BUSINESS DEDUCTIONS - DIVERSION OF PROFIT FOR MAINTAINING AND IMPROVING DIVIDEND,PAT AND GOODWILL - a brainstorming exercise.

[C.A. DEV KUMAR KOTHARI]

Dividend payment is for goodwill and business:

Dividend payment to shareholder is a very significant contributor towards goodwill improvement. Companies which regularly pay dividend command higher goodwill and credit worthiness in capital markets. The market price and price earnings ratio of share improves. A company which has good track record of profit earnings and dividend payment can raise capital in Indian and overseas markets easily than a company which has poor record of dividend payment.   

Company and shareholders are different persons

 A company and its shareholders are distinct persons. A company's property, liabilities, incomes, losses, etc., are not those of its shareholders. The contract between a company and its shareholders is governed by the memorandum and articles of association of the company, and the prospectus or other document constituting terms and conditions of issue of shares or other securities.

Number of shareholders have increasing and they are widespread not only within India but also abroad. The gap between a Company's management and shareholders is widening. Hence the need for thinking about mandatory dividend, and increasing shareholders' say in dividend decisions so as to protect shareholders' interest, ensuring sharing of profits before they are earned, and paying some dividend by imposing contractual and legal obligations on the companies.

Memorandum and Articles of Association of any company are very important in deciding terms and conditions between company and its shareholders. As in case of changes and variation in contracts, a company can with approval of general meeting with requisite majority, alter its memorandum and articles of association. A change in these documents are to some extent similar to variation of terms and conditions in any contract. Therefore, a valid variation in such documents is binding on company and its shareholders. 

Dividend payment is for servicing of capital already raised

 The memorandum of association and/or the prospectus specifies the business purposes for which funds are raised. After amending the contract, if contractual dividend is paid, it will be for the purpose of business. The following are a few examples of expenses/costs incurred in relation to shareholders which are generally allowed as business expenditure :

(i) Value of samples distributed, refreshments provided to shareholders at general meetings - CIT v. Tirrihannah Co. Ltd. 1991 -TMI - 21913 - (CALCUTTA High Court) and Addl. CIT v. Bangalore Turf Club Ltd. 1980 -TMI - 36570 - (KARNATAKA High Court)

(ii) Discount given to sharesholers on purchasing company's products.

(iii) Remuneration paid to shareholders in capacity of director, managing director, officer, employee of company or as a professional for services rendered by them.

(iv) Guarantee commission paid for standing as guarantor for the company.

(v) Interest on loans, deposits made by shareholdes and debentures held by majority shareholder- Eastern Investments Ltd. v. CIT 1951 -TMI - 49735 - (SUPREME Court ) (vi) Devaluation loss while remitting dividend to shareholders abroad - Goodricke Group Ltd. No. (2) v. CIT 1991 -TMI - 21092 - (CALCUTTA High Court)

(vii) Interest paid on capital borrowed to pay dividend - CIT v. Shree Changdeo Sugar Mills Ltd. 1982 -TMI - 28655 - (BOMBAY High Court), CIT v. Belapur Co. Ltd 1985 -TMI - 26541 - (BOMBAY High Court) and CIT v. Tingri Tea Co. Ltd. 1970 -TMI - 7924 - (CALCUTTA High Court)  

(viii) Share issue expenses, expenses in paying dividend, providing annual reports etc. to shareholders.

While allowing these expenses, it has been held that the expression 'for the purpose of business' is wider and it may take into account not only the day-to-day running of the business but also several other matters. Applying these principles, it can also be argued that dividend, if paid in terms of a contract entered into prior to the earning of income, is an allowable business expenditure, because dividend is reward for money invested and it is in the nature of expenditure; once it is declared, it has to be compulsorily paid. If it remains unclaimed, it has to be deposited in a separate account and then to be transferred to the Government's general fund. Thus, on declaration of dividend the money goes out of the pocket of the company for ever. It is not a gratuitous payment, nor a personal expense, nor a capital expense. It is not expressly disallowed under sections 40 and 40A of the Income-tax Act, 1961. The scope of the residuary provisions of section 37 or section 28 of the Act to allow business expenditure is wide and it should be liberally construed - CIT v. Kalyanji Mavji & Co. [2008 -TMI - 5829 - SUPREME Court.]

