DIRECT AND INDIRECT TAXES
Introduction:
Taxes are sometimes referred to as direct tax or indirect tax. The meaning of these terms can vary in different contexts, which can sometimes lead to confusion. In economics, direct taxes refer to those taxes that are collected from the people or organizations on whom they are ostensibly imposed. For example, income taxes are collected from the person who earns the income. By contrast, indirect taxes are collected from someone other than the person ostensibly responsible for paying the taxes. In law, the terms may have different meanings. In U.S. constitutional law, for instance, direct taxes refer to poll taxes and property taxes, taxes , which are based on simple existence or ownership. Indirect taxes are imposed on rights, privileges, and activities. Thus, a tax on the sale of property would be considered an indirect tax, whereas the tax on simply owning the property itself would be a direct tax. The distinction can be subtle between direct and indirect taxation, but can be important under the law. India has a well-developed tax structure with clearly demarcated authority between Central and State Governments and local bodies. Central Government levies taxes on income (except tax on agricultural income, which the State Governments can levy), customs duties, central excise and service tax. Value Added Tax (VAT), (Sales tax in States where VAT is not yet in force), stamp duty, State Excise, land revenue and tax on professions are levied by the State Governments. Local bodies are empowered to levy tax on properties, octroi and for utilities like water supply, drainage etc. In last 10-15 years, Indian taxation system has undergone tremendous refor reforms ms.. The The tax rate rates s have have been been ration rationali alized zed and and tax laws laws have have been been simpl simplifi ified ed resul resultin ting g in bette betterr comp complia liance nce,, ease ease of tax payme payment nt and bette betterr enforc enforcem emen ent. t. The The process of rationalization rationalization of tax administration administration is ongoing in India. Since April 01, 2005, most of the State Governments in India have replaced sales tax with VAT.
Taxes Levied by Central Government
Direct Taxes A direct tax is one paid directly to the government by the persons on whom it is imposed. This is a tax that, however oppressive in its nature, and unequal in its operation, is certain as to its produce and simple in it collection; it cannot be evaded like the objects of imposts or excise, and will be paid, because all that a man hath will he give for his head . Examples include some income taxes, taxes , some corporate taxes, taxes , and transfer taxes such as estate (inheritance) tax and gift tax. Different direct taxes are as follows: 1. 2. 3. 4. 5.
Tax on Corp Corpora orate te Inco Income me Capita Capitall Gai Gains ns Tax Perso Personal nal Incom Income e Tax Tax Tax Inc Incen enti tive ves s Double Double Taxat Taxation ion Avoida Avoidance nce Trea Treaty ty
Indirect Taxes The term indirect tax can be defined from different views. In the colloquial sense, an indirect tax is the charge that is collected by intermediary (like retail store) from the individual who holds the actual economic burden of the tax ( like customer). The intermediary files a tax return and eventually passes to the government. The indirect tax can be alternatively defined as the charge that is paid by one individual at the beginning, but the burden of which will be passed over to some other individual, who eventually holds the burden. Different indirect taxes are as follows: 1. 2. 3. 4.
Exci Excis se Du Duty Cust Custom oms s Duty Duty Serv Servic ice e Tax Tax Securiti Securities es Tran Transact saction ion Tax Tax
Basic concepts
1. Asses ssessm smen entt Yea Year r Section 2(9) of the act defines ‘assessment year’ as “the period of twelve months commencing on the first day of April every year”. An assessment year begins on 1st April of every year and ends on 31 st march of next year. For example, the current assessment year 2006-07 has begun on 1 st April, 2006 and will end on 31 st March, 2007. 2. Prev Previo ious us Year ear Section 3 of the act defines ‘previous year’ as for the purposes of this act, “previous year means the financial year immediately preceding the assessment year. Provided that, in the case of a business or profession newly set up, or a source of income newly coming to existence in the said financial year. The previous year shall be the period beginning with the date of setting up of the business, or as the case may be, the date on which the source of income newly comes into existence and ending with the said financial year. 3. Asses ssessm smen entt Section 2(8) of the Income Tax Act defines this term as “an assessment includes reassessment. This is an inclusive definition, which indicates that the term assessment includes reassessment, in addition to its normal meaning. Normally, an assessment means the process of determining and computing the amount of income and the tax due of a person. The computation of income and tax is to be done in accordance with the provisions of the Income Tax Act. 4. Asse ssessee Section 2(7) defines “assessee” as a person by whom any tax or any other sum of money is payable under the Act. A person is liable to pay tax as well as interest (for late payment of tax) or penalty (for concealment of income, fraud) under the Income Tax Act. Therefore, an assessee basically means a person liable to pay tax or interest or penalty. Assessee is a person : • • • • • • • •
Who is regarded regar ded as person in Income Tax Tax Act An individual Hindu undivided family A firm (Partnership) Company Association of person or body of individuals Local authority Every judicial person not covered by above.
