DIVERSION OF INCOME

PURPOSE-The essence of the principle of diversion of income by overriding title is that income must reach a person other than the assessee by reason of a pre-existing title to it. Even if a tax-payer incurs a legal obligation to apply a part of his income, it would still remain his taxable income unless assigned to the third party at the very source. OVERRIDING TITLE-- When an income is diverted by what is known as an `overriding title', the said income which is so diverted is considered not to be theincome of the assessee, thus escaping the rigors of taxation. This is asopposed to an application of income. A mere application of income after itis earned, would not escape taxation in the hands of the assessee. Diversion arises --where income is applied in a particular manner under statutory or contractual obligation or under the provisions of a document under which the company is constituted, such as memorandum or articles of association.In principle, if a person has alienated or assigned the source of his income so that it no longer remains his income, he cannot be taxed on income arising after assignment of the source.The reason is that it is not the income of the assessee at all. ifa person has alienated or assigned the source of his income so that it is nolonger his, he may not be taxed upon the income arising after the assignmentof the source. This principle is, of course, subject to statutory EXCEPTIONS ED Sassoon & Co Ltd vs CIT, 26 ITR 27(SC), where it was held that the office of managing agents and all the rights and benefits under the Managing Agency Agreement had been assignedand since the source of income itself had been assigned, the income had beendiverted by overriding title and no part of the income from the agency wouldthen become includable in the hands of the assignor. (DIVERSION) In Raja Bejoy Singh Budhuria v. C.I.T. (1 I.T.R. 135; PC), the assessee had succeeded to the ancestral estate on the demise of his father. Subsequent to such succession, his stepmother, who had a legal right to maintenance out of the estate of her husband, brought a suit of maintenance against him, and the the Court decreed that the assessee had to pay a fixed monthly sum to the stepmother. It was declared that the maintenance was a charge on the ancestral estate in the hands of the assessee. The question that arose before the Privy Council was whether the assessee was liable to be assessed as an individual in respect of the amount of maintenance payable to the stepmother; to that extent, what he diverted to her was not his income. It was not a case of application by the appellant of part of his income in a particular way. (DIVERSION) CIT vs Mathubhai C Patel, 238 ITR 403 (SC), theissue came up again. Here, the facts were that on death of the assessee'sfather, he inherited various assets as well as some liabilities in respectof borrowing from a bank by the father.The father had borrowed the amount during his life time in order to meethis income-tax liabilities. Various bank shares, which were inherited hadbeen pledged for this purpose. He was also required to meet the liabilitywhich had accrued out of the inherited assets and he was obliged to payinterest to the bank on the amount due to the bank. The dividend incomewhich the assessee received from the shares pledged with the bank was soughtto be taxed during the concerned assessment year. The assessee claimed thatsince he had also paid interest to the bank on the overdraft account, thesaid amount of interest was required to be deducted from the gross receiptsin order to compute the real income earned by him. The high court held infavour of the assessee.

