There are certain fundamental concepts which play a very elementary role
in the computation of income tax. One such concept is application of
income. Closely related to it is another fundamental concept called
diversion of income by overriding title. These two concepts have been a
constant source of litigation and have knocked the doors of the Supreme
Court and various High Courts on numerous occasions.
In case of diversion of income by overriding title, the income before coming to the hands of the assessee is diverted from the source itself and hence is not liable for tax. But in case of application of income the transaction is overlooked and the assessee in whose hands the income accrues becomes liable for tax. The distinction between these two concepts assumes importance as it helps in determining the liability of an individual to income tax. Once the income has accrued or arisen, the Income Tax Act (herein after referred as Act) is not concerned about what happened to it thereafter. In other words the Act is oblivious to the destination or disposal of the income.
Application of IncomeA cursory perusal of the S.60 of the Act will make it clear that unless there is transfer of the assets from which the income arises, the income arising from that asset will be included in the income of the transferor for computation of tax. The issue in Life Insurance Company v. Commissioner of Income Tax, Bombay City was whether, under S.28 of the Life Insurance Corporation Act, 1956 the surplus which is statutorily payable to the Central Government, is a permissible deduction from the surplus disclosed for the inter-valuation period ended March 31, 1963 or not?
The appellant contended that this was a case of diversion of income by an overriding charge in so far as a part of the surplus was compulsorily required to be paid to the Central Government. The Apex Court did not found any substance in the argument of the Corporation and held that the statutory obligation that has been imposed on the Corporation comes into effect only when the income accrues to the Corporation and not before that. Since the obligation has to be discharged only after the income has been received by the Corporation, there was no question of any overriding charge so as to result in diversion of any income to the Central Government. The researcher also sees in line with the Apex Court judgment. It is only a question of application of income. S.28 operates only after the surplus has reached the hands of the Corporation and therefore there is no diversion of any income by an overriding charge. In other words, S.28 provides for the manner in which the surplus is to be distributed after it has been properly determined.
The respondent in Commissioner of Income Tax, Bombay v. Sitaldas Tirathdas sought to deduct a sum of Rs. 1,350 in the first assessment year and a sum of Rs. 18,000 in the second assessment year on the ground that under a decree he was required to pay these sums as maintenance to his wife and his children. This was disallowed by the Income Tax Officer. The matter reached till the Supreme Court.
The Supreme Court made a distinction between the amount which a person is obliged to apply out of his income and an amount which by the nature of an obligation cannot be said to be the part of the income of the assessee. When the income does not reach the hands of the assessee due to diversion under an obligation, it is deductible. But on the other hand when the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence in law does not follow. The first kind of payment is exempted under the Income Tax Act but not the second one. The second one is a case of application of income which has been received. 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. On the facts and circumstances of the case it was held that it was a mere case of application of income to discharge an obligation. The wife and children of the assessee who continued to be members of the family received a portion of the income of the assessee only after the assessee had received the income as his own. Therefore there was no diversion of income by an overriding charge.
The testator in P.C. Mullick and Another v. Commissioner of Income Tax, Bengal appointed the appellants as executors and directed them to pay Rs. 10,000 out of the income on the occasion of his addya sradh. The executors paid Rs. 5,537 for such expenses, and sought to deduct the amount from the assessable income. The Judicial Committee disallowed the deduction. It held that whatever payments were made, were done once the income had reached the hands of the assessee and in pursuance of the obligation imposed upon them by the testator. This was not the case of diversion of income. It is submitted that the decision of the Judicial Committee in the above case rightly brings out the intention of the drafters of the Act. The Act is not concerned about how one spends his money, that is, the Act is indifferent to the destination of the income. What is of material concern is that whether the income has reached the hands of the assessee or not. Once it is in the hands of the assessee it is liable for tax.
The appellant in Provat Kumar Mitter v. Commissioner of Income Tax, West Bengal had under a contract assigned to his wife the right, title and interest to all dividends and sums of money which might be declared or might become due on account for the term of her natural life. In assessing the assessee the Income Tax Officer included the dividend paid to his wife as his income. It was contended by the assessee that the dividend which his wife received could not be deemed to be his income.. The department argued that since the shares continued to stand in the name of the assessee and the dividends had been declared in his name, the transfer of the dividend to the beneficiary was only an application of the dividend income and, therefore, the assessee could not claim exemption from being taxed on it as a part of his own income.
