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, 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 reforms. The tax rates have been rationalized and tax laws have been simplified resulting in better compliance, ease of tax payment and better enforcement. The process of rationalization of tax 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, some corporate taxes, and transfer taxes such as estate (inheritance) tax and gift tax. Different direct taxes are as follows:

1. Tax on Corporate Income 2. Capital Gains Tax 3. Personal Income Tax 4. Tax Incentives5. Double Taxation Avoidance Treaty

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. Excise Duty 2. Customs Duty 3. Service Tax 4. Securities Transaction Tax

Basic concepts

1. Assessment Year 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 31st march of next year. For example, the current assessment year 2006-07 has begun on 1st April, 2006 and will end on 31st March, 2007.

2. Previous Year 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. Assessment 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. Assessee 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 as person in Income 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. Income 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

2) Rent

3) Business Income

4) Sale of property or capital profit

5) Any other sources of income

a) Income from salaries

b) Income from house property

c) Profits and Gains from business and profession

d) Capital gains

e) Income from other sources

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 2(24) of the Act the term “Income” includes:-

Profits and gains. Dividends Voluntary contributions received by

a) a charitable or religious trust, orb) a specified institution (e.g. a scientific research 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 chargeable-a) under sec 28(ii) and (iii) of the Act (compensation for termination of a

contract for directorship or agency; income from services to members earned by a trade association)

b) under sec 41 (profits chargeable to tax as income from business e.g. recovery of bad debts, sale of scientific research asset ) etc. or

c) under sec 59 (profits chargeable to tax as income from other sources e.g. recovery of expenses claimed earlier).

Profits on sale of an import license, taxable under sec 28(iiia). Export cash assistance received from Government, taxable under sec 28(iiib). Refund of customs or excise duty received or receivable against exports, taxable

under sec 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). 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), taxable under sec 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.

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.

Scope of Total Income The following points should be noted in regard to scope of income:

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, or deemed to be received in India, in the previous year, by or on behalf of such person.

b) Accrues or arises, or is deemed to accrue or arise to him, in India. During the previous year

c) Accrues or arises to him outside India, during the previous 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 deemed to be received, in India, in the previous year, by or on half of such person.

b) Accrues or arises, or is deemed to accrue or arise to him, in India, during the previous year.

c) Accrues or arises to him, outside India, from a business 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 India, or is deemed to be received in India, in the previous year, by or on behalf of such person.

b) Accrues or arises, or is deemed to accrue or arise to him, in India, 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 Act.

Nature of IncomeResident and

Ordinary Resident

Resident but not Ordinary

ResidentNon Resident

1) Income received in India Taxable Taxable Taxable

2) Income which accrues or arises in India

Taxable Taxable Taxable

3) Income deemed to be received in India

Taxable Taxable Taxable

4) Income deemed to accrue in India

Taxable Taxable Taxable

5) Income which accrues and arises outside India from a

business controlled from India or profession setup in India

Taxable Taxable Not Taxable

6) Any other income which accrues or arises outside India

Taxable Not Taxable Not Taxable

Practical Examples

1) Scope of Total Income 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 2008-2009:

1) Salary from X Ltd. earned in India Rs.25000 of which Rs.10000 was received abroad.Salary from Y Ltd. earned abroad Rs.100000 of which Rs.30000 was received in India.

2) Income from let out hose propertyi) Situated in India Rs.40000 of which Rs.12000 was received abroad.ii) Situated abroad Rs.75000 of which Rs.15000 was received in India.

3) a) Dividend on shares of Indian companyi) Received in India Rs.11000ii) Received abroad Rs.89000

b) Dividend on shares of foreign company

i) Received abroad Rs.79000ii) Received in India Rs.21000

4) a) Income from proprietary business earned in India Rs.35000 of which Rs.5000 was received abroad.b) Income from foreign business:

i) Controlled from India Rs.50000 of which Rs.9000 was received in India, while the balance was received abroad.

ii) Controlled from abroad Rs.70000 of which Rs.19000 was received in India and Rs.51000 was received abroad.