5. Incom come tax tax Every Government derives revenues by levying taxes. Such taxes can be either “Indirect” or “Direct”. Indirect taxes are in the form of customs duty, excise duty, value added tax, service tax, etc. These indirect taxes are levied irrespective of the level of income of a person. On the other hand, direct taxes are levied directly based on the income of the person. The dictionary meaning of the word ‘Income Tax’ is “a tax directly levied on income or on incomes over a certain period”. Thus, income tax is a direct tax. Of all the direct taxes, the maximum revenue to the Government is from income tax. The law relating to it is contained in the Income Tax Act, 1961. The Income Tax Act is the machinery, which determines which persons are liable to tax. It also determines in respect of which incomes they are liable to tax. These incomes are classified under various heads and then taxed. They are as follows:
Different sources of income one can earn from
Heads of income defined in Sec. 14
1) Salary
a) Incom Income e from from salar salarie ies s
2) Rent
b) Incom Income e from from house house pro proper perty ty
3) Busi Busine ness ss Inc Incom ome e
c) Profits Profits and Gains Gains from from busines business s and profession
4) Sale Sale of prope property rty or or capita capitall profit profit
d) Capi Capita tall gain gains s
5) Any other other sour sources ces of inco income me
e) Income Income from other other sourc sources es
6. Return It is a declaration of income and tax Such declaration is by assessee Such declaration by assessee is based upon his knowledge and belief Such return is filed with income tax authority. • • • •
7. Income As per Section per Section 2(24) of the Act the term “Income” includes:• • •
•
•
•
•
•
•
• • •
•
•
• •
•
Profits and gains. Dividends Voluntary contributions received by a) a charit charitable able or religi religious ous trust trust,, or b) a specified specified institution institution (e.g. (e.g. a scientific scientific research research association, association, a sports association), except contributions specifically received towards the capital. Perquisites taxable under the head “salaries” u/s 17(2) (rent-free accommodation) or profits in lieu of salary taxable as salaries u/s 17(3) (retrenchment compensation). Special allowance or benefit specifically granted to an employee to meet expenses for the performance of his duties (entertainment allowance). Allowance to an employee to meet his personal expenses at office or to compensate him for the increased cost of living (dearness allowance). Benefit or perquisite obtained from a company by a director or a person having substantial interest in the company or their relatives (provision of motor car). Benefit or a perquisite obtained by a representative assessee (a trustee), or a beneficiary, or any amount paid by the trustee towards the sum due by the beneficiary. Any sum chargeableunder sec 28(ii) and (iii) of the Act (compensation for termination of a a) under sec contract for directorship or agency; income from services to members earned by a trade association) under sec 41 (profits chargeable to tax as income from business e.g. b) under sec recovery of bad debts, sale of scientific research asset ) etc. or under sec 59 (profits chargeable to tax as income from other sources e.g. c) under sec recovery of expenses claimed earlier). Profits on sale of an import license, taxable under sec 28(iiia). 28(iiia) . Export cash assistance received from Government, taxable under sec 28(iiib). 28(iiib). Refund of customs or excise duty received or receivable against exports, taxable under sec under sec 28(iiic). 28(iiic) . Benefit or a perquisite from business or profession (e.g. a gift received by a doctor from a patient), taxable under sec 28(iv). 28(iv) . Any interest, salary, bonus, commission or remuneration due to or received by a partner from a firm, to the extent allowed to be deducted under sec 40(b), 40(b) , taxable under sec under sec 28(v). 28(v) . Capital gains chargeable under sec 45 of the act. Profits of any business of insurance carried on by a mutual insurance company or a co-operative society, taxable under sec 44 or the First Schedule to the Act. Winnings from lotteries, prizes by draw of lots or by chance, crossword puzzles, races including horse races, card games, game show, entertainment programme on television in which people compete to win prizes, gambling or betting.
