primary objective of this section is to prevent closely held companies from distributing profits in the form of loans or advances to shareholders, thereby avoiding dividend taxation.
  • Taxability in the Hands of Shareholders: The amount deemed as dividend is taxable in the hands of the shareholder at the applicable income tax rates. This can be particularly relevant for high-net-worth individuals who may be subject to higher tax brackets.
  • Impact on Companies: Companies must carefully monitor transactions with shareholders having substantial interest to avoid the deemed dividend provisions. Proper documentation and adherence to corporate governance principles are essential.
  • Practical Challenges: Applying Section 2(22)(e) can be complex in practice. It requires a thorough understanding of the company's financial position, the nature of the transactions with shareholders, and the relevant legal precedents.

Example:

A closely held company provides a loan of INR 50 lakhs to a shareholder who holds 30% of the company's voting power. The company has accumulated profits of INR 40 lakhs. In this case, INR 40 lakhs will be deemed as dividend under Section 2(22)(e), and the shareholder will be liable to pay income tax on this amount.

Case Laws and Judicial Interpretations

Numerous case laws have interpreted the provisions related to "person with a substantial interest" and Section 2(22)(e). Some key principles established through judicial pronouncements include:

  • Substance Over Form: Courts emphasize the economic substance of transactions over their legal form. If a transaction is structured to circumvent tax laws, it may be disregarded.
  • Beneficial Ownership: The concept of beneficial ownership has been extensively discussed in various judgments, highlighting the importance of determining who ultimately enjoys the benefits of the shares.
  • Business Purpose: The genuineness of a loan or advance is considered. If the transaction lacks a genuine business purpose and appears to be solely for tax avoidance, it is more likely to be treated as a deemed dividend.
  • Accumulated Profits: The deemed dividend is limited to the accumulated profits of the company. The profits are to be considered as on the date the loan or advance is made.

Consulting with a tax professional is recommended to understand the specific implications of case laws on a particular situation.

Conclusion

The definition of "person with a substantial interest" is a crucial element in Indian Income Tax Law. It triggers various provisions, particularly the deemed dividend provisions under Section 2(22)(e), impacting both companies and shareholders. Understanding the nuances of this definition, including the concept of beneficial ownership, the threshold of 20% voting power, and the relevant case laws, is essential for ensuring tax compliance and avoiding potential tax liabilities. Companies, especially closely held ones, need to exercise caution when dealing with shareholders having substantial interest and maintain proper documentation to justify the legitimacy of transactions. As tax laws are subject to change and interpretation, it is always advisable to seek professional advice from a qualified tax consultant to navigate these complexities effectively.