Deemed Dividend under section 2(22)(b)

The taxability of ‘Deemed Dividend” is a complex issue in the Income Tax Act, 1961. Sub-clauses (a) to (e) of clause-22 of section-2 of Income Tax Act provides various cases where certain transactions will be taken as dividend. In this article, we will discuss the tax implication where a company issues debentures to its shareholders or issues bonus shares to its preference shareholders.

Distribution of debentures, debenture stock etc. [Section-2(22)(b)]
Section-2(22)(b) provides:
“Dividend includes:

a. Distribution to its shareholders by a company of debentures, debenture-stock or deposit certificates in any form, whether with or without interest and
b. Distribution to its preference shareholders of shares by way of bonus
to the extent the company possesses accumulated profits, whether capitalized or not.”

Following points are to be looked into in respect of sub-clause (b) of section 2(22):

• Unlike Section-2(22)(a), the distribution need not entail release of assets of the company.
• Where a company distributes debentures to its shareholders to the extent of accumulated profits, it will be deemed to be dividend.
• It does not matter whether debentures are issued with interest or without interest.
• Further, where bonus shares are issued to preference shareholders, it will be treated as dividend, to the extent of accumulated profits whether capitalized or not.
• However, issue of bonus shares to equity shareholders is not treated as ‘dividend’ either in clause (a) or clause (b) of section-2(22).

Tax implication in hands of company:-

• No tax implication in the hands of the company as the debentures/ bonus shares are issued by the company without any consideration and thus will not be a ‘transfer’ under section-47 of the Act.
• However, the company shall be required to pay Dividend Distribution Tax u/s 115-O of the Act in respect of A.Y. 2020-21. Such dividend shall be exempted in the hands of the shareholders u/s 10(34).
• Further, for A.Y. 2021-22 and onwards, the company shall not pay Dividend Distribution Tax and thus, dividend shall be taxable in the hands of the shareholders.

Tax implication in the hands of the shareholders:-

• Cost of acquisition of such debentures or bonus shares in the hands of shareholders shall be taken as ‘NIL’ as per section-55.
• For A.Y. 2020-21, such debentures and bonus shares deemed as dividend, will be exempt income in the hands of the shareholders.
• But, A.Y. 2021-22 and onwards, such debentures and bonus shares issued shall be a taxable dividend income in hands of shareholders.

Case Study-1:
The company has following position in its Balance Sheet:-
Equity share capital (including bonus Rs. 2, 00,000):- Rs. 10, 00,000
Retained Earnings: - Rs. 5, 00,000
The company distributes debentures of Rs. 8 Lakhs to its equity shareholders.

In this case, Accumulated profits of the company including capitalized profits = Rs. 5 Lakhs + 2 Lakhs = Rs. 7 Lakhs.
Therefore, any distribution by issue of debentures up to Rs. 7 Lakhs shall be treated as ‘Dividend’. Hence, in this case, out of distribution of Rs. 8 Lakhs, Rs. 7 Lakhs shall be deemed to be dividend and treated accordingly.

Case Study-2:
The company has following position in its Balance Sheet:-
Equity Share Capital (including bonus Rs. 2, 00,000):- Rs. 10, 00,000
Preference Share Capital: - Rs. 2, 00,000
Retained Earnings: - Rs. 14, 00,000
The company issues bonus shares to all shareholders at 1:1.

In this case, bonus shares issued to equity shareholders does not amount to deemed dividend. However, bonus shares issued to preference shareholders Rs. 2 Lakhs will be deemed to be dividend u/s 2(22)(b) and treated accordingly.