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What is deemed dividend?

Dividend refers to the returns a shareholder receives for investing in a company.

For example, let us say that Company ‘A’ is making sound amounts of net profit and wants to distribute the profits with its shareholders, The board of the company decides to give 3% returns per share to every shareholder. Each share unit costs Rs. 100, so for every share the shareholder receives Rs. 30, this amount is called ‘Dividend’.

Whereas, the deemed dividend is a particular amount or asset loaned to a shareholder who has a substantial share in that company, for the purpose of taxation the loaned amount is considered to be ‘deemed dividend’. The loan or advancement amount should only be provided from the accumulated profits of the company. It is to be noted that only private limited companies whose activities are not of public’s substantial interest are eligible for Deemed Dividend.

What is substantial interest in a company?

When a shareholder holds at least 10% of shares and 10% of the voting interest in a company, he is said to have a substantial interest in that company.

How does deemed dividend work?

Let us say that Mr. X is a shareholder of company ’Z’, He holds shares worth 20%. As of April 10, 2020, Company Z has an accumulated profit of Rs. 5,00,000. Now, Mr.’X’ approaches the board to request a loan of Rs. 1,00,000. Mr.’X’ being a shareholder having substantial interest in company Z, the board agrees to loan him Rs. 1,00,000, after a month i.e, on May 10th. Mr. X returns the loaned amount back (which is before the end of the current financial year), although Mr. X has returned the amount, Rs. 1,00,000 made from the accumulated profits, the loaned amount will be treated as ‘Deemed Dividend’.

Deemed dividend in the income tax act

Section 2(22)e of income tax act deals with how the types of loans and advances that the company makes for the shareholder is treated as deemed dividend. The following are the payment methods that are considered to be deemed dividend under this act,

  • Payments of loans, or lending assets to a shareholder who has a substantial interest in that company are treated as a deemed dividend, such amount must be given only from accumulated profits.
  • Loans extended to a parent company by a subsidiary company from accumulated profits.
  • Advances made by the company to its shareholders to install plant & machinery that enables him to exercise an export order.
  • Personal payments of shareholders made by the company will also be treated as deemed dividends.
  • Any loan given to the employee to indirectly benefit the director of the company.

Exceptions to deemed dividends

Few transactions, although has the nature of lending advances, are not treated as a deemed dividend, such as,

  • Loans and advances received by shareholders out of the share premium account can not be treated as deemed dividends.
  • Loans given by companies whose nature of business is money lending.
  • Loans adjusted as dividend declared and distributed.
  • The paying company can not be the one, where the public are substantially interested
  • Loans given to shareholders who do not have a substantial interest in the company.

How Deemed Dividend is treated under the Income-tax Act?

Before April 2018, deemed dividends were exempted from being taxed under dividend distribution tax. For the financial year 2018-19, deemed dividends made to shareholders were taxed.

Deemed dividends are subject to 30% dividend distribution tax for the company under section 2(22)e of the income tax act, but the tax is exempted for the shareholder.

Therefore, for deemed dividends paid to shareholders, the company will be taxed 30% of the loan amount, even though the loan amount has been settled by the shareholder in the same financial year.