Under the Income Tax Act, clubbing of income serves to tax transfer or distribution of income to family members, including spouses or minors, in the hands of the original owner in order to avoid evasion of tax. It is covered by Sections 60 to 64, inclusive, where such assets or incomes are made without adequate consideration or there is retention of control over the subject matter by the transferor. The major exemption under this rule is manual labor or special skills of minors. These provisions ensure fair taxation and reduce untoward misuse of tax-saving strategies, as held by several judgments.
1. Income transferred without transfer of asset under section 60
Provided that if under section 60 person transfers only the income from an asset but not the ownership of the asset itself then such income shall be considered transferred and shall keep its tax character in the hands of the transferor. This has the effect that a taxpayer cannot artificially shift his income to some other taxpayer without transferring the underlying asset.
Illustrations:
NRI lets out his bungalow & earns ₹84000 as rental income every year. When NRI sends the rental income to his friend without transferring the title of the bungalow still the rental income will be taxable in the hands of the NRI.
2. Transfer of Assets without adequate Consideration section 64
Whenever someone transfers assets to the spouse or son’s wife without getting adequate consideration Section 64 relates to the case. In that case all income from these assets gets clubbed with the transferor’s income.
Conditions for Clubbing
i. The transferor is an individual.
ii. Asset is transferred to spouse or son’s wife.
iii. Transfer without adequate consideration.
Illustration:
Mr A gifts RS.1 lakh to his wife which she puts in a Fixed Deposit. The interest earned thereon will be clubbed with Mr A’s income as it is gift without consideration. If wife had received the gift from her father the interest income would not be clubbed with Mr. A’s income and would be taxed in wife’s hands.
Facts of the case:
Abhay Kumar Mittal had claimed a deduction under the head house rent paid to his wife Shivani Mittal for assessment year 2013-14. The property was purchased his wife name and she had declared the rent received as income from house property in her income tax returns. The AO had also brought to notice a concern with regard to whether the wife of the assessee could acquire the property since out of Rs. 1.15 crores used for acquiring the same Rs. 87.50 lakh were funded by assessee. The AO appealed that in view of the fact that there was a significant contribution by the assessee and that the wife had no independent sources of income the rental income should be clubbed with the assessee’s income under Section 64 of the Income Tax Act 1961.
Submission by the Assessee :
1. Legitimacy of the Transaction: The assessee Said that the house rent paid to his wife was legitimate and that his wife had declared the rental income under income from house property in her returns.
2. Advance to Wife: It was explained by the assessee that his wife had borrowed money from him to make payment for the purchase of the property further that she had made repayments from her own funds including redemption of mutual funds and liquidation of fixed deposits.
3. No Prohibition of Rent to Spouse: The assessee argued that the Income Tax Act does not prohibit the claim of house rent allowance or pay any rent to one’s spouse so long as the transaction is genuine and transparent.
Observation of the Commissioner of Income Tax :
1. Income Clubbing : The CIT up held the order of the AO on clubbing of rental income u/s. 64 of the Income Tax Act. The CIT while rejecting the contention also cancelled this independent and stated that the wife did not have sufficient independent income to purchase the property and that most of the funds came from the assessee.
2. Inadequate Resources of the Wife: CIT correctly held that the wife had only nominal income during the previous years and could not independently invest in the property in question without the consideration of the financial support of the assessee.
3. Property as Joint Investment: CIT observed that the assessee had been listed as the second holder of a string of investments made in the wife’s name which also further raising doubts about the independence of her income.
ITAT Decision:
1. No Prohibition on Rent paid to Spouse: It was held that there is no legal restriction in Income Tax Act in the form of any prohibition for paying the rent to spouse. Wife declared the rental receipts in her income tax return and revenue authorities have accepted it.
2. legal Loan Repayment :The loan for acquiring the said property had been taken by the wife from the assessee and it had been repaid through genuine repayment channels such as redemption of mutual funds and liquidation of fixed deposits and thus accepted.
