Deemed dividend provisions are not applicable if significant part of the overall business is money lending

 

 

Introduction

The concept of Deemed Dividend under the Income Tax Act, 1961 envisages taxing of disbursements made by closely held companies by way of loan or advances to its shareholders holding ten per cent or more or to a company in which such shareholders are substantially interested. Whenever any amount is received as loan or advance by such shareholders from closely held companies, they would be liable to tax on the amount received as deemed dividend under section 2(22)(e) of the Income Tax Act, 1961. A shareholder will be liable for tax on the amount received from closely held companies albeit the loan or advance from the company for legitimate commercial business purposes. Recently, the Bombay High Court considered the concept of deemed dividend in the case of CIT v. Parle Plastics Limited (ITA No. 37 of 2002) and held that deemed dividend provisions are not applicable if

money lending business is a significant part of overall business of the lender company. An attempt has been made to analyze the ratio of the decision vis-à-vis deemed dividend provisions of the Income Tax Act.

Analysis of Section 2(22)(e) of the Act

In order to curb tax evasion, the concept of deeming certain payments or loans or advances to the shareholders who are substantially interested as income was introduced in the year 1987. Section 2(22) has five sub-clauses which lists several disbursements and payments made by the closely held companies. Section 2(22)(e) of the Act is applicable to companies in which public are not substantially interested that is closely held companies. This section is not applicable to listed companies, government companies, section 25 companies, mutual benefit finance companies declared by Central Government to be a Nidhi or Mutual Benefit society, companies in which one or more co-operative societies hold at least 50% voting shares throughout the year, etc. Here, the shareholder includes a corporate entity too.

The section 2(22)(e) of the Income Tax Act, 1961 deals with 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, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares and not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits, holding not less than ten percent 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 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.

Recent Case

Very recently, the Bombay High Court considered the question of deemed dividend in the case of CIT vs. Parle Plastics Limited (ITA No. 37 of 2002). In the case, the Court held that the provisions of deemed dividend shall not apply to a company whose significant part of overall business is money lending. In this case, the Court further held that the word ‘substantial’ used in the exclusions to the provision of deemed dividend does not mean a major part of more than fifty per cent. The Court also held that several factors like turnover, capital employed, profitability, manpower employed etc are need to be considered for determining whether a part of business is substantial to the overall business of the company.

Parle Plastics Limited is a company and taxpayer, engaged in the business of manufacture of plastic caps for packaged water bottles that are manufactured and distributed by Aqua Minerals Private Limited. Aqua Minerals Private Limited, who was in the business of production, sale and distribution of soft drinks, aerated water and mineral water and the taxpayer company engaged in the supply of plastic caps to them. Both the companies have common shareholders. They held 74 per cent shares in the taxpayer company and 66 per cent shares in Aqua Minerals Private Limited. The taxpayer company viz. Parle Plastics Limited had obtained unsecured loan from the Aqua Minerals Private Limited. In the assessment of taxpayer company, unsecured loan received from the above Aqua Mineral Private Limited was considered and taxed as a deemed dividend under section 2(22)(e) of the Income Tax Act, 1961.

Contentions of the parties in the case

The taxpayer company contended that lending of money by Aqua Minerals Private Limited was falling under exclusions provided under section 2(22)(ii) of the Income Tax Act, 1961 and hence it was expressly excluded from the ambit of section 2(22)(e) of the Income Tax Act, 1961 as deemed dividend. The department contended that the money lending was not a substantial part of Aqua Minerals Private Limited and consequently, the taxpayer company cannot be entitled to claim exemption under clause (ii) of sub-section(2) of section 2 of the Income Tax Act, 1961. Further the department contended that for consideration of money lending activity as a substantial part of the business of the lending company, the business of money lending must constitute more than 50 per cent of the business of Aqua Minerals Private Limited, a lending company.

Bombay High Courts’ verdict

The Court held that the taxpayer company’s business was complimentary to the business of Aqua Minerals Private Limited. It is common for a manufacturer of a product to grant advances to the suppliers of raw material or other parts used by the producer in production of its products. Such advances are commonly made in the usual course of business. The term ‘substantial part’ does not mean a ‘major part’ of more than fifty per cent that constitutes majority of the whole business. In order to determine, whether a part of business is substantial to overall business of the company, several factors such as turnover, profitability, capital employed, manpower used etc are to be taken into consideration. Further the Court taken into consideration that Aqua Minerals Private Limited had invested around 40 percent of the total assets into the business of lending which was a significant part of its business. The Court also recognized the intention of the word ‘substantial’ used in the section 2(22) of the Income Tax Act, 1961. The legislature had intentionally used the word ‘substantial’ instead of using other words like ‘major’ with specified percentage of the business or profit to be coming from the lending business of the lender company for the purpose of clause (ii) of Section 2(22) of the Act. Any business of a company which the company does not regard as small, trivial, or inconsequential as compared to the whole of the business is substantial business.

After considering the submissions of the tax payer company and the department, the Court held that money advanced by the Aqua Minerals Private Limited to the taxpayer company could not be treated as deemed dividend under section 2(22)(e) of the Income Tax Act, 1961 as money lending business was a significant part of the overall business of the aforesaid lender company in terms of exemption under section 2(22)(ii) of the Income Tax Act, 1961.

Conclusion

This is a one of the important rulings given by the Bombay High Court on deemed dividend under Income Tax law. In the verdict, the court held that the expression ‘substantial part’ was defined in the Act and about forty per cent of the total assets of the company were deployed in the business of lending and consequently, the lending was a significant part of overall business. Further, the Court held that the companies engaged in the business of money lending are exempt from deemed dividend provisions.