Diversion of Income
Diversion of Income is an obligation to apply the income in a particular way before it is received by the assessee or before it has arisen or accrued to the assessee results in diversion of income. The source is charged with an overriding title, which diverts the income. Therefore the essentials are the following:
(i) Income is diverted at source,
(ii) There is an overriding charge or title for such diversion, and
(iii) The charge / obligation is on the source of income and not on the receiver.
Examples of diversion by overriding title are –
(i) Right of maintenance of dependents or of coparceners on partition
(ii) Right under a statutory provision
(iii) A charge created by a decree of a Court of law.
Case Laws on Diversion of Income
CL 1: In the case Jit & Pal X-Ray Pvt. Ltd. Vs. CIT (2004) 267 ITR 370 (All), an assessee purchased a business as a going concern subject to the condition of payment of a percentage of profits to the vendor’s wife. The amount of profits so paid should be regarded not as application of income but as diversion of income at source by overriding title. Therefore, such amount of profit cannot be taxed in the case of the assessee.
CL 2: In a case where, partnership firm making payment to the spouse of the deceased partner, the Bombay High Court in CIT Vs. Nariman B. Bharucha & Sons – 130 ITR 863 has held that such payment are in the nature of diversion of income at source by overriding title. Hence, it cannot be taxed in the hands of partnership firm. Similarly, where a firm utilized the capital of retired partner, such retired partner is eligible for share of profit u/s 37 of the Indian Partnership Act, 1932 until his share is paid to him. The Allahbad High Court in CIT Vs. Varnasi Nagar Bika (2005) 275 ITR 140 (All) has held that the firm is entitled to claim the amount so paid to the retired partner applying the concept of diversion of income by overriding title.
CL 3: A co-operative society deducted certain amounts at prescribed rates from the cane price payable to members pursuant to instruction issued by the Director of Sugar and credited to certain funds such as Chief Minister’s Relief Fund, Hutment Fund, Area Development Fund and Cane Development Fund. The assessee society exercised dominion over these funds and was expected to utilize them in accordance with the guidelines issued by the by Government for which the Director of Sugar acted in a supervisory capacity to oversee proper utilization. In such cases, the concept of diversion of income at source by overriding of title does not apply and the entire income is assessable in the hands of society. S. Sahakari Sakhar Karkhana Ltd. Vs. CIT (2004) 270 ITR 1 (SC).
Application of Income
An application of income is an obligation to apply income, which has accrued or has arisen or has been received amounts to merely the apportionment of income. Therefore the essentials of the concept of application of income under the provisions of the Income Tax Act are:
(i) Income accrues to the assessee
(ii) Income reaches the assessee
(iii) Income is applied to discharge an obligation, whether self-imposed or gratuitous.