3. Property Registered in Wife’s Name: The Tribunal held that the property was registered in the wife’s name and she had shown rental income in her returns. The AO’s submission that no husband can pay rent to his wife was considered legally unsupportable by ITAT.
4. No justification for clubbing the Income: The Tribunal held that the action of the AO in clubbing the rental income under Section 64 was without justification and there was no legal basis for the action. the wife’s independent ownership of the property was established.
Key Takeaways:
1. No Legal Impediment for Paying Rent to Spouse: There is no legal bar under the Income Tax Act in paying rent to the spouse for the purposes of income tax if the transactions are genuine and on record. In this case the wife had declared the rent received in her income tax returns and the property was registered in her name.
2. Loan to Spouse and Repayment: There is no prohibition either from his side as well as her side for extending a loan from the spouse for the acquisition of further properties in order to widen the scope of business. Here she had even repaid the loan out of her own funds and in this regard the Tribunal accepted the same.
3. Section 64 clubbing of income: The ITAT correctly held that section 64 clubbing would apply only if income is derived out of property transferred without full consideration for value. However, in this case the rental income will not be clubbed as the property is genuinely owned by the wife and the rental income of the property has been declared by her.
4. The importance of documentation: The case is a good example of the significance of proper documentation of all monetary transactions, like loan agreements, repayment records, and tax returns that can validate the ownership and source.
3. Clubbing of Spouse’s Income from a Concern (Section 64(1)(ii))
Another important provison is that income made by a spouse from a concern, in which other spouse had an effective interest, shall also be clubbed with the latter. However the clubbing provisions do not apply to an income made by a spouse if he earns this due to employment solely on account of professional or technical qualifications.
Definition of Substantial Interest: According to Income Tax Act person is said to have substantial interest in the following cases:
- Has more than 20% of equity shares in the company.
- In case of a non-corporate concern they are entitled to at least 20% of the profits.
Mr. C owns 25% of a share holding in a company. Mrs. C gets ₹5,00,000 as a cheque drawn in her name as a salary from the same company but she has no technical or professional qualification. The salary will be clubbed with the income of Mr. C. But if Mrs. C had technical qualification then her income will attract separate tax.
Facts of the Case:The assesse was in the business of civil construction. For Assessment year 2003-2004 Asessee has claimed salary paid to wife . wife had passed out with degree in electronic & telecommunication. On his part the assessee argued that she was at work by handling plans for the execution of work and taking administrative decisions while making business.
In the process of the assessment, the AO disallowed the salary deduction and relied on the provisions of Section 64(1)(ii) of the Income Tax Act 1961. According to ITO the assessee had not placed substantial evidence that his wife was really associated with the business activities of the firm. The appeal presented by the assessee before the CIT was allowed. However the ITAT reversed the decision taken by the CIT and supported the view held by the AO. The matter then went to the Himachal Pradesh High Court.
Submission by the Assessee:
Shri Yashwant Chhajta engaged in civil construction claiming deduction salary paid to his wife Nanda Chhajta for assessment years 2003-04 and 2004-05. The assessee submitted that this was one such case where his wife was qualified in the field of electronics and telecommunications and seriously working with him. She had taken over the management of plans for work execution and other administrative decisions. He argued that salary was justified on his qualification as well as due to his active involvement in the business hence she should not be clubbed together with his income under Section 64(1)(ii) of Income Tax Act 1961.
Observation by the Income tax Officer :
The ITO rejected the deduction claimed by assessee for the salary paid to his wife by invoke Section 64(1)(ii). According to him the assessee has not produced any concrete evidence that his wife was indeed involved in the business. There was neither any document nor affidavit filed to indicate that she was involved in planning and decision making nor any clear explanation her technical qualifications were utilized in the business. The ITO submitted that the requirement of proof as to whether the income earned by the wife was solely attributable to her technical knowledge and professional qualification was not fulfilled by the assessee.
