Dividend is Return on Share Capital, Not Lending Activity: Supreme Court holds Dividend Income Not Eligible for S. 36(1)(viii) Deduction [Read Judgement]

In a recent reportable judgment, the Supreme Court clarified that dividend income does not qualify as “profits derived from the business of providing long-term finance” and is therefore not eligible for deduction under Section 36(1)(viii) of the Income Tax Act, 1961.

“Since the statute specifically mandates ‘interest on loans’, extending this fiscal benefit to ‘dividends on shares’ would defy the legislative intent. Therefore, we hold that dividend income does not qualify as profits derived from business of providing long-term finance” ruled the court.

A series of appeals was filed by the National Cooperative Development Corporation (NCDC) against the income tax department, which had claimed deductions on dividend income earned from investments in redeemable preference shares.

The Court rejected the corporation’s argument that such dividends were akin to interest from long-term finance and held that dividend is legally and commercially a return on share capital, not on lending activity.

The apex court noted down the settled law, observing that preference shares, despite having a fixed redemption schedule and fixed dividend rate, remain share capital and cannot be treated as loans or advances for tax purposes.

According to the bench, the immediate source of dividend income is the shareholder’s contractual relationship with the company, not any underlying agricultural or financing activity. A shareholder is not a creditor, the Court pointed out, and therefore cannot claim that dividend arises from business operations such as lending.

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Because Section 36(1)(viii) of Income Tax Act restricts deductions to profits derived from long-term loans or advances of not less than five years, dividends which arise from equity participation fall completely outside the statutory definition, said the court.

The Court clarified that Parliament deliberately limited the application of Section 36(1)(viii) after the Finance Act, 1995 in order to guarantee that the deduction only applied to revenue obtained directly from long-term financing and not from subsidiary or incidental operations.

The judges showed a clear line between the shareholder and a creditor. According to them, “a fundamental distinction exists between a shareholder and a creditor. The basic characteristic of a loan is that the person advancing the money has a right to sue for the debt. In stark contrast, a redeemable preference shareholder cannot sue for the money due on the shares or claim a return of the share money as a matter of right, except in the specific eventuality of winding up.”

Additionally, Justice Justice Pamidighantam Sri Narasimha and Justice Atul S. Chandurkar, in their extensive judgment said that allowing dividend income to qualify would defeat the legislative purpose by enabling financial corporations to claim incentives on unrelated investments simply because they also carry out lending operations.

Therefore the Division bench rejected NCDC’s argument that its activities formed a “single integrated business,” holding that fiscal benefits cannot be broadened by such characterisations when the statute uses strict linkage language like “derived from.”

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