Concept of Diversion of Income
Date : 9-08-2016
One of the fundamental principles of taxation is to tax income accruing or deemed to accrue in favour of the taxpayer. The concept of diversion of income and application of income though fundamental has great tax implication since it is a court made concept. It is well known that income when diverted before reaching the assessee is called as diversion of income, whereas when the income is applied after it reaches the assessee, either due to contractual obligation or exercise of discretion, it is called as application of income.
As explained by Apex Court The essence of the concept of diversion of income could be found in CIT v. Sitaldas Tirathdas (1961) 41 ITR 367 (SC). The Apex Court laid out the tests for determining when an income can be said to have been diverted at source as a result of a charge or overriding title. The following is the observation of the Apex Court in Sitaldas Tirathdas’s case which is quite often repeated in various judicial forums:
“The true test is whether the amounts sought to be deducted, in truth, never reached the assessee as his income. Obligations, no doubt, there are in every case, but it is the nature of the obligation which is the decisive fact. There is a difference between an amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where, by obligation, income is diverted before it reaches the assessee, it is deducted; but where the income is required to be applied to discharge the obligation after such income reaches the assessee, the same consequence, in law, does not follow. It is the first kind of payment which can truly be excused and not the second. The second kind of payment is merely an obligation to pay another a portion of one’s own income, which has been received and is since applied. The first is a case in which the income never reaches the assessee, who even if he were to collect it, does so, not as part of his income, but for and on behalf of the person to whom it is payable”.
A perusal of the above said landmark case gives us a few key points:
(i) an income diverted at source by overriding charge is not chargeable to tax in the hands of the actual recipient;
(ii) a charge created for diversion of income by overriding title will insulate the recipient from tax consequences and merely because he receives the same, he could not be taxed.
An example of overriding charge is that person giving a property as a gift to another person may create a charge that the recipient is eligible to enjoy the property and its income subject to satisfying certain conditions. The conditions could be to pay a specified sum to a particular person at periodic intervals or to share the rental income from the property with a particular person for a particular period of time.
In Nariman B. Bharucha’s case (1981) 130 ITR 863 Shri. Nariman Bharucha running a proprietary concern converted the same into partnership by admitting his two sons as partners and allotted 37.5 percent share to each son. The balance of 25 percent share of profit or loss was retained by him. The deed of partnership contained a recital that in the event of the demise of the erstwhile proprietor, the surviving partners have to pay 25 percent share of profits of the firm to the widow of the deceased partner (i.e. wife of erstwhile proprietor and mother of two surviving partners). It so happened that the erstwhile proprietor deceased and the firm paid 25 percent of profits to the widow of the deceased partner and claimed the same as expenditure. The claim of the assessee was negative by the revenue.
The court made a reference to the precedent in the case of CIT v. Patuck (1969) 71 ITR 713 (Bom) wherein it was held that whenever a charge is created, the income which has been made the subject of the charge ceases to be the income of the assessee and the charge creates an overriding title in favour of the charge-holder to recover the income before it reaches the hands of the assessee.
The court held that it is obvious from the deed of partnership that 25 percent of income of the firm did not belong to any of the two partners and if at all that income was received by them, it was for and on behalf of the charge-holder. The nature of the charge created by the document viz.
the partnership deed had an overriding title and such income clearly got diverted before the profits reached the partners of the assessee firm. Thus, a charge created on the profits of the partnership firm got diverted by overriding title and such portion could not be taxed in the hands of the firm. In present Scenario, the above decision and how it could be accommodated in the light of the tax provisions dealing with taxation of partnership firms, unfold an interesting scenario. The partnership firm must authorize the payment by overriding charge. Such authorization may be of two types
(i) before allowance of working partners’ salary and interest on capital; and
(ii) after allowance of working partners’ salary and interest on capital.
When the quantum of diversion of income is made with reference to the profits of the firm before allowance of interest on capital and working partner salary, it would be larger and where the diversion of income by overriding title is applicable after payment of interest on capital and working partners’ salary then it would be comparatively less. There is no prohibition in law with regard to such diversion of income by overriding title and therefore it could be advantageous to divert the income by overriding title before allowance of working partners’ salary and interest on capital.
In such a case, the deed would tacitly admit that the working partners’ salary and interest on capital are appropriation of profit. Whether it is a charge or appropriation of profit would make no difference so far as the income-tax law is consequence in recipient’s assessment.
The above said concept of diversion of income by overriding title exempts the actual recipient of income from tax consequences. However, the person to whom the income is diverted is chargeable to tax for the income so received by him.
An interesting case of a recipient receiving such payment from a partnership firm was discussed in Dy.CIT v. Mrs. Lakshmi M.Aiyar (2011) 131 ITD 436 (Mum). In this case, the assessee, a widow of deceased partner, became eligible for 5% of the gross receipts of the firm for a period of 10 years as per the condition laid down in the deed of partnership. She received a sum of ' 20.26 lakhs in the financial year 2004-05 but did not offer the same as income for the reason that it is a capital receipt and did not have any semblance of revenue nature.
The Tribunal held that the assessee had received the amount from the firm and such receipt was not in relation to any service or business done by her for the firm. It was not to compensate for any loss suffered by her because of the firm. Similarly, it is not a compensation for the services rendered by her either in present or in future. The Tribunal applied the Circular No.573, dated 21.08.1990 which exempts lump sum ex-gratia payment received by widow or legal heir of an employee who dies while in active service. The Tribunal held that the very spirit of the Circular is to exempt any payment made to the legal heirs of the deceased employee to support them in hardship and ensure livelihood and accordingly, such receipt is not chargeable to tax. It may be noted that the facts of the case relate to the financial year after the insertion of section 56(2) (v) (introduced by Finance Act, 2004 w.e.f. 01.09.2004) meant for taxing gifts from non-relatives. Conclusion Tax laws and for that matter any law has to accommodate the requirements of the users and administrators.
The aspects of practical relevance and application are always the corner stones of legislative wisdom. Income-tax law is no exception to these principles but yet the concept of diversion of income by overriding title and its tax consequence continues to be judge made law.