Accumulated profits

A dividend is usually just the profit a company decides to pay out to its shareholders. But companies can hand value to shareholders in other ways too — a loan, a distribution of debentures, a payment on winding up. Tax law does not let a company dodge dividend treatment simply by calling the payment something else.

Section 2(22) of the Income Tax Act defines deemed dividend, and the common thread through nearly every limb of that definition is the phrase accumulated profits — the company's stock of past earnings that have not yet been distributed. If a payment to a shareholder is funded out of accumulated profits, it can be treated as a dividend even though it does not look like one.

Section 2(22) lists several situations where a payment out of accumulated profits is deemed a dividend:

a) Distribution of accumulated profits to shareholders that involves releasing the company's assets. b) Distribution of debentures, debenture-stock or deposit certificates to shareholders out of accumulated profits, and bonus shares to preference shareholders out of accumulated profits. c) Distribution on liquidation, out of accumulated profits. d) Distribution on reduction of capital, out of accumulated profits. e) A loan or advance by a closely held company to its shareholder, out of accumulated profits. f) Payment on buy-back of shares by the company, in accordance with the Companies Act, 2013.

All of these were, until Assessment Year 2020-21, taxed differently — companies paid Dividend Distribution Tax (DDT), and the dividend itself was largely exempt in the shareholder's hands. Since the Finance Act, 2020 abolished DDT with effect from AY 2021-22, deemed dividend under Section 2(22) — like ordinary dividend — is taxable in the hands of the shareholder or unit-holder, under the head income from other sources, at their applicable slab rate.

From 1 October 2024, buy-back proceeds received by a shareholder are themselves taxed as dividend under income from other sources, with no deduction for expenses allowed against that income — and the shareholder's original cost of the bought-back shares becomes a capital loss, available for set-off under the usual rules.

Illustrative figures.

Acme Pvt Ltd, a closely held company, has Rs 2,00,00,000 of accumulated profits. During the year it:

1. Gives its majority shareholder, Mr Kapoor, an interest-free loan of Rs 15,00,000.
2. Buys back shares from another shareholder, Mrs Sharma, paying her Rs 30,00,000 for shares she had originally bought for Rs 8,00,000.

Mr Kapoor's loan. Because Acme is closely held and the loan is funded out of accumulated profits, the Rs 15,00,000 is deemed a dividend under Section 2(22)(e), taxable in Mr Kapoor's hands as income from other sources at his slab rate.

Mrs Sharma's buy-back. The full Rs 30,00,000 she receives is taxed as dividend under income from other sources, with no expense deduction allowed. Separately, her original cost of Rs 8,00,000 becomes a capital loss of Rs 8,00,000, which she can set off against other capital gains — she does not get to treat the buy-back as an ordinary capital gains sale at all.

Chapter 9 (Income from Other Sources), section 9.2 — Dividend Income — gives the full Section 2(22) list and the post-DDT taxation scheme, including the 1 October 2024 buy-back change. Expect a question asking whether a specific payment (a loan, a debenture distribution, a buy-back) counts as deemed dividend, and what "accumulated profits" is funding it.

• "Accumulated profits" is the funding source, not the payment itself — the same rupee amount is deemed dividend only if it is traceable to the company's built-up profits.
• DDT no longer exists (abolished from AY 2021-22) — deemed dividend is taxed in the shareholder's hands, not the company's.
• Buy-back proceeds are dividend income with no expense deduction, and the original cost becomes a separate capital loss — two consequences from one transaction, easy to under-count.
• A loan to a shareholder is deemed dividend only from a closely held company, out of accumulated profits — an ordinary commercial loan from a listed company is not caught by this provision.