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Concept of deemed dividend and tax thereon must be discontinued as it appears not effective.

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Concept of deemed dividend and tax thereon must be discontinued as it appears not effective.
By: CA DEV KUMAR KOTHARI
February 9, 2018
  • Contents

The Finance Bill 2018:

Concept of deemed dividend and tax thereon must be discontinued as it appears not effective.

Present provisions:

Section 2(22)(e),115O and 115 Q of the Income-tax Act,1961

Easy compliance and ease of doing business:

When policy of the government is to accept return of income in most of cases and to provide ease of doing business, the concept of deemed dividend is against both. It is highly complex and one cannot be sure whether the provision of deemed dividend is applicable or not. Furthermore, in view of changed circumstances, government policies and policies in corporate world, the concept of deemed dividend need to be reconsidered and dropped. However, just because of presumptions, and bias the concept is still in vogue and as per budget proposal, it is proposed to impose tax on companies instead of on shareholder of company.

Concept of deemed dividend and taxing same will cause difficulties and the flexibility of finances which a company and its stake holders can maintain and need to maintain will be difficult to maintain and financial operations will be difficult.

Closely held companies:

The concept of ‘deemed dividend’ is applicable only in case of closely held companies which are private or limited companies in which controlling stake is held by family members, relatives, friends and associates etc. who have joined and held some stake in company.

These companies are in nature of special purpose vehicles to carry business by making association of such persons who hold shares in company and company carry business.

Loan, advance, deposit etc.

When such a company gives loan, advance or deposit or any financial accommodation to its shareholder, who have a substantial stake in company, the understanding is that the amount given to shareholder is refundable. It is an items of asset for company and an item of liability for shareholder. There is no release of money or transfer of ownership on such sums from company to shareholder. Transactions may in nature of loan, advance, current account or mutual accommodation. The department raises disputes in many cases including in respect of business advances.

The amount received by shareholder from company is on capital account and is refundable, it is his liability. It is not of revenue or income nature in hands of shareholder.

Change in circumstances and practices:

Concept of deemed dividend must end because there are several changes in various related aspects. For example:

  • Concept of deemed dividend had importance when rate of tax on companies was very high whereas rate of tax on shareholders (other than companies) was low. Now rate of tax on companies is also low. In fact most of companies who have accumulated surplus, have shareholders also having similar rate of tax/ marginal rate of tax applicable in case of company and shareholder having substantial interest. In fact, in many situations, we find that the rate of effective tax is less in comparison to effective rate of tax on shareholders.
  • There were severe restrictions on remuneration which company could pay to shareholder who worked as director of company. Now restrictions have been relaxed and companies are in position to pay higher remuneration to its directors who are also shareholders.
  • More distribution- with changes in times companies who earn well, and accumulate surpluses are declaring higher dividend as compared earlier.
  • Tax is levied on company when company declare dividend to shareholders.

What is deemed dividend:

When a closely held company, having accumulated surplus gives any loan or advance to a shareholder who has 10% or more controlling stake in company, then such loan or advance to the extent company has accumulated surplus is deemed dividend. As per provisions, accumulated surplus on the day of giving loan is to be ascertained. Therefore, every time a company having accumulated surplus, pay any loan or advance to a shareholder who has substantial stake, accumulated surplus as on that day has to be ascertained. It is subject to litigation and very difficult work.

Budget proposal:

The effect of proposals in the budget in this regard is that if provision of deemed dividend is invoked, company shall pay tax on such deemed dividend @ 30% and applicable other levies. Earlier such deemed dividend was taxed in hands of shareholder in normal computation and at applicable rate of tax.

Reasons for proposal:

As per memorandum “The taxability of deemed dividend in the hands of recipient has posed serious problem of the collection of the tax liability and has also been the subject matter of extensive litigation”.

However, even after amendment to impose tax on company, it will still be difficult and subject to litigation. Though number of disputes may reduce because it will be with company and not with shareholders.

As per a recent judgment of the Supreme Court, if a shareholder is beneficial holder of shares, he will be liable to tax on deemed dividend. When tax in imposed in hands of company, it will be difficult for company to find out beneficial owners. A shareholder may hold shares as unregistered in his name, or in name of nominees. The company will only be able to check registered shareholders and any shareholder if a declaration has been filed by shareholder about beneficial holding.

