Chit funds are still a preferred investment option for many despite frequent news reports on scams by chit fund companies or its organisers.
Despite the wide prevalence of chit funds in India, the tax treatment of income from this instrument is not very clear.
Taking into account the spirit of the Income Tax Act, various court judgments and expert opinions, we decode the taxation aspect of chit funds in the hands of subscribers.
How it works
In a chit scheme, a group of people contribute towards the chit value periodically for a duration that equals the number of investors. Every month, an auction is conducted wherein the members bid for the chit amount.
The person who bids for the lowest amount — by offering the highest discount — is awarded the bid. The amount foregone by the winning bidder is distributed among all the members equally after deducting foreman’s commission and other charges. The amount distributed to each member is called dividend.
Attracts tax
Websites of even prominent chit fund companies state that the income derived in the form of dividend is not chargeable to tax. But this doesn’t seem to hold ground, for a couple of reasons.
Firstly, Section 56 of the Income Tax Act states that if income of any kind is not exempt from tax but is not chargeable under any of the heads specified — salary, house property, business and capital gains — then, such income is to be included under the head ‘income from other sources (IFOS).’
Secondly, there are court judgments stating income from chit funds is taxable.
For example, there are instances where ‘doctrine of mutuality’ was invoked by assessees to make the dividend income non-taxable. Doctrine of mutuality, which is applicable in case of clubs, argues that the members of the club and the club are one and the same and transactions between them are not applicable to tax. However, the Madras High Court, in the case of V. Raj Kumar vs. The Commissioner of Income Tax, held the mutuality principle did not arise in chit funds and dividend income deserves to be assessed as income.
Deduct the discount
Now, a doubt arises as to whether the discount forgone by a member on winning the auction can be claimed as deduction from dividend income. There doesn’t seem to be any explicit tax provision to answer this question.
Naveen Wadhwa, DGM, Taxmann.com says, “Discount should be treated as interest paid for amount taken in advance. It is more logical to consider net dividend income after deducting discount foregone for the purpose of taxation.” He cited tax treatment in a similar case where Income Tax Act allows setting-off interest paid on the loans taken — which are immediately not deployed but deposited elsewhere for an interim period — against interest income earned on deposits made from such loans.
There could be a case when discount foregone by a member is more than the dividend income received throughout the tenure of the chit. “Such loss is tax neutral,” adds Mr. Wadhwa.
Thus, if the net income (dividend minus discount) is positive, the difference is chargeable to tax under IFOS. But if it is negative, the loss doesn’t come under the purview of taxation.
Claim as expense
Seems unfair that the profit is taxed but loss is not given any benefit of deduction? There’s a silver lining.
In case the chit fund money is utilised for the purpose of business, any loss incurred out of the same is allowable as business expenditure.
Sunil Gidwani, partner, Nangia Advisors (Anderson Global) reiterates that the amount should be allowed as business expenditure as it is equivalent to the interest paid on a loan that is invested in a business.
Note, however, that income from chit fund continues to be taxable under IFOS and not business income of an assessee even if the chit amount is used for the purpose of business. This because, courts time and again have held that participating in a chit scheme is not a business of an assessee and hence it cannot be business income.
On accrual
The period in which profit/loss from chit fund is liable to tax gets tricky when the tenure of the chit does not fall within a single financial year.
Archit Gupta, founder and CEO, ClearTax, says, “Usually, assessees report the income from chit funds only in the financial year in which the chit is terminated. This is not without a reason as profit/loss from chits is based on the bidding interest of all members and can be determined only at the end of the chit tenure.”
However, it is prudent to disclose the dividend income and discount on an accrual basis. Because, various court judgments have held that both dividend and discount should be accounted based on percentage of completion method and not based on completed contract method.
For example, say, the chit scheme is valued at ₹2.4 lakh with a tenure of 24 months and comes with a monthly subscription of ₹10,000 beginning at the start of a financial year.
By the end of one year, say, an assessee received a dividend amount of ₹25,000 but the amount foregone as discount on winning the bid in the fourth month is ₹40,000.
Thus, for the said financial year, the assesses must disclose dividend income of ₹25,000 and discount amount of ₹16,000, reporting net income of ₹9,000 under the head IFOS. The discount of ₹16,000 here is calculated by spreading the discount of ₹40,000 over the remaining period of 8 months in the first financial year out of balance 20 months of the chit (as chit auctioned by assessee in fourth month) on proportionate basis ( ie ₹40,000 * (8/20)).
Published - December 01, 2019 10:46 pm IST
