Detailed Analysis of Section 2(22)(e) of the Income Tax Act, 1961

Section 2(22)(e) of the Income Tax Act, 1961, is a provision aimed at preventing the misuse of corporate funds by closely held companies. The provision treats certain loans or advances made by such companies to their shareholders as deemed dividends, thus bringing them within the tax net. This is done to discourage companies from providing funds to their shareholders in the form of loans or advances, which could otherwise be used to avoid the payment of taxes on actual dividends.

Provisions of Section 2(22)(e)

1. Definition of Dividend: Under Section 2(22), the term “dividend” is broadly defined to include not only the actual distribution of profits but also certain other transactions like loans or advances to shareholders. Sub-clause (e) specifically includes any loan or advance made by a closely held company to its shareholder, or to a concern in which such shareholder has a substantial interest.
2. Conditions for Applicability: For a loan or advance to be considered as a deemed dividend under Section 2(22)(e), the following conditions must be satisfied:
   • The loan or advance must be given by a company (which must be a closely held company).
   • The shareholder must own 10% or more of the voting power in the company.
   • The loan or advance must be made to the shareholder or any person connected with such shareholder, such as a relative or a concern in which the shareholder has a substantial interest (typically more than 20% of the capital or voting power).
3. Exclusion from the Scope of Section 2(22)(e):
   • Repayment of Loan: If the loan is repaid by the shareholder within the accounting year, it will not be treated as a deemed dividend.
   • Loans in the Ordinary Course of Business: If the loan or advance is given in the normal course of business (e.g., a lending company making a loan), it may not be treated as a dividend.
   • No Tax Deduction at Source: The company making the loan is not required to deduct tax at source (TDS) on these loans or advances, but the recipient is liable to pay tax on the deemed dividend.
4. Tax Treatment of Deemed Dividend:
   • The amount of the deemed dividend is taxable in the hands of the shareholder under the head “Income from Other Sources”.
   • The rate of tax will be as per the applicable tax slab for the shareholder, and it is not eligible for the dividend distribution tax (DDT) that applies to regular dividends.
   • The company, however, is not liable to pay any tax on the loan or advance made to the shareholder.

Illustrative Example

Let’s consider a closely held company, ABC Ltd., in which Mr. X holds 15% of the voting shares. ABC Ltd. gives a loan of ₹5,00,000 to Mr. X. This would be treated as a deemed dividend under Section 2(22)(e) because:

• Mr. X holds more than 10% of the voting shares.
• The loan is made to a shareholder (Mr. X).

As per the provisions, the amount of ₹5,00,000 will be taxable in the hands of Mr. X under the head “Income from Other Sources”. The company does not deduct any TDS on the loan, but Mr. X is required to pay tax on this amount.

Case Laws on Section 2(22)(e)

Several key judicial rulings have helped in interpreting Section 2(22)(e). Some significant case laws include:

1. CIT v. Raj Kumar (2006) 286 ITR 274 (SC)

• Facts: The Supreme Court held that if a company advances money to a shareholder, and the money is treated as a “loan,” the transaction could be taxed as a deemed dividend.
• Ruling: The Court ruled that even though the loan was provided as part of the company’s business dealings, it was still considered as a deemed dividend under Section 2(22)(e), as the money advanced was not repaid within the specified time frame and was given to a shareholder who held more than 10% of the voting shares.

2. Vodafone India Services Pvt. Ltd. v. Union of India (2014) 364 ITR 97 (SC)

• Facts: The issue involved whether a loan given by a subsidiary company to its parent company was subject to the provisions of Section 2(22)(e).
• Ruling: The Supreme Court held that loans between related parties are subject to Section 2(22)(e), even if the recipient is not the direct shareholder but is still connected in some manner (e.g., through common ownership). The Court clarified the scope of “shareholder” to include anyone with substantial interest in the company.

3. Dinesh Kumar Goel v. CIT (2012) 19 taxmann.com 69 (Delhi HC)

• Facts: The Delhi High Court considered a situation where a company advanced money to a shareholder who was also a director. The shareholder was given an unsecured loan that remained outstanding.
• Ruling: The High Court held that if the loan is advanced to a shareholder holding more than 10% voting power in a closely held company, the loan will be treated as a deemed dividend, subject to tax under Section 2(22)(e).

4. S. S. Rathore v. CIT (1993) 201 ITR 151 (MP HC)

• Facts: The case involved an individual who had taken a loan from a company in which he was a substantial shareholder.
• Ruling: The Madhya Pradesh High Court ruled that the loan amount should be treated as a deemed dividend under Section 2(22)(e) and should be taxed accordingly.

Important Considerations and Exceptions

1. Loans to Shareholders Holding Less than 10% Voting Power: Section 2(22)(e) applies only when the shareholder holds at least 10% of the voting power. Loans given to shareholders holding less than 10% of the voting shares are not covered under this provision.
2. Loans to Relatives and Concerned Entities: The provision also applies to loans given to a concern in which the shareholder has a substantial interest (typically 20% or more of the capital or voting power). It also extends to relatives of the shareholder, as defined under the Income Tax Act.
3. Impact on Small and Family-Owned Businesses: Section 2(22)(e) can have significant tax implications for closely held and family-owned businesses that often provide loans to their promoters or directors. These loans could lead to unintended tax liabilities for the shareholders if not properly managed.
4. Loans in Ordinary Course of Business: The section does not apply if the loan or advance is part of the ordinary course of business, such as when a company is in the business of lending money (e.g., a finance company).

