The Income Tax Act, 1961 deals essentially with the imposing of taxes, exemptions and procedure to be followed therewith. The income that is accrued or deemed to accrue on the tax payer is the tax income and the application and diversion of income are two fundamental yet confusing concepts in the Indian Tax law. Also, both of these are court made concepts.
In simple words, application of income means the income after its being earned by the assessee. Such income forms a part of the total income and thereby taxable as such income is applied by the assessee after earning it. Thereby, applied income will be taxable. For instance, A is liable to pay a sum of 10,000 rupees as monthly alimony to his wife, here A being employee of Mr. C asks him to pay the alimony and then disburse the rest to him. Here, it is an example of application of income as the wife does not have over-riding title over such amount. The amount that he spends is a fulfillment of duty after earning his salary and thereby taxable.
On the other hand, diversion of income means diverting the income even before it was earned. Here, there is an over-riding title over the amount of another person and thereby excluded from tax liability. For example, if XYZ is a partnership firm and they specify in their deed that 20% of whatever profits they are likely to earn will be given to X’s mother, and wives of Y and Z. This is a classic example of diversion of income. The rationale behind it is that the deed mentioning the above said provision has an over-riding entitlement over the money and it is a pre-condition for the firm to continue. Thereby, it is not taxable.
Now lets look into certain major developments in this regard.
Section 60 of Act says that unless there is a transfer of the assets from which the income arises, the income arising from that asset will be included for computing taxes.1 In Life Insurance Company v. Commissioner of Income Tax, Bombay2, the issue was whether under section 28 of the Life Insurance Corporation Act, 1956 the surplus payable to government a permissible deduction or not? Here, it was held that it is not an exemption from tax liability as the surplus is diverted only after the income has been received by the corporation.
In the case of Commissioner of Income Tax v. Sitaldas Tirathdas3, the respondent contended that the sum of amount he pays as alimony to his wife be deducted from computation of tax. In this case, the court underlined the difference between the amount which a person is obliged to pay out of his income and the amount which by its nature cannot be a part of his income. Only when the income does not reach the assessee the exemption is allowed not when he has an obligation after the accrual of income.
In yet another case of P.C. Mullick and Another v. Commissioner of Income Tax, Bengal 4, the issue was whether the money paid for ‘addya sradh’ by the executors from their income is deductible or not from tax liability. The court held that whatever income, the person uses after reaching his hands cannot be said to be a diversion of income. The court here emphasize on the intention of the legislators.
In Povat Kumar Mitter v. Commissioner of Incme Tax, West Bengal5, it was held that diversion of dividends to wife is just application of his income and thereby such dividends are also taxable.
The following are some of the major case laws with regard to diversion of income-
In the case of Raja Bejoy Singh Dudhuria v. Commissioner of Income Tax, Bengal6, the issue was whether the payment of a sum of 100 rupees by Raja to his step mother by a compromise decree taxable? The Calcutta High court held it is not deductible but on appeal to a judicial committee, the decision was reversed. It was held that the compromise decree creates an over- riding entitlement over the money and here he was just acting as a mediator between his step mother and the revenue generated. Thus exempted from tax liability.
Another interesting case in regard to diversion of income is Commissioner of Income Tax, Bombay v C.N Patuck7, wherein the assesee obtained a consent divorce decree. He made certain arrangements for paying maintenance to his two unmarried daughters. He entered into a tripartite agreement with the firm and his two daughters, where it was agreed that the money would be payable from his remuneration and profits likely to be received from the firm. And in the event of death of him or dissolution of partnership firm, a fist degree charge would be created in his share towards the daughters. Thereby, it was held to be a diversion of income as the person is a mere collector of those income and the over-riding entitlement is created by the daughters.
The Supreme Court in the case of Moti Lal Chhadami Lal Jain v. Commissioner of Income Tax8 observed the difference between application and diversion of income. If the obligation arises from an independent and antecedent title, it is essentially a diversion of income, however, if the obligation is self- imposing and gratuitous, the income is liable for taxation.
To sum up, if any third party becomes entitled to receive a sum of amount under the obligation of the assessee, it is a diversion of income but when after the receipt of the income the obligation arises to pay to a third party, it is not a diversion but in fact an application of income. Many people try to divert their income in such a way so as to avoid tax payment. For example, diverting the income to wife, children etc. The judiciary does not accept such kinds of tax avoidance. In some cases clubbing of taxes is done (sections 60- 65). Transferring of income without transfer of assets, income derived from revocable transfer of assets, clubbing of spouse income and minor income can be clubbed in order to avoid tax avoidance.
-Nathalia M Fenwick