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•
Contributions from employees to Provident Fund, or Superannuation fund, or Employees Insurance Fund etc. deducted by the employer from the salaries of the employees. Any sum received under a Keyman Insurance policy (i.e. a policy taken on the owner/director etc.), including bonus on such policy.
8. Person
“Person” includes:An individual A Hindu Undivided Family A Company A Firm An association of persons or a body of individuals, whether incorporated or not. A local authority Every artificial judicial person, not falling within any of the preceding sub-clauses. For the purpose of this clause, an association of persons or a body of individuals or a local authority or an artificial judicial person shall be deemed to be a person, whether or not such person or body or authority or judicial person was formed or established or incorporated with the object of deriving income, profits and gains.
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Scope of Total Income The following points should be noted in regard to scope of income:
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•
•
While Sec 4 makes the total income of the previous year chargeable to tax, Sec 5 defines the scope of the total income so chargeable to tax. It determines the extent and scope of income, which is chargeable to tax. The term “Scope of Income” means which items of income are included and which items are excluded while computing tax liability. The scope of income depends upon the residential status of the person. There are three broad categories of persons: a) Resident and Ordinary resident b) Non-resident and c) Resident but not Ordinarily resident. It should be noted that Sec 5 specifically states that the income is to be computed “subject to the provisions of this Act”. Thus, if any item of income is exempt under the provisions of the Act, it is to be excluded from the scope of income.
Resident and Ordinary Resident A Resident and Ordinary Resident is taxable in respect of any income, from whatever source derived, which: a) Is received, received, or deemed to be received received in India, in the the previous year year,, by or on behalf behalf of such person. b) Accrues or or arises, or or is deemed deemed to accrue accrue or arise arise to him, him, in India. India. During the the previous year c) Accrues or arises arises to him him outside outside India, India, during during the previous previous year. year. Thus, in the case of ‘resident and ordinary resident’, his total income includes any income received, or accruing or arising in India, and accruing or arising outside India. In short the entire ‘world income’ (Indian income + Foreign income) of an ordinary resident is to be included in his total income. Resident but not Ordinary Resident A person not ordinarily resident in India, is taxable is respect of any income, from whatever source derived, which: a) Is received, or or deemed to be received, received, in India, in the the previous year year,, by or on half of such person. b) Accrues or arises, arises, or is deemed deemed to accrue accrue or arise to him, in India, India, during during the previous year. c) Accrues or arises to to him, outside outside India, India, from a business business controlled controlled from or a profession set up in India. Thus in the case of a ‘not ordinary resident’, while the Indian income is to be included in the Total Income, the foreign income is to be included only if it is derived from a business controlled in or a profession set up in India. So, the liability of a ‘not ordinary resident’ in respect of the foreign income is much less as compared with that of the ‘ordinary resident’. Non Resident A person who is a non resident, is taxable in any respect of any income, from whatever source derived, which: a) Is received in in India, or is deemed deemed to be received in India, India, in the previous previous year, year, by or on behalf of such person. b) Accrues or arises, arises, or is deemed deemed to accrue accrue or arise to him, in India, India, during during the previous year. Thus, in case of a ‘non resident’ his taxable income includes only his Indian income during that year. The foreign income of a non-resident is not taxable under the
Indian Income Tax Act. So, the liability of a non-resident is the lowest among all the types of residents under the Income Tax Tax Act.
