When transactions are made between shareholders and family members of a company with close shareholders, tax authorities tend to scrutinise them. An example of such a transaction is one in which a company transfers money or other financial benefits to a son of a shareholder, claiming it is a gift. This raises a significant question under Indian tax law: Can a gift to a shareholder’s son be treated as a deemed dividend?
Understanding Deemed Dividend under Income Tax Law
Under Section 2(22) (e) of the Income-tax Act, 1961, is the scheme of deemed dividend. This is applicable to closely held companies and aims at ensuring that shareholders do not withdraw company profits in the form of loans or advances, rather than dividends, hence the avoidance of tax.
In this section, any loan or advance made by a company that is closely held may be deemed to be a dividend, as dividends may be paid upon the individual benefit of the shareholder who holds at least ten per cent of voting power or as it is made to the individual on accumulated profits. The focus is on determining the ultimate beneficiary of the payment by the shareholder.
Why are Gifts to Relatives Studied Carefully?
Section 2(22)(e) of the law does not specifically refer to an employee’s relatives, such as a son. Nevertheless, tax authorities are very careful about such payments since the transfer of money through relatives is occasionally employed as a way of indirectly benefiting the shareholder. The taxation is not activated by the mere existence of an interrelationship between a family, but leaves one wondering whether there is a motive in carrying out the transaction.
The important rule used by the courts and taxing bodies is that of substance over form. It is not the name that the transaction is called, but rather the way it works in practice.
When a Gift to a Shareholder’s Son Is Not a Deemed Dividend?
When the son of a shareholder is given an actual gift by a company, it is not considered a deemed dividend where such a son is an independent person and is not a shareholder, and the shareholder will not benefit directly or indirectly through such a gift. Personal payments that do not represent regular dividends (e.g. education expenses, medical expenses, or marriage) that are duly recorded and authorized do not generally come within the range of deemed dividend provisions.
It has always been the opinion of the courts that unless the payment fulfils the definition of a loan or an advance and the benefit is to the shareholder, Section 2(22)(e) could not be applied by suspicion or relationship.
When a Gift May be Treated as a Deemed Dividend?
The payment is not referred to as a gift; it is rather an indirect distribution of profits, which causes problems. When the money provided to the son is utilised in settling the personal liabilities of the shareholders or in acquiring assets on behalf of the shareholder, or when it is transferred continuously with no apparent reason, tax officials can consider this as a deemed dividend.
The frequent transfers, record keeping, board approval and complete control of the shareholder on the actions of the company support the department. When this happens, it is only the shareholder who benefits, and the son is just a pass-through.
Jurisprudential Approach and Key Law Principles
There has been a moderate stance in the interpretation of deemed dividend provisions by the courts. Section 2(22)(e) provides a legal fiction; it therefore has to be construed literally. The tax department will also have to prove that such a payment is in the form of a loan or advance and that it is in the interest of the shareholder.
Simultaneously, the courts have given the authorities an opportunity to access facts beyond what is written in the accounting entries and investigate the surrounding facts. Where the transaction is not of a commercial substance or is designed to evade the tax, the deemed dividend provisions have been sustained by the court.
Significance of Documentation and Commercial Substance
The documentation is vital in taxability. Adequate board resolutions, adequate accounting treatment, and purpose will assist in determining the sincerity of a gift. A singular remittance that has been verified by documents is much less risky than frequent remittances that are unexplained.
The companies also have to ensure that the transaction does not place an obligation on the son to repay money since this can be seen to be a loan and not a gift. Litigation risk is greatly minimized by transparency and consistency in records.
Practical Tax and Compliance Insight
Compliance-wise, businesses ought to be careful when paying their relatives shareholder-related payments. Professional advice should be taken on how to plan the transactions in advance, particularly when dealing with large sums. When the company is experiencing a lot of accumulated profits, any irregularities, however small, may raise eyebrows.
It is recommended that this payment should be specifically stated to be not dischargeable of any personal obligation of the shareholder and that it does not lead to any indirect benefit. In place of dividend payments or salary payments, where feasible, alternatives, including dividend payments or remuneration, where justified, can prove more tax efficient and transparent.
Conclusion
Any gift to a son of a shareholder is not deemed to be a dividend as per the Income-tax Act. Whether it is a loan or an advance paid in the benefit of the shareholder out of accumulated profits is the decisive factor. If it is a valid transaction that is well documented and independent, the provisions on deemed dividends should not apply. But when the structure is used as a conduit to transfer the company’s profits to shareholders, the tax implications may be immense. It thus becomes necessary to closely design, document and have legal sensibility to prevent unintended tax exposure as provided in Section 2(22)(e).
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