Which law applies?
A closely held company may need to treat a loan, advance or payment for a shareholder’s benefit as a dividend even when it has not declared one. For years governed by the Income-tax Act, 1961, the relevant provision is section 2(22)(e). For tax years beginning on or after 1 April 2026, use section 2(40)(e) of the Income-tax Act, 2025 and read it with the exclusions and definitions in section 2(40). The historical examples below use the 1961 Act. The dividend distribution tax regime under section 115-O ended for dividends declared, distributed or paid on or after 1 April 2020. For later periods, identify the person assessable and the withholding obligation separately.
What triggers deemed dividend?
| Test | What to check under section 2(22)(e) |
|---|---|
| Payer | The company must be one in which the public are not substantially interested. Apply the statutory definition in section 2(18); the company’s name or label does not settle this. |
| Shareholder | Identify the shareholder who beneficially owns qualifying shares carrying at least 10% of the voting power. Shares entitled to a fixed dividend rate are excluded from this test. Check the register, beneficial ownership and actual voting rights. |
| Payment | Test a loan or advance to that shareholder, a loan or advance to a concern in which that shareholder is a member or partner and has a substantial interest, and payments made on behalf of or for the individual benefit of such a shareholder. |
| Interest in the concern | A concern can be an HUF, firm, association of persons, body of individuals or company. For a non-company concern, the test is beneficial entitlement to at least 20% of its income at any time in the previous year. For a company, check the qualifying 20% voting-power test under section 2(32). |
| Amount | The amount treated as dividend cannot exceed the accumulated profits available on the payment date. Apply the test to the dated payments and reconcile the remaining profits. |
Exclusions and trade advances
Ordinary course of lending. A loan or advance to the shareholder or concern is excluded where it is made in the ordinary course of the company’s business and lending is a substantial part of that business. Registration as a lender or charging interest does not by itself establish either requirement. Review the company’s actual activities and the circumstances of the loan.
Trade advances. The Delhi High Court’s decision in Creative Dyeing & Printing and CBDT Circular No. 19/2017 distinguish genuine trade advances from financial accommodation. A payment against a specific purchase or service obligation may fall outside the loan or advance limb. A generic business rationale or agreement drawn up after payment does not establish a trade advance. Trace the contract, invoice, delivery and how the advance was adjusted.
Later dividend set-off. The 1961 Act separately excludes a later dividend to the extent the company actually sets it off against a payment previously treated as deemed dividend. Ordinary repayment of a loan does not qualify as that set-off.
Cross-border group treasury from 1 April 2026. The Finance Act, 2026 revised a specific exclusion under the 2025 Act for certain advances or loans between group entities. Check the statutory definitions and all conditions, including an eligible Finance Company or Finance Unit set up as a global or regional corporate treasury centre, the foreign location of the other entity, and the foreign listing of the parent or principal entity. Check the applicable Central Government notification for the specified country or territory before relying on this exclusion. A domestic group cash transfer does not qualify simply because it is arranged through a group treasury.
Calculate accumulated profits at the date of payment
Reconcile opening commercial profits to profits actually earned and losses incurred up to the payment date. The statutory calculation can include capitalised profits. A closing reserve balance or taxable profit figure alone is insufficient. Distinguish genuine share capital and share premium, unrealised revaluations, and other capital items from earned profits. Examine the terms and accounting of any subsidy before treating it as capital. Reconcile actual distributions and prior deemed distributions so the same profits are not counted twice; check the statutory adjustments that apply to the company.
Why same-year repayment does not cure an earlier payment
In Smt. Tarulata Syam v. CIT (108 ITR 345), the Supreme Court applied the predecessor provision in the 1922 Act and held that repayment during the same year did not undo the deemed dividend. For example, assume that a qualifying 15% shareholder received a ₹50 lakh accommodation loan on 1 June and the payer had ₹1 crore of accumulated profits on that date. If all conditions were met, the amount treated as dividend is ₹50 lakh even if fully repaid on 15 March. Test when each payment arose; a nil year-end balance does not establish its treatment.
