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SHARE PREMIUM IS NOT PROFIT OR SURPLUS FOR DEEMED DIVIDEND UNDER S. 2(22)(e)

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SHARE PREMIUM IS NOT' PROFIT' OR 'SURPLUS' FOR DEEMED DIVIDEND UNDER S. 2(22)(e)
By: Mrs. Uma Kothari
September 2, 2008

Share premium:

Depending on several factors relating to company, financial position, future prospects etc. a company can issue shares at par, at premium or at discount. Promoters strategy to have a proper mix of capital and reserves to strengthen capital base of the company and to have a precedence of issue of shares at premium so that in future shares can be issued at premium is also an important strategical decision. Many closely held companies have adopted practice of issuing shares at substantial premium with a view to keep authorized and paid-up capital low book value of share high, EPS high and incidentally to reduce cash outflow on account of dividend ( which is paid as a percentage of paid up share capital and also  on account of filing fees for higher authorized capital.

Share premium account:

Any sum collected in respect of issue of shares (except interest for delayed payment of allotment or call money) over and above paid-up of face value of shares is considered as share premium. This is a capital receipt and is not in nature of income or revenue receipt. This is to be shown as Reserve under the head 'Reserves and Surplus" in the balance sheet of the company as per provisions of the Companies Act. Share premium can be utilized only for purposes which are permitted under the Companies Act, 1956. Any other use is considered as reduction of capital which can be made only with approval of court. The provisions of Companies Act prohibit use of share premium account for declaration of dividend.

Share premium is a capital receipt and it is contributed by shareholders while subscribing or applying for shares to be issued by the company. Therefore, when a company issues shares at a premium, it receive share application money, allotment money and call money etc. from shareholders which consists some portion towards share capital and other towards premium.

As per common sense Share premium is not 'profit' or 'gain':

Share premium is capital receipt and contributed as such by the shareholders. The amount of premium is neither 'profit' nor 'gain' of the company, it is capital receipt to be accounted for as share  premium. This amount cannot be credited in the profit and loss account of the company.  This is not received as consideration for any goods sold or services rendered by the company. It is worth to mention that share premium is not treated as any item of 'income' as defined in S. 2(24) or as a business profit or gain u/s 28. Therefore, share premium account cannot be included in 'accumulated profits' of the company. It is capital receipt and is in nature of shareholders funds right from beginning. Any question as to "whether capitalized or not" cannot be raised for share premium. Because only profits can be kept as revenue reserve or they can be capitalized and transferred to capital reserve.   

Dividend by companies is prorata:

One of difference between partnership and company lies in relation to distribution of profits. In case of a partnership firm profit need not be distributed in the proportion of capital contributed by partners. The distribution of profit is based on agreed profit sharing ratio which is based on several factors like assets and capital contributed by partners, expertise and knowledge of partners, working contribution of various partners, personal goodwill of different partners, remuneration payable to working partners, etc.  

However the case of company and shareholders is different. In case of company profits are distributed according to the paid up share capital held by the shareholder of a particular class and according to the terms of issue and clauses in the articles of association. Broadly speaking dividend is a payment by company to its shareholders out of profits earned by company and such payment is made on prorate basis that is in proportion of paid-up capital held by shareholders on the record date. Therefore, dividend are out of current profits or accumulated profit of company and it cannot be out of capital.

Dividend is what is paid as dividend by the company to its shareholders as recommended by the Board and approved by the shareholders.  

Company can advance loan or advances to shareholders:

In course of money lending business or in course of other business a company may advance money by way of loans, advances or deposits to some of its shareholders according to the commercial and business requirements and other factors. However such loan, advance or deposit are refundable by the shareholders who receive them as loan, advance or deposit. Thus there is no release of any money from company to shareholder when a loan, advance or deposit is given.

 Furthermore, such loan, deposit or advance is not on uniform basis to all shareholders or in proportion of paid-up capital held by shareholders. Therefore any loan, deposit or advance, even if made to a shareholder or director is not 'dividend', as per general meaning understood by commercial and corporate world. However, in case of certain closely held companies , loan or advance made to a person who hold  more than specified stake individually or along with or through specified persons, then such loan can be considered as deemed dividend to the extent of  accumulated profits which the company have  on the day when such loan or advance is given.

If a company make loan, advance or deposit in its ordinary course of money lending business and such business is a substantial business then also provisions of deemed dividend is not applicable.

