Deemed dividend in case of closely held companies

DEEMED DIVIDEND
The concept of Deemed Dividend under the Income-tax Act, 1961(the Act) is not new. However, time and again many closely held company assessees and their controlling shareholders, to their surprise and dismay, realise very late the importance of this powerful taxing tool in the hands of the Assessing Officer.
The concept of Deemed Dividend is embedded in Section 2(22)(e) of the Income-tax Act, 1961 and was also embedded in section 2(6A)(e) of the Indian Income-tax Act, 1922. In nutshell, the concept envisages taxing certain payments made by closely held companies by way of loans or advances to certain shareholders of the company or to the concerns/companies in which they have substantial interest. Whenever any payment is made by way of loan or advance, the recipient of the loan or advance will be liable to be taxed on this amount as a dividend, to the extent to which the company has accumulated profits, under the deeming provisions of section 2(22)(e) although such loan or advance may have been given for genuine business purposes and even if the paying company may have received back the loan amount. Thus the section deems certain payments as dividend income which is not income under ordinary commercial parlance. Therefore,the name Deemed dividend.
The concept of deeming certain payments or loans or advances to substantial shareholders as income was introduced with the object of curbing tax evasion. Upto 31-5-1997 dividend was taxed in the hands of the recipient of the dividend. However many closely held companies never declared any dividend and accumulated profits in the company itself. Since no dividend was declared the same could not be taxed. However the companies did give loans or advances to substantial shareholders or to their concerns/companies who presumably enjoyed these funds but were not liable to pay any tax on the same as the amounts were loans or advances liable to be returned. These amounts of loans or advances are sought to be taxed as dividend by section 2(22)(e) of the Act by way of a deeming fiction..
Taxation of dividend under Income-tax Act, 1961 has undergone substantial changes in recent times. Effective from 1-6-1997 the scheme of taxation of dividend has been modified and is different from the old scheme . The essence of the old scheme was that the recipient of the dividend income was liable to pay the income-tax on the same, subject to certain exemptions. The new scheme essentially makes the dividend tax-free (section 10(33) of the Act) in the hands of the recipient (except cases covered under section 2(22(e)of the Act) and the dividend paying company has been made liable to pay tax on the amount of dividend declared , distributed or paid by it (Section 115-O of the Act). This tax is over and above the corporate income-tax which a company would normally pay. However there is no change in the scheme of taxation of Deemed Dividend contained in the section 2(22) (e) of the Act and such dividends are governed by the old scheme of taxation of dividend i.e. tax on deemed dividend is paid by the recipient and the paying company does not have to pay dividend tax but will be liable to deduct tax at source from such loans or advances/deemed dividend and pay the same to the Government.