Taxation of Dividend Income Under the Income Tax Act 1961

Dividend income is chargeable to tax in the hands of the recipient assessee under the head “Income from Other Sources”. The rate, timing, and manner of taxation depend primarily on:

  • The residential status of the assessee; and
  • The nature of the instrument generating such dividend, such as equity shares, mutual fund units, GDRs, AIFs, REITs/InVITs, etc.

This write-up provides a structured overview of how dividends are defined, when they are taxed, and how different forms of dividend income are treated under the Income Tax Act 1961.

Concept and Scope of Dividend

Statutory Meaning of Dividend

In its basic commercial sense, dividend refers to a distribution of the accumulated profits of a company to its shareholders, generally in proportion to their shareholding.

However, for income-tax purposes, the term has a much wider ambit. Under Section 2(22) of the Income Tax Act 1961, certain distributions and payments are treated as deemed dividend, even if they are not dividends in the traditional corporate law sense.

Items Treated as Dividend under Section 2(22)

The expression “dividend” under Section 2(22) covers, in addition to ordinary dividend:

  1. Distribution resulting in release of assets

    • Any distribution of accumulated profits by a company which leads to the release of company assets to shareholders is regarded as dividend to that extent.

  2. Debenture or deposit certificate distribution

    • If a company distributes debentures or deposit certificates (with or without interest) to shareholders out of accumulated profits, that value is considered as dividend.

  3. Allotment of shares to preference shareholders

    • When preference shareholders receive equity shares out of accumulated profits, such value may be taxed as dividend.

  4. Distributions on liquidation

    • Where, on liquidation of a company, any payment is made to shareholders to the extent it represents accumulated profits, such amount is treated as dividend.

  5. Distribution on capital reduction

    • Any payment or distribution on account of reduction of share capital to the extent it is attributable to accumulated profits is regarded as dividend.

  6. Loans or advances to specified shareholders/concerns

    • Any loan or advance given by a closely held company to:
      • A shareholder holding a substantial interest, or
      • A concern in which such shareholder has substantial interest,
        is treated as deemed dividend to the extent of the company’s accumulated profits. This is governed by Section 2(22)(e).

  7. Payment on buy-back of shares

    • In certain legacy situations, payments on buy-back might be covered; however, presently buy-back of shares is largely governed by specific provisions imposing tax on the company (subject to prevailing law), and not as dividend in the hands of the shareholder.

Items Not Regarded as Dividend

While Section 2(22) expands the scope of dividend, specific exclusions are carved out to avoid overreach and double taxation.

Key Exclusions from Dividend Treatment

The following are not treated as dividend under the Income Tax Act 1961:

  1. Issue of bonus shares to equity shareholders

    • When a company issues fully paid bonus shares to its existing equity shareholders out of reserves, such issue is not treated as dividend.

  2. Certain sums on liquidation

    • Payments on liquidation, to the extent they represent return of capital (and not accumulated profits), do not fall within the definition of dividend.

  3. Loans/advances by money-lending companies in ordinary course

    • If a company whose substantial business is money lending grants loans or advances to its shareholders in the ordinary course of its business, such loans/advances are not deemed dividend.

  4. Share allotment pursuant to demerger

    • Issue or distribution of shares to shareholders on account of a demerger is specifically excluded from the scope of dividend.