APPLICATION AND DIVERSION OF INCOME
The Income Tax Act, 1961 deals essentially with the imposing of taxes, exemptions and procedure to be followed therewith. The income that is accrued or deemed to accrue on the tax payer is the tax income and the application and diversion of income are two fundamental yet confusing concepts in the Indian Tax law. Also, both of these are court made concepts.
In simple words, application of income means the income after its being earned by the assessee. Such income forms a part of the total income and thereby taxable as such income is applied by the assessee after earning it. Thereby, applied income will be taxable. For instance, A is liable to pay a sum of 10,000 rupees as monthly alimony to his wife, here A being employee of Mr. C asks him to pay the alimony and then disburse the rest to him. Here, it is an example of application of income as the wife does not have over-riding title over such amount. The amount that he spends is a fulfillment of duty after earning his salary and thereby taxable.
On the other hand, diversion of income means diverting the income even before it was earned. Here, there is an over-riding title over the amount of another person and thereby excluded from tax liability. For example, if XYZ is a partnership firm and they specify in their deed that 20% of whatever profits they are likely to earn will be given to X’s mother, and wives of Y and Z. This is a classic example of diversion of income. The rationale behind it is that the deed mentioning the above said provision has an over-riding entitlement over the money and it is a pre-condition for the firm to continue. Thereby, it is not taxable.
Now lets look into certain major developments in this regard.
Section 60 of Act says that unless there is a transfer of the assets from which the income arises, the income arising from that asset will be included for computing taxes. In Life Insurance Company v. Commissioner of Income Tax, Bombay[1], the issue was whether under section 28 of the Life Insurance Corporation Act, 1956 the surplus payable to government a permissible deduction or not? Here, it was held that it is not an exemption from tax liability as the surplus is diverted only after the income has been received by the corporation.
In the case of Raja Bejoy Singh Dudhuria v. Commissioner of Income Tax, Bengal[2], the issue was whether the payment of a sum of 100 rupees by Raja to his step mother by a compromise decree taxable? The Calcutta High court held it is not deductible but on appeal to a judicial committee, the decision was reversed. It was held that the compromise decree creates an over- riding entitlement over the money and here he was just acting as a mediator between his step mother and the revenue generated. Thus exempted from tax liability.
To sum up, if any third party becomes entitled to receive a sum of amount under the obligation of the assessee, it is a diversion of income but when after the receipt of the income the obligation arises to pay to a third party, it is not a diversion but in fact an application of income. Many people try to divert their income in such a way so as to avoid tax payment. For example, diverting the income to wife, children etc. The judiciary does not accept such kinds of tax avoidance. In some cases clubbing of taxes is done (sections 60- 65). Transferring of income without transfer of assets, income derived from revocable transfer of assets, clubbing of spouse income and minor income can be clubbed in order to avoid tax avoidance.
FACTS OF THE CASE
For Assessment Year 1946-47, Pandit Thakurdas Bhargava, an advocate of Hissar, was assessed to income tax on a total assessable income of Rs 58,475 in the account year 1945-46. This sum included the amount of Rs 32,500 stated to have been received by the respondent in July 1945 for defending the accused persons in a case known as the Farrukhnagar case.
Shri Takur Das Bhargava stated in the trust deed that he had “decreased” his legal practice for the last few years and had reserved his professional income accruing after June 1944 for payment of taxes and charity. He then said: “accordingly, I have been acting on that. In the Farrukhnagar, district Gurgaon case, Crown v. Chuttan Lal etc., the relatives and the accused expressed a strong desire to get the case conducted by me during its trial. At last on their persistence and promise that they would provide me with Rs 40,000 for charitable purposes and I would create a public charitable trust thereof I agreed to conduct the case. The case is now over. The accused and their relatives have given me Rs 32,500 for charity and creating a trust. The said amount has been deposited in the Bank. If they pay any other amount that will also be included in that. Accordingly, I create this trust with the following conditions and with the said amount and any other amount which may be realized afterwards or included in the trust;”
The assessee, i.e., Shri Thakur Das Bhargava, claimed that the said amount of Rs 32,500 was not a part of his professional income, because the amount was given to him in trust for charity. This claim of the assessee was not accepted by the Income Tax Officer, nor by the Appellate Assistant Commissioner who heard the appeal from the order of the Income Tax Officer.
