Everything about Income Tax Planning

#1. Introduction

Before we go into the details of income tax planning, let’s understand few key principles of income tax first.

Income can be generated from diversified sources.

Majority earn income from a single source like job or business.

But there are people who earn income from variety of sources.

For income tax purpose, all incomes has been categorised into 5 types.

All types of income attract income tax.

But there are exemptions provided on some form of incomes.

But even before the income is taxed or exempted, it is essential to first learn to categorise one’s source of income.

In terminology of taxation, categorising income is commonly referred as “heads of income”.

It is extremely important for the tax payer to first categorise the income under its right heads.

This becomes specially important for those people who have multiple source of income.

In terms of income tax planning, it all starts with defining right heads for each flowing-in income.

#2. The “5 heads of income”

1. Income from salary.
2. Income from house property.
3. Profit from business.
4. Capital gain.
5. Other source of Income.

Lets elaborate more on the above 5 heads of income:

#2.1. Income from salary:

When a person receives a paycheck from a company for his job, it is called as salary.

Anybody paying some money to other cannot be treated as salary.

There must be a contract existing as per rule of law, which can established that:

• The Payer: is the Employer. 
• The Receiver: is the Employee. 

One this is established, an employee can receive the salary (remuneration’s) in following forms:

In reference to Indian income tax laws, the terminology is like this:

• Wages,
• Fees,
• Allowances,
• Advances,
• Gratuity,
• Pension,
• Retirement benefits etc.

If one receives money in any of the above forms, its category will be under the head “salary”.

#2.2. Income from house property:

The income earned by the owner of house property is taxable.

In case the house property is self-occupied, there will be no income. So tax liability is zero.

But if the house property is let-out on rent, then the income in hands of the owner may become taxable.

Let’s see how tax liability on income from house property is calculated.

The formula is like this:

#2.3. “Profits” from business:

Please note that term used here is profit and not income.

What is the difference between income and profit?

Income from business, minus the allowable expenses incurred while running the business, is profit.

Profit made by the business is liable for taxation.

In order to compute profit from business, it is essential for the tax payer to be aware about the allowed expenses available as deductions.

Otherwise one may end up calculating ones profits wrongly.

#2.4. Capital gain:

Generally, valuation of assets appreciates with time.

When such an asset is sold by the owner, the profit made in the sale is liable for tax.

Not all types of asset sale attract tax.

Personal asset in general do not attract income tax. But there are exceptions here as well.

Few assets whose profitable sale attracts income tax are:

• Immovable property,
• Movable property,
• Jewellery,
• Art work like painting etc.

As per income tax act, capital gain is further categorised into two parts:

1. Short term capital gain &
2. Long term capital gain.

Depending on the time period for which the asset was held by the seller, the capital gain will be short or long.

Short term capital gain will be applicable if the asset has been held for less than 3 years.

For paper assets like stocks, mutual funds, ETF’s etc, short term capital gain will be applicable only if asset has been held for less than 1 year.

All capital gains, not coming under short term capital gain, is liable for long term capital gain.

#2.5. Other income sources:

There are other types of income that do not fall under the above four categories.

Few examples of income sources which will fall under “other income” head are as below:

• Dividend earnings,
• Interest earnings,
• Gifts,
• Provident Fund income,
• Income from games like lottery, race course,  etc.

Till now what we have seen are the 5 heads of income. 

For the person who wants to calculate ones income tax liability shall do the following first:

• List down all source of income. 
• Categorise these income in the above 5 heads. 

Once this is done, the next step is to know about the exemption’s. 

What are exemption’s? Those income which will not attract income tax. 

#3. Income exempted from tax

People often think that government will tax all income. But this is not correct.

There are income types which do not attract any income tax.

Let’s see some common income types exempted from tax net:

• Agriculture income.
• Salary received from employer as LTA (conditional apply).
• Retirement income in form of gratuity, pension, leave encasement, compensation received upon voluntary retirement (up to prescribed limits).
• Income from insurance policy including bonus.
• House rent allowance (HRA) up to prescribed limits.
• Dividend income received from companies on which dividend distribution tax has been paid (Conditions apply).
• Long term capital gain tax (LTCG) applicable on sale of stock, pure equity mutual funds (Conditions apply).
• Etc.

These are few income types which are exempted from income tax net. 