Inclusive definition of Dividend in section 2 (22):

In  S. 2 (22) an inclusive and broad definition of 'dividend' is prescribed giving several cases of considering certain payments as dividend. In most of the clauses the condition of dividend being distribution to shareholders that is in proportion of share capital held is inherent that is the distribution shall be according to capital held. In most of the clauses the condition of distribution out of accumulated profits or surplus is also applied. Even if a surplus, profit or gain is capitalized and any distribution is made to shareholders, it can be considered as dividend. Therefore, capitalization of profits before distribution will not make a difference.

 Thus on overall reading of section it is evident that existence of accumulated profits and distribution according of capital held are common and this is in line with generally considered meaning of 'dividend' in commercial world.

In section 2 (22) Clauses a-d are applicable to all type of companies and they describe dividend as distribution to shareholders out of accumulated surplus. The distribution is to be in proportion of shares capital held.

 Whereas clause (e) is applicable only to closely held companies and in this clause the word 'distribution' is not used. Rather the word used is ' any payment …  by way of  loan or advance' to persons having stake in company which carries  more than specified percentage of voting rights in the company, in given circumstances.

Loan or advance when deemed Dividend u/s 2 (22) (e):

 This clause is with a view to impose a check on closely held companies to advance money, as loan, to substantially interested shareholders, out of its   accumulated profits instead of by way of dividend. Thus , the purpose is to avoid tax avoidance / or tax deferment by such companies while allowing such companies to make available substantial sums of money, out of accumulated profits, to its shareholders who hold substantial stake in the company.  This is clear from  the  provision because it is applicable only in respect of closely held companies, and apply only when the company advance money to a shareholder who is substantially interested (as defined from time to time) and not to any other shareholder or other person, and only when the company has accumulated surplus( as defined). Furthermore this is not applicable if the company has substantial money lending business and the money is advanced to such shareholders also in ordinary course of money lending business.

Share premium is not profit:

As discussed earlier, share premium is not in nature of 'profit' or 'gain', and therefore it cannot be regarded as accumulated profit. Therefore, irrespective of any restrictions, which the Companies Act may provide on its use or a company may provide through its memorandum of association or articles of association, the share premium cannot be regarded as 'profit' or 'gain' when it is received and as  'accumulated profit' or 'accumulated surplus', subsequently.

Recent decision of ITAT in context of S. 2(22) (e) and share premium:

In Deputy Commissioner of Income-tax, Co. Circle 2(2), New Delhi V. MAIPO India Ltd.

(IT Appeal No. 2266 (Delhi) of 2005 for Assessment year 1996-97 decided on

March 7, 2008 the question for consideration was whether  loan or advance given by a company, when the company had share premium as one of reserves in books of account can be considered as dividend u/s 2(22) (e)?

The Tribunal held No. The Tribunal relied heavily on the provisions of the Companies Act, 1956 according to which share premium cannot be used to pay dividend and it can be used only according to permitted purposes. Utilisation of share premium for any other purpose is considered as reduction of capital and the provisions for such reduction are applicable.

In this case assessee held 40% of the shares of another company "G", therefore it was a shareholder having substantial interest within the meaning u/s 2(22). During the previous year relevant to the assessment year 1996-97, it received an amount of Rs. 25,42,772 as  advance from 'G'. The amount was in the nature of loans and advances

The assessee repaid Rs. 14,31,000 and the balance remained outstanding. Assessing Officer included the balance amount of Rs. 11,11,772 as deemed dividend in the hands of the assessee under section 2(22)(e).  

The case of the assessee was that entire reserve and surplus amount appearing in the books of 'G' Ltd. consisted of share premium which was a capital receipt and could not have been distributed as dividend.

The Assessing Officer while rejecting assesses contention, took view that in sub-clause (e) of clause (22) of section 2, the words 'whether capitalised or not' did not appear, in contrast with the earlier clauses of the section where these words found a place and, therefore, it was immaterial that the reserve and surplus consisted only of capital receipt by way of share premium.

The Commissioner (Appeals) however, accepted the claim of the assessee. He, however, found that out of the reserve and surplus account of 'G' Ltd., Rs. 190 lakhs represented share premium and Rs. 1,85,821 was on account of balance in the profit and loss account. Accordingly, he sustained the addition of Rs.1,85,821 only and deleted the balance. The revenue being aggrieved preferred appeal before the Tribunal. The Tribunal noted and observed as follows:

A. There was a sum of Rs. 1,90,00,000 as reserves in  account of 'G' Ltd. as on 31-3-1996 which was by way of share premium collected by the said company.

