Overview On Deemed Dividend: Section 2(22)(e) Of The Income Tax Act

Generally, returns that an investor earns by buying shares of a company are called “dividends.” However, there is another category called “Deemed Dividend” that falls under the confines of “dividends” for the purpose of taxation.

Deemed dividends, like other dividends, are also a type of income that a shareholder receives, but they are distributed by closely held companies. Thus, only private companies with no substantial interest from the public can offer them.

Section 2(22)(e) of the Income Tax Act discusses the various rules regarding the taxation of deemed dividends. Keep reading to gather in-depth knowledge about this unique class of dividends.

What is Deemed Dividend under Section 2(22)(e) of the Income Tax Act?

A particular amount/asset loaned or extended in advance to a shareholder, who has a substantial stake in the company, is called a deemed dividend.

Under Section 2(22)(e) of the Income Tax Act, a payment is considered deemed dividend when a closely-held company gives —

A loan to a shareholder with a substantial interest in a company, i.e., one that holds at least 10% of the voting power. However, the shares that the investor owns should not qualify to receive a fixed rate of dividend
A loan or advance to a company or any business concern in which the shareholder is a member and has a substantial stake
An advance or loan to a shareholder for their individual benefit
A loan to a shareholder for the benefit of a company’s director

Loan or advance to a parent company
The deliverance of all the above-mentioned loans or advances should be during the year under consideration.

Note that this loan amount, or advance, needs to come from the company’s accumulated profits only. Furthermore, companies extending these loans should not be listed on a stock exchange.

Exceptions under Section 2(22)(e) of the Income Tax Act

There are a few transactions that might appear to fall into the category of “deemed dividend.” But when it comes to taxation, we cannot treat them as deemed dividends. Here are a few exceptions:

Loan or advance given to a shareholder out of the share premium account of a company
When a money lending company offers loans under the natural course of business.
Loans given to shareholders that are later adjusted upon declaring dividends and distributed
When a company providing loans is publicly trading and has substantial interest from the public

Loans given to shareholders who holds less than 10% of voting rights in the company
Any payment made by a company to buy back its own shares
Transactions that acts as an inter-corporate deposit
Any loan given during previous years and not in the current year

Also Read: A Comprehensive Guide On Forthcoming Mutual Fund Dividends

How Does Deemed Dividend Work?

The unique placement of deemed dividends in the general category of “dividend” makes it puzzling to understand how these loans/advances work. Additionally, the multiple inclusions and exclusions within this category make this task more confusing.

Thus, let’s take an example to understand the provisions of deemed dividends in a simple manner.

Let’s say ZYX Pvt. Ltd. is a closely-held company. Shweta is one of the company’s shareholders; she holds 20% of the shares.

As of April 31 2021, the company’s accumulated profits stood at Rs. 30 lakh. For a personal reason, Shweta needed a loan of Rs. 3 lakh and presented her request to the company’s board members. Due to her substantial interest in ZYX Pvt Ltd, board members approved her loan request.

After two months, on June 31 2021 (same financial year), Shweta returned the loan amount.

Note that as long as a company pays a shareholder through the accumulated profits, this loan will fall under deemed dividends.

Taxability of Deemed Dividend under the Income Tax Act

Generally, companies that offer dividends have to pay a Dividend Distribution Tax (DDT). Due to this, the recipient paid no taxes on these dividends. Before April 2018, companies that offered deemed dividends did not have to pay DDT.

However, the Union Budget of 2018 made amendments to Section 115-O of the Income Tax Act. Since the financial year 2018-19, it was made mandatory for every company to pay DDT at the rate of 30% (plus surcharge and cess) on every deemed dividend.

This amendment took place keeping in mind that closely-held companies could hide dividends in the form of loans or advances. Nonetheless, shareholders did not face any responsibility for paying this tax. Yet, they still had to pay nominal tax on the deemed dividend that they received.

That said, in Budget 2021, DDT was abolished; dividend income is now taxable in the hands of shareholders.

Also Read: Long Term Capital Gains From Mutual Funds

Final Word

Deemed dividend is a profitable way for a closely held company to offer loans or advances to shareholders with substantial interest. However, if you are thinking of obtaining deemed dividend, you should pay attention to the complex eligibility and taxation rules that govern this category of dividend.

Frequently Asked Questions

1. Can I get tax exemption on deemed dividends?

Unlike other dividends mentioned in Section 2(22) of the Income Tax Act, deemed dividends don’t offer tax exemptions. Thus, a shareholder has to pay a nominal tax on the loan or advance that they obtain from a closely held company.

2. What is Dividend Distribution Tax?

Dividend Distribution Tax is a tax levied on the profits that an Indian company distributes among its shareholders. As per Section 115-O of the Income Tax Act, companies had to pay a DDT of 15% on the dividend amount. However, DDT was 30% in the case of deemed dividend. In Union Budget 2021, DDT was abolished.

3. What is the meaning of surcharge and cess?

Surcharge and cess are the types of taxes that the government collects along with income tax. These two perform different functions. Cess is applicable for a particular reason and is charged at a rate of 4%. Meanwhile, surcharge acts as an extra fee and is collected from taxpayers in the higher income slab.

4. How did deemed dividends get their name?

Even though deemed dividends do not perform the same role as general dividends, they fall under this category. They get their name from the fact that Section 2(22)(e) of the Income Tax Act deems specific transactions/payments as dividend income.

5. What is the difference between capital gains and dividends?

A dividend is a payout that shareholders receive when a company distributes its profit. The shareholders do not have to sell their shares in the company to obtain dividends. Meanwhile, to obtain capital gains, an investor has to sell the capital assets.

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