Observation by the Commissioner of Income tax:
The CIT accepted the appeal of the assessee, disagree with order passed by the ITO. The CIT drew his conclusion that the wife of the assessee had an appropriate qualification. Therefore the salary paid to her should not be clubbed with the income of the assessee. ITO’s decision was rigid and fact that the wife had relevant qualification accepted the assessee’s submission regarding her role in the business
Tribunal’s Observation:
The ITAT inverted the decision of CIT and confirmed disallowance made by ITO. The Tribunal found that assessee did not present any evidence to show that his wife was involved with him in business although she was technically qualified. The Tribunal found that no documents were submitted to show that she was actively participating in the concern nor was there any material presented to show that she had taken administrative decisions or overseen work execution. The Tribunal observed that the burden of proof was not fulfilled for the proviso under Section 64(1)(ii) to be invoked and thus the salary paid to his wife was required to be clubbed with his income.
Judicial Judgment:
The Himachal Pradesh HC upheld order of the Tribunal and affirmed that the wife’s salary of the assessee should be clubbed with his income u/s. 64(1)(ii) of the Income-tax Act 1961. The court highlighted the point that even though the wife was technically qualified the assessee could not prove her active participation in the business which the proviso to Section 64(1)(ii) did not support. The court rejected the assessee’s argument that previous assessments allowed similar deductions holding that each assessment year must be judged independently based on the evidence presented.
The court held that just because she qualified herself as being involved with the business that was not enough proof.
Takeaways:
1. Onus of Proof on Assessee:
The Assessee would have to satisfactorily prove, however that the income of his spouse is only due to the exercise of technical or professional skills or knowledge and not liable to be excluded under Section 64(1)(ii) from salary.
2. Qualifications Alone Not Sufficient:
Possession of technical or professional qualifications alone is not enough to avoid clubbing of income. The assessee must reveal how the spouse actively applied these qualifications in the business.
3. Independent Assessment of Each Year:
The allowance made in previous assessments will not be similar in the subsequent assessments. All years are assessed on independent facts and records of proof that can be presented.
4. Property transfer by assesse to HUF Section 64(2)
When individual transfer property to HUF without acceptable consideration or Individual property converted to HUF property is clubbed with income of Assessee who made transfer. This clause is aimed at preventing individuals from shifting assets to the HUF to evade the taxes which often benefits from lower tax rates and exemptions.
Key Points:
- Insufficient Consideration:
If it is insufficient consideration transfer to HUF then the income from that asset will be taxed in the hand of the person who has transferred his property for that.
- Converting Individual Property to HUF Property:
If person converts his individual property into the HUF property the income from the converted property will still be liable to be charged in the hands of the person who was initially the owner.
- Exceptions:
This provision is applicable only when the property was originally owned by the person himself however if it was originally HUF property, by way of inheritance or otherwise then it would not apply.
Illustration:
Mr. A is also a member of an HUF and holds in his name some rental property. Then he transfers same property to his HUF without any consideration. Then income of Rent from that property accrued to the HUF would still be taxable in the hands of Mr. A u/s. 64(2) as property was transferred without adequate consideration.
K.Y. Patel v. CIT 1995 Tax Pub(DT) 0834 (Bom-HC) Date of Judgment: December 5, 1994
Facts of the case:
The assessee held certain foreign shares in his own name. On March 28 1970 he transferred these shares into his Hindu Undivided Family which consisted of himself his father and his mother as joint family property. During the assessment years 1975/76 and 1976/77 Income Tax Officer taxed the foreign dividend income arising on shares in the hands of the assessee under Section 64(2) of the Income Tax Act 1961. The assessee appealed stating that the foreign dividends were now HUF property.
Submission of the Assessee :
1. Declaration of shares as HUF Property:
The assessee took a stand that foreign shares, previously his personal property had been transferred to the HUF through a declaration dated March 28 1970 converting them into a joint family property. Hence the said income from that share foreign dividends cannot be included on his personal income for taxation.
2. Section 64(2):
The assessee further urged that Section 64(2) could be applied only when any individual property is converted into HUF property and the assessee is the karta of that HUF. In this case HUF consisted his father, mother and himself, he urged that he was not the karta and hence Section 64(2) could not apply to the transfer of shares into the joint family pool.
