In a significant ruling, the Supreme Court has said the funds available with a company in the form of profits should ordinarily be distributed among its shareholders. But if the controlling group of the company refuses to distribute the accumulated profits as dividends to shareholders and decides to advance the profits by way of loan to other concerns for the benefit of its shareholders, it would come under the purview of deemed dividend and be taxable.

A Bench comprising Justices SH Kapadia and BS Reddy said, Companies having accumulated profits and companies in which substantial voting power lies in the hands of the person other than the public (controlled companies) are required to distribute accumulated profits as dividends to the shareholders.

The Legislature realised that though funds were available with the company in the form of profits, the controlling group refused to distribute accumulated profits as dividends to shareholders but adopted the device of advancing the said profits by way of loan to its shareholders so as to avoid payment of tax on accumulated profits. This was the main reason for enacting Section 2(22)(e) of the I-T Act, Justice Kapadia said, writing the verdict. Section 2(22)(e) of the I-T Act deals with deemed dividend.

Relying on two judgements of the apex court, the Bench said Section 2(22)(e) of the Act postulates two factors: whether the payment is a loan and whether on the date of payment there existed accumulated profits. These two factors have to be correlated, said the apex court.

The verdict came in an appeal by the I-T department, which had sought to levy tax on Rs 5.99 crore of undisclosed income of an assessee. The court allowed the revenue departments plea.

In this case, MK Shah Exports made a payment amounting to Rs 5.99 crore to two firms MK Foundation and MK Industries for the benefit of assessee.

The revenue department assessed it as a deemed dividend under Section 2(22)(e) of the I-T Act. The Calcutta High Court had turned down the plea of the I-T department, saying the money was lent and advanced by MKSEPL to MKL and MKI in normal course of business. However, disagreeing with high courts reasoning, the apex court set aside its verdict.