The Hindu Business Line : When diversion of income holds good

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, says H. P. Ranina, citing several pieces of case law to illustrate.

WITH most people keen on avoiding paying tax on income earned, they resort to several devices. One such method is to transfer a part of the income directly to reserves.

Some tax-payers indulge in accounting jugglery by taking a part of the receipts directly to the credit of reserve fund in the balance-sheet without routing such amount to the profit and loss account, in the hope that it may escape the attention of the tax officer to whom the accounts are submitted along with the return of income.

Very often, this method is adopted where a statute requires the creation of a reserve fund.

Taking advantage of this statutory provision, a legal entity, be it a company, co-operative society, etc., takes the view that such amount required to be transferred to the reserve fund does not constitute its taxable income, on the ground that there is an overriding title (or overriding claim) for such amount — in this case, the statutory requirement of a reserve fund.

This principle of diversion of income by overriding title is undoubtedly sanctified by judicial authorities.

However, the scope of this principle has to be clearly understood so that it does not become a tool for evading tax on income received by an 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.

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.

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.

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.

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.T. v. 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 consequence, in law, does not follow."

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.

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 Co-operative 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.

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.

(The author, a Mumbai-based advocate specialising in tax laws, can be contacted at ranina@bom2.vsnl.net.in)

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