The concept of deemed dividend postulates two factors, whether the payment is a loan and whether on the date of payment there is accumulated profit. Closely-held companies having accumulated profits in which substantial voting power lies in the hands of promoters may distribute accumulated profits as dividends to their shareholders. In such companies, it is for this group to decide whether the profits should be distributed or not. The declaration of dividends is entirely within the discretion of this group. Therefore, the Legislature realised that though funds are available with the company in the form of profits, the controlling group may not distribute this as dividends to the shareholders but adopt the device of parting with the profits by way of loan to its shareholders to avoid payment of tax on accumulated profits. The main reason for enacting Section 2(22)(e) of the Income-Tax Act, 1961 is to counter this device. This point was considered by the Supreme Court in C.I.T v. Mukundray. K. Shah (290 I.T.R 433). The facts in this case were that the assessee was shareholder in MKTPL, a private company, which paid Rs 5.99 crore to two firms, MKF and MKI, in which the assessee was a partner. During a search conducted under Section 132 of the I-T Act, apart from cash and jewellery a diary belonging to the assessee was seized. That diary indicated investment by the assessee of Rs 26.35 crore in 9 per cent. RBI Relief Bonds during the accounting year ending March 31, 2000.
The Assessing Officer found that the bonds were purchased from the money received from MKF and MKI in books of account of which they were shown to have received loans from a private company, MKSEPL, in which the assessee had considerable voting power. On the basis of the diary and the cash flow chart, the Assessing Officer assessed the sum as deemed dividend in the hands of the assessee under Section 2(22)(e). Search, the key The Appellate Tribunal, on appeal by the Department, held that Section 2(22)(e) was attracted.
On appeal, the High Court reversed the decision of the Appellate Tribunal. The Supreme Court held that the Department was right in invoking the provisions of Chapter XIV- B of the I-T Act. The assessment order originated on account of a search conducted under Section 132(1), and in which the diary was found. The diary made the Assessing Officer hold an enquiry from whence emerged the cash flow statement and resulted in the detection of undisclosed income of Rs. 55.99 crore. Undisclosed income in the nature of deemed dividend did not arise from any scrutiny proceedings, tax evasion petitions, surveys, information received from external agency, etc. It was detected by the Assessing Officer wholly and exclusively as a result of a search and, therefore, the assessment order was rightly passed under Section 158-BC.
The investment in bonds had direct relation to Rs 5.99 crore received by MKF and MKI. Payments by these two firms to the assessee were used to buy the RBI Relief Bonds. The payments made by the company through the two firms were for the benefit of the assessee. Therefore, the funds were not used for repayment of loan, they were used for the purchase of bonds by the assessee. On amalgamation of SPCL with MKSEPL in 1998, the accounts of the two companies had merged. Therefore, the reserves had to be taken on the basis of the merged accounts. Question of benefit The question whether the payments made by the company were for the benefit of the assessee (shareholder) was a question of fact. The Tribunal had concluded that the payments routed through the two firms, MKF and MKI, were for the benefit of the assessee. That was a finding of fact; it was not perverse.
In C.I.T v. L. Alagusundaram Chettiar (109 I.T.R 508), the Madras High Court held that the word "payment" in Section 2(22)(e) means the act of paying. Therefore, in that case it was held that payment by the company to Karuppiah Chettiar was for the benefit of the assessee, the managing director of the company, L. Alagusundaram Chettiar, and was assessable as dividend in the hands of the assessee. This judgment held that the basic test to be applied in such cases is not whether the loan given is a benefit but whether payment by the company to Karuppiah Chettiar was for the benefit of the assessee who was the managing director of the paying company.
Applying the above test to the facts in the present case, the Supreme Court held that the Tribunal was right in holding, on examination of the cash flow statement, that MKSEPL had made payments to MKF and MKI for the benefit of the assessee which enabled the assessee to buy 9 per cent RBI Relief Bonds in the financial year 1999-2000. The two firms were used as conduits by the assessee. Further, the assessee had more than 10 per cent of voting power in MKSEPL during the block period. Further, the assessee had substantial interest of about 16 per cent in MKF. The timing of the repayments by the company to MKF and MKI and the immediate withdrawal of the funds by the assessee-cum- director-cum-shareholder and the timing of investment in purchase of bonds was almost the same. Moreover, in MKSEPL the assessee was not only a shareholder having more than 10 per cent of total voting power, he was also a director of that company. The company was also a partner in MKF and MKI, which explained why Rs 5.99 crore was routed by splitting the amount into two parts of Rs 2.79 crore and Rs 3.20 crore.
The concept of deemed dividend under Section 2(22)(e) postulates two factors, whether the payment is a loan and whether on the date of payment there is accumulated profit. These two factors have to be correlated and this correlation was done by the Tribunal in the instant case, coupled with the fact that all withdrawals were debited to the capital account of the firm. Therefore, the Supreme Court held that the High Court ought not to have disturbed the finding of fact arrived at by the Appellate Tribunal. To conclude, the expression "accumulated profits" means profits in the commercial sense. The expression includes tax-free profits - for example, agricultural income, and general reserve - but not normal depreciation or provision for taxation and dividends. "Accumulated profits" do not necessarily mean reserves and other profits as disclosed in the company's balance-sheet. In every case, the depreciation calculated at the income-tax rates should be deducted in computing "accumulated profits," even if lower depreciation has been provided for in the accounts.
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