Resident and Ordinary Resident
Resident but not Ordinary Resident
Non Resident
1) Income received in India
Taxable
Taxable
Taxable
2) Income Income which which accrues accrues or arise arises s in India
Taxable
Taxable
Taxable
3) Income Income deemed deemed to be be recei received ved in India
Taxable
Taxable
Taxable
4) Incom Income e deem deemed ed to to accru accrue e in India
Taxable
Taxable
Taxable
5) Inco Income me which which accr accrue ues s and and arises outside India from a business controlled from India or profession setup in India
Taxable
Taxable
Not Taxable
6) Any other other incom income e which which accrues or arises outside India
Taxable
Not Taxable
Not Taxable
Nature of Income
Practical Examples 1) Scope Scope of of Tota Totall Inco Income me Mr. Akash furnishes you with the following details of his income for the year ended 31-3-2008. Determine the scope of his total income for assessment year 20082009: 1) Salary from from X Ltd. Ltd. earned in India Rs.25000 Rs.25000 of which Rs.10000 Rs.10000 was received received abroad. Salary from Y Ltd. earned abroad Rs.100000 of which Rs.30000 was received in India. 2) Income Income from from let out out hose hose prop property erty i) Situ Situat ated ed in Indi India a Rs. Rs.40 4000 000 0 of of whi which ch Rs.1 Rs.120 2000 00 was was rec recei eive ved d abr abroa oad. d. ii) ii) Situ Situat ated ed abro abroad ad Rs. Rs.75 7500 000 0 of whi which ch Rs. Rs.15 1500 000 0 was was rece receiv ived ed in in Indi India. a. 3) a) Dividen Dividend d on share shares s of Indian Indian company company i) Received in India Rs.11000 i i) Received ab abroad Rs Rs.89000 b) Dividend on shares of foreign company i) Received abroad Rs.79000 i i) Received in India Rs.21000 4) a) Income from proprietary proprietary business business earned in India India Rs.35000 Rs.35000 of which which Rs.5000 Rs.5000 was received abroad. b) Income from foreign business: i) ii)
Cont Contro roll lled ed fro from m Indi India a Rs.5 Rs.500 0000 00 of of whic which h Rs.9 Rs.900 000 0 was was rece receiv ived ed in in Indi India, a, whi while le the balance was received abroad. Contro Controlle lled d fro from m abro abroad ad Rs.70 Rs.70000 000 of which which Rs.19 Rs.1900 000 0 was was recei received ved in India India and Rs.51000 was received abroad.
Nature of Income 1) a)Salary lary fro from X Ltd Ltd earned in India i) Received in India ii) Received Abroad b)Salary from Y Ltd earned abroad i) Received in India ii) Received abroad 2) Let Let out out House House prope property rty a) Situ Situat ated ed in in Indi India a i) Received in India ii) Received abroad b) Situ Situat ated ed abr abroa oad d i) Received in India ii) Received abroad 3) a) Divi Divide dend nd on shar shares es of Indi Indian an company i) Received in India ii) Received abroad b) Dividend on shares of foreign country i) Received in India ii) Received abroad 4) a) Income from property business earned in India i) Received in India ii) Received abroad b) Income from foreign business i) Controlled from India Received in India Received abroad ii) Controlled from Abroad Received In India Received abroad
Total amount
Resident and Ordinary Resident
Resident but not Ordinary Resident
15000 10000
15000 10000
15000 10000
30000 70000
30000 NIL
30000 NIL
28000 12000
28000 12000
28000 12000
15000 60000
15000 60000
15000 60000
11000 89000
11000 89000
11000 89000
21000 79000
21000 NIL
21000 NIL
30000 5000
30000 5000
30000 5000
9000 41000
9000 41000
9000 NIL
19000 51000
19000 NIL
19000 NIL
595000
335000
Non Resident
294000
2) Residential Status A person is classified, on the basis of legal status, into Individual, Hindu Undivided Family, Firm, Association of Persons, Body of Individuals, or Artificial Judicial Person. A person may be further classified, on the basis of residential status Into: a) A Resident in India b) A Non-Resident in India c) Ordinarily Resident d) Not Ordinarily Resident. It should be noted that: 1) Residential Residential status is to be determine determined d for every previous previous year year as it may change change from year to year. It depends upon the number of days a person is in India during the concerned previous year. 2) Residential Residential status is different different from citizenship. citizenship. An An individual individual may be the citizen citizen of Britain, but a resident in India. Similarly, an Indian citizen may be a non-resident in India. 3) Residential Residential status is important important in deciding deciding whether whether foreign income of a person person is taxable or not.
