Application and diversion of income are important concepts in the Income Tax law regime. They help tax authorities determine whether or not an income is taxable.
In this post, we shall discuss both these concepts along with some relevant illustrations and case laws.
Application of Income
Application of Income under Taxation law means spending of income after it has been earned by the assessee (the taxpayer) from whatever sources legal or illegal.
This is taxable as part of his total income during the assessment as it is merely an application of earned income. In other words, applied income shall be taxable in the hands of the assessee.
Illustration
Mr. Chatur Singh, a CEO of a multinational firm asks one of his employees Buddhu Singh, to pay $2 million per month to another employee Halagu Khan out of his (Chatur Singh’s) salary and disburse the remaining salary back to him.
This is a case of application of income by Chatur Singh because the salary is first generated in his name.
Once he has earned it in his account, only then Buddhu Singh can pay $2 million out of it to Halagu Khan. A mere arrangement to make one employee pay the other won’t make it a case of Diversion of Income.
Diversion of Income by Overriding Title
Diversion of Income is the process of diversion of income before the assessee (taxpayer) earns it.
Such amounts are excluded from the total income of the assessee during income tax computation as the income gets diverted to someone else before being earned by the assessee.
In such cases, there is an overriding title of a third party on the income of the assessee under which the income reaches the third party before the remaining amount goes to the assessee.
If a title or charge is created at the sources itself, it is called diversion of income by overriding of title and hence not taxable from the total income of the assessee.
Illustration II
M/s CBP is a partnership firm in which Chittu and his two sons Bittu and Pintu are partners.
The partnership deed provides that after Chittu’s death, Bittu and Pintu shall continue the business of the firm subject to a condition that 20% of the profit of the firm shall be given to Mrs. Battisi (wife of Mr. Chittu and mother of Bittu and Pintu). Will it be an application or diversion of income?
It is a case of diversion of income at the source itself. After the death of Mr. Chittu, the 20% amount of profit shall not be included in the total income of M/s CBP i.e. it is deductible from its total income.
This is because the clause mentioned in the partnership deed has given an overriding title of the 20% profit to Mrs. Battisi and such income is a precondition for the firm to continue its business.
In other words, this 20% profit reaches Mrs. Battisi before it becomes the income of the firm and hence it is a case of diversion of Income.
Illustration III
Sridhar is a partner in a trading firm ‘William and Sons Partnership’. Sridhar’s share is 25% in the said trading firm.
By a settlement deed, he had created a trust, assigning 50 percent out of his 25 percent right, title, and interest (excluding capital), as a partner in the trading, and a sum of Rs. 25,000 out of his capital in the firm in favor of the said trust.
Sridhar thereafter, claimed that 50 percent of the income attributable to his share from the firm stood transferred to the trust resulting in the diversion of income at source and the same could not be included in his total income for the purpose of his Income Tax assessment. Is Sridhar right?
No. it is a case of application of income because Sridhar being a partner in the trading firm, the capital, or profit on account of his share is first generated in his name.
Also, in the present case, the said trust does not become entitled to receive the amount (50 % of the income attributable to his share from the firm) under an obligation of an assessee even before he could lay a claim to receive it as his income.
The assignee gets no interest or right in the main partnership except the right to receive the part of the profit assigned to him under the said settlement deed between her and Sridhar.
Further, the assignee entering the said trust does not get any special interest in the main trading firm by overriding any title of Sridhar.
It just has a right to receive the part of the profit i.e. 50% of the income attributable to his share from the firm assigned to Sridhar under the settlement deed.
Case Law Analysis
In the case of Motilal Chhadmilal, a landlord had two commercial buildings. He created a college trust and became its trustee.
Thereafter, he gave one of his two commercial buildings to that college trust to operate from. He rented the second building to a company.
Later they entered into a tri-partite agreement whereby 10K out of 21K rent generated from the company would go to the college trust and if it does not then the college would have the right to sue the company.