Seven worked examples
The names and facts below are illustrative. They show how to apply the rules to different payment types.
1. An advance for laboratory services
Nova Bio-Pharma pays ₹1.50 crore to Nova Research Labs on 12 October under an agreement and purchase order dated 1 October for clinical stability trials. Dr. Rajesh has qualifying beneficial voting rights of 35% and 40%, respectively; the payer has ₹4 crore of accumulated profits. If the payment were financial accommodation and the other tests were met, the cap would allow the full ₹1.50 crore. If the payment is a genuine milestone advance for actual services, substantiate that character with the agreed deliverables, work records, invoices and settlement. Common ownership alone does not determine whether the payment is a loan or who is assessable.
2. Personal spending through a director’s running account
Vikram holds 60% of the qualifying votes in Apex Infratech. The company pays ₹75 lakh for his personal credit card bills, family tuition and a property booking and has ₹2.80 crore of accumulated profits available when those payments are made. Vikram later pays back ₹80 lakh, leaving a ₹5 lakh credit if the opening balance was nil and there were no other movements. On these assumptions the qualifying payments can produce ₹75 lakh of deemed dividend. Trace each dated payment, its purpose and the available profits: a peak debit alone is not the statutory measure. The final income tax and any advance tax interest depend on the applicable year, tax regime and other tax facts.
3. The accumulated profits cap
On 15 September, Horizon Manufacturing has paid-up capital of ₹1 crore, genuine securities premium of ₹5 crore, and ₹18 lakh of available accumulated commercial profits. It lends ₹50 lakh to Suresh, a qualifying 25% shareholder. If the other conditions are met, the deemed dividend is ₹18 lakh. The remaining ₹32 lakh is outside the deemed dividend amount on these facts.
4. Direct and trust-held shares
Ankit has 8% of Precision Gears’ votes directly. A family trust holds a further 12%; he is its sole trustee and primary beneficiary. The company pays ₹40 lakh to Ankit’s sole proprietorship. Review the share register, trust deed, beneficial rights and the capacity in which the shares are held. If the full trust holding legally counts toward Ankit’s qualifying votes, the total is 20%. His 8% direct holding alone is below 10%. A proprietorship is not a separate person from its proprietor for income tax. The trust roles alone do not determine whether the test is met; the facts also do not specify how much accumulated profit was available.
5. A loan to a partnership
Shanti Textiles lends ₹60 lakh to Shanti Weaving & Dyeing. Manoj has qualifying beneficial voting rights of 15% in the lender and is beneficially entitled to 30% of the firm’s income. Both thresholds are met and the lender’s ₹1.20 crore of available accumulated profits covers the full ₹60 lakh. Assuming the amount is a loan and no exclusion applies, ₹60 lakh is the amount potentially treated as dividend. Who can be assessed is a separate question; the withholding position must also be examined.
6. Advance for a custom machine
HeavyTech pays ₹90 lakh to Precision Lathes for a custom five-axis CNC machine. The machine is installed nine months later and the advance is credited against the final invoice. HeavyTech’s promoter holds 45% in the vendor; separately verify the nature of those voting rights and the promoter’s qualifying interest in HeavyTech. The purchase contract, engineering plans, delivery and invoice adjustment support the trade character of the payment. A long fabrication period does not itself turn a genuine purchase advance into financing.
7. TDS on a founder loan in FY 2024–25
On 10 May 2024, FastScale Software lends ₹1 crore at 8% interest to a qualifying resident founder-shareholder. It has ₹3.50 crore of available accumulated profits. Assume the loan is not excluded and no withholding concession applies. The ₹1 crore treated as dividend requires ₹10 lakh of TDS at 10% under section 194. The loan’s 8% interest does not remove the obligation. If the company first deducts on 5 July, the section 201(1A) interest for late deduction at 1% for each month or part is ₹30,000 for May, June and July. Late remittance, if any, attracts separate interest at 1.5% for each month or part from deduction to payment where the statutory conditions are met.
