Income Tax: Diversification, Default, and Residency Rules

Posted on Jan 22, 2026 in Economy

1. Diversification and Application of Incomes

Diversification of Income

Diversification of income refers to the strategy of earning income from multiple sources rather than relying on a single source. This is a fundamental risk management technique in personal finance and business.

• Risk Mitigation: By spreading income generation across various channels, an individual or business reduces the impact of poor performance or failure in any one area. For example, if a business relies only on one product and demand drops, its entire income is jeopardized.
• Examples of Diversification:
  • An employee receiving a salary (primary income) also earning rental income from property, interest income from fixed deposits, and dividend income from stock market investments.
  • A business expanding its product line, target markets, or service offerings.

Application of Income

Application of income refers to how the earned income is utilized or spent. From an accounting and taxation perspective, it deals with the use of funds after the income has been generated and received.

• Taxation Principle: A key principle in income tax is that the application of income is generally not deductible when computing taxable income. Tax is levied on the income before it is applied (spent or distributed).
• Examples:
  • Spending: Paying personal expenses (rent, groceries, clothes).
  • Investment: Buying financial assets (stocks, bonds) or physical assets (property).
  • Debt Repayment: Paying off loans (principal and interest).
  • Donations/Gifts: Giving money to charity or individuals.
• Distinction from Diversion: It is crucial to distinguish Application of Income from Diversion of Income by Overriding Title.

Application vs. Diversion

• Application (Taxable): The income first accrues to the person, and then they decide to apply it. The full amount is taxable in their hands. (Example: A salary earner pays their spouse’s school fee after receiving their salary).
• Diversion (Non-Taxable): The income is legally diverted to another party before it ever accrues to the assessee, due to a pre-existing legal obligation. The diverted portion is not included in the assessee’s income. (Example: A legal agreement requires a landowner to pay a fixed percentage of all rental income directly to a former partner before they receive it).

2. Assessee in Default (Under Indian Income Tax Law)

The term “Assessee in Default” is defined under the Income Tax Act, 1961 (India) and refers to a person (an assessee) who has failed to comply with a specific statutory obligation mandated by the Act. The most common scenarios relate to the obligations of deducting and depositing Tax Deducted at Source (TDS) and Tax Collected at Source (TCS).

Key Scenarios for Assessee in Default

An assessee is considered “in default” if they:

• Fail to Deduct Tax: They were legally obligated to deduct tax at source (TDS) from a payment (like salary, interest, commission, rent, etc.) made to another person, but failed to do so entirely or deducted it at a lower rate without a valid certificate.
• Fail to Deposit Tax: They deducted the tax at source from a payment but failed to deposit the deducted amount into the Central Government’s account within the specified due date.
• Fail to Collect Tax: They were responsible for collecting tax at source (TCS) on certain transactions (like sale of scrap, parking lot/toll plaza fees, etc.) but failed to collect it.
• Fail to Deposit Collected Tax: They collected the tax at source (TCS) but failed to deposit the collected amount into the Central Government’s account within the specified due date.

Consequences of Being Assessee in Default

When an assessee is deemed to be in default, they become liable for several punitive actions:

• Interest: They must pay interest on the amount of tax not deducted/collected or not paid/deposited.
  • Failure to Deduct/Collect: 1% per month or part of a month (from the date tax was deductible/collectible until the date it is actually deducted/collected).
  • Failure to Deposit: 1.5% per month or part of a month (from the date the tax was deducted/collected until the date it is actually paid to the government).
• Penalty: The Assessing Officer can levy a penalty equal to the amount of tax that was not deducted or not paid.
• Disallowance of Expenditure: For the payer (the assessee in default), the corresponding expense in the profit and loss account (from which TDS was supposed to be deducted) can be disallowed from their own total income calculation (in part or full, as per Section 40(a)(ia) of the IT Act). This increases their taxable income.

9. Exempted Incomes Under the Income Tax Act, 1961

Incomes that do not form part of the Total Income of an assessee are known as Exempted Incomes. These are primarily listed under Section 10 of the Income Tax Act, 1961. They are excluded from the tax net and are not considered for calculating the tax liability.

Twenty Exempted Incomes (Section 10)

10. Determination of Residential Status of an Assessee

The Residential Status of an assessee (an individual, HUF, Firm, Company, etc.) is the most crucial factor in determining the scope of their total taxable income under the Income Tax Act, 1961. Residential status is determined for each previous year and has nothing to do with citizenship or domicile.

I. Residential Status for an Individual Assessee

An individual is classified into one of three categories:

• Resident and Ordinarily Resident (ROR)
• Resident but Not Ordinarily Resident (RNOR)
• Non-Resident (NR)

Step 1: Determine if the Individual is a ‘Resident’ (R) or ‘Non-Resident’ (NR)

An individual is considered a Resident (R) if they satisfy at least one of the following two Basic Conditions under Section 6(1):

• If the individual satisfies at least one condition, they are a Resident (R).
• If the individual satisfies neither condition, they are a Non-Resident (NR).

Exceptions to the 60-Day Rule:

For the following two categories of Indian citizens/Persons of Indian Origin (PIOs), only Condition 1 (182 days) applies. Condition 2 is ignored:

• An Indian citizen who leaves India during the PY for the purpose of employment outside India (or as a member of the crew of an Indian ship).
• An Indian citizen or a Person of Indian Origin (PIO) who comes to India on a visit during the PY.

Step 2: If ‘Resident’ (R), Determine if ROR or RNOR

A Resident (R) will be a Resident and Ordinarily Resident (ROR) if they satisfy both of the following two Additional Conditions under Section 6(6). If they fail to satisfy even one of these two conditions, they are classified as a Resident but Not Ordinarily Resident (RNOR).

Suitable Examples (Individual Assessee)

Example 1: Resident and Ordinarily Resident (ROR)

• Assessee: Mr. A, an Indian citizen, has been living in India continuously for the last 15 years.
• Stay in PY: 365 days.
• Basic Condition 1: Satisfied (Stay is 365 days, which is ≥ 182 days). Result of Step 1: Resident (R).
• Additional Condition A: Satisfied (He was a Resident in all of the last 10 years, which is ≥ 2 years).
• Additional Condition B: Satisfied (He was in India for over 730 days in the last 7 years).
• Result of Step 2: Resident and Ordinarily Resident (ROR).
• Tax Liability: Taxable on his global income (Indian income + Foreign income).

Example 2: Resident but Not Ordinarily Resident (RNOR)

• Assessee: Mr. B, a PIO, comes to India for the first time in his life on a visit on April 1, 2024 (PY 2024-25) and stays for 150 days.
• Stay in PY 2024-25: 150 days.
• Stay in 4 preceding years (2020-21 to 2023-24): 0 days.