The Charge to Income Tax – Part 3

9. The diversion of income by overriding title - In this chapter we have seen that profits and income that arise (wherever or from Sri Lanka) or are derived from Sri Lanka, are ascribed to the person to whom the profits and income belong and are therefore chargeable to tax on him.

There are, however, certain situations in which profits and income may arise to the benefit or advantage of the taxpayer but have to be diverted to another or others by force of an overriding and enforceable legal obligation. The effect of such a diversion is that the profits and income thus diverted are not chargeable on the taxpayer.

In Raja Bejoy Singh Budhuria v CIT (PC) (1933, 1 ITR 135) the essential facts were that the Raja (assessee) succeeded to the family ancestral estate on the death of his father. Subsequently, his step-mother brought a suit for maintenance against him in which a consent decree was made directing the assessee to make a monthly payment of a fixed sum to her, declaring that the maintenance was a charge on the ancestral estate in the hands of the assessee. He claimed that what was paid to his stepmother could not be assessed on him but his claim was rejected and the payment was assessed on him as income.

Allowing his appeal, the Privy Council held that (p 138-139) “…the decree of the court by charging the appellant’s whole resources with a specific payment to his step-mother has to that extent diverted his income from him and has directed it to his step-mother; to that extent what he receives for her is not his income. It is not a case of application by the appellant of part of his income in a particular way; it is rather the allocation of a sum out of his revenue before it becomes income in his hands.” The Bejoy Singh case was cited with approval by the SC of Sri Lanka in A.A. Davoodbhoy v CGIR (1979,SLTC Vol. IV p 122 at 127). The appellant was carrying on business in partnership with his brothers. In due course he entered into a sub-partnership agreement (A1) with his son and daughters. His sole object was to share his share of profits or losses from the main partnership amongst himself and his children. The assessor disregarded A1 on the view that it was artificial or fictitious and continued to assess him on his full share of profits from the main partnership. The Court rejected the assessor’s approach and, moreover, held that A1 diverted parts of his income from the main partnership to his children. The effect of this judgment was subsequently neutralised by an amendment to the definition of a partnership in the income tax law, which now excludes a sub-partnership in any form. However, such amendment does not affect the continuing validity under our income tax law, of the principle of overriding diversion of income.

The principle based on the diversion of income by overriding title has been applied by the Indian courts in some other instances. In the expert commentary on the Law of Income Tax in India by Kanga, Palkhivala & Vyas (2004) the authors state (Vol. I p 223 ): “….It has been held that such diversion of income by overriding title need not necessarily be by a decree of court or by statutory or customary law (e.g., CIT v Pritam, 125 ITR 102), but may be under an attachment order of an income tax authority (Sarala Devi v CIT, 222 ITR 211), or under the provisions of a will (e.g., CIT v Kastoori, 254 ITR 304), or agreement (e.g., CIT v Manohar, 155 ITR 696), or deed (Savita v CIT, 154 ITR 449 ) like a deed of sale (e.g., CIT v Travancore Sugars, 88 ITR 1), or gift (e.g., Surajratnam v CIT, 106 ITR 576 ).”

The application out of income as distinct from diversion of income has not the same effect as the latter on the taxpayer; what is applied is taxable on him. A good illustration of application of income is the leading English case of Mersey Docks and Harbour Board v Lucas (1883, 2 TC 33): The Board was directed under an Act of Parliament to pay the surplus of its income, after meeting expenses and interest charges, into a sinking fund to extinguish the debt incurred in the construction of its docks.

In the HL, Lord Selborne (LC) said: “The word profits as here used means the incomings of the concern after deducting the expenses of earning and obtaining them before you come to the application of them. …….It is exactly the same thing as if there had been a declaration that after paying the current expenses and all other necessary outgoings…the clear surplus ….should be applied in a certain manner…..” It is easy to see here that the manner of application benefits the taxpayer (the deferred settlement of its debts) whereas, in an overriding diversion, what is diverted goes out of reach, irreversibly, to the benefit of another.

(The writer, B.Sc – Maths Special, University of Ceylon – 1955, is a Fellow of the Sri Lanka Institute of Taxation and former Deputy Commissioner of Inland Revenue Sri Lanka. He can be reached on 011-2712692.)