Time limit for completion of Block Assessment of Search cases [Section 158BE of the Income Tax Act, 1961]

Section 158BE of the Income tax Act, 1961 provides the time-limit for completion of block assessment as 12 months from end of the month in which the last of the authorisations for search has been executed.

Order of block assessment to be passed within 12 months [Section 158BE(1)]

Sub-section (1) of Section 158BE provides that the time-limit for completion of block assessment will be 12 months from end of the quarter in which the last of the authorisations for search under section 132 was executed or requisition under section 132A was made.

§  Date of execution of last warrant of authorization: 10.11.2024

§  Last date for completion of Block Assessment: 31.12.2025

ILLUSTRATION:

Suppose a search is initiated against an assessee on 10.08.2025 and the last of the authorization for search is executed on 05.10.2025, the Assessing Officer shall be required to complete the block assessment by 31.12.2026 [i.e., 12 months from end of December 2025].

NOTE : Where in pursuance to fifth proviso to clause (a) of sub-section (1) of section 158BC, If an additional 30-day extension is granted for block return filing, the time limit extends to 13 months.

Excluded periods - Period (not exceeding 180 days) to excluded for computing the period of limitation under section 158BE(1) [Section 158BE(2)]

Section 158BE (2) provides that in computing the period of limitation of 12 months, the period (not exceeding 180 days) commencing from the date on which a search is initiated under section 132 or a requisition is made under section 132A and ending on the date on which the books of account, or other documents or money or bullion or jewellery or other valuable article or thing seized under section 132 or requisitioned under section 132A, as the case may be, are handed over to the Assessing Officer having jurisdiction over the assessee, in whose case such search is initiated under section 132 or such requisition is made under section 132A, as the case may be, shall be excluded.

Period of limitation for completion of assessment or reassessment for the block period in the case of the other person referred to in section 158BD [Section 158BE(3)]

The period of limitation for completion of assessment or reassessment for the block period in the case of the other person referred to in section 158BD shall be 12 months from the end of the quarter in which the notice under section 158BC in pursuance of section 158BD, was issued to such other person:

§  Date of issue of Notice u/s 158BC in pursuance of Section 158BD : 05.01.2025

§  Last date for completion of Block Assessment : 31.03.2026

Exclusion of certain period for computing period of limitation for block assessment under section 158BE [Section 158BE(4)]

(i)      Clause (i) of section 158BE(4) provides that the period commencing on the date on which stay on assessment proceedings was granted by an order or injunction of any court and ending on the date on which certified copy of the order vacating the stay was received by the jurisdictional Principal Commissioner or Commissioner; shall be excluded in computing the time limit for conclusion of the proceedings. or

(ii)     Clause (ii) of section 158BE(4) provides that the period commencing from the date on which a reference or first of the references for exchange of information is made by an authority competent under an agreement referred to in section 90 or section 90A and ending with the date on which the information requested is last received by the Principal Commissioner or Commissioner or a period of one year, whichever is less; or

(iii)    Clause (iii) of section 158BE(4) provides that the time taken in reopening the whole or any part of the proceeding or giving an opportunity to the assessee to be re-heard under the proviso to section 129; or

(iv)    Clause (iv) of section 158BE(4) provides that        the period commencing from the date on which the Assessing Officer directs the assessee to get his accounts audited or inventory valued under sub-section (2A) of section 142 and-

(a)  ending with the last date on which the assessee is required to furnish a report of such audit or inventory valuation under that sub-section; or

(b)  where such direction is challenged before a court, ending with the date on which the order setting aside such direction is received by the Principal Commissioner or Commissioner; or

(v)     Clause (v) of section 158BE(4) provides that the period commencing from the date on which the Assessing Officer makes a reference to the Valuation Officer under sub-section (1) of section 142A and ending with the date on which the report of the Valuation Officer is received by the Assessing Officer; or

(vi)    Clause (vi) of section 158BE(4) provides that the period commencing from the date on which the Assessing Officer intimates the Central Government or the prescribed authority, the contravention of the provisions of clause (21) or clause (22B) or clause (23A) or clause (23B) of section 10, under sub-clause (i) of the first proviso to sub-section (3) of section 143 and ending with the date on which the copy of the order withdrawing the approval or rescinding the notification, as the case may be, under those clauses is received by the Assessing Officer; or

(vii)   Clause (vii) of section 158BE(4) provides that the period commencing from the date on which the Assessing Officer makes a reference to the Principal Commissioner or Commissioner under the second proviso to sub-section (3) of section 143 and ending with the date on which the copy of the order under clause (ii) or clause (iii) of the fifteenth proviso to clause (23C) of section 10 or clause (ii) or clause (iii) of sub-section (4) of section 12AB, as the case may be, is received by the Assessing Officer; or

(viii)  Clause (viii) of section 158BE(4) provides that the period commencing from the date on which a reference for declaration of an arrangement to be an impermissible avoidance arrangement is received by the Principal Commissioner or Commissioner under sub-section (1) of section 144BA and ending on the date on which a direction under sub-section (3) or sub-section (6) or an order under sub-section (5) of the said section is received by the Assessing Officer; or

(ix)    Clause (ix) of section 158BE(4) provides that the period commencing from the date on which an application is made before the Authority for Advance Rulings or before the Board for Advance Rulings under sub-section (1) of section 245Q and ending with the date on which the order rejecting the application is received by the Principal Commissioner or Commissioner under sub-section (3) of section 245R; or

(x)      Clause (x) of section 158BE(4) provides that the period commencing from the date on which an application is made before the Authority for Advance Rulings or before the Board for Advance Rulings under sub-section (1) of section 245Q and ending with the date on which the advance ruling pronounced by it is received by the Principal Commissioner or Commissioner under sub-section (7) of section 245R:

PROVIDED that where immediately after the exclusion of the aforesaid period, the period of limitation referred to in sub-section (1) or sub-section (3) available to the Assessing Officer for making an order under clause (c) of sub-section (1) of section 158BC is less than 60 days, such remaining period shall be extended to sixty days and the aforesaid period of limitation shall be deemed to be extended accordingly:

PROVIDED FURTHER that where after extension of the period referred to in the first proviso, the period of limitation for making an order of assessment or reassessment, as the case may be, expires before the end of a month, such period shall be extended to the end of such month.