B. As per section 78(1) of the Companies Act 1956 Act  the premium received shall be transferred to a separate account styled 'the share premium account', and provide that hat the provisions of the 1956 Act relating to the reduction of the share capital of the company shall apply as if the share premium account was paid-up share capital of the company.

C. S. 78 (2) provides five purposes for which alone the share premium account may be applied without attracting consequence of  reduction of the share capital. These are:

(i)  Issue and pay up fully paid bonus shares to be issued to the members;

(ii) to write-off preliminary expenses of the company;

(iii) to write-off expenses of issue of shares or debentures or under-writing commission paid or discount allowed on such issues;

(iv) To pay premium on the redemption of redeemable shares or debentures issued by the company;

(v) Purchase of its own shares or other specified securities in terms of section 77A.

Any other use or application of the proceeds of the share premium account will be treated as a reduction of the company's share capital and the provisions of the 1956 Act dealing with this subject stand attracted. The share premium account cannot be used otherwise than for the specific purposes mentioned above.

The Tribunal further considered that when there is a statutory bar on the share premium account being used for distribution of dividend, the deeming provisions of section 2(22)(e) cannot apply. Not only is there a prohibition on the distribution of the share premium account as dividend under the 1956 Act, the same is obliged to be treated as a part of the share capital of the company and this is made clear in section 78(1) of the 1956 Act which says that any payment out of the share premium account, except for purposes authorised by sub-section (2), will be treated as reduction of share capital attracting the provisions of the 1956 Act in relation thereto. This provision of the 1956 Act takes care of the argument of the revenue that section 2(22)(e) does not use the expression 'whether capitalized or not'. These words can have application only where the profits are capable of being capitalized. They are not applicable where the receipt in question forms part of the share capital of the company under the provisions of the 1956 Act.

The decision of the Commissioner (Appeals) that the amount of Rs. 1,85,821 alone out of the amount of Rs. 25,42,772 could be assessed as deemed dividend under section 2(22)(e) was thus affirmed by the Tribunal. The Tribunal has referred to the following judgments:

P.K. Badiani v. CIT [1976] 105 ITR 642 (SC) ),

The term "accumulated profits" should be construed in the commercial sense and not assessable or taxable profits liable to tax under 1922 Act.
Development rebate debited to profit and loss account and taken to reserve would amount to accumulated profits.

CIT v. Urmila Ramesh [1998] 230 ITR 422  

ITO held that the amount distributed on liquidation of company was the accumulated profits of the Company and assessable as "deemed dividend" u/s. 2(22) of Income-tax Act, 1961.

Court held that the amount received was not assessable because the Liquidator sold assets for less than their purchase price. "Profits" are to be actual profits calculated on commercial principles. Amount taxed u/s 41(2) in the hands of company did not represent "accumulated profits" for the purpose of section 2(22) of the Act. 

CIT v. Allahabad Bank Ltd. AIR [1969 SC 1058.= 2008 -TMI - 5136 - SUPREME Court]

Share premium account is to be included in the paid-up capital for the purpose of computing rebate if it is maintained as a separate account. The Explanation does not contemplate that the account must be kept apart from the reserves. If within the reserves it is an identifiable separate account, the share premium will qualify for inclusion in the paid-up capital for computing the reduction in rebate for super-tax.

Authors view:

In view of author, as discussed above, share premium is not profit or gain and therefore, it cannot be considered as accumulated profit. A loan or advance does not amount to release of funds in favour of person to whom loan or advance is given therefore, it is not dividend. Only for limited purpose of imposing income tax, and with a view to avoid tax avoidance or deferment, in some circumstances a loan or advance is considered as dividend. The purpose of this provision is also to avoid tax avoidance. Share premium is not a taxable income in hands of company, it is not accumulated profit so it cannot be used to pay dividend. Therefore, even if loan is given to a substantially interested person, and company has as means of finance share premium, it cannot be said that there is tax avoidance because the company has adopted method of giving loan instead of giving dividend to shareholder.

 
By: Mrs. Uma Kothari - September 2, 2008
 
 
 

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