Contractual charge on profits treated as diversion at source, making the payments deductible in computing business income

Contractual payments to a State Government were treated as a diversion of profits by title paramount where the agreement created a charge on net profits before they reached the assessee in the commercial sense. Applying the distinction between income diverted at source and income merely applied after receipt, the specified amounts were held not to form part of taxable income. The same payments were also characterised as revenue expenditure incurred under the contractual arrangement and were therefore deductible in computing business income under the applicable income-tax provisions.

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Issues: (i) Whether payments made by the assessee to the State Government under clause (7) of the agreements constituted diversion of profits by title paramount. (ii) Whether such payments were allowable as deductions under the relevant income-tax provisions.

Issue (i): Whether payments made by the assessee to the State Government under clause (7) of the agreements constituted diversion of profits by title paramount.

Analysis: The contractual stipulation created a paramount charge on the net profits, so that the specified portion did not form part of the assessee's income in the commercial sense. Applying the distinction between income diverted before it reaches the assessee and income merely applied after receipt, the obligation was held to operate at the source of the profits and not as a post-receipt application of income.

Conclusion: The payments were a diversion of profits by title paramount and not a mere application of income after accrual.

Issue (ii): Whether such payments were allowable as deductions under the relevant income-tax provisions.

Analysis: The amounts were treated as revenue expenditure and as amounts necessarily diverted under the contractual arrangement for the purpose of enabling the assessee to earn its profits. On that footing, they were deductible in computing the taxable income under the provisions applicable to the respective assessment years.

Conclusion: The deductions were allowable under section 10(2)(xv) of the Indian Income-tax Act, 1922 and section 37 of the Income-tax Act, 1961, in favour of the assessee.

Final Conclusion: The references were answered in favour of the assessee on all questions, and the impugned payments were held deductible as diverted income under the contractual charge.

Ratio Decidendi: Where a contractual obligation creates a paramount charge causing income to be diverted before it reaches the assessee, the diverted amount is not taxable income and, if otherwise revenue in character, is deductible in computing business income.

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