Diversion of Income vs. Application of Income: Unraveling the Taxation Dilemma

Introduction

Diversion of income and application of income are two concepts that are recognized under the Income Tax Act, 1961 in India. These concepts are used to determine the taxability of income in certain situations where income is diverted or applied by a taxpayer in a manner that may affect its tax liability. Let's delve into a detailed analysis of these concepts as per the Income Tax Act, 1961:

1. Diversion of Income:

Diversion of income refers to a situation where income is legally diverted by a taxpayer to a third party before it reaches the taxpayer, and the diverted income is not considered as the taxpayer's income for tax purposes. In other words, the income is diverted to another person before it becomes taxable in the hands of the taxpayer.

Under the Income Tax Act, for a diversion of income to be recognized, the following conditions must be met:

a) Existence of a legal obligation: There must be a legal obligation on the taxpayer to apply the income in a particular manner before it accrues or arises to the taxpayer. This legal obligation can arise from a contract, an agreement, a statute, or any other legal arrangement.

b) Diversion before accrual or arising of income: The income must be legally diverted to a third party before it accrues or arises to the taxpayer. Once the income accrues or arises to the taxpayer, it becomes taxable in the hands of the taxpayer unless it satisfies the conditions for diversion of income.

c) Diversion without the taxpayer's control: The income must be diverted to a third party without the taxpayer having control over it. The taxpayer must not have any power or control over the diverted income after it is diverted.

d) Genuine and bona fide transaction: The diversion of income must be a genuine and bona fide transaction, and it must not be a sham or colorable transaction intended to evade taxes.

If all these conditions are met, the diverted income will not be treated as the taxpayer's income for tax purposes, and it will be taxable in the hands of the third party to whom it is diverted.

2. Application of Income:

Application of income refers to a situation where income is applied by a taxpayer for a specific purpose or utilized in a particular manner, and such application or utilization is considered as a taxable event. In other words, the income is applied or utilized by the taxpayer for a particular purpose, and it is treated as the taxpayer's income for tax purposes.

Under the Income Tax Act, the concept of application of income is primarily used in cases where income is accumulated or set apart for the benefit of a specific person, such as a trust or a fund. In such cases, the income is considered as the taxpayer's income and is taxable in the hands of the person for whose benefit it is accumulated or set apart.

Diversion Of Income v/s Application Of Income

The Supreme Court decision in case of CIT v. Sitaldas Tirthdas (1961)  is the authority for the proposition that where by an obligation, income is diverted before it reaches the assessee, it is deductible from his income as for all practical purposes it is not his income at all (as it is diversion of income by overriding title). But where the income is required to be applied to discharge an obligation after it reaches the assessee, it is not deductible (as it is called as application of income). Thus, there is the difference between the diversion of income by an overriding title and application of income as the former is deductible while the latter is not.

Thus, when management of a company is taken over by another person from the existing team in consideration of percentage of future profit to the latter, in computing the business income of the former, such percentage of profits is diversion of income and hence, deductible [CIT v. Travancore Sugars and Chemicals Ltd. (1973)].

CONCLUSION

In conclusion, diversion of income and application of income are important concepts under the Income Tax Act, 1961 in India, which are used to determine the taxability of income in certain situations where income is diverted or applied by a taxpayer. It's crucial for taxpayers to understand these concepts and ensure that their transactions are in compliance with the legal provisions to avoid any potential tax implications. Consulting with a tax professional or seeking legal advice may be helpful in navigating the complexities of these concepts and ensuring compliance with the tax laws.

Article Compiled by:-

Mayank Garg

+91 9582627751

Disclaimer: Every effort has been made to avoid errors or omissions in this material in spite of this, errors may creep in. Any mistake, error or discrepancy noted may be brought to our notice which shall be taken care of in the next edition In no event the author shall be liable for any direct indirect, special or incidental damage resulting from or arising out of or in connection with the use of this information Many sources have been considered including newspapers, Journals, Bare Acts, Case Material. Charted Secretary etc.