APPLICATION OF INCOME
VS
DIVERSION OF INCOME
-By Mrs. Monica Pradyot
Assistant Professor
SOL, UPES
APPLICATION OF INCOME
VS
DIVERSION OF INCOME
• Both are court made concepts and are defined no where in the act
• The importance is that, one is taxable and the other is not
APPLICATION OF INCOME:
Where an assessee applies an income to discharge an obligation after the income reaches
the hands of the assessee, it would be an application of income. (Taxable)
DIVERSION OF INCOME:
Where there is diversion of income before it reaches the hands of the assessee, it cannot be treated as
an income of the assessee. (Not Taxable)
APPLICATION OF INCOME
VS
DIVERSION OF INCOME
• These concepts may seem easy to understand but while application in the set of facts it becomes
very difficult to mark a clear distinction between the two.
• In order to understand the concepts better it becomes inevitable to explore the interpretations
given by the court in different cases.
• Difference was highlighted in the case of [CIT v. Sitaldas Tirathdas (1961) 41 ITR 367 (SC)]
• The Apex Court laid down the tests for determining when an income can be said to have
been diverted at source as a result of a charge or overriding title (a.k.a TRUE TEST)
APPLICATION OF INCOME
VS
DIVERSION OF INCOME
• “The true test is whether the amounts sought to be deducted, in truth, never reached the assessee as his
income. 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.
• Where, by obligation, income is diverted before it reaches the assessee, it is deducted; but where the
income is required to be applied to discharge the obligation after such income reaches the assessee,
the same consequence, in law, does not follow. It is the first kind of payment which can truly be
excused and not the second.
• The second kind of payment is merely an obligation to pay another a 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”.
APPLICATION OF INCOME
VS
DIVERSION OF INCOME
• 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.
APPLICATION OF INCOME
• P.C. Mullick and Another v. Commissioner of Income Tax, Bengal
• The testator appointed 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.
DIVERSION OF INCOME
• In case of diversion of income by overriding title, the income before coming to the
hands of the assessee is diverted from the source itself and hence is not liable for tax.
• 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.
DIVERSION OF INCOME
• M/s ABC is a partnership firm in which A and his two sons B & C are partners. The partnership
deed provides that after the death of Mr. A, B & C shall continue the business of the firm subject to
a condition that 20 % of profit of the firm shall be given to Mrs. D (Wife of Mr. A/ Mother of B &
C).
• After the death of Mr. A, whether this 20% amount of profit be included in the Total Income of
Firm M/s ABC or is a case of diversion of income of M/s ABC and not taxable in its hands?
• This is a case if Diversion of Income and the said 20% amount shall not be included in the Total
Income of M/s ABC (i.e.) it is deductible from its Total Income. This is because the clause
mentioned in partnership deed has given an overriding title of the 20% profit to Mrs. D and such
income is a precondition for the firm to continue its business. In other words, this 20% profit
reaches Mrs. D before it becomes income of the firm and hence it is a case of diversion of Income.
DIVERSION OF INCOME
• Raja Bejoy Singh Dudhuria v. Commissioner of Income Tax, Bengal
• The step mother and the Raja had entered into a compromise decree whereby a sum of Rs. 1,
100 per month was to be paid to her for her maintenance. This amount was declared as a
charge upon the properties in the hands of the Raja by the Court. The Raja sought to deduct
this amount from his assessable income. This was disallowed by the High Court of Calcutta.
He went on appeal to the Judicial Committee.
• The Judicial Committee held that the amount which the Raja paid to his step-mother did not
constitute his income. This was a case of diversion of income by overriding title, as the Court
had created a charge on the whole resources of the Raja with a specific payment to his step-
mother. To that extent it was not his income.
DIVERSION OF INCOME
• Further it was observed that it is not a case where the appellant is applying his income in a
particular way rather it is the allocation of a sum out of his revenue before it becomes
income in his hands. It is submitted that given the facts and circumstances of the case it was
correctly held that the case was of diversion of income by overriding title. The assessee
never received the sum of Rs. 1,100/- in his hands. Even if he received it was not for himself.
He was acting as a mere collector of that income which was to be paid to his step-mother.
Thus, he was like a conduit pipe between his step-mother and the resources which generated
the income.
DIVERSION OF INCOME
• Due to the ingenuity of the people, Sec. 60 (Transfer of Income, without transfer of
assest) of the Income Tax Act, 1961 has been provided in the Act. The section tries to curb
the mischief whereby individuals try to escape tax liability by transferring the income.
• A cursory perusal of the Sec. 60 of the Act will make it clear that unless there is transfer of
the assets from which the income arises, the income arising from that asset will be included
in the income of the transferor for computation of tax.
