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Deemed Dividend: Section 2(22)(e) of the Income Tax Act, 1961
Dividends are one of the ways that companies reward their shareholders for investing in them. Dividends are usually paid out of the company's profits and are subject to tax in the hands of the shareholders. However, not all payments or benefits received by shareholders from a company are considered as dividends. There are some situations where certain transactions or arrangements are treated as dividends for tax purposes, even if they are not formally declared or distributed by the company. These are known as deemed dividends and are governed by Section 2(22)(e) of the Income Tax Act, 1961.
In this article, we will explain what is deemed dividend, how it works, what are the dividend provisions of Section 2(22)(e), who will pay tax on deemed dividends, what are the exceptions to deemed dividends, and what are the implications of deemed dividends for taxpayers.
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What is deemed dividend?
Deemed dividend is an income treated as a dividend, even if a closely held company does not distribute it. The Income Tax Act includes certain transactions and situations that are deemed to be dividends. These transactions are specified under Section 2(22)(e) of the Income Tax Act.
Deemed dividends apply only to private limited companies or companies in which the public is not substantially interested. These are also known as closely held companies. Deemed dividends do not apply to public limited companies or companies in which the public is substantially interested.
How does a deemed dividend work?
Deemed dividend arises when a closely-held company extends a loan or an advance to:
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Any of its shareholders who possess more than 10% voting power in the company or
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To any concern in which such shareholder is substantially interested or
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For the individual benefit of such shareholders or
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On behalf of such a shareholder
The loan or advance should be given out of the company's accumulated profits or the earnings of the current year or the previous year. The amount of loan or advance deemed dividends is limited to the extent of the company's accumulated profits.
For example, let us say that ABC Pvt Ltd is a closely held company, and Hari is one of its shareholders, who owns 15% of the shares. The company has accumulated profits of Rs.25 lakhs as of 31 March 2024. The company grants a loan of Rs.10 lakhs to Hari through an account payee cheque. In this case, the loan amount of Rs.10 lakhs will be treated as deemed dividends in the hands of Hari, as per Section 2(22)(e).
Section 2(22)(E) of Income Tax Act
Dividend income u/s 2(22)(e) of the Income Tax Act defines the term “dividend” to include any payment by a company, not being a company in which the public is substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) made after the 31st day of May 1987, by way of advance or loan to a shareholder, being 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) holding not less than ten percent of the voting power, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as ‘the said concern’) or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent that the company, in either case, possesses accumulated profits.
The section also provides some explanations and clarifications regarding the terms used in the section, such as:
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“accumulated profits,” about any company, means all profits of the company up to the date of distribution or payment or liquidation, subject to certain adjustments;
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“concern” means a Hindu undivided family, a firm or an association of persons, a body of individuals, or a company;
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a person shall be deemed to have a substantial interest in a concern, other than a company, if he is, at any time during the previous year, beneficially entitled to not less than twenty percent of the income of such concern;
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a person shall be deemed to have a substantial interest in a company if he is, at any time during the previous year, the beneficial owner of equity shares carrying not less than twenty percent of the voting power.
Taxability of Deemed Dividend under the Income Tax Act
Before April 2018, companies that paid regular dividends to their shareholders had to pay a Dividend Distribution Tax (DDT) tax on the dividends distributed. However, the shareholders receiving these dividends did not have to pay any tax on this dividend income. On the other hand, companies that gave deemed dividends to their shareholders in the form of loans, advances, etc., did not have to pay any DDT.
This led to a situation where closely held companies could give dividends in loans and advances rather than actual dividends to avoid paying DDT. So, to prevent this tax evasion, the Union Budget of 2018 amended the Income Tax Act to make payment of DDT mandatory for deemed dividends as well. As per this amendment that came into effect from the financial year 2018-19, companies now had to pay DDT at the rate of 30% plus surcharge and cess on both regular and deemed dividends given to shareholders.
While the companies had to pay this DDT, the shareholders receiving the dividends were not responsible for paying this tax. However, they still had to pay a small or nominal tax on the deemed dividend income they received. This ensured that dividends distributed in loans or advances did not escape taxation. However, in the 2021 Union Budget, the DDT was abolished altogether. As per the new system, effective April 2021, dividend income is taxable in the hands of the shareholders, whether received as actual dividends or deemed dividends.
Who Will Pay Tax On Deemed Dividends?
