Demed Dividend — Loans or Advances to Related Concerns

Dividend is an income under the Income-tax Act, 1961. The term ‘dividend’ is inclusively defined in section 2(22), vide five clauses, (a) to (e). These clauses primarily provide for treatment of certain distribution or payments, by the company, as dividend to the extent of the accumulated profits of the company. Clause (e) provides for payment of certain loans and advances by a company to a certain category of shareholders or for the benefit of this category of shareholders, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (popularly referred to as ‘deemed dividend’). This clause reads as under:

“(e) any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) 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 10% 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 (hereafter in this clause referred to as the said concern) or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent to which the company in either case possesses accumulated profits;”

These loans or advances to the specified shareholders or for the benefit of such shareholders or to the concerns in which such shareholders are substantially interested, are therefore taxable as dividend. Such dividend is not subject to the dividend distribution tax u/s.115-O, and is therefore a taxable income, not exempt u/s.10(34) of the Act.

In cases of payments of loans and advances to the specified concerns, the following questions have arisen before the courts in the recent past, in interpretation of this provision, namely, (a) whether the dividend under this clause is taxable in the hands of a shareholder or in the hands of the concern receiving the loan; (b) should the person being taxed be the registered as well as the beneficial shareholder; and (c) whether in cases of the fiduciary holding, the recipient can be taxed even where he is not the registered owner of the shares by presuming the recipient concern to be the shareholder. While the Bombay High Court had approved the decision of the Special Bench of the Tribunal that the dividend be taxed in the hands of the shareholder, only and not in the hands of the concern and further that the shareholder has to be both a registered shareholder as well as the beneficial shareholder, recently the Delhi High Court in a dissenting decision has taken a different view of the matter, holding that such dividend is taxable in the hands of the concern receiving the loan or advance where the firm is a beneficial shareholder, not following its own decision in an earlier case.

Universal Medicare’s case The issue came up before the Bombay High Court in the case of CIT v. Universal Medicare Private Limited, 324 ITR 263.

In this case, an amount of Rs.32 lakhs was transferred from the bank account of one company to the bank account of the assessee-company. One of the directors held over 10% of the equity capital of the company, which transferred the funds and also held over 20% of the equity capital of the assessee-company. This transfer was part of a misappropriation by a senior employee, who had opened bank accounts and carried out certain transactions to defalcate funds.

The assessee claimed that the amount was neither an advance nor a loan to the assessee, but represented misappropriation of funds by the senior employee. Alternatively, it was forcefully contended that, even assuming that this was an amount advanced to the assessee, for the purposes of taxation, the deemed dividend would be taxable in the hands of the shareholder and not in the hands of the assessee to whom the payment was advanced. The Assessing Officer concluded that the section 2(22)(e) provided for taxation in the hands of the recipient company and that they were attracted the moment a loan or advance was made and that subsequent defalcation of funds was immaterial. Noting that all the requirements of section 2(22)(e) were fulfilled, the Assessing officer concluded that the loan was to be treated as deemed dividend in the hands of the recipient company and not in the hands of the shareholder director.

The Commissioner (Appeals) affirmed the order of the Assessing officer. The Tribunal reversed the findings of the Commissioner (Appeals) on the reasoning that the amount was taxable in the hands of the shareholder director and not in the hands of the assessee-company and also on the fact that the amount was part of a fraud committed, and that the transaction was not reflected in its books of accounts of the company.

The Bombay High Court analysed the provisions of section 2(22)(e), and observed that the clause was not artistically worded. It noted that Parliament had expanded the ambit of the expression ‘dividend’ by providing an inclusive definition. It noted that the payment by a company had to be by way of an advance or loan. On facts, it noted that the Tribunal had found that no loan or advance was granted to the assessee-company, since the amount in question had actually been defalcated and was not reflected in the books of account of the assessee-company. According to the Bombay High Court, this was a pure finding of fact which did not give rise to any substantial question of law.

The Bombay High Court, on law, concurred with the construction placed on the provisions of section 2(22)(e) by the Tribunal. It held that all payments by way of dividend had to be taxed in the hands of the recipient of the dividend, namely, the shareholder; that the effect of section 2(22) was to provide an inclusive definition of the expression ‘dividend’ and clause (e) expanded the nature of payments which could be classified as dividend; that looking at the different types of payments covered by this clause, the effect of clause (e) was to broaden the ambit of the expression ‘dividend’ by taxing the shareholder where certain payments were made by way of a loan or advance or payments on behalf of or for the individual benefit of such a shareholder and that the definition did not alter the legal position that dividend had to be taxed in the hands of the shareholder and consequently, even assuming that the payment was dividend, the payment was taxable not in the hands of the assessee-company, but in the hands of the shareholder.

National Travel Services’ case

In this case, the assessee was a partnership firm, having three partners. It had taken a loan of Rs.28.52 crore from a company, in which the assessee had invested in equity shares constituting 48.18% of the capital of the company. However, the shares were acquired in the names of two of the partners of the assessee.