In view of above, the honourable Finance Minister must check:

  • How much deemed dividend has been taxed in last five years and tax has been collected thereon.
  • How many disputes have taken place in which revenue won the case or lost the case.
  • If deemed dividend was not taxable, how many working hours of various authorities and courts would have been saved.
  • If the proposed provision is implemented, how difficult it will be to tax deemed dividend in view of difference of opinions on various issues which involve mainly:
  • Shareholder or not,
  • Stake of holding how to be computed (direct and through others)
  • Share holder having substantial holding.
  • Any other concern in which shareholder is substantially interested.
  • Amount of accumulated surplus as apparent from audited accounts.
  • Amount of accumulated surplus after making adjustments for notes on accounts for un-provided expenses and liabilities.
  • Amount already deemed as dividend to be deducted.
  • Amount of accumulated surplus till date of giving loan or advance

All above and many other issues are highly contentious and time consuming to check and find correct position. Therefore, neither difficulties nor litigation is likely to be reduced simply by making companies liable to tax.

Unconstitutional provision:

Tax on income of any person can only be imposed. How company can be made liable to pay tax on income of shareholder?

Even constitutional validity of S. 115 O is doubtful.

Furthermore, constitutionality of S.2.22.e also need to be examined in changed circumstances. How a loan taken from company, which is refundable by shareholder, can be considered income? This is a liability, a receipt on capital account, and is not income.

How it can be taxed.

Therefore, it is requested to the honourable Finance Minister to drop the proposal and also to delete S. 2.22.e.

The proposed provisions are reproduced below with highlights added:

From THE FINANCE BILL, 2018

38. Amendment of section 115-O.

In section 115-O of the Income-tax Act,––

(a) in sub-section (1), the following proviso shall be inserted, namely:––

‘Provided that in respect of dividend referred to in sub-clause (e) of clause (22) of section 2, this sub-section shall have effect as if for the words “fifteen per cent.”, the words “thirty per cent.” had been substituted;’;

(b) in sub-section (1B), the following proviso shall be inserted, namely:––

“Provided that this sub-section shall not apply in respect of dividend referred to in sub-clause (e) of clause (22) of section 2.”

39. Omission of Explanation occurring after section 115Q.

After section 115Q of the Income-tax Act, the Explanation shall be omitted.

Notes on clauses:

Clause 38 of the Bill seeks to amend section 115-O of the Income-tax Act relating to tax on distributed profits of domestic companies.

It is proposed to insert a proviso to sub-section (1) of the said section so as to provide for levy of tax at the rate of thirty per cent. on distributed profits in the nature of dividend under sub-clause (e) of clause (22) of section 2.

It is further proposed to insert a proviso to sub-section (1B) of the said section 115-O so as to exclude the amount of dividend under sub-clause (e) of clause (22) of section 2 from the applicability of grossing up provisions of the said sub-section.

Clause 39 of the Bill seeks to omit the Explanation occurring after section 115Q of the Income-tax Act.

The said Explanation clarifies that the expression "dividends" shall have the same meaning as is given in clause (22) of section 2 but shall not include sub-clause (e) thereof.

It is proposed to omit the said Explanation consequent to the amendments made to section 115-O. This amendment will take effect from 1st April, 2018.

From Explanatory memorandum:

Application of Dividend Distribution Tax to Deemed Dividend

At present dividend distributed by a domestic company is subject to dividend distribution tax payable by such company. However, deemed dividend under sub-clause (e) of clause (22) of section of 2 the Act is taxed in the hands of the recipient at the applicable marginal rate. The taxability of deemed dividend in the hands of recipient has posed serious problem of the collection of the tax liability and has also been the subject matter of extensive litigation.

With a view to bringing clarity and certainty in the taxation of deemed dividends, it is proposed to delete the Explanation to Chapter XII-D occurring after section 115Q of the Act so as to bring deemed dividends also under the scope of dividend distribution tax under section 115-O. Further, such deemed dividend is proposed to be taxed at the rate of 30 per cent. (without grossing up) in order to prevent camouflaging dividend in various ways such as loans and advances.

This amendment relating to imposition of dividend distribution tax on deemed dividend will apply to transactions referred to in sub-clause (e) of clause (22) of section 2 of the Act undertaken on or after 1st April, 2018.

[Clause 38 & 39]

 

By: CA DEV KUMAR KOTHARI - February 9, 2018

 

 

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