The Court rejected the contention of the assessee and said that since the assessee did not assign the shares to his wife he therefore, retained the right to participate in the profits of the company. He did not part with that right. So the dividend accrued to him which was later given to his wife as per the contract. Therefore it was a case of application of income.The researcher opines that Act is not concerned with the ultimate destination of the income. What is to be seen is that in whose hands income accrues. Once the income is in the hands of the assessee, he is liable for tax. In other words if a person has alienated or assigned the source of his income so that it is no longer his, he may not be taxed upon the income arising after the assignment of the source.
Diversion of IncomeThe concept of application of income cannot be fully appraised without understanding the concept of diversion of income by overriding title. The following case laws would throw light on the matter. In Raja Bejoy Singh Dudhuria v. Commissioner of Income Tax, Bengal, the step mother and the Raja had entered into a compromise decree whereby a sum of Rs. 1, 100 per month was to be paid to her for her maintenance. This amount was declared as a charge upon the properties in the hands of the Raja by the Court. The Raja sought to deduct this amount from his assessable income. This was disallowed by the High Court of Calcutta. He went on appeal to the Judicial Committee.
The Judicial Committee held that the amount which the Raja paid to his step-mother did not constitute his income. This was a case of diversion of income by overriding title, as the Court had created a charge on the whole resources of the Raja with a specific payment to his step-mother. To that extent it was not his income. Further it was observed that it is not a case where the appellant is applying his income in a particular way rather it is the allocation of a sum out of his revenue before it becomes income in his hands. It is submitted that given the facts and circumstances of the case it was correctly held that the case was of diversion of income by overriding title. The assessee never received the sum of Rs. 1, 100 in his hands. Even if he received it was not for himself. He was acting as a mere collector of that income which was to be paid to his step-mother. Thus, he was like a conduit pipe between his step-mother and the resources which generated the income.
The assessee in Commissioner of Income Tax, Bombay v. C.N. Patuck, got a consent decree divorce from his wife. As a result of the compromise the assessee made certain arrangements for his two unmarried daughters. The decree contemplated a tripartite agreement between the firm of Messrs Patuck and Sons, the assessee himself and his two daughters. The agreement stated that the allowance would be paid out of the remuneration and profits payable to the assessee from the partnership firm. In the event of the partnership firm being dissolved or in the event of the retirement of the assessee from the said partnership or in case of his death the payment of the sums mentioned in this clause shall constitute a first charge on the share of the assessee. During the accounting year the assessee share of profits in the firm and his salary according to the statement of the case were first credited to his account and then the assessee made the payment to his daughters direct, though the receipts obtained from his daughters mentioned that the payments were made by the firm.
The assessee claimed that the amount paid to his daughter did not constitute his income at all and was not liable to tax. He claimed that the amount was at source diverted and ceased to be his income, because of the overriding title created in his daughter.. On the other hand the department contended that the profits were first paid to the assessee and then the assessee himself distributed the profits to his two daughters. The whole arrangement was merely made so as to ensure to the two daughters their maintenance.. The Court decided in the favour of the assessee. The decision of the Court was based on three grounds. Firstly, the very fact that the parties contemplated security for payment of the debt or obligation by the assessee in favour of his two daughters would give rise to a charge the moment the property which was to be a security for the payment is specified.
Secondly, if it were merely a case of the discharge of a personal obligation by the assessee in favour of his two daughters, then there is no reason why a tripartite agreement should be entered into. The fact that they were made parties to the agreement and agreed themselves to pay to each of the daughters the amounts of the maintenance due to them out of the remuneration and the one-third share in the profits of the partnership, clearly shows that it was the intention of the parties that the source or the profits should be bound. Therefore that part of the profits could never become the income of the assessee.
Finally, the daughters could claim their maintenance directly from the two partners out of the profits and to that extent they would have a title superior to that of their father in the profits.. The researcher agrees with the decision of the Court. What one has to see is whether the income has actually reached the hands of the assessee or not? Once it has reached in his hands there can be no diversion. But when he acts as a mere collector of the income or due to some charge the income gets diverted, he cannot be taxed for that amount.