3. Income Not Received:
Additionally Assessee argued that foreign dividend were not taxable in hands of assessee since foreign dividends has not been remitted during the said period.
Observations by the income tax officer:
Levy of Tax on Dividends:
The ITO held that foreign dividends in hands of the assessee were taxable under Section 64(2). He contended that only because the property has been converted into joint family property it was not exempted from being taxed in hands of the individual who originally owned the property.
Accrual of Income:
Assessing officer has held that foreign dividends accrued to assessee irrespective of it whether it was remitted to India or not. Thus, income was held to be taxable in hands of assessee on accrual basis rather than on a receipt basis.
Observation by the Commissioner of Income Tax :
1. Validity of the Transfer :
on the issue of declaration of the shares as joint family property is found to have held the view that even ITO was not wrong in applying the provisions of Section 64(2) since income from the converted property though now it formed part of HUF was still taxable in the hands of the individual based upon his interest in the joint family property.
2. Application of Section 64(2) :
The CIT rejected the assessee’s submission that Section 64(2) would attract only when the individual was the karta of the HUF, holding that the provision applied to all HUFs, regardless of whether the individual was the karta.
Tribunal’s view
The ITAT dismissed appeal of the assessee as it didn’t accept appeal filed by him. The Tribunal interpreted that Section 64(2) applies to all conversions of individual properties into HUF properties and does not only apply when the individual is karta. The Tribunal found no doubt in the language of the section and rejected the assessee’s contention that the expression HUF should be restricted to families where the individual is the karta.
Judicial Judgment:
The Bombay HC ruled in the revenue favor and held that Section 64(2) applied to all Hindu Undivided Families and not limited to those in which the individual was karta.
The court held that the term HUF used in Section 64(2) of the Income Tax Act must be applied in its general sense which includes all HUFs recognized under Hindu law, and does not limit the HUF consisting only of the individual, his spouse, and minor children.
The Court held that language of Section 64(2) is clear and clear-cut and there was no reason to understand it in a narrow sense. accordingly the income derived from the converted property (foreign shares) was taxable in the hands of the assessee irrespective of his status as karta.
The Court answered the question referred to it in the positive holding that the Tribunal was justified in applying Section 64(2) to case of the assessee.
Key Takeaways:
1. Broad scope of section 64(2): It applies to all HUFs be it karta or a member and there is no limitation as to what nature of HUF the converted property may belong to.
2. Income Clubbing: The income that arose from the property declared as HUF property continued to be taxable in the hands of the individual when it was transferred if the individual had an interest in the joint family property.
3. Accrual vs Receipt Basis: The share income in the foreign was accrued on and not receipt basis even when the dividends were not received in India.
4. No need for Restricted Interpretation: While dismissing the case for a restrictive interpretation of the term “HUF” under Section 64(2) the High Court declared that it applies to all families recognized under Hindu law.
5. Purpose of Section 64: The section disallows the transferor to evade tax by transferring his separated property to joint family property so that such income continues to remain taxable in the hands of the transferor.
4. Minor Child’s Income Provisions
1. Income of a Minor Child:
Under Section 64(1A) of Income Tax Act the income generated by a minor is considered part of the total income of the parent. This is subject to the following conditions:
The income is generated through manual work.
The income is generated based on some specialized knowledge or skill/talent.
2. Judicial Sanction:
The legality of Section 64(1A) was upheld by the Madras HC and the Patna HC noting that the provisions are aimed at avoiding tax evasion by attribute the child’s income to the parent who is effectively managing the income.
The courts establish that this provision doesn’t breach constitutional principles and serves as essential measure against tax avoidance through minors.
3. Exemptions for Minor’s Income:
Section 10(32): The parent can claim an exemption of Rs. 1,500 for every minor child whose income is clubbed under Section 64(1A).
The income accruing from any activity exercising the child’s special skills or manual work is not brought to tax on the parent’s books.
4. Inheritance and Trusts:
Income of a minor out of property inherited or held in trust for the benefit of the minor is considered the parent’s income unless it qualified as earned income.