At the Supreme Court, it was pointed out that the high court had relied on adecision in Udayan Chinubhai vs CIT, 111 ITR 584 (Guj). This decision hadbeen reversed by the Supreme Court in CIT vs Udayan Chinubhai, 222 ITR 456(SC), wherein the court had laid down at pages 464 and 471 as under: "If aman incurs a debt, he will have to pay the debt and till the debt is paid infull, he may have to pay interest on that debt. But whether the interest isallowable as a deduction or not will depend upon the provisions of theIncome Tax Act. No question of diversion of income by overriding title canarise in a case like this. A man has to pay his debts out of his income.Merely because of the liability to pay the debts, it cannot be said that theincome from the assets that he received on partition stood diverted byoverriding title to the creditors. ... The basic principle to be borne inmind in this type of cases is that when a person pays his debts or maintainshis wife or children or any body else whom he is obliged to maintain, theexpenditure incurred in such cases will be application of the assessee'sincome and not diversion of the income at source. If he does not pay what heshould have paid and is compelled by a court order to pay, it will still notbe a case of diversion of income at source. Even if a charge is created onthe properties of the assessee for enforcing payment, the position in lawwill not change." The Supreme Court found merit in the contention of the counsel for therevenue that a distinction had to be made between the asset being chargedwith the obligation to discharge the liability and the income from the assetbeing charged with the liability to pay interest. In the present case, thepledging of the shares was effected by the assessee's father to secure theloan advanced by the bank and it was not a case where the income from theshares had been charged with payment of interest payable on the loan.To sum up, where an assessee receives assets along with liabilities, in a testate or intestate succession, the payment of the interest in respect of aliability would not be an overriding charge on the income receivable inrespect of the assets received from the estate. In Provat Kumar Mitter v. C.I.T. (41 I.T.R. 624; SC), the assessee, who was a registered holder of 500 ordinary shares in a limited company, assigned to his wife, by a deed of settlement, the right, title and interest to all dividends and sums of money that might be declared or may be due and payable in respect of those shares for the term of her natural life and covenanted to deliver and endorse over to her any dividend warrant or other document of title to such dividends or sums of money and to instruct the company to pay such dividends and sums of money to her.The assessee claimed exclusion of dividends on the aforesaid 500 ordinary shares on the ground of transfer by diversion of income by overriding title.The Supreme Court repelled the contention by holding that the deed of assignment was, in its true nature, only a contract by the assessee to transfer, or make over, to his wife in future all dividends that may be declared in respect of the shares. Hence, the income continued to accrue to the assessee and was assessable in the hands of the assessee as his income, even though it was ultimately payable to his wife under the terms of the deed.It was a case of application of income after it had accrued and not a case of diversion of any sum of money before it became the income of the assessee nor was it a case where the assessee had received the income for someone else. (APPLICATION) In K. A. Ramachar v. C.I.T. (42 I.T.R. 25; SC), though the deed of settlement was irrevocable, each of the beneficiaries of the settlement was entitled to receive one-fourth of the share in the profits of the firm for eight years from the date of the settlement. The assessee's claim that those amounts were payable to the wife and children of the settlor under the obligation arising under the irrevocable deed of settlement was negatived on the ground that, on the facts, the effect of the deeds of settlement was that the profits were first to accrue to the assessee and then be applied for determination of the share payable to the beneficiaries. A stranger, even if he were an assignee, did not and could not have any direct claim to the profits.

The dispositions were, in law and in fact, portions of the assessee's income after it had accrued to him, and tax was payable by him at the point of accrual. (APPLICATION) The difference between "application of income after it reaches the assessee" and "diversion of income by overriding title before it reaches the assessee" was explained by the Supreme Court in C.I.Tv. Sitaldas Tirathdas. (41 I.T.R. 367): "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 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 e consequence, in law, does not follow." 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, Bengalappointed 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. In C.I.T. v.imperial Chemical Industries (India) P. Ltd. (74 I.T.R. 17; SC), the Court held that the payment of amounts by the respondent to the outgoing agents was not by an overriding title created either by act of the parties or by operation of law, and it could not be said that the amount of compensation paid to the outgoing agents did not form part of the respondent's income.(APPLICATION) In C.I.T. v. Jodhpur Co-operative Marketing Society (275 I.T.R. 372), the assessee, a co-operative society, claimed that Rule 68 of the Rajasthan Co-operative Societies Rules, 1966, framed under the Rajasthan Cooperative Societies Act, 1965, required the society to transfer twenty-five per cent of its net profits to a reserve fund.Hence, the said amount was deductible under Section 37 of the Income-tax Act, 1961, for the assessment year 1989-90.The Assessing Officer and the Commissioner (Appeals) disallowed the claim of the assessee, but the Tribunal held that the amount transferred to the reserve fund was business expenditure and, therefore, an allowable deduction. On appeal, the Rajasthan High Court held that neither did the reserve

fund go to any party other than the assessee itself nor was there any obligation to provide for such reserve before it became part of the net income earned by the society.The obligation to carry a part of its net profit to a reserve fund did not envisage diversion of any part of the profits to a person other than the society itself.There was no overriding title vesting in a third party other than the assessee to lay claim to the reserve fund independent of the co-operative society. (APPLICATION) CONCLUSION-To sum up, the essence of the principle of diversion of income by overriding title is that income must reach a person other than the assessee by reason of a pre-existing title to it. Even if a tax-payer incurs a legal obligation to apply a part of his income, it would still remain his taxable income unless the very source of the income is assigned to the third party. 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.