Block assessment within limitation period valid as search not concluded until ‘Restraint Orders’ lifted under section 132

Madras High Court holds that the block assessment order passed under Section 143(3) r.w. Section 158BC in Vedanta Ltd. (Assessee) case was within the stipulated period; High Court opines that for the purpose of computation of limitation what is relevant is not the date of initial search but the actual date of completion of search under Section 132; Highlighting the provisions of Section 132, High Court observes that there is a difference between “deemed seizure” as contemplated under the second proviso to Section 132(1) and the “Restraint Order or Prohibitory Order” as contemplated under Section 132(3); Outlining the explanation of “Restraint Order or Prohibitory Order” in Search and Seizure Manual 2007, High Court states that provisions of Section 132(3) stands exercised where it is not practicable to seize any books of accounts etc., and can be invoked only for reason other than those mentioned in the second proviso to Section 132(1), given it is not a deemed seizure; High Court emphasizes that the Search and Seizure Manual clarifies that as far as possible search of premises once started should continue till it is concluded; High Court reiterates that “Restraint Order or Prohibitory Order” under Section 132(3) will not tantamount to “deemed seizure”; Highlighting Supreme Court decision in VLS Finance Ltd. and others v. CIT and others (2016) 384 ITR 1 (SC), High Court observes that initiation and conclusion of search need not necessarily be concluded on the same day; States that the CBDT has also issued instruction that the search and seizure should be completed as early as possible and “Restraint Order or Prohibitory Order” should be lifted within the aforesaid period from the date of passing such orders; High Court opines that as long as the investigation is incomplete it cannot said that the search was completed for the purpose of limitation under Section 158BE; High Court states that the search of documents will be complete only after “Restraint Orders or Prohibitory Orders” passed are vacated after the search is complete; Examining the provisions of Section 158BC and Explanation 1 & 2 to Section 158BE, High Court opines that Section 158BE(1)(b) has to be read harmoniously with Section 132(3) which is fortified by the Supreme Court decision in VLS Finance Ltd.. [In favour of revenue] – [CIT, Mumbai v. Vedanta Ltd. [TS-698-HC-2025(MAD)] – Date of Judgement : 09.05.2025 (Mad.)]

Period of limitation of two years for block assessment under section 158BC/158BE would commence from date of Panchnama last drawn and not from date of last authorization

The short question which is posed for the consideration of this Court is, whether the period of limitation of two years for the block assessment under Section 158BC/158BE would commence from the date of the Panchnama last drawn or the date of the last authorization?

Dr. Rakesh Gupta, Learned counsel appearing on behalf of the respective assessees has vehemently submitted that in the facts and circumstances of the case, the High Court has erred in holding that the respective assessment orders were within the period of two years and therefore not barred by limitation.

It is submitted that in the present case the last authorization was on 26.03.2001 and therefore as per Explanation 2 to Section 158BE of the Act the last authorization would be the starting point of limitation. It is submitted that therefore even if the first authorization dated 13.03.2001 was executed on a later date i.e., on 11.04.2001, that would be of no consequence and for the purpose of reckoning the limitation period, the first authorization is irrelevant and it is the “last of the authorization” which has to be kept in mind. It is submitted that in the present case, the last authorization is dated 26.03.2001 which was executed on the same date and therefore the period of two years is to be counted from that date.

Shri Balbir Singh, learned ASG appearing on behalf of the Revenue has vehemently submitted that as per Explanation 2 of Section 158BE of the Act, when it is a case of search, period of limitation is to be counted from the date on which the last Panchnama was drawn. It is submitted that in the present case, the last Panchnama on conclusion of the search was drawn on 11.04.2001 and therefore the limitation period of two years would start from 11.04.2001. It is submitted that if the submission on behalf of the assessees is accepted, in that case, the Explanation 2 to Section 158BE would become nugatory and redundant.

It is further submitted by the learned ASG appearing on behalf of the Revenue that Explanation 2 to Section 158BE has been specifically inserted with a view to give last of the Panchnama as the starting point of limitation. It is submitted that the time for completion of the block assessment under Section 158BC/158BE is the conclusion of search/drawing of last Panchnama which will be relevant and not the dates of issuance of various authorizations. It is submitted that in a given case where number of authorizations are issued and relevant material/s is/are collected during the search on different dates on the basis of the different authorizations, ultimately the assessment proceedings would be on the basis of the entire material collected during the search and on the basis of the Panchnama drawn. It is submitted that therefore the date on which the last Panchnama was drawn is the relevant date for the purpose of block assessment. In support of his submission, Shri Balbir Singh, learned ASG has heavily relied upon the decision of this Court in the case of VLS Finance Ltd. & Another v. CIT & Another (2016) 12 SCC 32 (paragraphs 26 to 28).

Supreme Court upholds Delhi High Court ruling on interpretation of Explanation 2 to Section 158BE with respect to limitation period for completion of assessment under Section 158BC; Delhi High Court had set aside ITAT order by holding that the limitation period shall be reckoned from the date of last Panchnama though related to first search authorisation out of the two search authorisations; Assessee-Individual was subjected to search operation by authorisation dated 13.03.2001 for which the Panchnama was drawn on 11.04.2001 whereas prior to this on 26.03.2001 another search authorisation was issued for which Panchnama was drawn on the same day while the assessment was completed in April 2003; ITAT held that limitation period of two years from the end of the month shall be reckoned as per 26.03.2001, thus, held the assessment as time-barred whereas Delhi High Court held that the same shall be reckoned as per the date of last Panchnama i.e., 11.04.2001; Supreme Court relies on coordinate bench ruling in VLS Finance Ltd. & Another v. CIT & Another (2016) 12 SCC 32 wherein it was held that the relevant date for calculating limitation period would be the date on which the Panchnama is drawn and not the date on which the authorisation is issued; Supreme Court also observes that the date of Panchnama is relevant because the block assessment proceedings are initiated on the entire material seized during search operation recorded in the Panchnama; Supreme Court approves Delhi High Court’s view that the date of the Panchnama last drawn would be the relevant date for considering the period of limitation of two years and not the last date of authorisation; Rejects Assessee’s submission that the date of the last authorisation is to be considered for the purpose of reckoning limitation of two years by holding that it would frustrate the entire object and purpose of Explanation 2 to Section 158BE; Supreme Court, thus, dismisses Assessee’s appeals. [In favour of revenue] – [Anil Minda and Others v. CIT (2023) 453 ITR 1 : 292 Taxman 407 : 148 taxmann.com 407 : [TS-138-SC-2023] (SC)]

Second Panchnama prepared one year after authorisation, merely for extending limitation period; Quashes block assessment

