The Interconnect

Deemed dividend related issues: The Companies Act and accounting dimensions

Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
Feb 23, 2018

The Finance Bill, 2018, has made several amendments which are in the nature of anti-avoidance provisions or to nullify Court decisions, the latter being a very unfortunate trend. The focus of this article is to deal with the amendment made in the Dividend Distribution Tax(DDT) Chapter (XII – D), the combined effect of which is to bring deemed dividend of the nature contemplated in Section 2(22)(e) within the purview of Dividend Distribution Tax (DDT) and the amendment made in Section 2(22) to deal with certain aspects of “accumulated profits” in the context of a merger; as the intent of this column has always been, an attempt is also made to link up these tax provisions with certain non-tax provisions, so that an integrated view is achieved.

Loans and Advances by company to shareholder and related parties


As readers are aware, the provision of 2(22)(e) deal with loans and advances given by a closely held company to shareholders (holding not less than 10% of voting power) or to any concern in which such shareholder is a member or partner and in which he has a substantial interest i.e. 20% or more. Such loans and advances have been outside the purview of DDT, but are taxable in the normal course. However, taxability of loans advanced to the latter category (i.e. concern in which shareholders have substantial interest) has been the subject matter of controversy for quite some time and the controversy has been as follows: should the amount of the loan or advance be taxable in the hands of the shareholder (who has not received the loan or advance) or the concern which has got the loan and advance, which concern is not a shareholder? This controversy culminated in a decision of a Supreme Court in the case of Madhur Housing and Development company, wherein the Supreme Court, vide a decision dated 5th October,2017 upheld the decision of the Delhi High Court in the case of Ankitech Pvt. Ltd.; in the latter decision, the Delhi High Court held that the intention behind Section 2(22)(e) is to tax dividend in the hands of the shareholders and the concern which has received the loans or advances was not a shareholder and therefore, cannot be taxed; the shareholder has not received the dividend and therefore, also cannot be taxed.

The Amendment

It is the above Supreme Court decision that has been sought to be nullified by the amendment sought to be made by the Finance Bill 2018 in Section 115-O and the explanation to Chapter XIID; the latter is the explanation to the entire Chapter XII – D, which explanation seeks to exclude the dividend referred to any section 2(22)(e) from the scope of the DDT chapter; the Finance Bill 2018 seeks to omit the explanation and therefore, brings such kind of deemed dividend within the scope of DDT. The amendment to Section 115-O seeks to increase the rate of DDT on such 2(22)(e) dividend to 30%, instead of 15% (effectively this would mean almost 35%, including surcharges and cesses).

Implications and Interconnect with the Companies Act,2013

From a tax perspective, as mentioned above, this is unfortunate since not only does it seek to nullify the Supreme Court decision, but also puts an unjustified burden on a company which has given the loan to pay 35% tax on top of the loan. (there is also no clarity on what happens if the loan is repaid.) In any case, attention to readers is also drawn to the provisions of the Companies Act, and particularly Section 185, which seeks to regulate loans to related parties; the context is that it is important to understand whether such loans can be given in the first place. The Companies Act, 2013, over the last 4 years has been liberalised several times, to partly reduce some over stringent provisions, and one of such important liberalisations came as a result of the Companies (Amendment) Act, 2017.The Amendment Act, 2017, which, amongst others, has sought to amend the provisions of Section 185 which hitherto have been even more restrictive, its amended form, the provision still prevents the company from giving a loan to a Director or firm in which the Director or relative is a partner. However, in relation to a company in which a director is a director or member, there has been a liberalisation which permits such a loan, subject to a special resolution by the lending company in a general meeting (with significant details in the explanatory statement to the notice of the meeting) and further subject to the condition that the loans are utilised by the borrowing company for its principal business activity, (it may be pointed out that the second condition of the utilisation is strange, in the sense that the lending company cannot control the use by the borrowing company and perhaps, it might have been better to mention that the loan is given for the purpose of the borrowing company’s business.)

In any case, the key issue is that regardless of the amendments sought to be made by the Finance Bill, there continues to be restriction in the Companies Act for the granting of such loans or advances and it is important to interconnect these provisions, as opposed to look only at the tax provision treatment of “accumulated profits” in the context of amalgamation.

Amalgamation and Treatment of Accumulated profits

Backdrop & Amendment:

The second relevant issue which is the focus of this article is the related treatment of “accumulated profits” wherein what is sought to be amended is the characterisation of all profits in the books of the amalgamating company. It appears that the purpose of this amendment is to transition the characterisation of all profits into the amalgamated company; in case of a non IndAS company, it is possible to characterise such accumulated profits as capital reserves through the mode of accounting all under the purchase method under AS14.

The intent appears to be that if a dividend is declared by the amalgamating company the recharacterisation into capital reserve would bring such distribution out of the scope of the dividend taxed in the absence of accumulated profits. While there may not have been several cases like this, there have been a few and this appears to be an anti-avoidance measure which has been sought to address the few outlier cases.

Some related aspects:

Even from a pure tax perspective, assuming that dividend declared by the amalgamating company is not liable to DDT due to the absence of accumulated profits, it would be liable to tax as capital gains subject to quantum of dividend declared qua the cost (unless the shareholder is from a capital gains treaty friendly country, such as Singapore or Mauritius and is covered by the grandfathering clause by investments made till 31st March 2017);in that context, the amendment seems to be taxing a very narrow funnel.

In a non IndAS scenario( i.e. companies not covered by Business Combination Standard IndAS103), such accounting treatment under the purchase method may not even be possible because usually the amalgamation would be with a related party and that would require the business combination/amalgamation to be as per the pooling of interest method as per Appendix C to IndAS103. Accordingly, this may not even apply in a majority of the cases under the IndAS scenario.

Summing Up:

To conclude, one amendment has clearly been made to neutralise a Supreme Court decision, but Companies Act may prevent the giving of such loans in the first place; in the second situation, it seems to be intended to address outlier situations, and in any case, may not have much relevance qua companies covered by IndAS; it would, of course, hit a planning avenue which would have applied to a limited number of situations.

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