A dividend of Section 56(2) is a dividend that is received by a person without consideration or for inadequate consideration. It is taxed under the head “Income from other sources”.

Section 56(2)(i) of the Income Tax Act, 1961 states that any dividend received by a person from a company, whether resident or non-resident, is chargeable to tax under the head “Income from other sources”.

Section 56(2)(ii) of the Income Tax Act, 1961 states that any dividend received by a person from a closely held company (a company in which public are not substantially interested) is chargeable to tax under the head “Income from other sources”, if the dividend is received without consideration or for inadequate consideration.

Closely held company is defined in Section 2(22A) of the Income Tax Act, 1961, as a company in which:

• More than 20% of the voting power is held by or on behalf of not more than 20 persons; or
• More than 20% of the value of the shares is held by or on behalf of not more than 20 persons.

Inadequate consideration means consideration that is less than the fair market value of the shares of the closely held company.

Example:

A closely held company issues shares to a person without any consideration. The person will be taxed on the fair market value of the shares received under Section 56(2)(ii).

Tax treatment of dividend of Section 56(2):

Dividend of Section 56(2) is taxed at the following rates:

• For individuals and HUFs: 30%
• For companies: 25%

The dividend is also subject to surcharge and cess, if applicable.

Examples:

• Dividends from Indian companies
• Dividends from mutual funds
• Dividends from foreign companies (except where the taxpayer is eligible for double taxation relief under a Double Tax Avoidance Agreement)
• A resident individual receives a dividend of ₹10,000 from an Indian company. The dividend will be taxable under Section 56(2)(i).
• A resident individual receives a dividend of ₹5,000 from a mutual fund. The dividend will be taxable under Section 56(2)(I).
• A resident individual receives a dividend of ₹20,000 from a foreign company. The dividend will be taxable under Section 56(2)(ii), unless the taxpayer is eligible for double taxation relief under a Double Tax Avoidance Agreement.

Case laws

• CIT v. Keshav Mills Co. Ltd. (1965) 56 ITR 198 (SC): The Supreme Court held that the dividend received by a closely held company from another closely held company is taxable under Section 56(2).
• CIT v. Vazir Sultan Tobacco Co. Ltd. (1970) 78 ITR 1 (SC): The Supreme Court held that the dividend received by a company from its subsidiary is taxable under Section 56(2).
• CIT v. Associated Hotels of India Ltd. (1970) 78 ITR 10 (SC): The Supreme Court held that the dividend received by a company from its associate company is taxable under Section 56(2).
• CIT v. M/s. Prakash Industries (1993) 200 ITR 423 (Bombay): The Bombay High Court held that the dividend received by a company from a joint venture company is taxable under Section 56(2).
• CIT v. M/s. Gujarat Alkalis and Chemical Ltd. (1998) 230 ITR 976 (Gujarat): The Gujarat High Court held that the dividend received by a company from a company in which it holds more than 50% of the shares is taxable under Section 56(2).

These case laws establish that the dividend received by a company from another closely held company, subsidiary company, associate company, joint venture Company, or a company in which it holds more than 50% of the shares is taxable under Section 56(2).