#3. Allowable deductions on income

In addition to exemption’s, there are deductions. Deductions also helps us to save tax.

What are deductions? 

They are few selected “expenses” which reduce out tax liability. How?

But why deductions are allowed? To promote some type of expenses.

Government give incentives, to attract people to incur these expenses. 

This way they indirectly ask people to spend money in a certain way.

These allowable deductions in turn help people to save on tax.

Lets see here few deductions that people can utilise to reduce their income tax liability:

Section 80C:

Allowable amount that can be claimed under section 80C is Rs.150,000.

Few common expenses for which deductions can be claimed u/s 80C are as below:

• Life insurance premium paid for family (self, spouse & child)
• Annuity contract payment for family (self, spouse & child)
• Contribution to EPF, superannuation fund etc
• Contributions to PPF for family (self, spouse & child)
• Money deposited in Post Office Savings Bank in 10Y or 15Y a/c
• Amount spent to purchase NSC
• Amount spend to purchase ELSS Fund
• Amount spend to purchase pension funds offered by mutual funds
• Purchase of deposits issued by National Housing Bank (NHB)
• Tuition fees paid to school, college for full time education
• Principal portion paid for home loan
• Selected fixed deposits of scheduled bank
• Payments to Bonds issued by NABARD
• Savings under SCSS
• Purchase of 5Y term deposit of Indian Post Office

Section 80CCC: Premium payment towards annuity plan of LIC

Section 80CCG: Premium payment towards RGESS

Section 80D: Allows deductions for premium payment upon purchase of health insurance policies

Section 80DD: Allows deductions for expense incurred towards maintenance of a disabled person

Section 80DDB: Allows deductions for expense incurred towards medical treatment of senior citizens

Section 80E: Allows deductions for expense incurred towards interest payment of education loan

Section 80G: Allows deductions for expense incurred towards contribution to certain charitable trust

Section 80GG: Allows deductions for Expense incurred towards payment of rent if HRA is not received from company

Section 80U: Allows deductions for expense incurred towards maintenance/treatment of self of disabled person

Section 80TTA: Allows deductions for interest earned from savings back account up to Rs.10,000.

But does this explanation answer why government gives such incentives (deductions)?

All these incentives are such that it creates a win-win situation for the people, economy and business.

Speaking in general, these incentives do the following:

• Motives people to save, invest & insure. 
• This way government has more free cash. 
• Government use this free cash for economic growth.

#4. Who must pay Income Tax?

In fact, anybody who is working in India and is making money, should pay income tax to the Government of India.

But the tax liability substantially varies depending on who is paying the tax.

As per income tax act, the tax payers has been categorised into the following types:

• Individual
• HUF (Hindu Undivided Family)
• Company
• Firm
• Association of persons
• Local authority &
• Other people not included in above list

#4.1. Who is an individual?

Following two (2) types people are classified as “individual“:

(1). Person who has been residing in India for last 182 days or more (in the previous year).

(2) Person who has been residing in India for last 60 days or more (in the previous year), and 365 days or more in the 4 years preceding to the last year. 

Non-resident individual:

An Indian citizen who does not qualify the above criteria becomes an NRI.

NRI status makes the tax liability different than a “Resident Individual”.

How NRI’s are taxed in India?

NRI’s must pay tax (to GOI) only on those incomes which has been generated in India. Foreign income will not be taxed in India. 

Suppose there is a NRI who lives in Europe. But this individual has some income generating investments in India. 

In this case, all income generated in India becomes taxable for this NRI (as per allowable tax bracket). 

But the investment income earned by NRI’s are taxed differently than a resident individual. 

Interest earned on deposits maintained by an NRI in Indian banks (FCNR / NRE) do not attract tax.

If an NRI invests in shares, deposits, debentures etc in India, their short term gain will be taxed at a flat rate of 20%.

In case of long term capital gain, tax rate applicable will be only 10%.

#4.2. Who is HUF?

In a Hindu undivided family (HUF), assets belong to a family and not to any specific individual.

In such a case HUF is treated like an individual.

But of course, the income tax levied on HUF is different from an “individual”.

All persons in a family can jointly form a HUF.

But the condition is only one, they should be descendants from a common ancestor.

In HUF, spouse and unmarried daughters can also be included.

#5. Income tax slabs…

Gross total income, minus allowable deductions gives net taxable income.

On this next taxable income, one must apply the government approved tax slabs.