Section 158BE, read with section 132, of the Income-tax Act, 1961 - Block assessment in search cases - Time limit for completion of (Computation of limitation period) - A search under section 132 was conducted upon premises of assessee-company on 07.11.2000 based on authorisation dated 04.11.2000. Said authorisation was executed on 08.11.2000 when search was completed and panchnama was made. On 10.11.2000 a search was conducted on basis of fresh authorisation dated 10.11.2000, On 04.12.2000, investigation team again conducted search upon assessee under same old authorisation dated 10.11.2000 and passed prohibitory order under section 132(3) and items were inventorised. On 07.11.2001, i.e., almost after a period close to one year, investigation team again visited premises under same old authorisation dated 10.11.2000 for conducting search and prohibitory order passed on 04.12.2000 was converted into deemed seizure under section 132(1)(iii). There was nothing searched on this day except passing of conversion order from section 132(3) to 132(1)(iii). Later on, A block assessment order was passed on 28.11.2003. Assessee submitted that revenue could not conduct search after almost one year on basis of an old authorisation dated 10.11.2000 and draw a panchnama concluding search. It contended that limitation under section 158BE should begin from date of last drawn panchnama i.e., 08.11.2000, and, thus, impugned assessment order passed on 28.11.2003 was barred by limitation. According to revenue, limitation would start from 07.11.2001 when order of deemed seizure was passed under section 132(iii) by virtue of Explanation 2 read with section 158BE and, hence, block assessment framed vide order dated 28.11.2003 was within limitation period. Mumbai ITAT quashes block assessment order passed in case of assessee-company, holds that the assessment order is barred by limitation; Search & seizure action was conducted on the assessee-company under the authorisation dated 04.11.2000 and subsequently on 07.11.2001, i.e. almost after a period of close to one year, the investigation team visited the premises of the assessee under the same old authorisation and stated that the search is finally concluded; Rejects Assessing Officer’s contention that the limitation as per explanation 1 to Section 158BE will start from the date of last panchnama dated 7-11-2001 and thus the order passed on 28.11.2003 was not barred by limitation, states that The Explanation cannot override the main section as it refers to authorisation” and the panchnama cannot be looked at in isolation but the same has to be read along with the authorisation pursuant to which the panchnama is prepared.”; Explains that every fresh entry after a gap of many days would require a fresh authorisation so as to enable the search party to enter the premises for conducting search, holds that Search based on one authorisation issued one year back, the department cannot conduct search after one year and draw a panchnama stating conclusion of search and thereby contend that limitation under section 158BE of the Act r/w Explanation 2 thereto should begin from such last drawn panchnama.”; Remarks that Department could not keep search action in abeyance for a long period of almost one year from date of last authorisation more so when after a period of one year nothing was searched but only prohibitory order passed one year back was converted into deemed seizure. Therefore, panchnama dated 07.11.2001 drawn based on authorisation dated 10.11.2000 was bad in law and, therefore, limitation could not be counted from 07.11.2001 but it was ought to be counted from 10.11.2000 or at most from 04.12.2000. Therefore, assessment order dated 28.11.2003 was barred by limitation. [In favour of assessee] (Block period 01.04.1990 to 07.11.2000) - [Narang International Hotels (P) Ltd. v. DCIT (2020) 185 ITD 324 : 118 taxmann.com 454 : [TS-417-ITAT-2020(Mum)] (ITAT Mumbai]

For purpose of limitation under section 158BE, period is to be counted from date on which direction under section 142(2A) is served on assessee and not from date of issue of direction by Assessing Officer under section 142(2A)

Notice was issued under section 158BC on 29.10.1999 according to the provisions of section 158BE, the period of two years would start from 28.02.1999 from the end of the month in which the search was carried out. Therefore, assessment ought to have been passed before 28.02.2001. However, in the interregnum period, the Assessing Officer had ordered to furnish the audit report as required under sub-section (2A) of section 142 on 18.01.2001 which was required by the assessee on 23.01.2001. The audit report was submitted by the assessee on 17.07.2001.

Therefore, the questions which came for the consideration is as to whether the order of the assessment which has been passed on 24.08.2001 is time barred or not.

Held : In terms of section 158BE Explanation 1 clause (ii), the period of exclusion will commence from the day on which the Assessing Officer gives a direction under section 142(2A) and would end on the day when the assessee furnishes such audit report. The date of issuance of the notice is the day on which the Assessing Officer takes a decision to get the books audited, when such decision is conveyed to the assessee then only it results into direction. A purpose of interpretation of clause (ii) above, would mean, the date on which the decision/notice is served on the assessee and not the date of issue of direction. In that view of the matter, January 23, 2001 will be the crucial date from which the period to be excluded is to be reckoned, and therefore, the period which is required to be excluded in the period from 23.01.2001 to 17.07.2001 from 18.01.2001 to 23.01.2001 it was only decision, and not the direction. The learned ITAT has thus committed no error of law in holding the assessment order to be time barred. In that view of the matter, the issue is required to be answered in favour of the assessee and against the Department. [In favour of assessee] – [CIT v. Amar Nath Arora (2017) 398 ITR 108 : (2018) 99 taxmann.com 428 (Raj.)]

Period between date on which interim order was passed by High Court staying direction for special audit under section 142(2A), and date when High Court set aside direction for special audit, should be excluded in counting period of limitation for concluding block assessment

A search was conducted at the premises of the assessee on different dates in following manner: 

On 22.06.1998, first search was conducted. It was followed by further searches from time to time. On 05.08.1998, last search was conducted. Consequently, a notice was sent, in response of which, the assessee filed its return for block period in question. Thereafter, a direction was issued to conduct special audit. On petition before the High Court, the assessee challenged said direction for special audit. The High Court granted interim stay on said direction. On final hearing, the High Court quashed said direction, however, it was held that period for which stay operated would be excluded in counting limitation period for block assessment. On appeal before the Supreme Court:

Held : Explanation 1 to section 158BE grants benefit of exclusion only for those cases where the assessment proceeding is stayed by an order or injunction of the court. On literal construction, therefore, it becomes clear from the reading of this provision that the period that is to be excluded while computing the period of limitation for completion of block assessments is the period during which assessment proceedings are stayed by an order of a court and this provision shall not apply if the stay of some other kind, i.e, other than staying the assessment proceedings, is passed. Provision relating to limitation need to be strictly construed.

As a general rule, therefore, when there is no stay of the assessment proceedings passed by the Court, Explanation 1 to section 158BE may not be attracted. However, this general statement of legal principle has to be read subject to an exception in order to interpret it rationally and practically. In those cases where stay of some other nature is granted than the stay of the assessment proceedings but the effect of such stay is to prevent the Assessing Officer from effectively passing assessment order, even that kind of stay order may be treated as stay of the assessment proceedings because of the reason that such stay order becomes an obstacle for the assessing officer to pass an assessment order thereby preventing the Assessing Officer to proceed with the assessment proceedings and carry out appropriate assessment. For an example, if the court passes an order injuncting the Assessing Officer from summoning certain records either from the assessee or even from a third party and without those records it is not possible to proceed with the assessment proceedings and pass the assessment order, even such type of order may amount to staying the assessment proceedings. In that context, the High Court, in the impugned judgment has propounded the correct and relevant test, viz., whether the special audit is an integral part of the assessment proceedings, i.e., without special audit it is not possible for the Assessing Officer to carry out the assessment? If it is so, then stay of the special audit may qualify as stay of assessment proceedings and, therefore, would be covered by the said explanation.

