Opinion
Query .... XYZ

Facts of the case :

XYZ is a closely held public limited company of the “X” family engaged in the business of builders and developers of property.

The current shareholders funds of XYZ are 802.36 lakhs represented by equity share capital of Rs 65.80 lakhs and reserves of Rs 736.56 lakhs.

XYZ has joined a partnership firm “XD” which is formed by the 3 Directors/Shareholders of XYZ. XYZ is entitled to 55% of the profits or loss of the partnership firm and the balance 45% is equally shared (i.e., 15% each) by the 3 Directors/shareholders of XYZ.

Out of the 3 Directors of XYZ, 2 such directors/shareholders are beneficial owners of shares in XYZ. i.e., they hold more than 10% of the equity share capital in XYZ.

As per the partnership deed of “XD”, its capital has been fixed at Rs 1,00,000. However, additional capital can be raised with the mutual consent of partners. XYZ has then contributed Rs 280 lakhs in XD as additional capital on current account which bears interest @ 12% p.a. as per the deed of partnership.

In the above background, the querist has put the following queries for my consideration;

Queries :

1. Whether the amount contributed by XYZ to XD as additional capital be construed as deemed dividend u/s 2(22)(e) in the hands of 3 Directors/Shareholders?

2. If yes, will the treatment be different in any other circumstances?

3. What are the tax implications including TDS on this transaction?

4. Will the treatment be different if the holding of 3 Directors of XYZ in XD is reduced below 10% totally?
   I had the benefit of discussing the issues with Shri ABC who also enlightened me about the facts of the case. My comments and opinion on the queries raised is as under:—

1.  Section 2(22)(e) of the Income Tax Act, 1961 reads as under:–

“dividend includes any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) made after the 31st day of March 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten per cent of the voting power, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern) or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent to which the company in either case possesses accumulated profits”.

2. Explanation 2 to sub-section (22) of section 2 reads as under:—

“The expression “accumulated profits” in sub-clauses (a), (b), (d)& (e) shall include all profits of the company up to the date of distribution or payment referred to in those sub clauses”.

3. Explanation 3 to sub-section (22) of section 2 reads as under:—
   For the purposes of this clause,

1. “concern” means a Hindu undivided family, or a firm or and association of persons or a body of individuals or a company.
    

2. A person shall be deemed to have a substantial interest in a concern, other than a company, if he is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the income of such concern.

4. From the above definition, it can be summarized that loan or advance given to a concern is treated as deemed dividend u/s 2(22)(e) if the following conditions are cumulatively satisfied:-

1. Loan or advance is given by a company in which the public are not substantially interested.

2. Loan or advance is given after May 31, 1987.

3. The company should possess accumulated profits (excluding capitalized profits) at the time it makes payment of loan or advance; and

4. loan or advance is given to a concern (i.e., HUF, or a firm or an association of persons or a body of individuals or a company) in which a shareholder (who is a registered shareholder as well as beneficially holding at least 10% of the equity share capital) of the company has substantial interest. (i.e., he is beneficially entitled to at least 20% of income of such concern).

5. The company has 736.56 lakhs of accumulated profits in the form of Reserves.
    

6. The term ‘advance’ or ‘loan’ is nowhere defined u/s 2(22). However meaning assigned to it elsewhere in the Act in the context may be useful. Explanation (iii) to section 269T states that “ loan or deposit means any loan or deposit of money which is repayable after notice or repayable after a period and in case of a person other than a company, includes loan or deposit of any nature”.
   From the above definition it transpires that amount contributed in the form of capital cannot be construed as loan as capital contributed is not repayable after notice nor it is repayable after a specific period.

7. Section 269SS of the Income-tax Act prohibits acceptance of loan or deposit otherwise than by way of account payee crossed cheque if the amount is in excess of Rs 20,000. Explanation (iii) to s.269SS defines loan or deposit as ‘loan or deposit of money’. In this context, reliance can be placed in the decision of Shrepak Enterprises vs. DCIT 64 ITD 300 (Ahd) wherein it was held that payment of amount made by a partner to a firm is payment to self and does not partake the character of loan or deposit in general law and, therefore, provisions of s.269SS would not be applicable to such payment.
    

