Tax law in India has a provision for “deemed dividend”, that is, income treated as dividend by creation of legal fiction. Let us take the example of a company X Pvt. Ltd. (that is, a company in which the public are not interested) with shareholders A & B, each holding more than 20% shares in X. Suppose further that there is another company, Y Pvt. Ltd., whose shareholders are A & B, again each holding more than 10% shares. It has been observed in the last that in order to avoid taxation on dividend income in the hands of shareholders, X may advance a loan to Y and the benefit of the loan is ultimately reaped by A & B because of their shareholding in Y. To plug this gap, the Legislature thought it fit to introduce the legal fiction.
According to the law, the following shall be deemed dividend in the hands of the shareholder: Any payment made by a company, not being a company in which the public are substantially interested, of any sum …..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…………….to the extent to which the company in either case possesses accumulated profits.
The legal fiction created here is that the provision above seeks to tax as dividend, that which is paid otherwise than as dividend.
The authorities usually misconstrue this provision of law and in the example which we have considered, the authorities tend to tax Y Pvt. Ltd. for dividend income. Let us, however, consider the provision in detail:
For a payment to be considered dividend, it has, therefore, to satisfy the following:
- It must be paid by a company in which the public are not substantially interested (a private company);
- It should be by way of loan or advance (but would, of course, exclude loans or advances made in the regular course of business);
- It must be paid to a shareholder who should be a person who is the beneficial owner of shares with not less than 10% voting power; or
- It must be paid to a concern in which such shareholder has substantial interest (10% for companies and 20% for other forms of business);
- It should be paid from accumulated profits.
The important point to note here is that the person who can be taxed is the shareholder and not the recipient of the loan /advance. Furthermore, the shareholder, if he has himself received the loan or advance, must have beneficial ownership of the prescribed percentage. In case the amount has been paid to a concern in which the shareholder has interest, then it must be substantial interest (10% for companies and 20% for other forms of business).
In the case of C P Sarathy Mudaliar, the Supreme Court had held that when the Act speaks of shareholder, it refers to registered shareholder. What the legal fiction has achieved is enlarging of the field of dividend. By no means can it be concluded that it has enlarged the definition of shareholder. It is, therefore, possible that somebody may own shares in a company but may not be the beneficial owner of those shares – deemed dividend would not apply in that case. Similarly, someone may be the beneficial owner of shares but may not be the shareholder – deemed dividend would not apply in such a case either.
It is respectfully submitted that in cases where the authorities have sought to tax the dividend in the hands of Y (as in our example), they are misinterpreting the law. The dividend should, instead, be taxed in the hands of the shareholder.
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