The question, therefore, is as to whether, in the given case, the High Court was right in holding that the special audit was not only a step in the assessment proceedings, but an important and integral step, in the absence of which an assessment order could not be made. In support of the aforesaid conclusion, the High Court referred to the judgment in Auto and Metal Engineers v. Union of India [1998] 229 ITR 399/97 Taxman 363 (SC) wherein this Court examined in detail as to what constitutes assessment proceedings. The Court in that case was interpreting Explanation 1 to section 153, which is pari materia to Explanation 1 to section 158BE which is relevant for instant case. The said provision was interpreted thus - the object of the Explanation seems to be that if the Assessing Officer was unable to complete the assessment on account of an order or injunction staying the assessment proceeding passed by a court the period during which such order or injunction was in operation should be excluded for the purpose of computing the period of limitation for making the assessment order. The process of assessment thus commences with the filing of the return or where the return is not filed, by the issuance by the Assessing Officer of notice to file the return and it culminates with the issuance of the notice of demand. The making of the order of assessment is, therefore, an integral part of the process of assessment. Having regard to the fact that the object underlying the Explanation is to extend the period prescribed for making the order of assessment, the expression 'assessment proceeding' in the Explanation must be construed to comprehend the entire process of assessment starting from the stage of filing of the return or issuance of notice under section 142(1) till the making of the order of assessment. Since the making of the order of assessment is an integral part of the assessment proceeding, it is not possible to split the assessment proceeding and confine it upto the stage of inquiry and exclude the making of the order of assessment from its ambit. An order staying the passing of the final order of assessment is nothing but an order staying the assessment proceeding.

Therefore, the High Court was correct in holding that the special audit was an integral step towards assessment proceedings. The argument of the assessee that the Court had quashed the order directing special audit would mean that no special audit was needed and, therefore, it was not open to the revenue to wait for special audit, may not be a valid argument to the issue that is being dealt with. The Assessing Officer had, after going through the matter, formed an opinion that there was a need for special audit and the report of special audit was necessary for carrying out the assessment. Once such an opinion was formed, naturally, the Assessing Officer would not proceed with the assessment till the time the special audit report is received, inasmuch as in his opinion, report of the special audit was necessary. Take a situation where the order of special audit is not challenged. The Assessing Officer would naturally wait for this report before proceeding further. Order of special audit followed by conducting special audit and report thereof, thus, become part of assessment proceedings. If the order directing special audit is challenged and an interim order is granted staying the making of a special report, the Assessing Officer would not proceed with the assessment in the absence of the audit as he thought, in his wisdom, that special audit report is needed. That would be the normal and natural approach of the assessing officer at that time. It is stated at the cost of repetition that in the estimation of the Assessing Officer special audit was essential for passing proper assessment order. If the court, while undertaking judicial review of such an order of the Assessing Officer directing special audit ultimately holds that such an order is wrong (for whatever reason) that event happens at a later date and would not mean that the benefit of exclusion of the period during which there was a stay order is not to be given to the revenue. Explanation 1 which permits exclusion of such a time is not dependent upon the final outcome of the proceedings in which interim stay was granted. [In favour of revenue] – [VLS Finance Ltd. v. CIT (2016) 386 ITR 407 : 289 CTR 256 : (2017) 81 taxmann.com 358 (SC)]

  

Concept of Diversion of Income by Overriding Title

One of the fundamental principles of taxation is to tax income accruing or deemed to accrue in favour of the assessee. The concept of diversion of income and application of income though fundamental has great tax implication since it is a court made concept. It is well known that income when diverted before reaching the assessee is called as diversion of income, whereas when the income is applied after it reaches the assessee, either due to contractual obligation or exercise of discretion, it is called as application of income.

In India, the Income Tax Act provides provisions to prevent the diversion of income by overriding titles. These provisions are designed to ensure that the person who earns the income is the one who is taxed on it, regardless of who may have legal title to it.

One of the key provisions in this regard is Section 60 of the Income Tax Act, 1961 which provides that any income arising to an individual shall be deemed to belong to that individual, even if the income is paid or credited to someone else.

Additionally, Section 64 of the Income Tax Act, 1961 provides that if any income is transferred without adequate consideration to a spouse or minor child of an individual, such income will be deemed to belong to the individual and will be taxed as his or her income.

Furthermore, Section 61 of the Income Tax Act 1961 provides that any income arising to an individual from assets transferred by him or her to another person without adequate consideration will be deemed to belong to the transferor and will be taxed accordingly.

These provisions are meant to prevent individuals from transferring their income to others in an attempt to avoid taxation.

Diversion of Income by Overriding Title

Diversion of income by overriding title means that the income is diverted because of legal obligation. The source of income is subject to a legal obligation. In case the income is diverted because of a legal obligation, then the income shall not be included in the  income of the person who has diverted the income but shall be taxable in the hands of recipient.

Thus, where a third person becomes entitled to receive the amount under an obligation of an assessee even before he could lay a claim to receive it as his income, there would be diversion of income by overriding title.

In other words, Diversion of income by overriding title refers to situations where income that would otherwise belong to a taxpayer is diverted to another party before the taxpayer can use it. This concept ensures that only income genuinely accruing to the taxpayer is taxable. For diversion to occur under overriding title, the obligation must prevent the income from ever being part of the taxpayer’s income.

Application of Income

But when after receipt of the income the same is passed on to a third person, in discharge of the obligation of the assessee, it will be a case of application of income and not diversion of income.

In other words, application of income occurs when a taxpayer, having already received income, chooses to allocate or use parts of it for specific obligations or purposes. Unlike diversion, the income has already accrued to the taxpayer and is available for his use before being applied to meet obligations.

Overriding Title

An overriding title imposes a condition that prevents income from being part of the taxpayer’s income, typically through contractual obligations or trusts that designate the use of income towards specific purposes before it becomes available to the taxpayer.

Section 4 of the Income Tax Act, 1961 recognises the principles of diversion of income by overriding title. Where income is diverted before it reaches the hands of the assessee, it amounts to diversion at source.

FOR EXAMPLE:

In case of a lottery, as per the lottery agreement certain percentage of the first prize is to be paid to the state government and the lottery agent. In this case, the lottery income is subject to a legal obligation and therefore the amount paid to the state government and lottery agent is on account of a legal obligation. Therefore ,the said amount is not taxable in the hands of winner. 

What is diversion of income by overriding title

What is diversion of income by overriding title is no more a subject-matter of legal controversy. As observed by the Supreme Court in CIT v. Sitaldas Tirathdas (1961) 41 ITR 367 :

“. . . the true test [for the application of diversion of income by an overriding charge] is whether the amount 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 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. It is the first kind of payment which can truly be excused and not the second. The second 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 eager to collect it, does so, not as part of his income, but for and on behalf of the person to whom it is payable. . . .” (p. 374).

To the same effect is the decision of the Supreme Court in CIT v. Imperial Chemical Industries (India) (P) Ltd. (1969) 74 ITR 17 (SC) where the question of overriding title again came to be considered by the Supreme Court. In this case, it was observed :

“. . . An obligation to apply the income in a particular way before it is received by the assessee or before it has accrued or arisen to the assessee results in the diversion of income. An obligation to apply income accrued, arisen or received amounts merely to the apportionment of income and the income so applied is not deductible. The true test for the application of the rule of diversion of income by an overriding title is whether the amount sought to be deducted in truth never reached the assessee as his income. . . .” (p. 24)

The Hon’ble Apex Court had an occasion to elaborate on the concept of diversion of income in the case of CIT v. Bijli Cotton Mills (P) Ltd. (1979) 116 ITR 60 (SC) and the Hon’ble Apex Court held that for an income to be considered diverted at source, there must be an overriding title that diverts the income before it reaches the assessee and that if such title exists, the income never becomes the property of the assessee and, therefore, does not become taxable in their hands.