Failure to deduct can trigger default proceedings. The first proviso to section 201(1) can relieve the default if the resident payee filed the required return, included the sum, paid the tax due and the payer furnishes the prescribed accountant’s certificate (Form 26A). Interest may still be due. Section 271C can impose a penalty equal to the tax not deducted, ₹10 lakh in this example, subject to the reasonable-cause protection in section 273B and the facts of the case.
What to document before transferring funds
- Identify the ownership and voting rights on both sides and record the purpose of the payment before authorising it.
- For trade advances, keep the agreement, purchase order, pricing, milestones, proof of delivery or performance and the invoice reconciliation. Record the payer’s commercial benefit.
- Separate director expenses, business reimbursements, remuneration, declared dividends and loans in the ledger. Review dated entries during the year and keep a calculation of available accumulated profits.
- Check Companies Act sections 185 and 186 separately. Section 185 restricts loans and related support to directors and specified connected parties, subject to its own exceptions and conditions. Where section 186 applies, calculate the higher of 60% of paid-up share capital, free reserves and securities premium combined, or 100% of free reserves and securities premium combined. Check Board consent, any required prior special resolution and financial institution approval, applicable exceptions, disclosures and the minimum interest benchmark based on the Government Security yield closest to the loan tenor.
- Record the withholding decision, residency, dates, and follow-up. Use dated related-party ledgers and bank reconciliations to investigate advances and repayments. assureFinancials can be used as part of that recordkeeping workflow.
Frequently asked questions
Does repaying a loan before year-end prevent deemed dividend?
Repayment does not reverse a payment already within the provision. Test the transaction when made and separately consider any statutory exclusion or qualifying dividend set-off.
Who is taxed on a loan to a sister company or other concern?
Check the statutory facts and binding case law for the relevant jurisdiction. The Bombay High Court in Universal Medicare held on its facts that the borrowing company could not be taxed as the shareholder. In Gopal and Sons (HUF), the Supreme Court treated the recipient HUF as taxable on the facts before it, which included shares held in the name of its karta. The Supreme Court referred the issue raised in National Travel Services to a larger bench; its reference order does not itself decide the issue finally. CBDT Circular No. 19/2017 is about trade advances and does not resolve who can be assessed.
Do advances for actual goods or services qualify for the trade advance treatment?
They may fall outside the loan or advance limb when the facts show a genuine trade payment. Evidence of the underlying supply, performance and adjustment matters.
Does securities premium count as accumulated profits?
Genuine securities premium is a capital contribution, subject to section 52 of the Companies Act. It does not enter the example’s accumulated commercial profits merely because it appears among the company’s reserves.
How does dividend withholding work?
Section 194 under the 1961 Act generally required 10% withholding for qualifying dividend payments to resident shareholders. The non-cash exception for an individual shareholder depended on the annual aggregate paid or likely to be paid by that company: up to ₹5,000 through 31 March 2025 and up to ₹10,000 from 1 April 2025 while the 1961 Act applied. For tax years beginning on or after 1 April 2026, apply the applicable entry in section 393 of the 2025 Act. Non-resident payments and special cases require a separate check.
How can finance teams monitor related party loans?
Keep a dated transaction register with opening balances, payment purposes, supporting records, repayments, ownership evidence, accumulated profit calculations and withholding decisions. Reconcile it to bank and ledger entries during the year and before filing.
Sources
- Income-tax Act, 1961: sections 2, 194, 201, 271C and 273B
- Income-tax Act, 2025, as amended by the Finance Act, 2026: sections 1, 2 and 393
- Income-tax Department: Form 26A under rule 31ACB
- CBDT Circular No. 19/2017 on trade advances
- Delhi High Court: CIT v. Creative Dyeing & Printing Pvt. Ltd.
- Bombay High Court: CIT v. Universal Medicare Pvt. Ltd.
- Supreme Court: Gopal and Sons (HUF) v. CIT
- Supreme Court: National Travel Services v. CIT, reference order
- Supreme Court: Smt. Tarulata Syam v. CIT
- Companies Act, 2013: sections 52, 185 and 186