Mutual Funds

Is chit fund income taxable?

Satya Sontanam | Updated on December 02, 2019 Published on November 30, 2019

Net earnings from such schemes have to be included under ‘income from other sources’

Chit funds are still a preferred investment option for many, despite frequent news reports of scams by companies or fund organisers. Despite wide prevalence of chit funds, the tax treatment of income from this instrument is not very clear.

Taking into account the spirit of the Income Tax Act, various court judgements and expert opinions, we decode the taxation aspects of chit funds in the hands of the subscribers.

How it works

In a chit scheme, a group of people periodically contributes towards the chit value for a duration (months) that equals the number of investors. Every month, an auction is conducted wherein members bid for the chit amount.

The person who bids for the lowest amount — by offering the highest discount — is awarded the bid. The amount foregone by the winning bidder is distributed among all the members equally after deducting the foreman’s commission and other charges. The amount distributed to each member is called dividend.

How it is taxed

Does the dividend received by members of a chit scheme attract income tax? Websites of prominent chit fund companies state that the income derived in the form of dividend is not chargeable to tax. But this doesn’t seem to hold ground, for a couple of reasons.

Firstly, Section 56 of the Income Tax Act states that if income of any kind is not exempt from tax but also is not chargeable under any of the heads specified — salary, house property, business and capital gains — such income is to be included under the head ‘income from other sources (IFOS)’.

Secondly, there are court judgements stating that income from chit funds is taxable.

For example, there have been instances wherein the ‘doctrine of mutuality’ has been invoked by assessees to make the dividend income non-taxable. The ‘doctrine of mutuality,’ which is applicable in clubs, argues that the members of the club and the club is one and the same, and transactions between them is not applicable to tax. However, The Madras High Court, in the case of V Raj Kumar vs The Commissioner of Income Tax, held that the mutuality principle does not arise in chit funds, and stated that the dividend income deserves to be assessed as income.

Deduct the discount

Now that dividend income is taxable, a question arises — can the discount forgone by the member on winning the auction be claimed as deduction from dividend income? There doesn’t seem to be any explicit tax provision to answer this question.

Naveen Wadhwa, Deputy General Manager, Taxmann.com, says: “Discount should be treated as interest paid for the amount taken in advance. It is more logical to consider net dividend income after deducting discount foregone for the purpose of taxation.”

He cited the tax treatment of a similar case where the Income Tax Act allows setting off interest paid on the loans taken — which are immediately not deployed but deposited elsewhere for an interim period — against the interest income earned on deposits made from such loans.

There could be a case when discount foregone by a member is more than the dividend income received throughout the tenure of the chit. “Such loss is tax-neutral,” adds Wadhwa. Thus, if the net income (dividend minus discount) is positive, the difference is chargeable to tax under IFOS. But if it is negative, the loss doesn’t come under the purview of taxation.

Claim as expense

Seems unfair that the profit is taxed but the loss is not given any benefit of deduction? There’s a silver lining. If the chit fund money is utilised for the purposes of a business, any loss incurred out of the same is allowable as business expenditure.

Sunil Gidwani, Partner, Nangia Advisors (Andersen Global), reinforces that the amount should be allowed as business expenditure as it is equivalent to the interest paid on a loan that is invested in a business.

Note, however, that income from chit funds continues to be taxable under IFOS and not as business income of an assessee even if the chit amount is used for the purpose of business. This is because courts, time and again, have held that participating in a chit scheme is not a business of an assessee, and hence it cannot be business income.

On accrual

The period in which the profit/loss from a chit fund is liable to tax gets tricky when the tenure of the chit does not fall within a single financial year. Archit Gupta, founder and CEO, ClearTax, says: “Usually, assessees report the income from chit funds only in the financial year in which the chit is terminated. This is not without a reason as the profit/loss from chits is based on the bidding interest of all members and can be determined only at the end of the chit tenure.”

However, it is prudent to disclose the dividend income and discount on an accrual basis because various court judgements have held that both dividend and discount should be accounted based on percentage of completion method and not completed contract method.

For example, say, a chit scheme is valued ₹2.4 lakh with a tenure of 24 months and a monthly subscription amount of ₹10,000 at the start of a financial year.

By the end of one year, say, an assessee received a dividend amount of ₹25,000, but the amount foregone as discount on winning the bid in the fourth month is ₹40,000.

Thus, for the said financial year, the assesses must disclose a dividend income of ₹25,000 and a discount amount of ₹16,000, reporting a net income of ₹9,000 under the head IFOS. The discount of ₹16,000 here is calculated by spreading the discount of ₹40,000 over the remaining period of eight months in the first financial year out of the balance 20 months of the chit (as the chit was auctioned by assessee in fourth month) on a proportionate basis (₹40,000 x (8/20)).

Published on November 30, 2019
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