The deemed dividend taxability depends on the recipient's status and the transaction's nature. The following table summarizes the tax treatment of deemed dividends in different scenarios:
Recipient | Transaction | Tax Treatment |
|---|---|---|
Individual shareholder | Loan or advance from a closely held company | Deemed dividend is taxable as income from other sources at the applicable slab rates |
Concern in which shareholder has a substantial interest | Loan or advance from a closely held company | Deemed dividend is taxable as income from other sources at the applicable slab rates |
Individual shareholder | Payment for individual benefits from a closely held company | Deemed dividend is taxable as income from other sources at the applicable slab rates |
Closely-held company | Loan or advance from another closely held company | Deemed dividend is taxable as income from other sources at the rate of 30% (plus surcharge and cess) |
Public limited company | Loan or advance from a closely held company | Deemed dividend is not taxable, as Section 2(22)(e) is not applicable to public limited companies |
It is important to note that the payer company, i.e., the closely-held company that gives the loan or advance, is not liable to pay any dividend distribution tax (DDT) on the deemed dividend. DDT applies only to the actual dividends declared and distributed by the company, not the deemed dividends.
Exceptions to deemed dividends
Some exceptions or exclusions exist to the applicability of deemed dividends under Section 2(22)(e). These are:
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Loan or advance given by a company engaged in the business of money lending, where the loan or advance is provided in the ordinary course of its business;
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Loan or advance given to a shareholder, subsequently adjusted against the dividend declared and distributed by the company;
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Loan or advance given to a shareholder subsequently converted into equity shares of the company, subject to certain conditions;
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Loan or advance given to a shareholder, who is also a director of the company, to meet the expenditure incurred or to be incurred by him for the business or profession of the company, subject to certain conditions;
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A loan or advance is given to a shareholder who is also an employee of the company to meet the personal expenditure of such shareholder or his relatives, subject to certain conditions.
Difference Between Deemed Dividends And Actual Dividends
Category | Deemed Dividend | Actual Dividend |
|---|---|---|
Applicable on | Closely held companies | Public companies |
Dividends to shareholders | Loans and advances distributed to shareholders | Dividends distributed to shareholders |
Shareholder requirement | >10% voting power | All shareholders |
Tax rate | 30% + cess and surcharge | 15% if dividend > Rs. 5,000 |
In summary:
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Deemed dividend applies to closely held companies when they provide loans/advances to significant shareholders
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Actual dividend applies to dividends distributed by public companies
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Deemed dividend has a higher tax rate of 30% + cess/surcharge with no minimum threshold
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Actual dividend has a lower tax rate of 15% if the dividend is above Rs. 5,000
Conclusion
Deemed dividend is a concept that aims to prevent tax avoidance by closely held companies and their shareholders, who may resort to transactions equivalent to dividend distribution without paying any tax on them. Deemed dividend is treated as income in the hands of the recipient and is taxed accordingly. However, some exceptions and exclusions to the applicability of deemed dividends should be considered before entering into any such transactions. Deemed dividend is a complex and technical topic, and it is advisable to consult a professional tax consultant before taking any action based on this article. Share this Guide article with colleagues or friends so they too can benefit from this valuable information. You can also take Taxbuddy tax expert services if you have doubts about deemed dividends.
Frequently Asked Questions
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How is a deemed dividend taxed?
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Deemed dividends are taxable in the hands of the recipient shareholder under the income from other sources. The company does not get any deduction for the amount. The deemed dividend is subject to dividend distribution tax at applicable rates. It is also taxable for resident shareholders as per their income tax slab rates.
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What does deemed profit mean under the Income Tax Act?
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Certain transactions, such as transfer of assets for inadequate consideration, receipt of compensation on termination of the agency, excessive remuneration to directors, etc., are deemed as profit for tax purposes under sections like 2(22)(e), 28(iv), 40A(2), and others. Even if actual profit is not earned, the amount is considered income and taxed accordingly.
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What are the dividend distribution provisions under the Income Tax Act?
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Section 2(22) of the Income Tax Act defines dividends. Apart from actual dividends, other transactions are deemed as dividends for tax purposes, like loans/advances to shareholders, payments for shareholder benefit, distribution on buyback, distribution of assets on liquidation, etc. Domestic companies declaring dividends must also pay Dividend Distribution Tax (DDT) under section 115-O.
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How is dividend income under section 2(22)(e)(ii) taxed?
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Any loan or advance given by a closely held company to a shareholder holding 10% or more voting power is considered a dividend under sec 2 22 e. Such income is taxable in the hands of the recipient shareholder as income from other sources. The company does not get a deduction and must pay dividend distribution tax.
Prachi Jain
Chartered Accountant
Prachi Jain is a Chartered Accountant with a passion for simplifying finance and tax-related matters through her insightful and informative blogs. With a background in finance and a deep understanding of tax regulations, Prachi has established herself as a trusted source of financial wisdom. Prachi is committed to empowering her readers with the knowledge they need to make informed financial decisions. Her expertise and dedication shine through in every blog post, helping her audience navigate the intricacies of finance and taxes with confidence. Follow Prachi Jain's blog for practical insights and guidance on managing your finances effectively.
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