Once the tax slabs are imposed on the taxable income, one’s tax liability can be calculated.

Every year in the Union Budget, the Finance Ministry of India confirms/alters the prevailing tax slabs applicable on one’s income.

One may ask why there are tax slabs and not one single tax rate?

To take care of the income disparity. How?

The logic goes like this, people who earn less shall pay lower tax than high earning people. 

More tax-burden shall be on the rich. Why? Because they can afford to pay higher taxes.

Based on this concept, the prevailing tax slabs in India is as below:

Age < 60 years (Men, Women & HUF) – FY 2018-2019

60 years < Age < 80 years (Men & Women)

Age > 80 years (Men & Women)

#6. Example of Income tax Calculation…

Lets take example of a person (individual below 60 years of age) whose income and other details are as below:

• Income from Salary – Rs.12,00,000,
• Interest Income – Rs.1,00,000,
• Deduction u/s 80C – Rs.1,50,000.

What will be the net taxable income of this person?

 = 12,00,000 + 1,00,000 – 1,50,000 = Rs.11,50,000

What will be the tax liability of this person?

Before we compute the tax liability, lets break Rs.11,50,000 into following slabs:

1. @0% Tax – Rs.2,50,000
2. @5% Tax – Rs.2,50,000.
3. @20% Tax – Rs.5,00,000.
4. @30% Tax – Rs.1,50,000

Now lets compute the Tax Liability:

First Rs.2,50,000 = Zero. 
-Next Rs.2,50,000 = 05% x 2,50,000 = Rs.12,500. 
-Next Rs.5,00,000 = 20% x 5,00,000 = Rs.1,00,000. 
-Next Rs.1,50,000 = 30% x 1,50,000 = Rs.45,000 
Total calculated Tax = 12,500+1,00,000+45,000 = Rs.1,57,500 
Total Tax Liability = Rs.1,57,500 + Education Cess. 
Education Cess = 3% x 1,57,000 = Rs.4,725. 
Total Tax Liability = Rs.1,57,500 + 4,725 = 1,62,225.

#7. Concept of Marginal Tax Rate

There is another concept called “Marginal Rate of Tax”.

As per this rule, not everybody is taxes similarly. How?

Lets see examples:

(1) People below 60 years of age are taxed differently than people above 60 years of age.

(2) NRI’s are taxed differently that resident Indian nationals.

(3) High earning people are taxed differently than low earning people.

Lets try to understand the concept of marginal tax rate with more specific example:

Example1:

Suppose your taxable income (salary) is Rs.12 Lakhs.

You also invested some money in bank deposit where in you have earned an income of Rs.26,000 in last year.

How your total income will be taxed?

The answer is, the total income will be taxed at the applicable marginal rate of tax.

What does this mean?

Actually the authorities are saying you to compute your tax liability as per your applicable tax slabs.

What is your tax slab? 

Salary Portion: Rs.12,00,000

Interest Income Portion: Rs.26,000

Here you will note that the interest income is being charged 30% tax rate and not 0%, 10% or 20%. This is what it means by margin tax rate.

The highest rate applicable for your salary income will be applicable on interest portion of the bank deposit.

Hence tax to be paid on interest income will be 30% of Rs.26,000.

Example2:

Taxable income from job Rs.995,000. Interest earned on bank deposit Rs. 26,000.

What tax will applicable on interest earned on bank deposit?

Salary Portion: Rs.9,95,000

Interest Income Portion: Rs.26,000

The highest rate applicable for your salary income will be applicable on interest portion of the bank deposit.

What is the highest rate applicate in this example2? 20%.

Hence tax to be paid on interest income will be 20% of Rs.26,000.

#8. How dividends paid by mutual funds are taxed?

We know that dividends paid by companies are tax free in the hand of the shareholders.

But not many people know how dividends paid by mutual funds are taxed.

The problem with mutual funds is that they are not of same type.

So, when mutual funds pay dividends, it is pertinent to understand what is the source of income.

#A. Equity based funds.

These funds has a portfolio which is 65% or more rich in equity.

These equity linked funds, book profits, and distribute it to their unit holders as “dividends”. .

The dividend is paid (by the fund house) after payment of corporate dividend tax (CDT).

Before Feb’2018, dividend paid by equity-based funds were not taxable in the hands of investors. 

But post Feb’2018, this dividend income is also taxed @10%. 