Contractual  dividend

When articles of association is amended, fund created as well as dividend paid as per revised articles of association becomes contractual obligations of the company.

 In the changed circumstances, it is essential that the articles of companies should contain provisions so as to enable the shareholders to have an assurance to get dividend. Companies may amend their articles of association and incorporate clauses on the following lines :-

(i) Dividend Fund Account - 30 per cent of profits computed in accordance With the provisions of the Companies Act, 1956 shall be credited to a separate account named as 'Annual Dividend Fund A/c.' The fund so created shall be maintained in a separate account and/or  invested separately. Income derived from the investments out of the fund shall also be accumulated in the same account.

(ii) Minimum annual dividend- The Annual Dividend Fund Account shall be used only for the purpose of declaration of annual dividend. Subject to the availability of Annual Dividend Fund, the Board shall recommend a minimum of 10 per cent annual dividend.

(iii) Lower dividend - In case the balance in the Annual Dividend Fund Account is not sufficient to recommend 10 per cent annual dividend, then the Board shall recommend dividend at a rate lower than 10 per cent and distribute the entire amount lying in the Annual Dividend Fund Account.

(iv) Shareholders discretion - Shareholders holding shares carrying at least ten per cent of voting rights may propose to declare dividend out of the Annual Dividend Fund Account, at a rate higher than the rate of annual dividend recommended by the Board. The annual dividend at such higher rate shall be declared by the company if it is approved by ordinary resolution in the annual general meeting.

(v) Board to hold funds - The Board shall hold the Annual Dividend Fund monies and investments for and on behalf of the shareholders of the company.

(vi) Tax on dividend distributed, if any, shall also be paid out of annual dividend fund account.

The above-mentioned amendment can be made at the initiative of the Board of Directors who can convene a general meeting, or the shareholders holding 10 per cent share capital can requisition a general meeting for the proposed amendments by way of special resolutions. The Securities and Exchange Board of India (SEBI) and the stock exchange can also probably intervene in the matter and enforce amendment of the articles by amending the listing requirements.

Benefits of amendments

 Assured sharing of profit before the earning - The most important advantage of the proposed amendments will be that the declaration of dividend to remunerate shareholders of the company will be more logical, fair and reasonable because the shareholders will have an assured share in profit before the profit is earned and they will get dividend out of the 'Annual Dividend Fund Account' till there is balance in it.

PAT/EPS improvement - It can be argued that the amount which a company is bound to credit to the Annual Dividend Fund Account is not the income of the company because it is diverted at source by way of an overriding title before the income is earned, as per the legal and contractual obligations. Furthermore, in view of the changed circumstances as discussed earlier, the amount to be credited to the Annual Dividend Fund Account can also be claimed as an expenditure wholly and exclusively incurred for the purpose of business as it is to service funds provided by the shareholders and it will improve the reputation and goodwill of the company.

On the principles of diversion by way of overriding title or as an allowable expenditure we may rely on the following decisions :

(i) CIT v. Travancore Sugars & Chemicals Ltd. [2008 -TMI - 6378 - SUPREME Court]. - In this case, the assessee-company purchased from the then Government of Travancore one sugar mill, a distillery unit and a tincture factory. Besides the consideration for purchase of the manufacturing units the assessee also agreed to pay 20 per cent of its profits, as and when profits accrued to the company. The share in profit which was payable to the Government as per the agreement was not allowed by the Income-tax authorities as a deduction. However, the Supreme Court allowed it as an expenditure as well as by way of diversion of income at source by holding as follows :

Viewing from any point of view, whether as a revenue expenditure or as an overriding charge on the profit-making apparatus or as an expenditure laid out and expended wholly and exclusively for purposes of trade, the amount was an allowable deduction under the Act.