Basic Conditions Basic Conditions for individual whether he is resident/non-resident in India Sec 6(6): A) He/she should should be resident resident in India for a period period of 182 182 days or more during during previous previous year OR B) He/she should should be in India for for a period of 60 60 days or more more during previous previous year and and 365 days during last 4 previous year. Note: The condition of 60 days will be enhanced or increased in following cases: 1) When an Indian Indian citizen leaves leaves India for a period of 60 days days or more will be increased increased to182 days if he/she is there for employment / working as a member of crew of Indian Ship. 2) If an Indian Indian citizen or a person person of Indian Indian origin comes to India for a visit during during previous year.
An individual can be ordinarily resident in India: C) If he is resident resident for any 2 years years out of 10 preceding preceding previous previous year AND D) If he is in India for for a period of 730 730 days out of last last preceding preceding 7 years. Therefore, if an individual is satisfying either A or B of basic condition and satisfying both the condition C and D then he will be regarded as resident and ordinarily resident. If an individual is satisfying A or B but he fails to satisfy either both the conditions of C and D then he will be regarded as resident but not ordinarily resident. Practical Example: Mr. X an Indian Citizen has settled abroad for the last twenty-five years. His stay in India in the last few years was as under:
Year
Days
Year
Days
1991-1992
170
1997-1998
125
1992-1993
59
1998-1999
105
1993-1994
110
1999-2000
121
1994-1995
39
2000-2001
157
1995-1996
210
2001-2002
183
1996-1997
196
He did not come to India prior to 1991. Determine his residential status for the Assessment Year 2002-2003. Would your answer change if his stay in India in the previous year 2001-2002 Solution: A) Ascertai Ascertaining ning whether whether a resid resident ent 1) Mr. Mr. X is a citizen citizen of India India coming coming to India on on a visit. visit. 2) Mr. Mr. X will be a resident resident only if he is in India India from 1-4-2001 1-4-2001 to 31-3-2002 31-3-2002 for for 182 days or more. 3) He is in India for for 183 days from from 1-4-2001 1-4-2001 to 31-3-2002. 31-3-2002. Conclusion: Mr. X is a resident as he satisfies the conditions.
B) 1) a) b) 2)
Ascertaining Ascertaining whether an ordinary ordinary resident. resident. Mr. Mr. X will be an ordinary ordinary resident resident if:if:He is a reside resident nt for 9 out out of 10 prece preceding ding years years and He is in India between between 1-4-1994 1-4-1994 and 31-3-2001 31-3-2001 for for 730 days. Mr. Mr. X is a non-resident non-resident in the preceding preceding 3 previous previous years years 1998-99, 1998-99, 1999-2000, 1999-2000, and 2000-2001 as his stay in each of these years is less than 182 days. Hence, he cannot be a resident for 9 out of 10 years. Since he fails to satisfy condition 1(a), there is no need to check the next condition 1(b).
Conclusion: Mr. X is a resident but not ordinarily resident.
C) Stay of of 63 days days in 2001-2 2001-2002: 002: If X stays in India in the previous year 2001-2002 for 63 days only then he would become a Non-resident in India for the assessment year 2002-2003. As per the exception to the 2 nd condition in Sec 6(1), an Indian citizen settled abroad becomes resident in India only when his stay in India during the previous year is 182 days or more. Conclusion: As X does not satisfy this condition, he will be Non-resident for the assessment year 2002-2003. 3) Income from House Property Sec 22 of the Income Tax Act defines the basis of charge of income under the head – Income from house Property. It states that “Annual value of the property, consisting of any building or lands appurtenant thereto, of which the assessee is the owner, shall be chargeable to Income Tax under the head “Income from House Property”. This is however not applicable to the property occupied for the purpose of any business or profession carried on by the owner, profits of which are chargeable to income-tax. On further analysis of this provision, we will see that four conditions must be satisfied before a particular income is taxed under this head. These are: 1) The property must contain of a building or a land attached to or connected with such building. 2) The assessee must be the owner of the house property. 3) The property should not have been occupied by the assessee for the purpose of carrying on his business or profession.
