TDS on Salaries Earned by Religious Nuns: Application of the Doctrine of Diversion of Income by Overriding Title

The author is Paras Khetan, a Fourth Year Student from National Law School of India University, Bangalore.

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Introduction:

Recently, a three-judge bench of the Supreme Court dismissed a batch of appeals challenging the deduction of tax at source on the salaries given to religious nuns who worked as teachers in government schools. In doing so, the Supreme Court reaffirmed the decision of the division bench of the Madras High Court in Union of India and Ors. v The Society of Mary Immaculate. 

This blog post seeks to analyse the application of the doctrine of diversion of income by overriding title by the Court. In doing so, it compares this doctrine with the “agency relationship test” devised by the courts in the United States (“US”) to argue that the application of this test would lead to the same conclusion i.e. the salaries earned by the religious nuns is liable to tax deductible at source (“TDS”).

The Decision in Society of Mary Immaculate

In the case of Society of Mary Immaculate, the Madras High Court had to decide whether the salaries received by catholic nuns for their services rendered in government school as teachers were liable to TDS under Section 192 of the Income Tax Act, 1962 (“the Act”). The nuns argued that their canon law prohibits them from owning money as they are bound by their vow of poverty. They argued that they have suffered a civil death and everything that they earn during their lifetime belongs to their religious congregation. On the other hand, the Income Tax Authorities argued that the Act is agnostic to personal law and applies equally to everyone. The Court went into multiple issues surrounding the dispute. These included the interpretation of a circular issued by the Central Board of Direct Tax (“CBDT”) exempting the salaries received by religious nuns, applicability of canon law under Section 192, issue of civil death of the nuns, application of the doctrine of diversion of income by overriding title, and violation of fundamental rights under Article 25 and 26 of the Constitution of India. The Court negated all these contentions to hold that the salaries received by catholic nuns are liable for TDS under the Act.

This controversy has been the subject of other judicial decisions as well. In Fr. Sabu P. Thomas v. Union of India, the Kerala High Court held that the doctrine of diversion of income by overriding title would not be helpful in removing the tax liability of religious nuns. Similarly, in Provincial Superior v. Union of India, the Kerala High Court again delved into the same issues raised earlier and held that salaries earned by religious nuns are subject to TDS under the Act.

In all these decisions, the determining factor was the applicability of the doctrine of diversion of income by overriding title. This doctrine is taken up in more detail in the next section.

The Doctrine of Diversion of Income by Overriding Title

It is a well-settled principle of taxation law that the chargeability of tax is not dependent on the manner of utilisation of the income. However, an exception to the above is created in the form of the doctrine of diversion of income by overriding title. This doctrine prescribes that the income of a recipient would be exempt from his total taxable income if there is an overriding title over that income in favour of someone else. The landmark decision in CIT v. Sitaldas Tirathdas, held that:

In our opinion, the true test is whether the amount sought to be deducted, in truth, never reached the assessee as his income. Obligations, no doubt, there are in every case, but it is the nature of the obligation which is the decisive fact. There is a difference between an amount which a 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; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow. (emphasis mine)

This dicta of the Supreme Court has been referred to in multiple subsequent judgments (see Vibhuti Glass Works v. CIT and National Cooperative Development Corporation v. CIT) with approval. It was further explained in CIT v. Sunil J. Kinariwala that the doctrine would only apply when a third person is entitled to receive the amount even before the assessee could lay a claim to receive it as his income.

In the instant case, the religious nuns were arguing that their religious congregation has an overriding title to the salaries earned by them by virtue of their canon law. This meant that no TDS was deductible under Section 192 as the salaries were actually owned by the religious congregation which is exempt from paying taxes under Section 11 of the Act. The Madras High Court held that the doctrine is inapplicable in the present case. The doctrine prescribes that if the income is one which is to be applied in the discharge of an obligation after it reaches the assessee, then the doctrine would not be applicable. In the present case, the obligation to transfer all income earned by the nuns to the religious congregation only applies after the income has been earned and received by the nuns. It is a mere case of “application of income” and not “diversion of income”. The religious congregation does not have an independent legal entitlement to the same before the income is received by the nuns. Therefore, the nuns remain the legal owners of the salaries and are liable to TDS.

The “Agency Relationship Test” in US

In the US, a similar test (called the “agency relationship test”) has been derived to determine the taxability of income earned by members of religious congregations. The US Federal Court in Fogarty v United States laid down six relevant factors in determining whether an individual earns their income as an agent of the religious congregation for the purpose of taxation. These are (i) the degree of control exercised by the religious congregation over the member; (ii) ownership rights between the member and the religious congregation; (iii) the purposes or mission of the religious congregation; (iv) the type of work performed by the member vis-a-vis the purposes or mission; (v) the dealings between the member and the third-party employer, including the circumstances surrounding inquiries and interviews, and the control or supervision exercised by the employer; and (vi) the dealings between the employer and the religious congregation. This was further reaffirmed in Schuster v Commissioner of Internal Revenue where the Federal Court accepted the “agency relationship test” and rejected the rigid and narrower “agency triangle theory”. In both these cases, the Court held that the assessee in question earned their wages in their individual capacity rather than as an agent of the religious congregation. The most important factor that the Court relied on was that the assessees had a superior entitlement to the wages earned by them i.e. the paychecks were first received by the assessee which were then endorsed to the religious congregation. In another case, United States v Hartshorn, it was held that the lack of intention of the employer to make the religious congregation as the beneficiary of the contract would also indicate that no agency relationship exists between the members and the religious congregation. 

Applying this test and the underlying factors to the case of religious nuns in the context of India, it is clear that the nuns would not be eligible to escape tax liability using this test as well. The fact that the nuns earned their salaries in an individual capacity which was then later transferred to their religious congregation and that the government schools had never indicated any intention to make the religious congregation as a beneficiary of the employment contract between the nuns and the school indicates that the present case would fail the “agency relationship test”. This is also visible from the proceedings before the Supreme Court where the Chief Justice emphasised that the salaries are received by the nuns in their personal account. Therefore, the Madras High Court’s judgment and the Supreme Court’s decision to not entertain the Special Leave Petition would be acceptable in jurisdictions outside India as well. Similar issues have not arisen for judicial determination in other major common law jurisdictions such as the United Kingdom, Canada, Singapore and South Africa.

Conclusion

This blog post has critically appraised the Madras High Court’s judgment holding that salaries earned by nuns is liable for TDS under the Act, in the context of the application of the doctrine of diversion of income by overriding title. The Supreme Court rightly dismissed the Special Leave Petition against the High Court’s decision. It was further highlighted that the Indian approach to this issue would also be supported by the jurisprudence in the US where similar issues have arisen. Therefore, the Indian courts have rightly held that members of religious congregations are liable to pay taxes and no religion-specific exemption can be made for certain members of the society under the Act.