Understanding "Person Who Has a Substantial Interest in the Company" Under Income Tax Act, India

The Income Tax Act, 1961, uses the concept of a "person who has a substantial interest in the company" in several provisions to determine tax liabilities and obligations. Understanding who qualifies as such a person is crucial for both individuals and companies to ensure compliance with the law. This article delves into the definition, relevant provisions, implications, and complexities surrounding this term under the Indian Income Tax framework.

Defining "Substantial Interest": Section 2(32) of the Income Tax Act, 1961

Section 2(32) of the Income Tax Act, 1961, defines "person who has a substantial interest in the company" in relation to a company. According to this section, a person is considered to have a substantial interest in a company if:

• Holding Beneficial Ownership of Equity Shares: The person is the beneficial owner of equity shares carrying not less than 20% of the voting power in the company. The focus is on beneficial ownership, not merely legal ownership. This means the person must have the right to enjoy the benefits associated with the shares, such as dividends and voting rights.
• Entitlement to Not Less Than 20% of Profits: The person is beneficially entitled to not less than 20% of the profits of the company. This is an alternative criterion to the equity shareholding and focuses on the person's right to receive a significant portion of the company's earnings.

Key takeaways from the definition:

• Beneficial Ownership is Critical: The law emphasizes beneficial ownership. A person registered as the shareholder but acting as a nominee for someone else isn't considered to have a substantial interest unless they also benefit from the shares.
• Threshold of 20%: The 20% threshold is a hard limit. Holding even 19.99% wouldn't qualify a person as having a substantial interest under this section.
• Either Voting Power or Profits: Meeting either the 20% voting power criterion or the 20% profit entitlement criterion is sufficient to establish a substantial interest.
• Applicability to All Types of Companies: This definition generally applies to all types of companies, whether public or private, unless specifically excluded under other provisions of the Income Tax Act.

Relevance of "Substantial Interest" in Various Sections of the Income Tax Act

The concept of "person who has a substantial interest in the company" is relevant in numerous sections of the Income Tax Act. Here are some prominent examples:

1. Section 40A(2)(b): Disallowance of Excessive or Unreasonable Payments

• Context: This section deals with situations where a company makes payments to related parties, and the Assessing Officer believes that such payments are excessive or unreasonable.
• Relevance: "Person who has a substantial interest in the company" is included within the definition of "related party." If a payment is made to a person who has a substantial interest in the company (or to a relative of such person, or to a company in which such person has a substantial interest, etc.), the Assessing Officer can disallow the excessive or unreasonable portion of the payment while calculating the company's taxable income.
• Objective: To prevent companies from artificially reducing their taxable income by channeling funds to related parties through inflated expenses.

2. Section 56(2)(vii): Taxation of Gifts and Benefits

• Context: This section deals with the taxation of certain gifts and benefits received by individuals or HUFs.
• Relevance: If a company, in which the recipient has a substantial interest, provides any movable property (such as shares, securities, jewelry, etc.) to such recipient for inadequate consideration or without consideration, the difference between the fair market value and the consideration (if any) may be taxable in the hands of the recipient.
• Objective: To prevent tax evasion by disguising income as gifts or benefits from companies controlled by the recipient.

3. Section 2(22)(e): Deemed Dividend

• Context: This section defines certain payments made by a company to its shareholders as "deemed dividends," which are taxable in the hands of the shareholders.
• Relevance: If a company, which is not a company in which the public are substantially interested, makes a loan or advance to a shareholder who has a substantial interest in the company, or to a concern in which such shareholder is a member or partner and in which he has a substantial interest (not less than 20% of the income of such concern), the loan or advance may be treated as a deemed dividend to the extent of the company's accumulated profits.
• Objective: To prevent companies from distributing profits to shareholders in the form of loans or advances to avoid dividend distribution tax. The amendment made by Finance Act, 2018 has significantly altered the taxation of Deemed dividend.