4) The Annual Value of the House Property is to be taxed under the head “Income from House Property”
Pre-Construction Interest: 1) Where property property has been constructed constructed or purchased purchased with borrowed borrowed funds, funds, the interest payable for the period prior to acquisition or construction, can be deducted in 5 equal installments beginning with the previous year in which property is acquired or constructed and 4 succeeding years. 2) However, However, any amount amount already allowed allowed as deduction deduction any other other provision provision of the Act cannot be claimed again. 3) Interest is to be aggregated aggregated from the the date of borrowing borrowing till till the end of of the previous previous year prior to the year in which the house is completed. 4) It sho shoul uld d be noted noted that: that: (a) A fresh fresh loan can be taken specifically to repay the original original loan taken for purchase/construction of a house. The interest on such fresh loan ca also be deducted. (b) If interest is not paid on time time the late payment charges charges or interest interest on interest cannot be deducted. (c) Brokerage Brokerage paid for arranging arranging the housing loan loan cannot be deducted. deducted. (d) Only simple, and and not compound, compound, interest can be deducted. deducted.
Annual Value: The income from house property is determined on the basis of ‘Annual Value’. It is the Annual Value of the house property, which is charged to tax, after allowing certain deductions therefrom. Sec 2(2) define ‘Annual Value’ in relation to any property, as its annual value determined by Sec 23. Thus, the annual value is always in relation to some property. i)
ii) ii)
iii) iii)
Under Sec Under Sec 23, the annual value of any property is deemed to be: The sum for which the property might reasonably be expected to be let from year to year Wher Where e the the prop proper erty ty or or any any par partt of itit is let let and and the the actu actual al ren rentt rece receiv ived ed or or receivable by the owner in respect thereof is in excess of the amount received or receivable. Where Where the the pro proper perty ty or or any any part part there thereof of is is let let and and was was vaca vacant nt duri during ng the the who whole le or or any part of the previous year due to which the actual rent received or receivable is less than the amount, the amount so received or receivable whichever is more.
Practical Example: Mr. X owns a house at Delhi, which is let out. Fair rent of the house is Rs.24000 whereas actual rent received is Rs30000. He also received Rs.10000 from the tenant for charges towards lift, generator and security. He makes the following expenditure in respect of the house property: Particulars 1) Munici Municipa pall taxe taxes s pai paid d by Mehra. 2) Fire Fire ins insur uran ance ce.. 3) Colle Collecti ction on charg charges. es. 4) Repai pairs. rs.
Amount
4000
Particulars 5) Land Land reve revenu nue. e. 6) Grou Ground nd rent rent pai paid. d.
Amount 3800 2000
2400 500 2000
Interest on borrowed capital during the previous year 2001-2002 is Rs.4000. Funds borrowed on April 1, 1998, Rs.40000 @ 10% interest p.a. were used for construction of the house which was completed on March 31, 2002. Compute the income earned by Mr. Mehra from his let-out house property during the assessment year 2002-2003.
Solution: Name of the owner: Mr. Mehra Previous year: 2001-2002. Assessment year: 2002-2003. Computation of Income of House Property Particulars
Amount
Amount
Gross Annual Value
Higher of RLV (Rs.24000) or Rent received (Rs.30000)
30000 4000
Less:
Municipal taxes paid Net Annual Value Less: Deductions u/s 24 1) Standard Deduction (30% of 26000)
(A-B)
26000
2) Interest on borrowed funds during previous year.
7800
3) Interest on borrowed funds during pre-construction period.
4000
2400 E) Net Income from House Property
14200
(C-D) 11800
Working Notes: ‘Rent’ includes only charges for house property. Charges received for lift etc. are taxed not as ‘income from house property’ but as ‘income from other sources’. 1) Pre-cons Pre-construc truction tion intere interest st is computed computed as follows: follows: a) Construction Construction completed completed in previous year 2001-2002. 2001-2002.
b) Pre-construction Pre-construction period = Period Period from from date of borrowing to to end of of Preceding Preceding Financial Year = 1-4-1998 to 31-3-2001. c) Pre-construction Pre-construction Interest = Rs.40000 Rs.40000 x 10% 10% x 3 years years = Rs.12000. Rs.12000. d) Pre-construction Interest Allowance during current previous year = 1/5 x 12000 = Rs.2400.