Is diversion of income taxable?

The source of income is subject to a legal obligation. In case the income is diverted because of a legal obligation, then the income shall not be included in the income of the person who has diverted the income but shall be taxable in the hands of recipient.

If an assessee voluntarily diverts his income to some other person, then the income so diverted shall be included in the income of the person who diverted the income and shall not be taxable in the hands of the recipient.

NOTE

§  An income diverted at source by overriding charge is not chargeable to tax in the hands of the actual recipient;

§  A charge created for diversion of income by overriding title will insulate the recipient from tax consequences and merely because he receives the same, he could not be taxed.

How Diversion of income by overriding titles Works?

Diversion of income by overriding titles is a tax avoidance scheme that works by transferring income or assets to another party through a legal document known as an overriding title. The overriding title can be in the form of a lease, license, or other legal agreement that allows the income or assets to be diverted to another party. Here’s how it typically works:

§  An individual or company creates an overriding title, which is a legal document that transfers the right to receive income or assets from one party to another.

§  The overriding title is usually structured as a lease, license, or other legal agreement that allows the income or assets to be diverted to another party.

§  The individual or company then pays the income or assets to the other party, who may be a related party, such as a family member, or an unrelated party, such as a shell company.

§  By doing this, the individual or company can reduce their tax liability, as the income or assets are no longer directly attributed to them.

Assessee contract liquor manufacturer for UBL; Income by overriding title of UBL not taxable in Assessee’s hand

Lucknow ITAT holds that the Assessee is merely a contract manufacturer of the liquor for United Breweries Ltd., (UBL) and UBL is the de facto earner of income arising from manufacture and sale of its brands of liquor and bottled at the facility of the Assessee; Thus, upholds the CIT(A) order deleting the addition for Assessment years 2013-14 to 2017-18 towards understatement of income; While examining the concept of diversion of income by overriding title, ITAT notes that it is the presence of overriding title that causes income to be re-directed before it reaches the hands of the Assessee; Places reliance on Supreme Court judgment in CIT v. Imperial Chemical Industries India (P) Ltd. (1969) 74 ITR 17 (SC), CIT v. Bijli Cotton Mills (P) Ltd. (1979) 116 ITR 60 (SC) wherein it was held that for an income to be considered diverted at source, there must be an overriding title that diverts the income before it reaches the Assessee and that if such title exists, the income never becomes the property of the Assessee and, therefore, does not become taxable in their hands; Takes note of Brewery and Distillery Agreement entered into between the Assessee and UBL and observes that UBL has given non-exclusive, non-assignable and non-transferable right to the Assessee to carry out manufacturing, bottling and sale of beer for UBL and for this service, UBL agreed to compensate the Assessee at the prevailing market rates; Rejects Revenue’s argument that since the Assessee was the Excise Licensee under the Excise Act and that UBL had no Excise License in its name, it could not be said that the Assessee was carrying on business exclusively for and on behalf of UBL; Having perused various terms of the Agreement, Excise Licenses, Sales Invoices, Gate Passes, Bank accounts, ITAT opines that the Assessee is only a contract manufacturer for UBL and in effect the sales alleged to have been effected by the Assessee were in fact sales of UBL; Finds that in the present case, undisputedly, the Assessee has only acted as a manufacturing agent for other party, i.e., UBL and as per the Agreement and various documents, nothing more than a contract manufacturer can be attributed to the Assessee; Points out that in the present case, the Assessee has been obligated by virtue of Agreement to divert the income/revenue at source and is entitled only towards reimbursement of expenses and bottling charges and nothing less nothing more; Rejects Revenue’s reliance on Karnataka High Court judgment in PCIT, Bangalore v. Chamundi Winery & Distillery (2018) 408 ITR 402 : 97 taxmann.com 568 (Karn.) by observing that the facts of the case in the aforementioned case are diametrically opposite to the facts of the present case, thus the same would not apply to the present case; Thus dismisses Revenue’s appeals. [In favour of assessee] (Related Assessment years : 2013-14 to 2017-18) – [ACIT, Bareilly v. Wave Distilleries and Breweries Ltd. [TS-192-ITAT-2025(LKW)] – Date of Judgement : 28.02.2025 (ITAT Lucknow)]

SLP dismissed against order of High Court that where assessee-firm paid certain amount to a retired partner on basis of provisions made in partnership deed, said payment would amount to a diversion of income at source by overriding title, and, therefore, same should be treated as deductible expenditures for income tax purposes

Assessee-firm paid certain amount to a retired partner on basis of provisions made in partnership deed.  Deed provided that partner whose share was determined on account of resignation, retirement or death, should also be paid by continuing partners of firm, a sum equivalent to one and a half times share of profits and remuneration received by him in last accounting year immediately preceding date of determination of his share. This was primarily based on premise that partner of firm during his tenure would render service to clients for which bills might have been raised, but payments in full might not have been received and would be received after partner retires, dies or resigns. Assessee claimed such payment by way of a deductible expenditure. Assessing Officer denied claim of assesse. Tribunal allowed said claim - On appeal, High Court upheld order of Tribunal and held that payments to retiring partner amounted to a diversion of income at source by overriding title, and therefore, same should be treated as deductible expenditures for income tax purposes. Against said order revenue filed Special leave petition - Assessee submitted that it had availed of benefit under Direct Tax Vivad Se Vishwas Act, 2020 as well as Rules made thereunder and consequently, issues which arose in this special leave petition had now been rendered infructuous. In view of said development, special leave petition had been rendered infructuous and accordingly, stood disposed of in aforesaid terms. [In favour of assessee] – [PCIT v. Wadia Ghandy & Co. (2023) 155 taxmann.com 229 (SC)]

Development authority taxable since income vests with State Govt. only on dissolution; Rejects ‘diversion of income’ plea

Uttarakhand High Court dismisses Assessee’s appeal, holds income received by development authority to be taxable since its income and liabilities were to vest with the State Government only on its dissolution; Assessee, constituted under the U.P. Urban, Planning & Development Act was subjected to scrutiny assessment for Assessment years 2006-07 and 2007-08 whereby Revenue found that Assessee was maintaining an infrastructure fund, to which a fixed portion of its receipts were credited and infrastructure related expenses were incurred out of the same; Revenue allowed the expenditure incurred and rejected Assessee’s arguments that State Government had a overriding title on the receipts and that there was diversion of income by overriding title, thus made an addition of Rs. 8.49 Cr. for Assessment year 2006-07 and similar assessment was made for Assessment year 2007-08, which was upheld upto ITAT; High Court refers to Article 289 and the Supreme Court ruling in Adityapur Industrial Area Development Authority v. Union of India (2006) 153 Taxman 107 (SC) wherein it was held that “it is futile to contend that the income of the appellant/ Authority is the income of State Government, even though the Authority is constituted under an Act enacted by the State Legislature by issuance of a Notification by the Government thereunder”; High Court, in the light of relevant provisions of the U.P. Urban, Planning & Development Act, 1973, observes that Assessee is a separate entity and distinct from the State, having its own legal identity, and can sue or be sued in its own name. [In favour of revenue] – [Mussoorie Dehradun Development Authority v. ACIT [TS-413-HC-2022(UTT)] – Date of Judgement : 20.05.2022 (Uttarakhand)]