4. Other Sections:

• The concept also becomes relevant in the context of transfer pricing regulations (Section 92C) where transactions between associated enterprises, including those where a person has substantial interest, are scrutinized.
• It also impacts deductions claimed under Chapter VI-A, like Section 80G, where donations to certain entities connected to persons with substantial interest might face restrictions.

Implications of Having a Substantial Interest

Having a substantial interest in a company carries significant implications under the Income Tax Act. These include:

• Increased Scrutiny: Transactions between the company and the person with a substantial interest are subject to greater scrutiny by tax authorities to ensure they are conducted at arm's length and not designed to evade taxes.
• Potential for Disallowance of Expenses: As mentioned earlier, expenses paid to a person with a substantial interest may be disallowed if deemed excessive or unreasonable.
• Taxability of Benefits: Any benefits or perquisites received from the company may be taxable in the hands of the person with a substantial interest.
• Attribution of Income: In certain situations, income may be attributed to the person with a substantial interest if the company is used as a vehicle to avoid taxes.
• Implications for Deemed Dividend: Loans or advances received from the company may be treated as deemed dividends, leading to tax liability.

Complexities and Challenges

The application of the "substantial interest" concept can be complex in certain situations:

• Indirect Holding: Determining beneficial ownership can be challenging, especially when shares are held through multiple layers of entities or trusts. Tax authorities may need to "pierce the corporate veil" to identify the ultimate beneficial owner.
• Partnership Firms and AOPs: When a person is a partner in a partnership firm or a member of an Association of Persons (AOP), determining their share of profits or voting power in the company can be complicated. The terms of the partnership deed or the AOP's constitution will be crucial.
• Changing Ownership Structures: Changes in ownership structures, such as mergers, acquisitions, or transfers of shares, can affect whether a person has a substantial interest in a company. The timing of these changes is critical.
• Shareholding Agreements: Shareholding agreements may contain provisions that affect voting rights or profit entitlements. These agreements must be carefully considered when determining whether a person has a substantial interest.
• Beneficial vs. Legal Ownership: Differentiating between legal and beneficial ownership requires careful examination of the facts and circumstances. Simply being a registered shareholder doesn't automatically mean having a substantial interest. The real economic benefits of the shares must accrue to the individual.

Case Laws and Judicial Interpretations

Several court cases have interpreted and clarified the meaning of "person who has a substantial interest in the company." These cases provide valuable guidance in applying this concept:

• Commissioner of Income-Tax vs. Bhagwati Developers (P) Ltd. (2012): This case emphasizes the importance of beneficial ownership in determining whether a person has a substantial interest. The court held that the mere fact that a person is a registered shareholder is not sufficient; they must also be the beneficial owner of the shares.
• CIT v. Bhaumik Colour P. Ltd (2009): This case highlights the importance of looking at the overall circumstances to determine whether a transaction is genuine or designed to evade taxes.

(Note: Specific case law citations should be verified and updated to reflect the most recent legal precedents.)

Due Diligence and Compliance

Given the complexities and implications of the "substantial interest" concept, companies and individuals should take the following steps to ensure compliance:

• Maintain Accurate Records: Maintain accurate records of shareholding, profit entitlements, and any related agreements.
• Conduct Due Diligence: Conduct thorough due diligence to identify all persons who may have a substantial interest in the company.
• Seek Professional Advice: Consult with tax professionals to understand the implications of having a substantial interest and to ensure compliance with the Income Tax Act.
• Disclose Related Party Transactions: Disclose all transactions with persons who have a substantial interest in the company in the company's tax returns.
• Arm's Length Pricing: Ensure that all transactions with related parties are conducted at arm's length to avoid disallowance of expenses.

Conclusion

The concept of "person who has a substantial interest in the company" is a critical element of the Indian Income Tax Act. Understanding the definition, implications, and complexities associated with this term is essential for both individuals and companies to ensure compliance with the law. By carefully monitoring ownership structures, conducting due diligence, and seeking professional advice, taxpayers can minimize the risk of tax disputes and penalties. Staying updated with the latest judicial pronouncements and amendments to the Income Tax Act is also crucial for navigating the intricacies of this area of taxation.