Director Loans: Section 185 and Section 2(22)(e) Are Not One Question

A director's current account is the single most-examined ledger in a private company audit, and the reason is that one balance can be tested under two different statutes with two different consequences.

Move money to a director and you are in section 185 of the Companies Act. Move it to certain shareholders and you may be in section 2(22)(e) of the Income-tax Act. The same entry, read by two authorities, with penalties on one side and tax on the other.

Section 185: what changed, and what did not

Section 185 is often remembered as a flat prohibition on loans to directors. It has not read that way since the 2017 amendment, and treating it as an absolute bar produces qualifications that are not warranted.

The current position is closer to: a company shall not advance a loan to a director or to any person in whom the director is interested — with a carve-out permitting loans to certain entities where the company follows a specified route, including a special resolution and an end-use condition.

What survives untouched is the scope of who counts. "Any person in whom the director is interested" reaches well past the director:

• A private company where the director is a director or member.
• A body corporate where directors exercise 25% or more of the voting power.
• A firm in which the director or a relative is a partner.
• A relative of the director.

That last one does most of the damage in practice. A payment to a director's brother's firm is not obviously a section 185 transaction when you are looking at the ledger name, and it is squarely one.

Section 2(22)(e): the tax consequence nobody budgets for

Section 2(22)(e) taxes certain payments as deemed dividend — a loan or advance by a closely-held company to a shareholder holding 10% or more of the voting power, or to a concern in which such a shareholder has a substantial interest.

Two features make this expensive and surprising.

It is taxed in the recipient's hands, not the company's. The director takes a temporary advance, repays it two months later, and still has dividend income for the year.

Repayment does not undo it. The charge attaches when the payment is made. A loan taken in June and cleared in August was still a loan in June.

And the ceiling is the company's accumulated profits. A company with large reserves and a small director advance has the whole advance exposed.

Section 185 asks whether the company was allowed to pay. Section 2(22)(e) asks what the payment cost the person who received it. Answering one does not answer the other.

Why the ledger will not tell you

The reason this is hard has nothing to do with the sections and everything to do with identification.

Nothing in a Tally ledger marks a party as related. "Sunrise Traders" is a name. Whether it is a firm in which a director's spouse is a partner is a fact that lives in the client's head, in a Form MBP-1, or nowhere.

So the work splits into two halves that firms usually keep separate: establishing who the related parties are, and then finding every transaction with them. Doing the second by scanning ledger names finds the obvious ones and misses exactly the ones that matter — the entity two relationships away that nobody thought to look at.

There is a third consequence of the same identification, easy to forget: once a party is related, every transaction with it is also an AS 18 disclosure, and section 188 may require board or member approval for the contract itself. One fact, three obligations.

How Audcrix runs it

Audcrix treats related-party identity as a fact established once and then applied everywhere, rather than as a search repeated in each module.

• Parties are mapped once. Nature, relationship and value are held per party, and every transaction with that party is then found across the whole voucher population rather than by name-matching a ledger.
• Each party discloses on its own leg, so a P&L expense ledger for a related party discloses under the expense it actually is, not lumped into a single related-party total.
• Section 185 and section 2(22)(e) are evaluated together, because they are two readings of one payment. The 185 analysis runs the exemption test and returns a verdict per party rather than a blanket answer.
• Entity type gates the test. Section 185 is a Companies Act obligation; a firm, an LLP or a trust is not asked a question that does not apply to it, and the reason is stated on the card.
• Overrides are logged. When a CA concludes a party is or is not related, that judgement is recorded with who made it and when — which is the trail a peer reviewer asks for.

The design assumption is that identification is the hard part and computation is the easy part. Most tools invert that, and it is why they find the obvious related party and miss the one that costs money.

Audcrix is audit and compliance intelligence for Indian CA firms. It maps related parties once and applies them across every transaction in the population. See how it works.