Deemed Dividend

A deemed dividend arises when a company, instead of distributing profits as dividends, extends loans or advances to certain shareholders or entities. Specifically, if a company provides a loan or advance to a shareholder holding a substantial interest—defined as owning at least 10% of the voting power—or to a concern in which such a shareholder has a significant stake, the amount is treated as a deemed dividend. This classification ensures that profits are taxed appropriately, even if not distributed in the traditional dividend form. It's important to note that this provision primarily applies to closely held companies, where public participation is minimal or absent.

How does a deemed dividend work

The mechanism of deemed dividends operates to curb the practice of profit distribution through indirect means. Here's how it functions:

1. Loan or Advance Provision: A company extends a loan or advance to a shareholder possessing substantial interest or to a related concern.
2. Accumulated Profits Assessment: The company must have accumulated profits at the time of granting the loan or advance.
3. Taxation Trigger: The extended loan amount, to the extent of the company's accumulated profits, is treated as a deemed dividend and is taxable in the hands of the recipient.

This approach ensures that companies do not bypass dividend distribution tax by channeling profits through loans or advances to significant stakeholders.

Section 2(22)(e)

Section 2(22)(e) of the Income Tax Act, 1961, delineates specific scenarios where distributions are considered deemed dividends:

1. Loan or Advance to Substantial Shareholders: If a company provides a loan or advance to a shareholder holding at least 10% of voting rights.
2. Loan or Advance to Associated Concerns: Loans or advances extended to entities where such a substantial shareholder has a significant interest.
3. Payments on Behalf of Shareholders: Any payment made by the company on behalf of or for the individual benefit of a substantial shareholder.
4. Payments for Shareholder's Individual Benefit: Payments made by the company for the personal advantage of the substantial shareholder.
5. Utilisation of Accumulated Profits: The company's accumulated profits are utilised for these transactions, leading to their classification as deemed dividends.

These provisions are designed to prevent the evasion of tax liabilities through indirect profit distributions.

Exceptions to deemed dividend

While Section 2(22)(e) outlines specific instances of deemed dividends, certain exceptions exist to ensure genuine business transactions are not unduly taxed:

1. Regular Business Transactions: Advances or loans extended during the ordinary course of business, especially if the lending is part of the company's regular operations.
2. Substantial Interest Threshold Not Met: If the recipient shareholder does not hold at least 10% of the voting power in the company.
3. Lack of Accumulated Profits: When the company lacks accumulated profits at the time of granting the loan or advance.
4. Public Companies: Companies in which the public holds a substantial interest are generally exempt from these provisions.
5. Inter-Corporate Loans: Loans or advances between companies, where the recipient is not a shareholder in the lending company, are excluded.

Who will pay tax on deemed dividends

Deemed dividend taxation is an essential aspect of Indian tax law, ensuring that indirect profit distributions are appropriately taxed. The responsibility of paying tax on deemed dividends primarily lies with the recipient of the loan or advance. However, the nature of taxation depends on the recipient's classification and the company's structure.

The table below provides a detailed breakdown of who bears the tax liability and how deemed dividends are treated under different circumstances:

Recipient	Taxability	Tax Rate & Treatment
Individual Shareholder	The deemed dividend is taxed in the hands of the individual shareholder as 'Income from Other Sources'.	Taxed as per the individual’s applicable income tax slab rates.
Concern (e.g., Partnership Firm)	If the loan or advance is extended to a firm, association, or entity where the substantial shareholder has significant interest, it is taxed in the concern’s hands.	Taxed at the applicable business tax rate of the concern.
Company (Publicly Held)	Publicly held companies are generally exempt from deemed dividend provisions as they have diversified ownership and public participation.	Not applicable
Company (Closely Held/Private Limited)	If a closely held company provides loans or advances to substantial shareholders (holding at least 10% voting rights), the amount is deemed as dividend.	Taxed at 30% under Section 115-O.
Hindu Undivided Family (HUF)	If an HUF receives a loan from a closely held company, taxation depends on whether a substantial shareholder within the HUF holds a 10% or greater stake.	Taxed as per HUF’s income slab rates.

Conclusion

Deemed dividend provisions under Section 2(22)(e) of the Income Tax Act serve as a safeguard against the indirect distribution of profits, ensuring that such transactions are subject to appropriate taxation. For stakeholders in closely held companies, comprehending these regulations is vital to maintain compliance and make informed financial decisions. By recognising the scenarios that constitute deemed dividends and the associated exceptions, companies and shareholders can navigate their financial interactions within the legal framework, thereby avoiding unintended tax liabilities. If you are looking for safe investment option, then you can consider investing Bajaj Finance Fixed Deposit. With a top-tier AAA rating from financial agencies like CRISIL and ICRA, they offer one of the highest returns, up to 8.60% p.a.

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