Concept & Distinction between real income & deemed income

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Taxation Concept & distinction between of Real Income vs. Deemed Income:

The distinction between real income and deemed income is a fundamental concept in income tax law. It determines when and how income becomes taxable. Here’s an overview of the relevance of real income vis-à-vis deemed income, along with the legal framework supporting this distinction:

Real Income:

The fundamental principle of income tax is to tax real income—what a person actually earns. Real income is based on accrual or receipt, reflecting the actual financial gains made by an individual or entity. Taxation of real income ensures that tax is levied on the true financial position of the taxpayer.

Accrual of Income:

- Income becomes taxable based on the principle of accrual when the right to receive that income vests in the assessee. This means that the assessee must have a legal right to receive the income.
- For income to accrue, there must be a debt owed to the assessee by another party, establishing a right to payment. Without this debt, the income cannot be said to have accrued or become due.

Right to Receive Income:

- The crux of real income lies in the acquisition of a right to receive income. If the assessee has not acquired such a right, it cannot be said that income has accrued to them, and thus, it is not taxable.

Deemed Income:

Deemed income is a legal construct where certain receipts or transactions are considered as income for tax purposes, even if they do not represent actual income. The concept is used to curb tax evasion and ensure that income that could be easily hidden or manipulated is brought into the tax net.

Deemed Income under Income tax Law – Statutory Fiction: While real income is based on the actual accrual or receipt of income, deemed income arises through statutory provisions where the law deems certain receipts or accruals as income, even if they do not represent real income. Sections such as 9, 45, 50, 56, 68, 69, 69A, 69B, 69C, 69D, 93, 94, and 172(2) of the Income Tax Act create such statutory fictions where income is deemed to accrue or arise and must be assessed as income, irrespective of whether it has been shown as such in the accounts.

Examples of Deemed Income: Examples of Deemed Income: Section 9: Income deemed to accrue or arise in India, such as income from business connections, property, assets, or capital gains. Section 45: Capital gains deemed to accrue on the transfer of a capital asset. Sections 68 to 69D: Unexplained cash credits, investments, expenditures, etc., which are treated as deemed income under the law.

Stamp Duty Valuation (Section 50C): For the purpose of computing capital gains on the sale of immovable property, the Income Tax Act deems the stamp duty valuation as the sale consideration, even if the actual sale price is lower. This provision was introduced to prevent the practice of underreporting sale prices to avoid tax, with the balance being paid in black money. This measure is justifiable as it prevents tax evasion and ensures that the real value of the transaction is taxed, aligning with the broader goal of fairness and transparency in the tax system.
Income from Undisclosed Sources (Sections 68 to 69D): Sections 68 to 69D deal with unexplained cash credits, investments, expenditures, etc. These provisions treat unexplained amounts as deemed income. If a taxpayer cannot satisfactorily explain the source of certain receipts or investments, they are deemed to be income and taxed accordingly. These provisions are designed to prevent the concealment of income and ensure that all financial activities are accounted for and taxed.
Clubbed Income (Sections 60 to 64): Income that is legally earned by another person but is attributable to the taxpayer (e.g., income transferred to a spouse or minor child) is deemed to be the income of the taxpayer. This prevents tax avoidance through the transfer of assets or income to family members in lower tax brackets. The clubbing provisions are aimed at preventing tax avoidance strategies that exploit the tax slab system by shifting income to lower-taxed individuals.
Income from Substantial Interest (Section 2(22)(e)): Loans or advances given by a company to a shareholder with substantial interest (10% or more voting power) are deemed as dividends under Section 2(22)(e) and taxed as income. This provision targets the practice of companies distributing profits to shareholders in the guise of loans to avoid dividend distribution tax. This ensures that profits distributed by a company are taxed appropriately and prevents the misuse of loans to avoid taxes on dividends.

Practical Implications on real income versus deemed income:

Notional income refers to income that a person could have earned but did not. Unlike real income, it does not represent actual financial gain but a potential income that might have been received under different circumstances. Taxing notional income would contradict the basic principle of taxing actual earnings.
Assessees must ensure accurate reporting and compliance with both real income and deemed income provisions. Failure to account for deemed income can result in penalties and legal challenges.
The distinction between real and deemed income affects the taxability of various transactions. While real income focuses on actual accrual or receipt, deemed income includes items brought into the tax net by statutory provisions, regardless of their actual receipt or accrual.

Legal Position on real income versus deemed income

The concept of real income versus deemed income plays a critical role in determining tax liability. While real income relies on the actual right to receive, statutory provisions can deem certain amounts as income even if they haven’t been realized. Taxpayers and professionals must carefully navigate these provisions to ensure accurate tax reporting and compliance, considering both the substance of transactions and the legal fictions created by the Income Tax Act.

Scope of Total Income: Section 5 defines scope of total income,

which includes:

Income received or deemed to be received in India.
The Income that accrues or arises, or is deemed to accrue or arise, in India.
Income that accrues or arises outside India during the relevant previous year.

Judicial Precedents real income versus deemed income

Deemed income provisions are often introduced to address tax evasion and avoidance strategies that exploit loopholes in the law. By treating certain transactions as income, these provisions ensure that the tax base is not eroded and that all sources of potential income are adequately taxed. Despite their intent, deemed income provisions can sometimes lead to the taxation of amounts that do not represent actual financial gain. This can be seen as contradictory to the principle of taxing real income and may impose a burden on taxpayers who have not realized any actual income.

CIT v. Shoorji Vallabhdas & Co. (1962) (Supreme court):

The Supreme Court held that only real income that genuinely accrued or was received during the relevant financial year should be taxed. This ruling emphasizes that mere book entries or hypothetical income without a right to receive cannot be taxed.

CIT v. Shiv Prakash Janak Raj & Co. (P.) Ltd. (1996) (Supreme court):

The Supreme Court ruled that disputed income should not be taxed until it is realized, supporting the principle that income must be real and not hypothetical to be taxed under Section 5.

CIT v. M/s Excel Industries Ltd (2013):

The Supreme Court reiterated that hypothetical income that has not been realized should not be taxed. The court emphasized that the Assessing Officer should adopt a pragmatic approach, focusing on real income rather than a pedantic one that taxes unrealized or hypothetical income.

Conclusion:

The balance between taxing real income and imposing tax on deemed income is crucial for a fair and effective tax system. While the primary goal of income tax is to tax real earnings, the introduction of deemed income provisions is often necessary to prevent tax avoidance and maintain the integrity of the tax base. Understanding these provisions is essential for taxpayers to navigate their tax obligations and ensure compliance with the law.