It was held to be an application because the rent was first generated in the name of the landlord.
CIT v Sunil J Kinariwala
In CIT v Sunil J Kinariwala, 2002 the Supreme Court made a distinction between a partner of a firm assigning his share in favor of a third person and a case where he creates a sub-partnership with his share in the main partnership.
The apex court had held that in the former case, the assignee gets no interest or right in the main partnership except the right to receive the part of the profit assigned to him under the deed but in the case of a sub-partnership, the assignee acquires a special interest in the main partnership.
The court held that-
“Under the scheme of the Act, it is the total income of an assessee, computed under the provisions of the Act, that is assessable to income tax. So much of the income which an assessee is not entitled to receive by virtue of an overriding title created in favor of a third party would get diverted at source and the same cannot be added in computing the total income of the assessee.”
When a third person becomes entitled to receive the amount under an obligation of an assessee even before he could lay a claim to receive it as his income, there would be a diversion of income by overriding title; but when after receipt of the income by the assessee, the same is passed on to a third person in discharge of the obligation of the assessee, it will be a case of application of income by the assessee and not of diversion of income by overriding title.
Bejoy Singh Dudhuria v CIT
The decision of the Privy Council in Bejoy Singh Dudhuria v Commissioner of Income Tax, 1933, is illustrative of the principle of diversion of income by overriding title.
In this case, under a compromise decree of maintenance obtained by the stepmother of the assessee, a charge was created on the properties in his hand.
The Privy Council, reversing the judgment of the Calcutta High Court, held that the amount of maintenance recovered by the stepmother was not a case of application of the income of the assessee.
PC Mullick v CIT
In contrast, in P.C. Mullick v Commissioner of Income Tax, 1938 under a Will, certain payments had to be made to the beneficiaries by the executors and the trustees (assessees) from the property of the testator.
It was held by the Privy Council that such payments could only be out of the income received by the assessees from the property, therefore, such payments were assessable as income tax in the hands of the assessees and there was no diversion of income at source.
Whereas in the former case (Bejoy Singh), the step-mother of the assessee acquired the right to get the maintenance by virtue of charge created by the decree of the court on the properties of the assessee even before he could lay his hands on the income from the properties, but in the latter case (PC Mullick), the obligation of the assessee to pay amounts to the beneficiaries was required to be discharged after receipt of the income from the properties.”
CIT v Sitaldas Tirathdas
In CIT v Sitaldas Tirathdas 1961, the court held that the test is to check/read the nature of the obligation. If ‘A’ has a better claim/title to the income of the assessee, it will be a case of diversion not application. It can be created voluntarily as well. In the words of Justice Hidayatullah,
“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.
Whereby the obligation income is diverted before it reaches the assessee, it is deductible; but where 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.
It is the first kind of payment that can truly be excused and not the second. The second payment is merely an obligation to pay another 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.”
This decision was re-affirmed in the Sunil J.Kinariwala case which we have discussed earlier, that it will be a diversion when a third person or entity becomes entitled to receive the amount before the assessee could even lay a claim to receive it as his income; but if the income is passed by the assessee on to a third person in discharge of his obligation, it will be a case of application of income.
Murlidhar Himatsingka v CIT
Similarly, in Murlidhar Himatsingka v CIT 1966, the apex court held that if there are several persons who are partners in a firm and one of them agrees to share the profits derived by him with a stranger entity, this agreement does not make the stranger a partner in the original firm.
Conclusion: Application and Diversion of Income
To conclude, if a third party becomes entitled to receive the amount under an obligation of an assessee even before the assessee could lay a claim to receive it as his income, it would be a case of diversion of income by overriding title.
But when after receipt of the income by the assessee, the same is passed on to a third party in the discharge of the obligation of the assessee, it will be a case of application of income by the assessee and not of diversion of income by overriding title and hence taxable under the Income Tax Act, 1961.
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