5. Objections to Section 64(1A):
The Article 14, right to equality challenges raised, raising questions of why a minor’s income would be treated differently for tax purposes when it gets included in the parent’s income. However courts have upheld it as constitutionally valid.
6. Revocable Transfers of Assets (Section 61)
If an asset is transferred but the transferor reserves the right to revoke that transfer then the incomes so derived are taxed in the hands of the transferor. It occurs when the transferor retains control over the asset even though it may appear the asset has been transferred to some other person or persons.
Illustration:
If the transfers are to a minor and the transferees keep the income and the power to revoke is reserved to the transferor, the income of the trust will be taxable in the hands of the transferor.
CIT v. Laxman Swaroop Goel 2012 Tax Pub(DT) 0159 (P&H-HC) Judgment date: 6 October 2010
Facts of the Case:
Laxman Swaroop Goel is the father of minor children who inherited land from their maternal grandfather. The land was acquired and enhanced compensation including interest was awarded to the minors.
In this case the Assessing Officer imposed the interest on the enhanced compensation by incorporating it as capital gains on the assessee’s income under section 64(1A) of the Income Tax Act 1961.
This view was agreed with by the CIT as well as the Tribunal. The amount did not acquire finality and should not be levied in the father’s hands, as the interest income of minor children belonged to inherited property. This view was agreed with by the CIT as well as the Tribunal.
Submission by Assessee:
The assessee claimed that the interest on enhanced compensation was under dispute and had not acquired finality due to the pendency of the case before the High Court.
The assessee also submitted that the income from inherited property of minor children cannot be clubbed with that of the father’s income under section 64(1A).
Observations by the Income Tax Officer :
- The ITO had considered enhanced compensation received by minor children as income clubbed with the income of the father under section 64 (1A) as taxable in the year of receipt.
Observations by the Commissioner of Income Tax
- CIT accepted the contention of the assessee that the amount had not acquired finality because it was in dispute.
- It was held that since the income of minor from inheritance property was not immediately available to them but would be available only on attaining their majority it could not be clubbed with parent’s income.
Tribunal’s View:
- It upheld the decision by CIT(A), wherein it held that interest on enhanced compensation was in dispute, and income could not be clubbed with the father’s income, till finality had been reached.
- It also reaches the conclusion that section 64(1A) was not applicable in this case since the incomes had not accrued to the minors as yet.
Judicial Judgment:
- The Punjab and Haryana High Court cancelled the CIT(A) and Tribunal orders.
- Enhanced compensation interest was held to be taxable in the year of receipt though the matter was under dispute because as Supreme Court’s decision CIT v. Ghanshyam (HUF) [(2009) 315 ITR 1 (SC)].
- It further held that section 64(1A) applies to the income of minor children from inheritance properties and such income is liable to be clubbed with the father’s income.
Key Takeaways:
1. Enhanced Compensation Taxability: Interest on enhanced compensation is taxable in the year of receipt even if the matter is under dispute.
2. Application Section 64(1A): The income of minor children from inherited property must be clubbed with that of the parent under section 64(1A) of the Income Tax Act 1961.
3. Judgment of Ghanshyam’s Case Applied: Judgment rendered in CIT v. Ghanshyam (HUF) is evenly applicable to the cases of increased compensation. According to it the compensation accrued along with interest thereon is taxable in the year of its receipt.
Clubbing of Losses
If any income arising from a source is clubbed under the Income Tax Act then any loss arising from that source must also be clubbed. This way profits and losses deriving from the transferred asset are subject to taxation.
Illustration.
In case a husband transfers shares to his wife without consideration, and shares incur capital loss then this loss would get clubbed with the husband’s income and will be set off against his other taxable incomes.
Conclusion :
The clubbing provisions in the Income Tax Act prevent a person from evading income tax by transferring income or assets to family members, such as a spouse or a minor child. Even though he transfers it he still has the tax liability unless he is genuine and proper documented. This helps ensure fair tax and has the income attributed correctly. Courts have legitimized these provisions by restating what they see to be the policy that income should be taxed only where it actually arises.
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