1. Facts of the Case
Mr. A, an individual assessee, is a partner in a firm. Through a settlement deed, he has created a trust and assigned 10% of his share of profit (excluding capital interest) from the partnership to that trust. The assignment is limited to his right, title, and interest in the income portion of the firm, and not to his capital contribution or partnership position.
Mr. A claims that this income, which is redirected to the trust, constitutes a “diversion of income by overriding title” and should not be taxed in his hands.
2. Issues in the Case
The following legal questions arise:
- Whether the assignment of 10% profit by Mr. A to the trust amounts to diversion of income by overriding title or application of income?
- Is Mr. A legally justified in excluding such income from his total income under the Income Tax Act, 1961?
- Whether the income so diverted should be taxed in the hands of the trust or in the hands of Mr. A?
3. Legal Principles and Relevant Judgements
A. Diversion of Income vs Application of Income
- Diversion of income by overriding title occurs when income is not received by the assessee because of a legal obligation, and belongs to another person at source.
- Application of income happens when income is first received by the assessee, and then passed on to another person voluntarily or through obligation.
Only diversion at source exempts the income from taxation in the hands of the original recipient.
B. Key Judgements:
- CIT v. Sitaldas Tirathdas (1961) 41 ITR 367 (SC)
Held that mere obligation to apply income for another’s benefit does not amount to diversion. Only diversion at source by overriding title qualifies. - CIT v. Murlidhar Jhawar & Purna Ginning & Pressing Factory (1966) 60 ITR 95 (SC)
Reinforced that income must be diverted before it accrues to the assessee for it to be excluded from his total income. - CIT v. K.A. Ramachar (1961) 42 ITR 25 (SC)
Assignment of a share in partnership profits to a trust or family member is not diversion of income; the assessee is still the partner, and income accrues to him first. - CIT v. Manilal Dhanji (1962) 44 ITR 876 (SC)
If a partner assigns part of his profits to someone else but continues to be a partner, income first accrues to the partner, and the transfer is treated as application, not diversion.
C. Income Tax Act, 1961 – Section 60
- As per Section 60, income transferred without transferring the asset remains taxable in the hands of the transferor.
- In this case, Mr. A transferred only the income rights, not the partnership interest (asset). Thus, income continues to be taxable in his hands.
4. Possible Judgement
Based on the facts and settled law:
- The income from the firm accrues first to Mr. A, as he continues to be a partner.
- The assignment of 10% profits to the trust under a settlement deed does not transfer the source of income (i.e., the partnership share), but merely redirects the application of income after accrual.
- Therefore, this is a case of application of income, not diversion by overriding title.
- As such, Mr. A is legally not justified in claiming that this amount is not taxable in his hands.
- The income of 10% assigned to the trust will still be included in Mr. A’s total income, and any payment to the trust will be considered a post-tax application of income.
