What is Deemed Dividend Under Section 2(22)(E) of Income Tax Act

Deemed Dividend-Meaning

Dividend refers to the returns a shareholder receives for investing in a company. Dividends are usually paid out of the company's profits and are subject to tax in the hands of the shareholders.

For example, let us say that Company ‘A’ is making sound amounts of net profit and wants to distribute the profits with its shareholders, The board of the company decides to give 3% returns per share to every shareholder. Each share unit costs Rs. 100, so for every share, the shareholder receives Rs. 30; this amount is called a ‘Dividend’.

Whereas the deemed dividend is a particular amount or asset loaned to a shareholder who has a substantial share in that company, for the purpose of taxation, the loaned amount is considered to be a ‘deemed dividend.’ The loan or advancement amount should only be provided from the company's accumulated profits. It is to be noted that only private limited companies whose activities are not of public substantial interest are eligible for a Deemed Dividend.

---

What is substantial interest in a company?

"Substantial interest" in a company generally refers to a significant ownership stake or financial interest held by an individual or entity in a particular business. When a shareholder holds at least 10% of shares and 10% of the voting interest in a company, he is said to have a substantial interest in that company.

In many cases, substantial interest is determined by the percentage of ownership or control an individual or entity holds in a company. For instance:

• Ownership Percentage: A substantial interest might be considered if an individual or entity holds a certain percentage of shares or voting rights in a company. This threshold can differ from country to country or may be specified in tax laws.
• Control and Influence: Apart from ownership, substantial interest can also relate to the level of control or influence an individual or entity has over a company's operations, decision-making, or strategic direction.
• Direct and Indirect Holdings: It can encompass both direct ownership and indirect holdings through related entities, family members, trusts, or other structures, depending on how ownership is distributed or controlled.

The concept of substantial interest often plays a crucial role in tax laws, especially concerning matters such as:

• Dividend Taxation: Countries might apply different tax rates or rules for individuals or entities with a substantial interest in a company when receiving dividends.
• Capital Gains Tax: Taxation on gains realized from selling shares or interests in a company might differ for individuals or entities with substantial interests compared to others.
• Tax Reporting and Compliance: Individuals or entities with substantial interests might have additional reporting requirements or obligations under tax laws.

---

How does a deemed dividend work?

Let us say that Mr. X is a shareholder of company ’Z’, He holds shares worth 20%. As of April 10, 2020, Company Z has an accumulated profit of Rs. 5,00,000. Now, Mr.’X’ approaches the board to request a loan of Rs. 1,00,000. Mr.’X’ being a shareholder having substantial interest in company Z, the board agrees to loan him Rs. 1,00,000, after a month i.e, on May 10th. Mr. X returns the loaned amount back (which is before the end of the current financial year), although Mr. X has returned the amount, Rs. 1,00,000 made from the accumulated profits, the loaned amount will be treated as ‘Deemed Dividend’.

---

Section 2(22)(E) of Income Tax Act

Section 2(22)e of the Income Tax Act deals with how the types of loans and advances the company makes for the shareholder are deemed dividends. The following are the payment methods that are considered to be deemed dividends under this act,

• Payments of loans or lending assets to a shareholder who has a substantial interest in that company are treated as a deemed dividend; such amount must be given only from accumulated profits.
• Loans extended to a parent company by a subsidiary company from accumulated profits.
• Advances made by the company to its shareholders to install plant & machinery that enable him to exercise an export order.
• Personal payments of shareholders made by the company will also be treated as deemed dividends.
• Any loan given to the employee will indirectly benefit the company's director.

---

Exceptions to deemed dividends

Few transactions, although has the nature of lending advances, are not treated as a deemed dividend, such as,

• Loans and advances received by shareholders out of the share premium account can not be treated as deemed dividends.
• Loans given by companies whose nature of business is money lending.
• Loans are adjusted as dividends are declared and distributed.
• The paying company can not be the one where the public is substantially interested
• Loans are given to shareholders who do not have a substantial interest in the company.

---

Taxability of Deemed Dividend under the Income-tax Act?

Before April 2018, deemed dividends were exempted from being taxed under the dividend distribution tax. Also, companies that paid regular dividends to their shareholders had to pay a Dividend Distribution Tax (DDT) tax on the dividends distributed.

But it was observed that 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. From the financial year 2018-19, deemed dividends made to shareholders were taxed.

Deemed dividends are subject to a 30% dividend distribution tax for the company under section 2(22)e of the Income Tax Act, but the tax is exempted for the shareholder.

Therefore, for deemed dividends paid to shareholders, the company will be taxed 30% of the loan amount, even though the shareholder settled the loan amount in the same financial year.

---

Who Will Pay Tax On Deemed Dividends?

---

Exceptions to Deemed Dividends under Section 2(22)(e):

The following are some key exceptions where loans or advances are not treated as deemed dividends:

1. Loans in the ordinary course of business:
   If the company is engaged in the business of money lending, any loan or advance provided to shareholders in the ordinary course of its business is not considered deemed dividends.
2. Loans adjusted against dividends declared:
   A loan or advance given to a shareholder that is later adjusted against the declared and distributed dividend is excluded from being treated as deemed dividend.
3. Loans converted to equity:
   If a loan or advance provided to a shareholder is later converted into equity shares of the company under specific conditions, it is not treated as a deemed dividend.
4. Loans to directors for business expenses:
   Loans or advances given to a shareholder who is also a director, specifically for business or professional expenses of the company, are excluded, subject to certain conditions.
5. Loans for personal expenses of employee-shareholders:
   If the loan is given to a shareholder who is also an employee to cover personal expenses of the shareholder or their relatives, it may be exempt from being considered a deemed dividend, subject to specific conditions.

Here’s an improved version of the content on exceptions to deemed dividends and the difference between deemed dividends and actual dividends:

---

Difference Between Deemed Dividends and Actual Dividends

Dealing with deemed dividends and their exceptions can be tricky for shareholders and directors, especially under Section 2(22)(e) of the Income Tax Act. Misunderstanding these provisions can lead to unintended tax liabilities, higher rates, and compliance issues.Our experts help you structure transactions efficiently, leveraging exceptions where applicable, so you pay only what you owe. Connect with the experts.

---