Both these officers held that the assessee had received the amount of Rs 32,500 as his professional income and the trust which the assessee later created by a deed of Trust dated August 6, 1945, did not change the nature or character of the receipt as professional income of the assessee; they further held that the persons who paid the money to the assessee did not create any trust nor impose any obligation in the nature of a trust binding on the assessee, and in fact and law the trust was created by the assessee himself out of his professional income; therefore, the amount attracted tax as soon as it was received by the assessee as his professional income, and its future destination or application was irrelevant for taxing purposes.
From the order of the Appellate Assistant Commissioner a further appeal was carried to the Income Tax Appellate Tribunal, Delhi Branch; its conclusion drawn from the facts found was expressed in the following words: “The income in this case did not at any stage arise to the assessee. Keeping in mind the express stipulation made by the assessee when he accepted the brief, there was a voluntary trust created, which had to be and was subsequently reduced into writing after the money was subscribed. The payments received from the accused and other persons were received on behalf of the trust and not by the assessee in his capacity as an individual. In this view, we delete the sum of Rs 32,500 from the assessment.”
The appellant in this present case, then moved the Tribunal for stating a case to the High Court on the question of law which arose out of the order of the Tribunal.
The Tribunal was of the opinion that a question of law did arise out of its order, and this question is formulated in the following terms: “Whether the sum of Rs 32,500 received by the assessee in the circumstances set out in the trust deed later executed by him on August 6, 1945, was his professional income taxable in his hands, or was it money received by him on behalf of a trust and not in his capacity as an individual.”
A case was accordingly stated to the High Court under Section 66 of the Indian Income Tax Act, and the High Court by its judgment dated August 3, 1953, answered the question in favour of the assessee, holding that “the sum of Rs 32,500 received by the assessee was not received by him as his professional income but was received on behalf of the trust and not in his capacity as an individual”.
The appellant then moved the High Court and obtained the certificate of fitness.
ISSUES FRAMED BY THE COURT
“The question before us is what is the proper legal inference from the aforesaid facts found by the Tribunal.”
The issue before the Apex Court was to decide whether the application of the principles of Application & Diversion of Income under Income Tax Act was rightly applied to the facts of the case or not.
Due to contradicting opinions of the Tribunal and the High Court, this matter warranted final settlement by the supreme adjudicator of disputes.
ARGUMENTS ADVANCED BY THE COUNSELS AND RESPONSES BY THE BENCH
Appellant: On behalf of the appellant it has been contended that the inference which the Tribunal and the High Court drew is not the proper legal inference which flows from the facts found, and according to the learned Attorney-General who appeared for the appellant the proper legal inference is that the amount was received by the assessee as his professional income in respect of which he later created a trust by the deed of trust dated August 6, 1945. He has submitted that there was no trust nor any legal obligation imposed on the assessee by the persons who paid the money, at the time when the money was received, which prevented the amount from becoming the professional income of the assessee. He has also contended that even the existence of a trust will make no difference, unless it can be held that the money was diverted to that trust before it could become professional income in the hands of the assessee.
Respondent: Learned counsel for the respondent has referred to a number of decisions where the principle laid down in Bejoy Singh Dudhuria case was applied, and has contended that where there is an allocation of a sum out of revenue as a result of an overriding title or obligation before it becomes income in the hands of the assessee, the allocation may be the result of a decree of a court, an arbitration award or even the provisions of a will or deed.