Before the Delhi High Court, the assessee highlighted that the issue as to whether the person to whom the payment was made should not only be a reg-istered shareholder but a beneficial shareholder as well was concluded by the Delhi High Court in the case of CIT v. Ankitech Pvt. Ltd., (ITA No. 462 of 2009) and other cases, decided on 11th May 2011 (43-A BCAJ 327, June 2011 — full text available on www.itatonline.org), where the Court had held that the loan or advance could be taxed only in the hands of the shareholder, and not in the hands of the company receiving the loan or advance and had observed therein that the expression ‘shareholder, being a person who is the beneficial owner of shares’ referred to in section 2(22)(e) meant that the shareholder should be both a registered shareholder and a beneficial shareholder.

In addition, it was argued that for the purposes of income-tax, a partnership firm is different from its partners. A reference was made to various provisions of the Companies Act [including section 187(c) and section 153 read with section 147], and to SEBI guidelines on joint shareholding in respect of partnership firm, in support of the proposition that the partnership firm in its own right could be the shareholder as distinguished from the partners themselves. Reliance was placed by the assessee on the decision of the Allahabad High Court in the case of CIT v. Raj Kumar Singh and Co., 295 ITR 9, where the Court had held that the conditions stipulated in section 2(22)(e) were not satisfied where the assessee firm was not the shareholder of a company which gave the loan, but partners of the firm were its shareholders.

On behalf of the Department, it was argued that on first principles, under the Indian Partnership Act, a partnership firm was not a separate entity but was synonymous with the partners. It was argued that when shares were acquired by a partnership firm, for want of its own separate legal entity, the shares had to be bought in the names of partners, and in no case, shares could be held in the name of the partnership firm however, for all intended purposes, it was the partnership firm, which was the shareholder in such a case.

The Delhi High Court agreed that the person to whom the loan or advance was made should be a shareholder as well as beneficial owner and proceeded further to examine the question whether the assessee firm could be treated as a shareholder having purchased shares through its partners in the company, or whether the shareholder necessarily had to be a registered shareholder and hence the shares should have been registered in the name of the firm, itself. The Delhi High Court observed that if the assessee’s contention was accepted, a partnership firm could never come within the mischief of section 2(22)(e), because the shares would be necessarily purchased by the firm in the names of its partners since it did not have any separate entity of its own and the firm therefore could never be a registered shareholder.

According to the Delhi High Court, by requiring a firm to be a registered shareholder, the very purpose of enactment of this provision would be defeated, and this would lead to absurd results. The Delhi High Court observed that though a deeming provision had to be strictly construed, it had also to be taken to its logical conclusion by making the law workable and to meet that in case of the purchase of shares by the firm in the name of its partners, it was the firm which was to be treated as shareholder for the purposes of section 2(22)(e).

The Delhi High Court therefore concluded that a partnership firm was to be treated as the shareholder even if the shares were held in the names of its partners, and it was not necessary that the partnership firm had to be the registered shareholder. The loan received was held to be taxable as deemed dividends in the hands of the partnership firm.

Observations

The ratio of the decision in National Travel Services’ case where applied to the issues discussed here is that a person for being taxed has to be a registered and the beneficial shareholder so however in cases of the fiduciary ownership the beneficial owner can be presumed to be the registered owner even where he may not be the one. Such an assumption, found to be permissible in law by the Court, however makes no departure from the understanding held so far that the dividend under clause (e) can never be taxed in the hands of a specified concern where the concern is not holding any shares, beneficially or otherwise, in the capital of the company which makes the payment of the loan or advances. In cases where the payment is sought to be taxed on the basis of the common shareholder, the tax if any shall continue to levied in the hands of the shareholder only and not in the hands of the recipient concern. The ratio of the Court’s own decision in the case of Ankitech Pvt. Ltd. remains uncontroverted to that extent.

The Rajasthan High Court in the case of CIT v. Hotel Hilltop, 313 ITR 116 (Raj.), held that in the case of a payment of an advance by a company to a partnership firm, where a shareholder of the said company holding 10% or more of the shares of the company and who also had substantial interest in the said partnership firm, the amount of payment could not be taxed as a deemed dividend in the hands of the firm, but would be taxed in the hands of the individual, on whose behalf or for whose individual benefit, being such shareholder and partner, the amount was paid by the company to the partnership firm.

The Special Bench of the Income-tax Appellate Tribunal, in the case of ACIT v. Bhaumik Colour Pvt. Ltd., 313 ITR (AT) 146 (Mum., SB), has held that if a person is a beneficial shareholder but not a registered shareholder, or if a person is a registered shareholder but not the beneficial shareholder, then the provisions of section 2(22)(e) will not apply and in that view of the matter dividend u/s.2(22)(e) cannot be taxed in the hands of a concern where a certain shareholder is a partner with a substantial interest.

The decision of the Delhi High Court in National Travel Services’ case seems to be primarily applicable to cases of partnership firms owning shares in companies which shares are held in the names of their partners. As noted the decision does not seek to alter the understanding in respect of the loan or advances received by the firm where the firm does not hold any shares directly or indirectly through partners of the company in which case, it is only the shareholder who would be taxable i.e., a person who is the owner of the shares of the company and is also the partner of the firm and is otherwise the registered and the beneficial owner of the shares.

