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)]