International Tax & Transfer Pricing aspects of Deemed Dividend u/s 2(22)(e)

Background

The Income Tax Act, 1961 (‘the Act’)¹ provides for charging of tax on the Income of a taxpayer. Section 2(24) defines “Income” which includes “Dividend” in its ambit.

Dividend is defined in Section 2(22) of the Act which also includes income that shall be deemed as Dividend. One of the categories covered under Section 2(22) is Deemed Dividend on account of loans to shareholders. Clause (e) of Section 2(22) provides that—

Analysis of Statutory Elements

The above deeming fiction has certain key elements for application:

1. The payer of Loan should be a company in which the public is not substantially interested.
2. It should be a loan or an advance granted by the payer company (lender) to the receiver company (borrower).
3. The taxation shall be to the extent of accumulated profits of the payer entity.

Further, a key element under consideration for Deemed Dividend taxability is the identification of the taxable entity for loan granted, i.e., either the Borrower entity or the Shareholder, under Section 2(22)(e). Based on a cursory perusal of the aforesaid section and for the ease of understanding, it can be broadly divided into two scenarios:

From a bare reading of the above section, it can be noted that the above section applies if BOTH conditions are satisfied:

1. Loan is given to a concern (borrower company) in which the shareholder of the lender company is also a MEMBER.
2. Such shareholder of the lender company holds substantial interest viz. 20% or more voting power in the borrower company.

If the above conditions are fulfilled, the loan granted to the extent of accumulated profits of the lender company is considered deemed dividend liable to taxation.

Taxpayer for Deemed Dividend u/s 2(22)(e)

While Scenario A is quite clear (i.e., taxability should arise in the hands of the shareholder who is also a borrower of a loan), a pertinent question to evaluate in Scenario B is in whose hands shall such deemed dividend be taxable viz. (A) Borrower concern (Company C) or (B) Shareholder (Company A):

• View-1: CBDT Circular No. 495 dated 22 September 1987 supports taxation in the hands of borrower concern, viz. Company C.
• View-2: The Special Bench of the Mumbai Tribunal in the case of Bhaumik Colour (P) Ltd.² held that in the absence of indication in Section 2(22)(e) of the Act to extend the legal fiction to a case of loan or advance to a non-shareholder, loan or advance cannot be taxed as deemed dividend in the hands of such a non-shareholder. The decision of the Special Bench has been affirmed by the Bombay High Court in Universal Medicare (P) Ltd.³ and the Delhi High Court in Ankitech Private Limited⁴.
  
  The Supreme Court in Madhur Housing and Development Company⁵ provides a view on this controversy and held that a deemed dividend is not taxable in the hands of a loan recipient concern if such concern is not a shareholder of the lender company. It is taxable in the hands of shareholders having substantial interest in both the entities.
  
  Recently, the Ahmedabad Tribunal in the case of Aaryavart Infrastructure P. Ltd⁶ held that deemed dividend under Section 2(22)(e) of the Act is taxable only in the hands of the shareholder and not the recipient of loan/advance.

Thus, View-2 is a better view providing taxability in the hands of the common shareholder. However, if the taxpayer is desirous of having taxability in the hands of the borrower concern, it can rely on the circular.

Tax Treaty Interaction for a Non-Resident Shareholder

OECD Model Tax Convention⁷ provides for the following definition of Dividend (divided in two parts for ease of analysis):

Section 2(22)(e) uses the expression ‘by way of advance or loan’. It is pertinent to examine the meaning and scope of the terms ‘loan’ & ‘advance’:

• Loan: Black’s Law Dictionary defines ‘loan’ as “an act of lending, a grant of something for temporary use, a sum of money lent at interest.”
• Advance: In the same dictionary, ‘advance’ is defined as “a payment made in anticipation of a contingent or fixed future liability or obligation.”

Based on the above definition, participation in profit is a pre-condition to term it as Dividend under the Tax Treaty and excludes debt-claims viz. Loan or advance. Thus, it is not covered in the first part of the definition.

There are two possible views for the Second part (“other income subjected to the same taxation treatment as income from shares”):

• View-1: Income is not defined in the Tax Treaty; reference is made to Section 2(24) which includes Section 2(22)(e). Thus, it falls under the “Dividend” Article in the Tax Treaty.
• View-2: Though Income is defined in Section 2(24), the term used in the treaty is “Income from Shares”. Deemed dividend under Section 2(22)(e) is per se not an income from shares, but income because of holding a certain percentage of shares in both entities. This additional condition is not envisaged in the tax treaty.

Under Article 31 of the Vienna Convention on the Law of Treaties (VCLT), treaties must be interpreted in good faith according to ordinary meaning. Furthermore, in Indian jurisprudence, ‘Distribution’ and ‘Payment’ have distinct legal connotations:

Thus, it can be concluded that such a loan transaction does not get classified as a dividend under the Tax Treaty. Consequently, it falls under Article 21 (“Other Income”) if not effectively connected with a Permanent Establishment (PE).

Transfer Pricing Aspects

Consider Scenario B where a loan is granted to a related foreign entity having a common shareholder, and the lender is an Indian entity. Key issues include:

1. Reporting it as ‘Dividend’ vs ‘Loan’.
2. Which entity’s name is to be reported — the Common Shareholder or the Borrower Concern.

Analysis of Reporting Requirements in Form 3CEB

Under Section 92B(1)(c) of the Act, international transactions include capital financing, lending, or any debt arising during the course of business. Hence, a loan to an Associated Enterprise (AE) must be reported in Form 3CEB at Arm’s Length Price (ALP).

Section 2(22)(e) deems a loan to be a dividend as a legal fiction. However, well-settled principles establish that a legal fiction cannot be extended beyond its intended scope:

• Bengal Immunity Co. Ltd. v. State of Bihar¹⁰ — Legal fictions are created for definite purposes and must be limited to that legitimate field.
• CIT v. Mother India Refrigeration Industries (P.) Ltd.¹¹ — Confirmed that legal fictions must be confined to the purpose for which they are enacted.
• CIT v. C.P. Sarathy Mudaliar¹² — The Supreme Court held that deemed dividend is an artificial definition and not a real dividend. The loan must be repaid and does not become shareholder income in reality; therefore, it requires strict construction.

Therefore, the accounting reality is a loan, and it should be reported as a Loan to an AE in Form 3CEB.

Secondary Adjustment on Deemed Dividend u/s 92CE

Under Section 92CE(2), if a secondary adjustment is not repatriated to India within the prescribed time, it is deemed to be an advance to the AE carrying notional interest.

• View-1: Reading Section 92CE with Section 2(22)(e) together creates a potential litigation risk where the deemed advance is characterized as a deemed dividend.
• View-2: Section 92CE creates a distinct statutory fiction/presumption solely to charge notional interest. As ruled by the Supreme Court in M/s. Bhuwalka Steel Industries Ltd. v. Union of India¹³:
  • Fiction: Assumes something known to be false.
  • Presumption: Assumes something that may possibly be true and may be rebutted by evidence.

Conclusion

Deemed Dividend under Section 2(22)(e) is a specialized anti-avoidance provision that frequently gives rise to litigation. With India emerging as the 3rd largest global economy and a primary supply chain hub attracting substantial foreign direct investment, the interaction between domestic deeming fictions, International Tax treaties (DTAAs), and Transfer Pricing will play an increasingly pivotal role. Clear guidelines and administrative certainty from the Government will be instrumental in mitigating disputes and bolstering investor confidence.