Even if nuns and priests handed over salaries to their religious congregation according to their religious calling, principle of diversion of income by overriding title would not apply

Nuns/Priests, payments to) - Concept of civil death propounded by Canon Law is not real; civil death contemplated under rule of law is only civil death provided for in section 108 of Indian Evidence Act, 1872 and it is alien to Income-tax Act and, thus, inapplicable for claiming exemption from tax/TDS liability. If in spite of vow of poverty undertaken by nuns or priests of a religious congregation, they work for gain and receive salary, irrespective of whether ultimate beneficiary is somebody else or not, their salaries would partake character of income. Where nuns and priests handed over salaries received from their employment in educational institutions where they were engaged as part of their duty, to their religious congregation according to their religious calling, principle of diversion of income by overriding title would not apply to salary received by them. [In favour of revenue] – [Provincial Superior v. Union of India (2021) 129 taxmann.com 154 (Ker.)]

Bellary Mines - Sale proceeds transferred to SPV under Supreme Court order, diversion of income

Bangalore ITAT holds that the sale proceeds from undeclared stock of iron ore outside the sanctioned lease area was diversion of income from source to the SPV by an overriding title in accordance with Supreme Court order, and in the alternative, even if such sale proceeds is considered as taxable on an accrual basis it is deductible as trading loss; Holds that The moment income accrues, assessee gets vested with the right to claim it, even though it may not be made immediately; Holds that total income of each year is to be determined separately and hence income has to be assessed in the right assessment year and, hence, rejects the contention that there is no need to do so since the relevant income was offered to tax in the subsequent assessment years and such offer was revenue neutral since the tax rate was uniform; Holds that sale proceeds from undeclared stock of the assessee was income even though such proceeds were transferred to an SPV because the undeclared stock was the outcome of mining by the assessee in course of its regular business and that the proceeds from its sale therefore assumes character of income in the hands of assessee such income accrued to assessee, on the date of sale by MC ; Holds that there is uncertainty in the receipt of such income from the undeclared stock since the Supreme Court has ordered the proceeds to be demarcated on the basis of whether the undeclared stock was located inside the sanctioned lease area or outside with only the former payable to the assessee, and hence, it cannot be said that any sale proceeds accrued to the assessee on the date of sale sale proceeds from undeclared stock shall be taxable when it is actually received. [in favour of assessee] (Related Assessment year : 2013-14) – [Veerabhadrappa Sangappa & Co v. ACIT, Bellary [TS-668-ITAT-2020(Bang)] – Date of Judgement : 08.12.2020 (ITAT Bangalore)]

Yum Restaurant’s marketing arm taxable on franchisee advertising contributions; Rejects ‘income diversion’ plea

Delhi ITAT upholds taxability of advertisement contribution received by assessee [a wholly owned step down subsidiary of Yum Restaurants incorporated on a non-profit making principle for managing advertising & marketing at local store level] from franchisees, rejects assessee's diversion of income by overriding title plea for Assessment year 2002-03; Assessee co., its parent co. and the franchisees had entered into tripartite agreements [franchisee agreement] whereby assessee received certain contributions from the franchisees in order to carry on co-operative advertising, rejects assessee's contention that since the contributions received were for the predefined purposes for incurring them on AMP [advertising, marketing and promotion] activities, the contributions were diverted at source by overriding title; Cites Supreme Court decision in Sitaldas Tirathdas’s case wherein it was held that Where, by the obligation income is diverted before it reaches the assessee, it is deductible..”, observes that in present case it is after the receipt of income that the obligation to spend on AMP arises, also notes that  there is no obligation on the assessee to spend any definite amount every year .”;  Further rules that merely mentioning that it will act on the non-profit basis does not make the income received by the assessee....diverted by overriding title.”, observes that  the assesse is carrying out the business of advertisement, marketing and publicity for certain parties [i.e. franchisees] from whom it receives money and against the said receipts, expenses are made.”, and thus holds that surplus of income [i.e. contribution] over expenditure is taxable; Also rejects assessee's plea of non-taxability on the basis of mutuality, notes that apart from contributions received from various franchisees, contributions had also been received from Pepsi Foods Ltd. as also from parent co., who were neither franchisees nor beneficiaries. [In favour of revenue] - [Yum! Restaurants Marketing (P) Ltd. v. ITO [TS-544-ITAT-2019(DEL)] – Date of Judgement : 09.09.2019 (ITAT Delhi)]

Earmarked donations from property-sale proceeds as per ‘Will’, not ‘application’ but income ‘diversion’

Madras High Court reverses ITAT order for Assessment year 2012-13, allows exclusion of payment to charities from sale consideration as per the ‘Will’ while computing capital gains on property sale applying the principle of diversion of income by overriding title;  In the ‘will’ executed by assessee’s father, there was a direction to the executor of the will to pay certain demarcated sum to charitable institutions / CRY etc. upon sale of the property and the balance amount was to be paid to assessee, Assessing Officer had rejected assessee’s claim of exclusion of such sum from the sale consideration while computing LTCG; Rejects Revenue's stand that the term ‘absolutely’ in the will bequeaths the entire sale consideration to the assessee and the payments to the charitable institutions was application of the money and not diversion of income by overriding title, remarks that the will has to be read in its entirety and not in bits & pieces as done by the revenue” to understand the intention of the testator; Rules that ‘The testator did not bequeath the ..property but bequeathed part of the sale consideration...’, holds that assessee at no point of time was entitled to receive the entire sale consideration; Notes that the will specifically earmarked donations to be made to the charitable institutions before the assessee was entitled to the consideration. [In favour of assessee] (Related Assessment year : 2012-13) – [Kumar Rajaram v. ITO (International Taxation), Chennai [TS-504-HC-2019(MAD)] – Date of Judgement : 05.08.2019 (Mad.)]

