One of the 1st concepts that you would have studied in Income Tax- Application of Income V/s Diversion of Income. Very simple yet confusing!!!!

In this blog we will discuss and try to put some light on these two basic concepts. Let’s get started-

1. Application of Income means spending of Income after it is being earned by the assessee. Such amount shall not be excluded from total income of the assessee as it is merely application of earned income. In other words, applied income shall be taxable in the hands of the assessee.

2. Diversion of Income is the process of diverting income before it is earned by the assessee. Such amount shall be excluded from the Total Income of the assessee as the income is diverted to someone else before being earned by the assessee. In case of diversion of Income there is an over- riding title of any other person on such income. So the income before being earned by the assessee reaches such person and hence not chargeable to tax in hands of the assessee. 

3. Example of Application of Income: – Mr. A is liable to pay Rs. 2,000/- per month to Ms. B (his ex-wife) as an alimony sum. Mr. A being an employee of Mr. C, instructs him to pay Rs.2,000/- per month out of his salary and disburse the remaining salary to him. Whether this amount of Rs.2,000/- per month be included in the Total Income of Mr. A or is it a case of diversion of income of Mr. A and not taxable in his hands?

This is a case of Application of Income by Mr.A and not diversion of Income and hence it will be included in the Total Income of Mr. A. This is because this amount of Rs. 2,000/- per month is an obligation of Mr. A to pay to Ms. B out of his income and not an income in which Ms. B had over riding entitlement from Mr. C before being earned by Mr. A. In other words, this is an Income of Mr. A, which is applied by him to fulfill an obligation and hence included in his Total Income and a mere arrangement to make Mr. C make such payments directly to Ms. B won’t make it a case of Diversion of Income.

4. Example of Diversion of Income: – M/s ABC is a partnership firm in which A and his two sons B & C are partners. The partnership deed provides that after the death of Mr. A, B & C shall continue the business of the firm subject to a condition that 20 % of profit of the firm shall be given to Mrs. D (Wife of Mr. A/ Mother of B & C). After the death of Mr. A, whether this 20% amount of profit be included in the Total Income of Firm M/s ABC or is a case of diversion of income of M/s ABC and not taxable in its hands?

This is a case if Diversion of Income and the said 20% amount shall not be included in the Total Income of M/s ABC (i.e.) it is deductible from its Total Income. This is because the clause mentioned in partnership deed has given an overriding title of the 20% profit to Mrs. D and such income is a precondition for the firm to continue its business. In other words, this 20% profit reaches Mrs. D before it becomes income of the firm and hence it is a case of diversion of Income.

I hope this would have given you some clarity on these two basic concepts of Income Tax.

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Qualification: CA in Practice
Company: Vinay Sethi and Associates
Location: Delhi, New Delhi, IN
Member Since: 17 Apr 2018 | Total Posts: 3
Hello, CA. Shekar Shankar from New Delhi. A Practicing Chartered Accountant by profession, Partner in Vinay Sethi and Associates, and a teacher by passion. Teaching gives me happiness and I Wish to make a difference by sharing the power of knowledge by teaching in a simple manner and in the process View Full Profile

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2 Comments

  1. vswami says:

    OFFHAND
    ‘Application’v (X) ‘Diversion’

    ” Application” ia a term , more appropriately used in certain special contexts; for instance, see the provisions of the iT Act governing tax exemption of ‘charitable trusts’.
    As such, strictly viewed, accvording to the referred scheme, to the extent the funds – including contributions, are applied for the purposes of the Trust, the amounts so applied are not includible in the computation of its totlal inome.

    Notewrthy that, the two concepts covered in the write-up have been subjectd to violent tweaking in recent timeds; so much so those do not necessarily require or permtted to be construed as before ; that is, are not amenable to being interpreted as originally intended.

    Suggesat to look througfh the ongoing controversy and the endless discussions wrt inter alia, –
    the denial of a deduction for amounts expended for CSR ; and
    problems confronted with in repesct of indirect tax regime – e.g. levy of tax on service /supply under the erstwhile law, now GST in its place, as well !

    May be MORE on the indicated lines one could think of, by waqy of supplementing /adding value to the chosen topic !

    Any independent thoughts to intelligently spare and eminently share ?

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