8. The dictionary meaning of “advance” says that something (esp. money) which is paid before it is due.
    

9. The dictionary meaning of “loan” says that it is something (esp. money) which is lent out and is to be returned.
    

10. Thus, by looking at the above definition of ‘loan’ and ‘advance’, we can make out that capital contribution is neither in the nature of a loan nor in the nature of advance. This is because capital contribution is not being lent for the purpose of claiming it back (like in the case of a ‘loan’) nor it is a contribution made before it is due (like in the case of ‘advance’).
     

11. From the above, it appears that in order to attract the provisions of s. 2(22)(e), the important consideration is that there should be a loan/advance by a company to its shareholder. Every payment by a company to its shareholder may not be a loan/advance. To be treated as a loan, every amount paid must make the company a creditor of the shareholder for that amount.
     

12. Thus, in our opinion, the introduction of capital by a company in a partnership firm is not in a nature of loans and advances and therefore will not attract the provisions of s.2(22)(e) and thus the question of TDS on this transaction does not arise at all.
     

13. It may also be noted that even as per the Indian Partnership Act, 1932 and even in the eyes of general law, the relationship between the partner and the partnership firm is one and the same. Thus, any payment made by a partner to its firm or vice versa is nothing but payment to self and does not partake the character of loan or advance. A partner is nothing but the agent of the firm and the partnership firm represents the compendium of the business.
     

14. Thus, capital contribution by a partner in a firm cannot be said to be in the nature of a ‘loan’ or an ‘advance’.
     

15. In addition to the above, the querist can also rely on the decision of Ardee Finvest (P) Ltd. vs. DCIT 79 ITD 547(Del) wherein it was held that receipt in nature of share application money cannot be construed as loan or advance and therefore the provisions of s.2(22)(e) does not apply. Only where the transaction is found to be of nature of loans or advance, deeming provisions can be invoked. Fiction cannot be given a wider meaning that what it purports to do.
     

16. Reliance can also be placed in the decision of S.R.Sarkar vs. ITO 83 Taxman 38(Cal)(Mag) wherein it was held that loan advanced by a company to its director to meet foreign trip expenses which is allowed as a deduction in the hands of the company and in respect of which revenue had not discharged burden of proof that amount was in fact given as an advance to the assessee within the meaning of s.2(22)(e) could not be treated as deemed dividend u/s. 2(22)(e).
     

17. The facts of the querist indicate that the provisions of s.2(22)(e) are not applicable in their case for the simple reason that in order to attract the provisions of s.2(22)(e), (i) the shareholder must be a beneficial owner in the company (i.e., he must hold atleast 10% of the equity share capital) and (ii) he must have a substantial interest in the income of the partnership firm. (i.e., he should have at least 20% share in the profits of the firm). These two conditions require cumulative compliance before s. 2(22)(e) is attracted.
     

18. However, in the case of the querist, the shareholder, though is a beneficial owner of 10% shares of the company, he does not have a substantial interest in the partnership firm and therefore the provisions of s.2(22)(e) cannot be applied.
     

19. In support of the above, reliance can be placed on the decision of Bharti Overseas Trading Co vs. DCIT 106 Taxman 172 (Del) (Mag) wherein the facts were very similar to that of the querist. In this case it was held that for invoking the provisions of s.2(22)(e), the shareholder must fulfil the two conditions simultaneously which are cumulative in nature. Thus, where the assessee — firm was a shareholder who had beneficial interest of 10% in the company but had only 15% interest in the profits of the firm, loan taken by the assessee — firm could not be treated as deemed dividend u/s. 2(22)(e).
     

20. In view of the above, the replies to the queries can be summarized as under and the company is advised to follow them.

1. Amount contributed by XYZ to XD will not be construed as deemed dividend u/s. 2(22)(e).

2. Not Applicable.

3. The question of TDS does not arise at all as interest paid to partners is not liable for TDS.

4. As the case of the querist is not covered by the provisions of s.2(22)(e), there is no need to reduce the share of the partner in the partnership firm by further 5%.

I hope this meets the queries of the Company. I shall be pleased to offer any clarifications that may be required in the matter.