DECISION: RATIO AND OBITER OF THE CASE
“We think that the question raised in this case can be decided by a very short answer, and that answer is that from the facts found by the Tribunal the proper legal inference is that the sum of Rs 32,500 paid to the assessee was his professional income at the time when it was paid and no trust or obligation in the nature of a trust was created at that time, and when the assessee created a trust by the trust deed of August 6, 1945, he applied part of his professional income as trust property. If that is the true conclusion as we hold it to be, then the principle laid down by the Privy Council in Bejoy Singh Dudhuria case has no application. It is indeed true, as has been observed by the High Court, that a trust may be created by any language sufficient to show the intention and no technical words are necessary. A trust may even be created by the use of words which are primarily words of condition, but such words will constitute a trust only “where the requisites of a trust are present, namely, where there are purposes independent of the donee to which the subject-matter of the gift is required to be applied and an obligation on the donee to satisfy those purposes”. The findings of the Tribunal show clearly enough that the persons who paid the sum of Rs 32,500 did not use any words of an imperative nature creating a trust or an obligation. They were anxious to have the services of the assessee in the Farrukhnagar case; the assessee was at first unwilling to give his services and later he agreed proposing that he would himself create a charitable trust out of the money paid to him for defending the accused persons in the Farrukhnagar case. The position is clarified beyond any doubt by the statements made in the trust deed of August 6, 1945. The assessee said therein that he was reserving his professional income as an advocate accruing after June 1944 for payments of taxes and charity and, accordingly, when he received his professional income in the Farrukhnagar case he created a charitable trust out of the money so received. The clear statement in the trust deed, a statement accepted as correct by the Tribunal, is that the assessee created a trust on certain conditions etc. It is not stated anywhere that the persons who paid the money created a trust or imposed a legally enforceable obligation on the assessee. Even in his affidavit the assessee had stated that “it was agreed that the accused would provide Rs 40,000 for a charitable trust which I would create in case I defend them, on an absolutely clear and express understanding that the money would not be used for any private and personal purposes”. Even in this affidavit there is no suggestion that the persons who paid the money created the trust or imposed any obligation on the assessee. It was the assessee’s own voluntary desire that he would create a trust out of the fees paid to him for defending the accused persons in the Farrukhnagar case. Such a voluntary desire on the part of the assessee created no trust, nor did it give rise to any legally enforceable obligation. In the circumstances the Appellate Assistant Commissioner rightly pointed out that “if the accused persons had themselves resolved to create a charitable trust in memory of the professional aid rendered to them by the appellant and had made the assessee trustee for the money so paid to him for that purpose, it could, perhaps, be argued that the money paid was earmarked for charity ab initio but of this there was no indication anywhere”. In our opinion the view taken by the Appellate Assistant Commissioner was the correct view. The money when it was received by the assessee was his professional income, though the assessee had expressed a desire earlier to create a charitable trust out of the money when received by him. Once it is held that the amount was received as his professional income, the assessee is clearly liable to pay tax thereon. In our opinion the correct answer to the question referred to the High Court is that the amount of Rs 32,500 received by the assessee was professional income taxable in his hands.”
“Our conclusion is that there was no overriding obligation imposed on the assessee at the time when the sum of Rs 32,500 was received by him. ”
The rightful Hon’ble Justice presiding on this case came to the conclusion that there was no binding legal obligation on Shri Thakur Das Bhargava when he received the compensation for his services. It was only after the payment by the clients of Shri Thakur Das Bhargava that he transferred the money to a trust.
CONCLUSION
As I have read and understood the case, the principles of Application and Diversion of Income are quite clear as far as legislation and its intent is talked about.
The difference arises on their being a charge on the income of Shri Thakur Das Bhargava or not. As has been clearly distinguished in the case of Bejoy Singh Dudhuria v CIT, there was no charge on the income of the Respondent and hence it cannot be said that the activities would be covered under the rules of Diversion of Income.
At the time when this money was paid to the assessee no trust or obligation in the nature of trust was created. The clients who paid the money did not create any trust nor imposed any legally enforceable obligation on the assessee. The money when it was received by the assessee was his professional income though he had expressed a desire earlier to create a charitable trust out of the money when received. The assessee’s own voluntary desire to create a trust out of the fees paid to him did not create a trust or a legally enforceable obligation.
[1] 1996 AIR 1720 JT 1996 (2) 336
[2] (1933) 35 BOMLR 811
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