Income Tax Appellate Tribunal (ITAT) Kolkata in a recent judgment has held that the exempted capital gains is not a part of the expression ‘accumulated profits’ as per Explanation to section 2(22) and if a company has only negative accumulated profits after exclusion of exempted capital gains the provisions of section 2(22)(e) of the Income Tax Act, 1961  cannot be invoked.

Case Details:
ITA No. 1703/Kol/2014 and  ITA No. 2140/Kol/2010: Asstt. Year : 2007-2008
Manoj Murarka (Appellant) vs ACIT (Respondent)
Date of Order: 20-11-2015

Question:
The only issue to be decided in the appeal of the assessee was as to whether the exempt capital gain is to be excluded from accumulated profits for the purpose of section 2(22)(e).

Brief Facts of the Case:
The assessee was an individual having Substantial shareholding (41.84%) in shares of M/s Bathilivala and Karani Financial Consultants Pvt. Ltd ( ‘BKFCPL’). The company advanced monies of Rs. 7305169/- and Rs. 11357000/- (Total Rs. 18662169/-) to his family members (daughter, son and wife). The company BKFCPL was not engaged in the business of money lending but in the business of dealing in shares, securities and other investments. The original assessment was completed u/s 143(3) which was later sought to be revised by the CIT u/s 263 in order to examine the aspect of deemed dividend in respect of amounts overdrawn by the assessee from BKFCPL. Eventually order u/s 263 was also passed holding assessment order passed by AO as erroneous and prejudicial to the interests of the revenue to the extent of Rs. 49,12,000/- towards deemed dividend in respect of amounts overdrawn by the assessee.

On appeal, CIT(A) deleted the addition made towards sums overdrawn by assessee’s daughter and son as they were not shareholders of BKFCPL and held that the deemed dividend could be taxed only in the hands of shareholder holding more than 10% voting power in the company from which monies were drawn. However, the addition in respect of amount overdrawn by the assessee was confirmed by ignoring the contentions of the assessee that if the long term capital gains which is exempt from tax is excluded from accumulated profits there was only negative accumulated profits.

Contentions of the Assessee
The assessee argued that the CIT directed the Assessing Officer to examine the aspect of deemed dividend only in respect of amounts overdrawn by the assessee and not in respect of other family members. Reliance was place on the judgments in CIT vs Hindustan Coconut Oil Mill reported in (2002) 255 ITR 428 (Cal) and• CIT vs Howrah Flour Mills Ltd reported in (1999) 236 ITR 156 (Cal). It was also asserted that son and daughter were  not shareholders of the company and provisions of section 2(22)(e) could not be invoked. Further it was submitted that provisions of section 2(22)(e) creates a deeming fiction and hence has to be construed strictly as per Apex Court judgment in CIT vs C.P.Sarathy Mudaliar reported in (1972) 83 ITR 170 (SC).

Also, it was argued that the accumulated profits figure as on 31.3.2007 admittedly included exempted long term capital gains and hence if the same was reduced then there will be only negative accumulated profits and accordingly the provisions of section 2(22)(e) could not be invoked. That the expression accumulated profits would include capital gains only if it is chargeable to tax u/s 45 of the Act and not otherwise. Reliance was place on the decisions in  CIT vs Mangesh J Sanzgiri reported in 119 ITR 962 (Bom) and ACIT vs Gautam Sarabhai Trust No. 23 reported in (2202) 81 ITD 677 (AHD ITAT) The Learned AR also stated that he could not find any contrary decisions from the Supreme Court or any other High Court on this issue and accordingly prayed for exclusion of exempted long term capital gains from accumulated profits and consequently there would be no positive profits to invite the provisions of section 2(22)(e) of the Act.

Contentions of the Revenue
It was argued that the clubbing provisions u/s 64 does not bifurcate clubbing of regular income and clubbing of deemed income. It only states that income of minor should be clubbed with the parent whose total income is greater. That obviously would include deemed dividend income also. Reliance was place on the decision of the Apex Court in the case of L. Alagusundaram Chettiar vs. CIT reported in (2001) 252 ITR 893 (SC).

The Revenue further contended that the expression accumulated profits did not include capital gains only upto 1.4.1956 and not thereafter and hence there is no scope for reducing the exempted long term capital gains from accumulated profits

Important Excerpts from ITAT Judgment
We find that the Learned AO had travelled beyond the jurisdiction vested on him by the order of the Learned CIT u/s 263 of the Act by treating the amounts overdrawn by the son and daughter of the assessee thereby bringing the same to tax as deemed dividend.

In this regard, the following decisions relied upon by the Learned AR are well placed :-
CIT vs Hindustan Coconut Oil Mill reported in (2002) 255 ITR 428 (Cal)
...........
CIT vs Howrah Flour Mills Ltd reported in (1999) 236 ITR 156 (Cal)

In the instant case, the monies were advanced directly by the company to the son and daughter of the assessee and it is not the case of the revenue that the monies were subsequently transferred by son and daughter to the assessee and the children merely acted as a conduit to draw monies from the company for onward transmission to the assessee. We hold that the provisions of section 2(22)(e) of the Act creates a deeming fiction and hence needs to be viewed strictly.

Moreover, it is also observed that both the son and daughter of the assessee are not shareholders in the lending company (i.e BKFCPL) and hence the deemed dividend, if any, could be assessed only in the hands of the shareholders and not otherwise. This argument was taken by the assessee even before the lower authorities and the revenue had not brought on record any contrary evidence to this fact. Hence we hold that the provisions of section 2(22)(e) of the Act could not be invoked in respect of amounts paid to Nishita Murarka (daughter) to the tune of Rs. 25,90,000/- and by Saahil Murarka (Son) to the tune of Rs. 70,07,000/- and accordingly, the grounds raised by the revenue in this regard are dismissed.

We find that for the purposes of artificial categories of dividends which are created by the provisions contained in section 2(22) of the Act, accumulated profits do not include any capital gains, except those which are taxable as such. Thus, accumulated profits would not include capital gains made during a period when they were not taxable under the Act, nor capital gains which are not chargeable even during the period the capital gain tax is in force. Consequently, any payment made to a shareholder of a company of non-taxable capital gains of the company would not be dividend.

We hold that the legal fiction created in the Explanation 2 to section 2(22) of the Act that ‘accumulated profits’ shall include all profits of the company upto the date of distribution or payment should be understood to include the current year profits of the company and not otherwise. In other words, for reckoning the accumulated profits, apart from the opening balance of accumulated profits, the profits earned in the current year also are to be added and then the total accumulated profits should be considered for the purpose of calculation of dividend out of accumulated profits, if any. The said Explanation nowhere contemplates to bring within the ambit of expression ‘accumulated profits’, any capital profits which are not liable to capital gains tax. Accordingly, even going by the provisions of the statute, it can safely be concluded that the capital gains could be included for reckoning the accumulated profits only when the said capital gains has been duly subjected to tax. In the instant case, the capital gains derived by the company to the tune of Rs. 197.20 lacs is exempt and hence the same should not be included in accumulated profits and if the same is excluded, then there is only negative accumulated profits available with the company. Admittedly, the provisions of section 2(22)(e) could be invoked only to the extent of the company possessing accumulated profits. In the absence of accumulated profits, there is no scope for making any addition towards deemed dividend.

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