What does it mean?

It means, dividend received from equity based funds are not tax-free in hands of the investors. 

The investor must pay 10% tax on their dividend income originating from equity based funds. 

#B. Debt based funds.

These funds has a portfolio which has equity component less than 65%.

These debt funds earns majority of short term income in form of interests.

Here Dividend Distribution Tax (DDT) is applicable here.

The mutual fund house shall pay DDT @28.84% for debt based based. 

What it means for the investors?

DDT should be paid by the mutual fund companies, before distributing the dividends to unit holders.

So dividend received from debt based funds are tax free in hands of the investors. 

#9. How interest income is taxed?

Interest income is taxable at the marginal tax rate.

Not all interest is taxable, but majority is taxable. 

Government of India provides some “exemptions “in interest income as well.

Example: There are tax free bonds issued by government of India (Infrastructure bonds, NHAI Bond etc).

When NRI parks their money in India in form of bank deposit, the interest earned on such deposits are tax free.

There are some debt linked financial instruments, whose interest income is subjected to TDS.

What is TDS? Tax Deducted at Source. 

This TDS is collected to ensure that a portion of tax is received by the government upfront.

TDS is a small portion of income tax, that an investor shall pay on the accrued interest income. 

What does it means?

Lets relook at #7, Example-1. 

The person earned an interest of Rs.26,6000. On this interest the total tax to be paid was Rs.7.800. 

Suppose on payment of Rs.26,000 as interest, TDS of RS,1,2000 was already deducted. 

It means, the net tax payable by the person on the interest income will be only Rs.6,600 (7,800 – 1,200).

#10. Indexation benefit and income tax liability?

Indexation can dramatically reduce ones long term capital gain tax liability.

Indexation is nothing but adjusting ones cost of investment purchase for inflation.

Let’s see how this is done:

Example:

Suppose you bought a mutual fund unit @ Rs.150 in year 2012-13. This fund offers indexation benefits.

The units purchased in 2012-13 was sold in year 2016-17 at a price of Rs.200.

• What will be the capital gain in a normal case?
• What will be the capital gain applying indexation?

Long term capital gain (without indexation) will be Rs.50 (Rs.200-Rs.150).

Now lets apply the indexation.

To do this we will have to see the Cost of Inflation Index (CII) published by government of India. This is very readily available in internet.

From this chart I could get the following data:

• Index for year 2012-13: 852
• Index for year 2016-17: 1,125

Lets see how to use indexation to calculate net capital gain.

Actual cost of purchase of mutual fund units. Rs.150

Cost of purchase of mutual fund units (using indexation formula):

Cost after indexation = (index in year 2016-17 / index in year 2012-13) X Actual cost of purchase

= (1125/852) * 150 = Rs.198

Long term capital gain (after indexation) will be Rs.2 (Rs.200-Rs.198).

You can see, how long term capital gain has gown down from Rs.50 to Rs.2 due to indexation.

Indexation can dramatically reduce ones tax liability. 

#11. How capital gains are taxed?

Equity (Shares & equity oriented mutual funds):

• 15% – Short term capital gain tax (STCG)
• Conditions apply – Long term capital gain tax  (LTCG)

All other securities:

• At marginal tax rate – Short term capital gain tax (STCG)
• 10% – Long term capital gain tax  (LTCG) – without indexation
• 20% – Long term capital gain tax  (LTCG) – indexation

Exemptions:

LTCG is exempt from tax on sale of residential property if the profit is reinvested back to buy or construct another residential property in India.

The new residential property must be purchased within 1 year of sale of earlier property.

LTCG is again exempt from tax on sale of residential property if the profit is reinvested back to buy a bond issued by NHAI or REC.

This bond has a lock in period of 3 years.

The maximum LTCG that can saved using bond route is Rs.50 lakhs.

Final Words…

If one know the key income tax rules, it is possible to drastically reduce one’s tax liability.

This can be done by investing one’s money in such a way that, in addition to providing investing advantage, it also saves tax in short term.

As a honest citizen of country, it is good to pay tax to the government, but overpaying tax is not advisable.

When Government allows us to save on income tax, then why to overpay it?

Over payment of income tax can be prevented by doing immaculate income tax planning.

I know that a majority would like to save income tax in an ethical way.

But they fail to do so in absence of right information.

I hope this article will provide the needful information all in one blog post.