While the Delhi High Court has carved out an exception in the cases of partnership firms that own the shares of the company and such firms on account of the fact that partnership firms cannot hold the shares in their own names are holding the shares in the names of the partners. In doing so, the Delhi High Court has taken a view different from that of the Allahabad High Court and the Court in doing so has also not followed the ratio of the decision of the Allahabad High Court in Raj Kumar Singh and Co.’s case (supra).

The concept that the reference to the term ‘shareholder’ means registered shareholder has been laid down by the Supreme Court as far back as in the cases of CIT v. C. P. Sarathy Mudaliar, 83 ITR 170 and Rameshwarmal Sanwarmal v. CIT, 122 ITR 1, which was in the context of an HUF as the shareholder of a company. In fact, even earlier a similar view was taken by the Supreme Court in the case of Howrah Trading Co. Ltd. v. CIT, 36 ITR 215, in the context of taxation of dividends in the hands of a shareholder who had not lodged his shares for transfer, though he had acquired a beneficial interest in the shares. These decisions were rendered in the context of the law as it stood prior to the amendment by the Finance Act, 1987 made effective from 1st April 1988.

The provisions of section 2(22)(e) were amended with effect from 1st April, 1988, by the Finance Act, 1987. Prior to the amendment, only a loan or advance to a shareholder, being a person who had a substantial interest in a company, or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, was taxable as dividend. The amendment introduced the requirement of the shareholder being a beneficial owner of shares holding not less than 10% of the voting power, as well as extended the definition to concerns in which such shareholder was a member or partner, in which he has a substantial interest. This amendment also inserted the definition of ‘concern’ in explanation 3(a), to mean an HUF, or a firm, or an association of persons or a body of individuals or a company.

Does the insertion of this requirement of beneficial ownership of shares mean that the concept of registered shareholder is no longer relevant and therefore once a person is found to be a beneficial owner the dividend will be taxable in his hands, irrespective of the fact that he is not a registered shareholder? The Special Bench of the Income-tax Appellate Tribunal, in the case of ACIT v. Bhaumik Colour Pvt. Ltd., 313 ITR (AT) 146 (Mum., SB), has held that it is a principle of interpretation of statutes that once certain words in an act have received a judicial construction in one of the superior courts, and the Legislature has repeated them in a subsequent statute, the legislature must be taken to have used them according to the meaning which a Court of competent jurisdiction has given them. The Tribunal therefore held that the expression ‘being a person who is the beneficial owner of shares’ only qualifies the word ‘shareholder’ and does not in any way alter the position that the shareholder has to be a registered shareholder, nor substitute the requirement to a requirement of merely holding a beneficial interest in the shares without being a registered holder of shares. The Tribunal therefore held that if a person is a beneficial shareholder, but not a registered shareholder, or if a person is a registered shareholder, but not the beneficial shareholder, then the provisions of section 2(22)(e) will not apply.

The issue therefore is whether a partnership firm can be regarded as a shareholder in a company where the shares are held by the partners of the partnership firm for and on behalf of the firm. Similar can be the case where the shares are held by the karta of an HUF for and on behalf of the HUF and the trustee of a Trust for and on behalf of the Trust. Whether the shares are assets of the partnership firm or the individual assets of the partners would normally be determined based on how the firm and the partners have treated the assets — for instance, disclosure of the shares as assets of the partnership firm or the partners in their respective accounts, disclosure of the dividends as income of the partnership firm or the partners in their respective accounts, etc. While there may not be any dispute about the beneficial ownership of the firm over the shares, it is not possible to hold the firm as the legal owner in view of the corporate laws prohibiting the holding of shares in the names of the firm and in that view of the matter it is not possible to hold the firm as a registered shareholder and if that be so the dividend cannot be taxed in the hands of the firm and also not in the hands of the partners where the beneficial ownership is not with them.

The fact that a firm is specifically listed among the entities that are regarded as ‘concern’ indicates that the intention is also to rope in loans or advances to partnership firms, and to achieve that the payments to such concerns has to be taxed but will be taxed in the hands of such person who owns shares with certain percentage of voting rights and is also the partner holding a substantial interest in the firm. Dividend cannot be taxed in the hands of the firm in cases where the firm is not the owner of the shares as even the Delhi High Court does not suggest so. Where the firm is the owner of the shares it may not be taxable in its hands in view of the decisions referred to above. The ratio of the Delhi High Court decision therefore, if at all, applies only to a limited situation of a partnership firm, where the partnership firm treats the shares as its own assets, but the shares are held in the names of partners on behalf of the partnership firm.

Since the entire purpose is to tax dividends, and dividends can arise only to the shareholder, the better view of the matter is that it is only the shareholder who can be taxed, even if the advance is to a concern in which he is substantially interested, since the shareholder is deriving an indirect advantage or benefit through such concern.