(ii) CIT v. Surat Jilla Kamdar Sahakari Sangh Ltd. 1992 -TMI - 21234 - (GUJARAT High Court) - In this case, the assessee was granted a loan of Rs. 3 lakhs by the Government at a subsidized rate of interest of 2.5 per cent per annum, which was to be repaid in 5 equal annual instalments. Over and above the repayment of the loan and interest, the assessee, under the terms and conditions of the loan agreement, was also obliged to provide for and pay 25 per cent of its profit to the Government. The relevant terms and conditions in the loan agreement read as follows :

"Every year, the Sangh has to provide 25% out of gross profit towards loan charges to the Government. Rs. 3,35,008 be repayable in five equal annual instalments. The guarantee amounts at ½% shall be remitted to the Government treasury."

On a consideration of these terms and conditions, the Gujarat High Court held that the assessee,under agreement, was required to make provision at the rate of 25 per cent out of the gross profits which were payable by the assessee to the Government and, therefore, profits to that extent were diverted in favour of the Government by way of overriding title and, were deductible from income.

(iii) CIT v. S. Arumugham Pillai 1968 -TMI - 7471 - (MADRAS High Court)  - In his case, the assessee was a partner in two firms - B firm and J. Firm. J advanced money to B as and when needed and the amount so advanced was treated in the books of B as the capital of the assessee. Under a written agreement between the assessee and the other two partners of J, it was agreed that the income of the assessee from B as its partner was to be shared by the assessee and the other two partners of J. The Madras High Court held that the agreement between the assessee and the other partners of J had the effect of making an effective diversion at source of the profits by an overriding title created by it and, hence, the real income of the assessee was only l/3rd of his share of income in B and 2/3rds of the income was diverted at source, in favour of the other two partners of J.

In view of the above mentioned decisions, it can be argued that if a company is contractually and/or legally required to credit a certain percentage of annual profits to the Annual Dividend Fund Account to be maintained separately and used only for payment of dividend and no other purpose, and even in an year of loss, from the balance in the Annual Dividend Fund Account, the company can pay dividend in accordance with the articles of association, then it appears that the amount to be compulsorily credited to the Annual Dividend Fund Account shall not be income of the company because it will get diverted at source by an overriding title.

Alternatively, it also appears that the amount so credited to the Annual Dividend Fund Account can also be treated as an expenditure incurred wholly and exclusively for the purpose of the business of the company because the money raised by way of share capital is used by the company for the purpose of its business and the amount which is to be credited to the Annual Dividend Fund Account in terms of the articles of association is an allowable business expenditure because it is neither personal expenditure nor capital expenditure nor a specifically disallowed item. These claims find support from the judgment of the Supreme Court in the case of Travancore Sugars & Chemcials Ltd. [2008 -TMI - 6378 - SUPREME Court.]

 Avoidance of double taxation - If a part of profit is diverted at source in favour of shareholders, then the company will not be required to pay tax on it. Only the shareholders will be required to pay the tax on dividend received by them. Thus, double taxation of the dividend will come to an end.

 Boosting capital market - Contractual and mandatory dividend shall improve the relationship between company and shareholders and enhance the goodwill of the company. Investment in shares will become more attractive. The Indian public. Non-resident Indians (NRIs) foreign nationals and foreign financial institutions, etc., shall find companies having mandatory dividend clauses, more attractive than those not having such clauses.

All the above-mentioned advantages will certainly have the cumulative effect of giving a boost to the capital market and making the equity cult more popular among the public.

Current provisions:

As per Section 115 O, dividend distribution tax and dividend distributed are not allowable as expenditure. However this provision does not affect the condition of transferring certain contractual amount to annual dividend fund account. Therefore, the contribution to annual dividend fund may be allowed as expenditure because there is no bar under section 115 O. However, dividend distributed from annual dividend fund account shall not be allowed as expenditure for the reason of provisions of Section 115 O as well as for the reason that it was allowed at the time of creation of annual dividend fund account and second time deduction is not permissible.

Published Article on related topic:

The readers may refer to article titled "Case study and suggestions about allowability of dividend" published in the Chartered Accountant -November 2008 issue.

Request from readers:

Readers are requested to place their suggestions, remarks and feedback on the website so that the purpose of article can be achieved in greater manner.