Section 2(22)(e) is a critical provision that ensures that closely held companies do not use loans or advances to shareholders as a method of profit distribution to avoid tax on dividends. The provision ensures that any loan or advance made by such companies to their shareholders (holding 10% or more of the voting power) is taxed as a deemed dividend in the hands of the recipient. Several judicial pronouncements have clarified its scope and applicability, and taxpayers need to be cautious when structuring transactions involving loans and advances from closely held company.

Why to Calculate Accumulated Profits Under Section 2(22)(e) of the Income Tax Act

The calculation of accumulated profits under Section 2(22)(e) of the Income Tax Act, 1961 is crucial because it determines whether a loan or advance provided by a closely held company to its shareholders (or related parties) is considered a deemed dividend and subject to tax. Section 2(22)(e) was introduced to prevent the misuse of corporate funds for personal benefits and tax avoidance, where shareholders or related parties receive funds from the company in the form of loans or advances, which would otherwise not be taxable if treated as loans.

Here’s why and how the calculation of accumulated profits plays a central role in determining whether a loan or advance is taxable as deemed dividend under Section 2(22)(e):

1. Understanding “Deemed Dividend”

Under Section 2(22)(e), a loan or advance given by a company to its shareholder or a concern in which the shareholder has a substantial interest (at least 20% of voting power or capital) is treated as a deemed dividend, if the company has sufficient accumulated profits. The section is designed to prevent the avoidance of dividend taxation by distributing company funds in the form of loans instead of formal dividends.

Deemed dividend can only occur if the company has accumulated profits (i.e., profits that have been retained by the company and not distributed as dividends).

Therefore, calculating the accumulated profits is the first step in determining whether a loan or advance will be considered a deemed dividend and taxed as income in the hands of the recipient.

2. What Constitutes Accumulated Profits?

The term “accumulated profits” is defined broadly and includes the total of a company’s retained earnings or profits accumulated over the years. These profits are available for distribution to shareholders as dividends.

In calculating accumulated profits, several adjustments are made, including:

• Retained Earnings: Profits that have been retained in the company after paying taxes and dividends over time.
• Reserves: Any special reserves or capital reserves that are considered part of the company’s retained earnings.
• Depreciation: For a more accurate calculation, depreciation must be factored in, as it reduces the book profits available for distribution.

The accumulated profits are considered for determining whether a loan or advance qualifies as a deemed dividend. If the company has accumulated profits, then any loans or advances made to shareholders or related parties may be treated as a deemed dividend.

3. Why the Calculation is Important

The calculation of accumulated profits is vital for several reasons:

a. Determining Deemed Dividend Status

• Section 2(22)(e) treats loans or advances from a closely held company to its shareholders (holding at least 10% of the voting power) or related entities as deemed dividends if the company has accumulated profits. If the company does not have any accumulated profits, then loans or advances will not be treated as deemed dividends, and no tax will be levied on the shareholder.
• Without the correct calculation of accumulated profits, it would be difficult to ascertain whether the company has sufficient profits to treat a loan as a deemed dividend.

b. Tax Implications for Shareholders

• If the loan is treated as a deemed dividend, it will be taxable in the hands of the shareholder as income from other sources. The shareholder will need to include the deemed dividend amount in their income and pay tax according to their applicable tax bracket.
• If the accumulated profits are incorrectly calculated or overlooked, a taxpayer could be subjected to tax on amounts that are not truly available for distribution.

c. Avoidance of Tax Evasion

• One of the key objectives behind Section 2(22)(e) is to prevent tax evasion. Shareholders may attempt to draw funds from a company in the form of loans or advances, bypassing the requirement to pay taxes on dividends. By linking loans to the presence of accumulated profits, the law ensures that only companies that have profits available for distribution can provide loans that are treated as deemed dividends.

d. Ensuring Fairness and Consistency

• By establishing a clear mechanism to determine accumulated profits, the law ensures that the treatment of loans as deemed dividends is consistent and based on accurate financial data.
• Calculating accumulated profits ensures that genuine business loans or advances that are intended for operational purposes (and not as a disguised dividend) are not taxed as deemed dividends. It allows companies and shareholders to operate within the scope of the law while avoiding unwarranted tax burdens.

4. How Are Accumulated Profits Calculated?

Accumulated profits are calculated by considering the profits that a company has retained over the years after paying taxes, dividends, and other distributions. The following components are considered in the calculation:

1. Net Profit (after tax) as per the company’s financial statements.
2. Adjustments for Depreciation: Depreciation, being a non-cash charge, reduces the book profits of the company. The Telangana High Court, in a landmark ruling, clarified that accumulated profits should be computed after adjusting for depreciation.
3. Reserves and Surplus: Any special reserves or capital surplus that have been retained in the company and have not been distributed as dividends are also part of accumulated profits.
4. Past Dividends Paid: Dividends that have been paid out in previous years reduce the accumulated profits available for distribution.

5. Recent Judicial Developments

The Telangana High Court has made it clear that depreciation adjustments must be considered when calculating accumulated profits for the purpose of Section 2(22)(e). This decision emphasizes that accumulated profits should reflect the company’s true financial position and should not be overstated by failing to account for depreciation.

This ruling is significant as it ensures that the company’s true financial health is considered before applying Section 2(22)(e), which in turn helps prevent incorrect assessments of deemed dividends.

6. Summary

The calculation of accumulated profits under Section 2(22)(e) is crucial for determining whether a loan or advance made by a closely held company to its shareholder (or related party) is treated as a deemed dividend and thus subject to tax. The primary purpose of this provision is to ensure that companies cannot distribute profits under the guise of loans or advances without paying the appropriate taxes on them.

By accurately computing accumulated profits, considering necessary adjustments such as depreciation, companies can ensure compliance with tax laws while also avoiding unnecessary tax liabilities.