Clubbing income: Tax return mistakes that many discover only after receiving a notice

While many taxpayers are aware that gifts received from specified relatives are tax-free, far fewer appreciate that income arising from assets transferred by way of gift to a spouse, minor child, or daughter-in-law may still be taxable in the hands of the transferor.

The result is a recurring pattern. The recipient reports the income in their tax return; the transferor excludes it; and the discrepancy only surfaces when the tax department examines the source of funds during assessment proceedings.

Gift may be tax-free, not the income

The most common mistake relates to transfers made to a spouse. A taxpayer may gift money to a spouse who invests it in fixed deposits, shares, or mutual funds. Since the investments are held in the spouse's name, the income is often reported on the spouse's return. However, where the transfer is made without adequate consideration, the income arising from the transferred asset must be clubbed with the transferor's income.

The issue is particularly relevant in an era where family members increasingly maintain separate investment portfolios and demat accounts. Recent litigation has also highlighted that clubbing disputes are not confined to gains alone; questions can arise even where losses are claimed on investments funded by the other spouse.

Clubbing income and tax credit

A practical aspect frequently missed during return filing is the treatment of tax deducted at source (TDS) or tax collected at source (TCS). If income is required to be clubbed in the hands of the transferor, the corresponding tax credit should ordinarily follow the income.

Taxpayers sometimes club the income but fail to claim the related tax credit, resulting in avoidable refund mismatches and rectification requests. The converse situation can also trigger queries from the tax department.

The income of a minor child is another area where errors are common. As a general rule, such income is clubbed with the income of the parent whose total income before clubbing is higher. Once the income is clubbed with one parent, taxpayers should ordinarily continue following the same approach in subsequent years unless circumstances materially change. Where the parents of a minor child do not survive, the income of the minor child needs to be clubbed in the hands of the guardian.

However, clubbing does not apply in every situation. Income earned by a minor child on account of manual work or through application of the child's own skill, talent, specialized knowledge, or experience is excluded from clubbing. These exceptions are often overlooked, leading either to excessive clubbing or incorrect reporting.

Documentation matters

Many clubbing disputes ultimately turn on evidence rather than legal interpretation. Tax authorities frequently seek to trace the source of funds used for making investments. Taxpayers who are unable to establish whether an investment was funded through gifted money, independent earnings, or accumulated savings often find themselves facing prolonged correspondence with the department.

Maintaining a clear trail of bank transfers, gift documentation and investment records can significantly reduce the risk of future disputes.

A provision that deserves attention

The clubbing provisions are intended to prevent diversion of income without a corresponding transfer of tax liability. Yet, many tax notices arise not because taxpayers deliberately ignored the law, but because they assumed that ownership of an asset and taxability of its income are always identical.

As taxpayers finalize their returns this filing season, it may be worthwhile to spend a few extra minutes reviewing investments in the name of the spouse and minor children. In many cases, the question is not who owns the asset, but whose return should ultimately include the income.

Ashish Karundia is a practising Chartered Accountant and author. Views are personal.