Income clubbing can be taxing

Dilip wanted to create a regular stream of income for his wife, a homemaker. He hit upon a simple idea, which accomplished two goals at once. He had quite a bit of money invested in various fixed deposits.

He redirected all the quarterly interest payments to her, which would form a regular income for her.

This way, he thought, he would be relieved from showing the interest as part of his income as well. It boiled down to a lower tax burden on him. He discussed what he had done with his friend, Ashok, a chartered accountant.

Ashok smiled at Dilip’s vanity. Wasn’t the tax man smarter than a thousand Dilips put together?

As per income tax laws, when income alone is transferred without transferring the asset giving rise to such an income, it is deemed to be the income of the transferor. So here, even if Dilip’s wife receives the interest payments on the fixed deposits, the income would still be counted in his hands. Dilip was dumbstruck.

Where is it applicable

He asked Ashok if there were any other situations in which the clubbing of his wife’s income in his hands could happen. He wanted to be careful. Ashok dusted off his Income Tax Ready Reckoner. The Act had indeed envisaged a few circumstances.

One was a situation when an ‘asset’ was transferred without adequate consideration. Here, the income earned on the asset by the transferee would be clubbed with the transferor’s income. To understand this, Ashok gave the example of the rental income from Dilip’s house back in his home town.

Let’s suppose Dilip simply changed the ownership of the house to his wife so as to receive the rentals in her name. Unless his wife had really bought the house by paying an adequate sum of money, the rental income would still be clubbed in his hands.

Dilip’s wife was smart. When he had initially discussed the idea of transferring the fixed deposit interest to her, she mentioned something about making money out of it by investing it in shares. Thinking back on this, worry lines appeared on Dilip’s forehead.

The clubbing of the interest in his hands was bad enough. What if she made capital gains on those shares? Was that also to be added to his income? Thankfully, Ashok told him that income made from investments out of the clubbed income would not be so added. Dilip breathed a little easier.

Relief from clubbing

Using the shares example, Ashok also explained other circumstances to Dilip under which there could be relief from clubbing and taxes. If Dilip transferred (without adequate consideration) any shares to his wife, technically the dividends would be treated as part of Dilip’s income and taxed in his hands. However, since dividend income is exempt from tax currently, it would not add to Dilip’s tax burden, Ashok pointed out.

Second, if any company (whose shares Dilip transferred to his wife) issued say, bonus debentures to its shareholders and his wife received interest on those debentures, then that income too would not be added to Dilip’s.

The act clearly explained this rule as “income on the asset transferred is to be clubbed, but if there is any accretion (addition) to the asset, any income on such accretion shall not be clubbed”. Dilip relaxed a bit more. After all, the clubbing provisions were logical he thought.

By then, another provision had caught Ashok’s eye. It wouldn’t be applicable to Dilip, he said but it was always better to know. Ashok mentioned the firm run by their mutual friend Kapil.

Here Kapil took home whatever profits he made, after ploughing back a small portion into the firm. His wife, a homemaker, helped out in the day-to-day activities off and on.

In this case, Ashok said, any salary Sunitha receives from the firm would be clubbed in Kapil’s hands. Kapil wouldn’t have to club her income only if it can be shown Sunita possessed the qualification, knowledge and experience to perform the job.

Dilip was now effectively convinced that clubbing provisions were necessary, as they were aimed at preventing sham transactions. He decided to pay taxes on the FD interest, and devote some more thought towards securing his wife a regular income stream.

> vardhini.c@thehindu.co.in