Payment for self-imposed obligation vide Articles of Association, not income diversion

Mumbai ITAT denies deduction to assessee company for payment (of 0.5% of the total annual income) to a Charitable Trust every year by way of Clause in the Articles of Association (AOA) during Assessment years 2010-11 to 2012-13, rejects assessee’s contention that the amount was diverted at source by overriding title and has been paid wholly and exclusively for the purpose of business; Revenue disallowed the claim of deduction holding that 0.5% of the total annual income of the assessee paid over to trustees of the Trust as per clause 10 of AOA had no business expediency, assessee however contended that right from the inception, the amount is earmarked for charity; Observes that assessee did not explain any business expediency for diversion of income to the trust, further holds that no basis was provided for making payment of business receipt to such trust ; Holds that assessee created self-imposed obligation vide AOA to pay 0.5% of total income; Holds that AOA does not entitle the assessee to debit an amount in the name of the trust as this clause cannot override the provisions of the Income Tax Act, ITAT remarks that, the charge created as per the charter incorporation document of the company is not a charge of income and does not have any overriding effect on the income arising in India.” [In favour of revenue] (Related Assessment years : 2010-11, 2011-12 & 2012-13) – [Creation Publicity (P) Ltd. v. ITO [TS-615-ITAT-2017(Mum)] - Date of Judgement : 30.11.2017 (ITAT Mumbai)]

Nature and effect of assessee’s obligation decides whether it is diversion or application of income; income not receivable by virtue of overriding title not includible in total income

The Supreme court of India observed that under the scheme of the Act, it is the total income of an assessee, computed under the provisions of the Act, that is assessable to income-tax. So much of the income which an assessee is not entitled to receive by virtue of an overriding title created in favour of a third party would get diverted at source and the same cannot be added in computing the total income of the assessee. The principle is simple enough but more often than not, as in the instant case, the question arises as to what is the criteria to determine, when does the income attributable to an assessee get diverted by overriding title ? The determinative factor, in our view, is the nature and effect of the assessee’s obligation in regard to the amount in question. When a third person becomes entitled to receive the amount under an obligation of an assessee even before he could lay a claim to receive it as his income, there would be diversion of income by overriding title; but when after receipt of the income by the assessee, the same is passed on to a third person in discharge of the obligation of the assessee, it will be a case of application of income by the assessee and not of diversion of income by overriding title. [In favour of revenue] (Related Assessment year : 1974-75) – [CIT v. Sunil J. Kinariwala [TS-32-SC-2002] – Date of Judgement : 10.12.2002 (SC)]

Contractual obligations to pay specific sums to deceased partners’ legal representatives do not equate to diverted income

Assessee, who was an architect by profession, was carrying on his profession in partnership, with his father B and one T as partners. B died on 05.09.1963 and on his death a new partnership deed was drawn under which it was provided that in event of death or retirement of T goodwill of firm will belong to assessee and that assessee would pay to his heirs or to him price of his share. Partnership deed enabled assessee to pay aforesaid amount within one year so that his business might not suffer. T died on 04.11.1967 and assessee paid certain amount to wife of T in assessment year 1971-72 under various clauses of the partnership deed.

The following question of law at the instance of the revenue:

“Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the sums of Rs. 60,000 and Rs. 99,333 paid to the widows of the deceased partners did not constitute assessee's income and was rightly excluded by the AAC from its total income ?”

Amounts paid as share of deceased, which accrued to him till date of his death and as a price of his share to legal heirs, were an income which accrued to assessee. It could not be said income representing amounts paid to T’s legal heirs was diverted by overriding title.

The above facts clearly indicated that what was paid was by way of price of the share of the deceased partner in the partnership. It was at the most application of income that accrued to him. The surviving partner had been given time of two years in the first case and one year in the second case to pay the amount. There was nothing in these clauses to suggest that there was any diversion of income by overriding title. Considering the facts of the case in the light of the Supreme Court cases in CIT v. Sitaldas Tirathdas (1961) 41 ITR 367 (SC) and CIT v. Imperial Chemical Industries (India) (P) Ltd. (1969) 74 ITR 17 there was no diversion of income at source by overriding title. The partnership deed put an obligation on the surviving partner to pay certain amounts by way of price of the share of the deceased partner to his legal representative. Even the payment was not to be made immediately and it could be deferred for a period of one year in the second case. All these factors clearly went to show that it was a case of application or apportionment of income and not of diversion by overriding title. The fact that the application was to discharge an obligation undertaken by the assessee made no difference.

On a careful consideration of the various decisions and applying the test laid down by the Supreme Court in Sitaldas Tirathdas’s case (supra) to the facts of the present case, it was clear that this was not a case of diversion of income by overriding title. It was a clear case of application of income in fulfilment of legal obligation after it had arisen or accrued to the surviving partner. In that view of the matter, the Tribunal was not justified in holding that there was diversion of income by overriding title. [In favour of revenue] (Related Assessment year : 1971-72) – [CIT v. V.G. Bhuta (1993) 203 ITR 249 ; 115 CTR 39 : 71 Taxman 207 (Bom.)]

Payments made to mother of partners under a partnership agreement deductible for determining assessee’s income

In Nariman B. Bharucha’s case (1981) 130 ITR 863 Shri. Nariman Bharucha running a proprietary concern converted the same into partnership by admitting his two sons as partners and allotted 37.5 percent share to each son. The balance of 25 percent share of profit or loss was retained by him. The deed of partnership contained a recital that in the event of the demise of the erstwhile proprietor, the surviving partners have to pay 25 percent share of profits of the firm to the widow of the deceased partner (i.e. wife of erstwhile proprietor and mother of two surviving partners). It so happened that the erstwhile proprietor deceased and the firm paid 25 percent of profits to the widow of the deceased partner and claimed the same as expenditure. The claim of the assessee was negative by the revenue.

The Tribunal held that an effective and valid charge was created in favour of the mother and by virtue of that charge, which was enforceable in a court of law, an overriding title was created in her favour and the income of the firm to that extent was diverted at source by an overriding title.

It is obvious that not only the equal share in the income of the two partners, but also the firm's assets were subjected to a charge to the extent of 25 per cent of the firm’s income. This 25 per cent of its income did not belong to any partner, and if it was received by any of the partners, it was for and on behalf of the charge holder. The amount of 25 per cent of the firm's income was, therefore, diverted before the profits reached its partners. The Tribunal was, therefore, right in law in holding that to the extent of the valid charge in favour of Mrs. N, the firm's income was diverted by an overriding title and the impugned payment was deductible. [In favour of assessee] – [CIT v. Nariman B. Bharucha’s case (1981) 130 ITR 863 (Bom.)]