In Diwan Kishen Kishore v. Commissioner of Income-tax, there was an impartible estate governed by the law of primogeniture, and under the custom applicable to be family, an allowance was payable to the junior member. Under an award given by the Deputy Commissioner acting as arbitrator and according to the will of the father of the holder of the estate and the junior member, a sum of Rs. 7,200 per year was payable to the junior member. This amount was sought to be deducted, which was disallowed. The appellants argued that the payment which was made was necessary and obligatory payment, and therefore the deduction should be allowed. Due to the distinctive nature of the estate, the junior member is not entitled to separate his share and collect his income directly. Hence in lieu of his share a separate allowance is given to him. That allowance therefore, cannot form the part of the income of the assessee.
It was held it was not a case of application of income. Since, the junior member cannot claim himself to be a member of the coparcenary with the assessee, the assessee was merely acting as a collector of the allowance on his behalf. The Court further substantiated its decision by pointing out the fact that the junior member cannot legally claim an increase in the allowance even if the income of the estate materially increases.
The researcher is of the opinion that this case should be distinguished from instances where an allowance is given by the head of the Hindu coparcenaries to its members by way of maintenance. In that situation the income generated by the resources of the Hindu joint family comes to the hands of the karta of the family which he distributes among the coparceners as per their needs. Unless there is a partition in the family, the coparceners who receive separate maintenance, still remain the members of the joint Hindu family. Therefore, providing maintenance allowance to them is a case of application of income.
The Supreme Court in Moti Lal Chhadami Lal Jain v. Commissioner of Income Tax, observed that what is of cardinal importance is the nature of obligation by reason of which the income becomes payable to a person other than the one entitled to it. Where the obligation flows out of an antecedent and independent title, it effectively diminishes the total income of an individual and so it would be a case of diversion. Whereas when the obligation is self imposed or gratuitous, it is only a case of application of income.
From the above observation of the Apex Court, it is submitted that there is a difference between an amount which a person is obliged to apply out of the income and an amount which by the nature of the obligation cannot be said to be the part of the income.
The issue in Gallotti Raoul v. Assistant Commissioner of Income Tax was whether the social charges which the French nationals are liable to contribute compulsory be deducted from salary and then be taxed or the gross salary without adjustment of the social charges be taxed?
The argument which was put forth by the appellants was that the amount that was contributed by the employer to the social security was similar to a primary charge existing on the income and therefore an overriding title existed on the salary income of the employees. On the other hand it was contended by the respondent that since the contributions were made only after the receipt of income, it was a case of application of income.
The Supreme Court held that the since the affiliation was compulsory in nature, it made the social security organization an earning partner alongside of the assessee. In other words, the assessee earns not only for himself but also for the social security organization. Therefore on the amount which had to be contributed towards the social security organization, the assessee had no right over it at all and thereby no domain on it. The researcher is of the opinion that the Court had aptly decided the above case. This is because, even before the assessee could claim his salary, the social security charge is set apart for being handed over to the social security organization and thereby the employee never has the chance of even touching it. It is rightly an instance of diversion of income.
Income emanates from a source. Income is got through receipt or accrual or it is deemed to accrue. Under the Income Tax Act, once the income has come into existence it is liable for tax. Taxable event is the source generating the income. When I earn income, I set apart it for certain things. It may arise under a contractual obligation or statutory obligation or involuntary/voluntary disposition. It is not every obligation under which an income is applied is taken into account while computing tax. The emphasis is on the nature of the obligation. If the nature of obligation is such that the income gets diverted before it reaches the hands of the assessee due to operation of law or due to creation of charge, then such amounts are deductible while computing the tax liability of the individual. Rational behind this is that presence of an independent title effectively slices away a part of the corpus of the right of the assessee to receive the entire income. On the other hand if the obligation is self imposed, it is a mere application of income.
Due to the ingenuity of the people, S.60 has been provided in the Act. The section tries to curb the mischief whereby individuals try to escape tax liability by transferring the income. Unless and until the source has been assigned to someone else, it will not fall within the domain of diversion of income. The test is to see precisely at what time the transfer had taken place. If transfer had taken place after the accrual of income then it is an application of income. But if transfer has taken place after the assignment of source then it is not application of income. There exists 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. All this has to be seen in the broader context of the Act that the Act is nonchalant about the destination or disposal or what happened to the income once it has accrued in the hands of the assessee.
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