Nature of IncomeResident and

Ordinary Resident

Resident but not Ordinary

Resident

Non Resident

1) a)Salary from X Ltd earned in Indiai) Received in Indiaii) Received Abroad

b)Salary from Y Ltd earned abroad i) Received in India ii) Received abroad

2) Let out House propertya) Situated in Indiai) Received in Indiaii) Received abroadb) Situated abroadi) Received in Indiaii) Received abroad

3) a) Dividend on shares of Indian companyi) Received in Indiaii) Received abroadb) Dividend on shares of foreign countryi) Received in Indiaii) 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

1500010000

3000070000

2800012000

1500060000

1100089000

2100079000

300005000

900041000

1900051000

1500010000

30000NIL

2800012000

1500060000

1100089000

21000NIL

300005000

900041000

19000NIL

1500010000

30000NIL

2800012000

1500060000

1100089000

21000NIL

300005000

9000NIL

19000NIL

Total amount 595000 335000 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 status is to be determined for every previous year as it may change from year to year. It depends upon the number of days a person is in India during the concerned previous year.

2) Residential status is different from citizenship. An individual may be the citizen of Britain, but a resident in India. Similarly, an Indian citizen may be a non-resident in India.

3) Residential status is important in deciding whether foreign income of a 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 be resident in India for a period of 182 days or more during previous year

OR

B) He/she should be in India for a period of 60 days or more during previous year 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 citizen leaves India for a period of 60 days or more will be increased to182 days if he/she is there for employment / working as a member of crew of Indian Ship.

2) If an Indian citizen or a person of Indian origin comes to India for a visit during previous year.

An individual can be ordinarily resident in India:

C) If he is resident for any 2 years out of 10 preceding previous year AND

D) If he is in India for a period of 730 days out of last 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

1992-1993

1993-1994

1994-1995

1995-1996

1996-1997

170

59

110

39

210

196

1997-1998

1998-1999

1999-2000

2000-2001

2001-2002

125

105

121

157

183

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) Ascertaining whether a resident1) Mr. X is a citizen of India coming to India on a visit.2) Mr. X will be a resident only if he is in India from 1-4-2001 to 31-3-2002 for 182 days

or more.3) He is in India for 183 days from 1-4-2001 to 31-3-2002.

Conclusion: Mr. X is a resident as he satisfies the conditions.

B) Ascertaining whether an ordinary resident.1) Mr. X will be an ordinary resident if:-a) He is a resident for 9 out of 10 preceding years andb) He is in India between 1-4-1994 and 31-3-2001 for 730 days.2) Mr. X is a non-resident in the preceding 3 previous years 1998-99, 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 63 days in 2001-2002: 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 2nd 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 has been constructed or purchased with borrowed 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, any amount already allowed as deduction any other provision of the Act cannot be claimed again.

3) Interest is to be aggregated from the date of borrowing till the end of the previous year prior to the year in which the house is completed.

4) It should be noted that:(a) A fresh loan can be taken specifically to repay the 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 the late payment charges or interest on interest cannot be deducted.

(c) Brokerage paid for arranging the housing loan cannot be deducted.(d) Only simple, and not compound, interest can be 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) 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

ii) Where the property or any part of it is let and the actual rent received or receivable by the owner in respect thereof is in excess of the amount received or receivable.

iii) Where the property or any part thereof is let and was vacant during the whole 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 Amount Particulars Amount

1) Municipal taxes paid by Mehra.

2) Fire insurance.3) Collection charges.4) Repairs.

4000

2400

500

2000

5) Land revenue.6) Ground rent paid.

3800

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 ValueHigher of RLV (Rs.24000) or Rent received (Rs.30000)

Less: Municipal taxes paidNet Annual Value (A-B) Less: Deductions u/s 24

1) Standard Deduction (30% of 26000)

2) Interest on borrowed funds during previous year.

3) Interest on borrowed funds during pre-construction period.

E) Net Income from House Property (C-D)

7800

4000

2400

30000

4000

26000

14200

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-construction interest is computed as follows:a) Construction completed in previous year 2001-2002.b) Pre-construction period = Period from date of borrowing to end of Preceding

Financial Year = 1-4-1998 to 31-3-2001.c) Pre-construction Interest = Rs.40000 x 10% x 3 years = Rs.12000.d) Pre-construction Interest Allowance during current previous year = 1/5 x 12000 =

Rs.2400.