Assessee was partner in a firm - By a compromise decree passed by Court as a result of divorce of assessee with his wife, assessee was made liable to pay certain monthly payments to his unmarried daughters - By a tripartite agreement entered into between assessee, partnership-firm and daughters, firm agreed to pay agreed payments out of share of profits payable to assessee - Assessee had created charge in favour of his two daughters and there arose an overriding right or title in favour of daughters to get remuneration and profits which to extent of that right or title ceased to be remuneration and or profits of assessee - Therefore, assessee was entitled to deduction of amount paid to his daughters from his total income

Section 4 of the Income-tax Act, 1961 [Corresponding to section 3 of the Indian Income-tax Act, 1922] – Income –The assessee was a partner in a firm. The assessee was a married man but some time in 1951 his marriage with his wife came to be dissolved and a divorce was granted to him with other consequential reliefs. As a result of this compromise the assessee made certain provisions for the two unmarried daughters. Under a tripartite entered into between the assessee, his daughters and the firm, the assessee agreed to pay certain monthly amounts to his daughters. The aforesaid payments were agreed to be paid by the firm out of the profits payable to the assessee. For the assessment years 1957-58 and 1960-61, the assessee claimed that the amount paid to his daughter under the terms of the decree and the agreement did not constitute his income at all and was not liable to tax. He claimed that the amount was at source diverted and ceased to be his income, because of the overriding title created in his daughter. The ITO held that, though the payment was legally enforceable against the assessee, the payment of the above sum amounted to nothing more than the discharge of a personal obligation and that there was no provision in the Act to allow expenses of a personal nature. On appeal the AAC allowed the assessee’s claim. On appeal by the revenue, the Tribunal confirmed the order of the AAC. On reference:

Held : In the instant case so far as the decree was concerned, the creating of a charge was clearly contemplated. The agreement was not merely an agreement between the father and the two daughters but it was a tripartite agreement and was signed also by the remaining two partners of the assessee in the firm. If it were merely a case of the discharge of a personal obligation by the assessee in favour of his two daughters, one was at a loss to know why the two partners of the assessee should have been made parties to the agreement. The fact that they were made parties to the agreement and agreed themselves to pay to each of the daughters the amounts of the maintenance due to them out of the remuneration and the one-third share in the profits of the partnership, clearly showed that it was the intention of the parties that the source or the profits should be bound. That part of the profits thus could never become the income of the assessee. Once a stipulation like this was made in the document it was clear that the profits could never have been obtained directly by the assessee himself. On the other hand, the daughters would be entitled directly to claim the maintenance out of the profits from the two partners who had agreed to pay the same to them and to that extent they would have a title superior to that of their father in the profits. That would constitute such an overriding title as would make that portion of the profits which was payable to them ceased to be the profits of the assessee himself long before it became his income. The stipulation in the agreement whereby the two partners bound themselves to pay to the two daughters the maintenance due to them out of the remuneration and profits due to the assessee, was a special and a very important circumstance which distinguished this case from any other case. It was a circumstance which put it beyond any doubt that the source of the income was intended to be bound by the assessee in favour of his daughters giving rise to a charge.

It was, therefore, held that the Tribunal was right in the view which it took that upon the two documents in this case the assessee created a charge in favour of his two daughters and that there arose an overriding right or title in favour of the two daughters to get the remuneration and profits which to the extent of that right or title ceased to be the remuneration and/or profits of the assessee. [In favour of assessee] – (Related Assessment years : 1957-58 and 1960-61) – [CIT v. C.N. Patuck (1969) 71 ITR 713 (Bom.)]

Income diverted by overriding title can be taxed as the income of the assesse, but only if the diversion is made with the intention of creating a legal obligation to divert the income

Section 5 of the Income-tax Act, 1961 [Corresponding to section 4(1) of the Indian Income-tax Act, 1922] - Income - Accrual of - Assessee-firm was managing agents of two companies - It was entitled to receive as its commission, 10 per cent of freight charged. In 1948 on request of managed companies assessee agreed to reduce commission to 2½ per cent from 10 per cent . In assessment proceedings, ITO took view that amount of larger commission had already accrued during relevant previous year and same was thus assessable.

Income-tax is a levy on income. No doubt, the Income-tax Act takes into account two points of time at which the liability to tax is attracted, viz., the accrual of the income or its receipt; but the substance of the matter is the income. If income does not result at all, there cannot be a tax, even though in book-keeping, an entry is made about a “hypothetical income”, which does not materialise. Where income has, in fact, been received and is subsequently given up in such circumstances that it remains the income of the recipient, even though given up, the tax may be payable. Where, however, the income can be said not to have resulted at all, there is obviously neither accrual nor receipt of income, even though an entry to that effect might, in certain circumstances, have been made in the books of account. This was exactly what had happened in instant case. Here the agreements within the previous year replaced the earlier agreements, and altered the rate in such a way as to make the income different from what had been entered in the books of account. A mere book-keeping entry cannot be income, unless income has actually resulted, and in the instant case, by the change of the terms the income which accrued and was received consisted of the lesser amounts and not the larger. This was not a gift by the assessee firm to the managed companies. The reduction was a part of the agreement entered into by the assessee firm to secure a long-term managing agency arrangement for the two companies which it had floated.

In this Case, the Supreme Court of India considered the question of whether income diverted by overriding title could be taxed as the income of the assessee. The case involved a partnership firm, which had entered into an agreement with a company, under which a portion of the profits of the firm was diverted to the company.

The Supreme Court held that if the owner of the income deliberately creates a diversion of income by overriding his legal obligation to receive that income, then the income will be taxed as his own income. The court further observed that if the diversion of income is made voluntarily and without any legal obligation, then it would not qualify as a diversion of income by overriding title.

The court also held that the principle of diversion of income by overriding title is not limited to cases of voluntary gifts or donations. It can also be applied in cases where there is a legal obligation to divert the income. The court noted that the diversion must be a real and bona fide arrangement, and not a mere pretense or sham.

Since reduction in share of commission was part of agreement entered into by assessee-firm to secure long-term managing agency agreement for two companies, High Court was right incoming to conclusion that larger income neither accrued nor was received by assessee firm during relevant assessment year. The appeal was dismissed. [In favour of assessee] (Related Assessment year : 1948-49) - [CIT v. Shoorji Vallabhdas & Co. (1962) 46 ITR 144 (SC)]

Where by obligation income is diverted before it reaches assessee, it is deductible; but where income is required to be applied to discharge an obligation after such income reaches assessee, no deduction can be allowed - Assessee claimed deduction of amount paid under a consent decree as maintenance to his wife and children – Instant case was one of application of a portion of income to discharge an obligation after assessee had received income as his own - Therefore, same was not deductible

Issue : whether the sum paid towards maintenance can be claimed as a deduction on the ground that the same is diversion of at source by overriding title or application of income.

Section 4 of the Income-tax Act, 1961 [Corresponding to section 3 of the Indian Income-Tax Act, 1922] - The assessee claimed deduction from his total income of the amount paid under a consent decree as maintenance to his wife and children. The ITO however disallowed said deduction and same was confirmed by the AAC and the Tribunal. On reference, the High Court held that the income to the extent of the decree must be taken to have been diverted to the wife and children, and never became income in the hands of the assessee and hence, was an allowable deduction. On appeal to the Supreme Court:

Held : 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 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. It is the first kind of payment which can truly be excused and not the second. The second 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. The instant case was one in which the wife and children of the assessee who continued to be members of the family received a portion of the income of the assessee, after the assessee had received the income as his own. The case was one of application of a portion of the income to discharge an obligation and not a case in which by an overriding charge the assessee became only a collector of another’s income. Therefore, the assessee was not entitled to the deduction claimed. [In favour of revenue] (Related Assessment years : 1953-54 and 1954-55) – [CIT v. Sitaldas Tirathdas (1961) 41 ITR 367 (SC)]