Deemed Dividend under Section 2(22)(e)

The term ‘Dividend’, as generally understood, refers to the return(s) earned by a shareholder for investing in a company by buying its shares. Such dividend was tax-free for the recipient as companies paying dividends already pay Dividend Distribution Tax when they pay out the dividend.

Interestingly, for the purpose of Indian tax laws, a dividend also included ‘Deemed Dividend’ in its ambit. This article throws light on the taxability of deemed dividend.

Before navigating the intricacies of deemed dividends, let's clarify the fundamental concepts of dividends and their treated counterparts.

Dividends: A shareholder's reward for investing in a company, dividends represent a portion of the company's profits distributed back to its owners. It's essentially a financial return on your investment.

Deemed Dividends: Not every financial benefit received by shareholders qualifies as a traditional dividend. The Income Tax Act outlines specific situations under Section 2(22)(e) where certain transactions are deemed equivalent to dividends for tax purposes, even if no formal dividend distribution occurs.

Latest Update

In Budget 2020, the Finance Minister has abolished Dividend Distribution Tax (DDT). Now the incidence of dividend income taxation is shifted to investors from the companies.

Update from budget 2021:

Deemed Dividend under Section 2(22)(e)

According to Section 2(22)(e), when a company in which the public are not substantially interested*, extends a loan or an advance to:

a. any of its shareholders who has more than 10% voting power in the company or 
b. to any concern in which such shareholder is substantially interested or 
c. for the individual benefit of such shareholder or 
d. on behalf of such shareholder to the extent the company has accumulated profits, such payment would be deemed as a dividend under Section 2(22)
*a company in which public is not substantially interested is otherwise called a closely held company.

Exceptions

Payment under circumstances specified below will not be treated as a deemed dividend: 
a. Loan given by a company involved in money lending, where loans have been extended in the ordinary course of business 
b. Loan extended to shareholders, subsequently adjusted against dividend declared and distributed later

Illustration

Here is a simple illustration to explain the provisions of deemed dividends.

ABC Pvt Ltd. is a company, the public is not substantially interested in. Hari is one of the company shareholders, who hold 15% shares. The company has accumulated profits of Rs.25 lakhs as on 31 March 2018. The company granted a loan of Rs.100,000 to Hari, by way of an account payee cheque. He repaid the amount on 5 May 2018.

In this case, even if the loan has been repaid by Hari, the loan amount granted to the extent of accumulated profits are treated as deemed dividend.

Income tax implications

Earlier (prior to 1st April 2018), companies that pay out deemed dividends would not pay DDT on such payments. 
Budget 2018 introduced an amendment to Section 115-O that addresses this. 
It mandated such companies to pay DDT at the rate of 30% plus applicable surcharge and cess on transactions carried out on or after 1 April 2018. 

This amendment has been introduced because the taxability of deemed dividend in the hands of recipient made tax collection on it from the shareholder difficult. As a result, the shareholder doesn’t have to pay any taxes on such receipts. 

In Budget 2021, the burden of paying tax on dividend is transferred to the shareholders. Now the companies are not liable to pay Dividend Distribution Tax (DDT) while distributing dividends to the shareholders, i.e. DDT is abolished. 
These amendment has put all this to rest.

Here are some key scenarios classified as deemed dividends under Section 2(22)(e):

1. Release of Company Assets: When a closely-held company distributes its accumulated profits or assets directly to shareholders, it triggers deemed dividend taxation.
2. Debentures, Deposit Certificates, and Bonus Shares: If a closely-held company issues debentures, deposit certificates, or bonus shares to preference shareholders from its accumulated profits, it falls under the deemed dividend category.
3. Liquidation: When a closely-held company liquidates and distributes its accumulated profits amongst shareholders, it's treated as deemed dividend income for tax purposes.
4. Capital Reduction Distribution: Any distribution of accumulated profits to shareholders during a capital reduction in a closely-held company also qualifies as deemed dividend.
5. Loans or Advances from Accumulated Profits: If a closely-held company provides loans or advances to its shareholders using accumulated profits, this benefit is similarly treated as deemed dividend income.

Taxability of Dividends: Understanding how dividends are taxed for both companies and shareholders, post-April 1, 2020, is crucial.

For Companies:

• Dividend Distribution Tax (DDT) has been abolished.
• Companies now deduct Tax Deducted at Source (TDS) on dividends at a rate of 10%.
• No TDS is required if the dividend paid to a shareholder per financial year doesn't exceed Rs. 5,000.

For Resident Shareholders:

• Depending on how you hold the shares (trader/investor), dividend income falls under either business/profession income or income from other sources, influencing applicable tax rates.
• A special concessional rate of 10% applies to dividends received by resident individuals working in specific industries if earned through Global Depository Receipts (GDRs) purchased in foreign currency.

For Non-Resident Shareholders:

• Dividend income, including for Foreign Portfolio Investors (FPIs) and Non-Resident Indian (NRI) citizens, is taxed at a flat rate of 20%.
• An exception exists for the investment division of an offshore banking unit, enjoying a reduced tax rate of 10%.
• GDR dividends of Indian companies or PSUs bought in foreign currency are also taxed at 10% without deductions.