In an interesting decision, the Bombay high court considered a situation where a foreign company held half the equity and preferential capital in the Indian company. Under the collaboration agreement between the two companies, it was provided that the research in India would be financed out of the dividend earned by the foreign company on preferential shares.

The foreign company, therefore, took the view that preferential share dividend was not taxable as it was diverted at source for funding research. The Assessing Officer held that the dividend was taxable and the Income-tax Appellate Tribunal upheld this assessment.

On a reference in the case of Warner Lambert Co.Ltd.v. C.I.T. ((1998) 101 TAXMAN 25), the Bombay high court held that the company's claim was based on the ground that the amount was not includible in the total income as, under a contractual obligation for the disbursement of research and development expenditure, it had been diverted at source by an overriding title.

The learned counsel appearing on behalf of the assessee contended that the preference dividends did not represent the assessee's income because of a charge or an overriding title thereto. As per the counsel, since a charge was created in respect of preferential dividend paid by the Indian company, this income did not accrue to the assessee.

He submitted that as the dividend paid by the Indian company was diverted at source by an overriding title, this income did not belong beneficially to the assessee. Consequently, the same was not assessable in the hands of the assessee.

He further submitted that the Tribunal committed an error in holding that since the preference dividend was received bythe assessee in its own right and used for certain research activity of the Indian company, it was liable to be taxed in the hands of the assessee. In support of these submissions, the learned counsel relied upon the following decisions:

(i) C.I.T. v. C.N. Patuck (71 I.T.R. 713 (Bom.))

(ii) C.I.T. v. Nariman B.Bharucha & Sons (130 I.T.R. 863 (Bom.))

(iii) Somaiya Orgeno-Chemicals Ltd. v. C.I.T. (216 I.T.R. 291 (Bom.))

(iv) C.I.T. v. M.D. Manohar Rao (155 I.T.R. 696 (A.P.))

In reply, the counsel appearing on behalf of the Revenue contended that a charge was not created in respect of the preferential dividend payable by the Indian company to the assessee, the dividend payable to the assessee on the preferential shares was not diverted at source by an overriding title and the Tribunal was right in holding that the preferential dividend was received by the assessee in its own right, and, thereafter, used for research activity carried out by the Indian company.

The learned counsel further submittedthat, on the facts of the present case, the dividend was not diverted at source by an overriding title. Hence, dividend received by the assessee on the preferential shares was its own income and taxable accordingly. The learned counsel for the Revenue relied upon the following decisions in support of his submissions:

(i) C.I.T. v. Sitaldas Tirathdas (41 I.T.R. 367 (S.C.))

(ii) Associated Power Co. Ltd v. C.I.T. (218 I.T.R. 195 (S.C.))

(iii) C.I.T. v. V. G. Bhuta (203 I.T.R. 249 (Bom.))

(iv) Mrs. Meherbai N. Sethna v. C.I.T. (209 I.T.R. 453 (Bom.))

(v) Colaba Central Co-operative Consumers' Wholesale & Retail Stores Ltd. v. C.I.T. (229 I.T.R. 209 (Bom.))

The Supreme Court in the case of Sitaldas Tirathdas had observed that the true test for application of the rule of diversion of income by an overriding title was whether the amount sought to be deducted, in truth, never reached the assessee as his income. The nature of the obligation was the decisive factor.

There is a difference between anamount which the person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where, by the obligation, income is diverted before it reaches the assessee, it is deductible.

However, where the income is applied to discharge an obligation after such income reaches the assessee, in law the same consequences do not follow, as the assessee is merely under an obligation to pay to another a portion of his own income.

In Associated Power Co. Ltd., the Supreme Court held that the monies credited to the contingency reserve fund under the statutory provisions were the monies belonging to the assessee and were not diverted by an over-riding title.

The Bombay High Court in the case of Colaba Central co-operative Consumers Wholesale & Retail Stores Ltd. held that the obligation to apply certain amounts out of the income for a particular case cannot amount to diversion of income by an overriding title.

In this case, theassessee was a co-operative society and the State Government contributed to the share capital of the assessee under an agreement.

The amounts set apart by the assessee as capital contribution redemption fund as per the stipulation in the agreement, was held to be income accrued to the assessee and that there was no diversion of income by an overriding title. The agreement between the parties stipulated that the amounts should be invested with the Government and should not be used for the business of the co-operative society. The Court held that the amount belonged to the assessee even though it was to be invested with the Government and there was no diversion by overriding title.

Considering the decisions of the Supreme Court in the cases of Sitaldas Tirathdas and Associated Power Co.Ltd. and of the Bombay high court in the cases of V.G. Bhuta, Mrs. Meherbai N. Sethna and Colaba Central Co-operative Consumers Wholesale & Retail Stores Ltd., it was concluded that, on the facts of the present case, thecharge was not created in respect of the preferential dividend receivable by the assessee from the Indian company.

In the Court's opinion, this was not a case of diversion of income at source by an overriding title, but the dividend was first received by the assessee in its own rights and, thereafter, applied for the research activity of the Indian company. The letter written by the assessee clearly showed that the assessee of its own volition agreed that the preferential dividend receivable by it would be used as contribution for financing the research activity of the Indian company.

The aforesaid decision lays down the correct principle of law and it marches with the hypothesis that unless the income is diverted at source and never reaches the assessee, it would be taxable in his hands though it is subsequently applied for a particular purpose.