The application of income after the accrual by the assessee means the expenditure of income. Such amount will not be excluded from the total income of the assessee as it is just an application for earned income. In other words, the applicable income will be taxable in the hands of the assessee.
Diversion of income is the process of turning income before it is earned by the assessee.
Such amount shall be excluded from the total income of the assessee as the income is given to someone else before it is earned fully by the assessee. In case of diversion of income any other person on such income has an over-riding title. Hence the income before it is earned by the assessee reaches such a person and is therefore is not chargeable to be levied tax, in the hands of the assessee.
Tax is the outstanding amount we pay for the privileges of membership in an organized society - Franklin D.. Roosevelt
There are some basic concepts that play a very preliminary role in the calculation of income tax. One such concept is the application of income. If closely related, this is another fundamental concept called the diversion of income by overriding the title.
These two concepts have been a constant source of litigation and have knocked the doors of the Supreme Court and various High Courts on several occasions.
Application of Income
A cursory request of Section 60 of the Act would make it clear that until the transfer of the assets from which income arises, the income arising from that asset will be included in the income of the transferor for computing tax. The issue of Life Insurance Company v. Commissioner of Income Tax, Bombay City, was whether under Section 8 of the Life Insurance Corporation Act, 1956, a permissible deduction for deduction from surplus which is statutorily payable to the Central Government is legitimate or not?
Also, questions like whether the inter-assessment period ended on March 31, 1963 or not, were made to be answered.
1. Bejoy Singh Dudhuria v. CIT
The decision of the Privy Council in Beusingh Dudhuria v. Commissioner of Income Tax, 1933 is clear about the principle of income by title.
In this case, under a compromise decree of maintenance received by the stepmother of the assessee, an allegation was made on the assets in his hand. The Privy Council overturned the judgment of the Calcutta High Court, stating that the amount of maintenance recovered by the stepmother was not a matter of application of income of the assessee.
Diversion of Income
Diversion of income is the process of diversion of income before it is earned by the assessee (taxpayer). Such amounts are excluded from the total income of the assessee during income tax calculation as the income is passed on to someone else, before it is fully earned by the assessee.
In such cases, an assessee has an over-riding title to the income of a third party, under which the income reaches the third party before the balance goes to the assessee. If a title or charge is created at the source itself, it is called a diversion of income by overriding the title and is therefore not taxable from the total income of the assessee.
1. P.C Mullick v Commissioner of Income Tax
In contrast, under the case, P.C. Mullick v Commissioner of Income Tax, 1938, certain payments were to be made to the beneficiaries by the executors and trustees from the assets of the examinee. It was held by the Privy Council that such payments could only be excluded from the income received by the recipients from the property, therefore, such payments were assessable as income tax in the hands of the assessors and there was no division of income at source.
Henceforth, income originates from a source. Income is received through receipt or accrual or is deemed to be earned. Under the Income Tax Act, once income comes into existence it is liable to tax. Taxable income is an income-generating source.
For instance, when I earn an income, I set it aside for a few things. It can arise under a contractual obligation or statutory obligation or involuntary/voluntary disposition. It is not every obligation under which an income is applied when computing tax.