bombay_high_court_rules_that_money_%20lending_business_is_exception_to_deemed_dividend_provisions

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EY Tax AlertBombay High Court rules that money lending business is

exception to deemed dividend provisions

29 October 2010


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Executive summary

This Tax Alert summarizes a recent ruling of theBombay High Court (HC) in the case of M/s ParlePlastics Ltd. (Taxpayer) [ITA No. 37 of 2002][1]. The

issue before the HC relates to certain provisions inthe Indian Tax Laws (ITL) that provide for taxability,as dividend, of certain advances or loans made by acompany to another concern when thelender/borrower have a common shareholder withsubstantial interest (deemed dividend provisions).However, advance or loan is not treated as deemeddividend if it is made by the lending company in theordinary course of its business and the lending ofmoney is a substantial part of the companysbusiness.

The HC held that in order to constitute substantial

part of the business, the lending of money need notbe the major part i.e., more than 50% of the lendingcompanys business. In the facts of this case, loansand advances were more than 40% of the totalassets and interest income was more than totalprofits of the lending company. The HC held thatdeemed dividend provisions were not applicable tothe loan received by the Taxpayer from such acompany.

Background

The ITL contains an expanded definition ofdividend which, in addition to conventional

[1]Source: www.hcbombayatgoa.nic.in

dividend or distributions, includes payment ofan advance or a loan made by a closely-heldcompany to its shareholder or to a concern inwhich the shareholder has a substantialinterest.

However, if such an advance or loan is made bya company in the ordinary course of businesswhere the lending of money is a substantial partof the companys business, it is not treated asdividend (exception).

Facts

The Taxpayer is engaged in the business ofmanufacture of plastic caps for bottles and

supplied them to Lending Company (LCo) andothers. It took loans from LCo and paid intereston it.

LCo is engaged in the business of production,sale and distribution of soft drinks, aeratedwater and mineral water. In addition, LCo is alsoengaged in the business of lending money.Nearly 40% of total assets of LCo comprisedloans and advances. Furthermore, interestincome earned was more than the total profitsof LCo.

The Taxpayer and LCo have commonshareholders which triggered applicability ofdeemed dividend provisions.

A pictorial depiction of the arrangement isgiven below:

The Tax Authority added loan balanceappearing in the Taxpayers books as dividend

to the Taxpayers income.

On appeal by the Taxpayer, the first appellateauthority held that only the loans which werereceived by the Taxpayer during the relevant taxyear could be treated as deemed dividend.

The Taxpayer further appealed to the IncomeTax Appellate Tribunal (ITAT) which ruled infavor of the Taxpayer. It held that the Taxpayerscase was covered by the exception as lending ofmoney comprised substantial part of LCosbusiness.

The Tax Authority appealed to the HC againstthe ITATs ruling.

Common

shareholders

LCo Taxpayer

Loan

>10% >20%
http://www.hcbombayatgoa.nic.in/http://www.hcbombayatgoa.nic.in/


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Tax Authoritys

contentions

All the prerequisites for applying deemeddividend provisions were satisfied in theTaxpayers case. The exception was notapplicable since lending of money did notcomprise substantial part of LCos business.

In order to constitute substantial part, thelending of money should be a major part of thebusiness of the company i.e., it shouldconstitute more than 50% of the total business.In LCos case, the loans and advancescomprised only about 40% of the LCos total

assets. Hence, the loan advanced by LCo to theTaxpayer was covered by deemed dividendprovisions and not saved by the exception.

Taxpayers contentions

The Taxpayer is covered by the exception sincelending of money comprised substantial part ofLCos business.

Since 40% of total assets of LCo comprisedloans and advances and interest income earnedwas more than LCos total profits, lending ofmoney did constitute substantial part of LCosbusiness.

HCs ruling

Deemed dividend provisions were attracted inview of the common shareholder relationship.

However, the said amount was saved by theexception since the amount was lent in theordinary course of LCos business and lending ofmoney comprised substantial part of LCosbusiness.

The Taxpayers business was complementary toLCo since the Taxpayer was a supplier of plasticcaps to LCo. It is common for a manufacturer ofa product to give some advance to the supplierof raw material or other parts used by themanufacturer in manufacturing its products.

Such advances are commonly made in usualcourse of business.

The expression substantial part does notconnote an idea of being the major part or thepart that constitutes majority of the whole. Ifthe Legislature had intended substantial part tomean more than 50% of the lending companysbusiness, it would have used the expressionmajority of business or at least prescribed aspecific minimum percentage of business. It isnot possible to give any fixed definition of theword substantial in relation to a substantialbusiness of a company. Any business of acompany which the company does not regard assmall, trivial or inconsequential, as compared tothe whole of the business, is substantialbusiness.

For ascertaining whether a part of the businessis a substantial part of the overall business ofthe company, the proportion of the followingfactors of that part, as compared to the totalbusiness can be looked into: Turnover

Profits Manpower or human resources Capital employed

A part of business may comprise substantialpart if its turnover is substantial even if itsprofit is relatively small or if its profit issubstantial even though turnover is relativelysmall.

Applying the above tests to the Taxpayersfacts, lending of money can be regarded assubstantial part of LCos business since 40% ofthe total assets comprised loans and advancesand interest income earned was more thanLCos total profits. Hence, the Taxpayer wascovered by the exception and the loan advancedby LCo could not be treated as dividend in theTaxpayers hands.

Comments

Since the term substantial part of the business

occurring in the exception is not defined in the ITL,there is an ambiguity as to when lending of moneycan be regarded as substantial part of a companysbusiness. This HC ruling provides useful guidance onthis issue and sets out the parameters which need tobe examined in each case. It also provides guidancethat in order to constitute substantial part, it need


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not necessarily constitute more than 50% of thecompanys total business. Since the proposed DirectTaxes Code 2010 contains identical provisions ondeemed dividend and exception, the ratio of thisruling will be useful even after the Code comes intoforce.


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