Beginner

Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.

Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.

This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.

Tax is defined as a compulsory contribution to state revenue, levied by the government on your income and business profits, or added to the cost of some goods, services and transactions. The important part of this definition is compulsory contribution to state revenue. You have no option but to pay your taxes.

5 main heads of income under the income tax law:

Your income is broadly classified under five heads for the purpose of taxation. The five heads are:

• Salary: If you are employed, all the income that you derive from your employer will be taxed under this head according to your applicable tax bracket. Your taxable income will include your salary, bonus, perquisites, commissions, allowances and almost everything else that your employer gives you in cash or kind but you can also benefit from certain deductions such as House Rent Allowance (HRA), contribution towards PF etc. For example, if your salary is Rs 1,00,000 per month, you may only get Rs 70,000 in hand because Rs 30,000 can get deducted in tax, assuming that your applicable tax bracket was 30% and there were no eligible deductions declared. 

• Income from house property: If you derive rental income from letting out a home or shop or such property, then the rental income would be taxed under this head. In order to calculate the taxable rental income, municipal tax and the interest paid are deducted from the net rental income.

  For example: Your property which is on rent, gives you a rental income of Rs 1,80,000 per annum. Assessee would be allowable for repair and maintenance of the property, rent collection expenses etc a standard deduction, equivalent to 30%. In this example it would be 30% X Rs 180,000, or Rs 54,000. Therefore, your effective rental income will be Rs 180,000 – Rs 54,000, or Rs 1,26,000.

  Let us also say that you bought this property with a loan, the interest on which, is Rs 1,25,000 annually. This expense will need to be deducted from the rent income to get the taxable income. In this case the taxable rental income is Rs 1,26,000 – Rs 1,25,000, or Rs 1000. Tax will need to be paid on this amount, which is simply added to your taxable income from salary, and other income sources and treated similarly as per the applicable tax bracket.

• Profits and gains of business or profession: If you run a business or profession, all your profits, gains, interest on capital, etc. would be taxed under this head. For example, you are running a consultancy business and getting a consultancy fees of Rs 2,00,000 per month. You may also have corporate expenses of Rs 50,000 (expenses such as salary, travelling and conveyance, mobile expenses, etc). Your taxable income will simply be your earnings – your expenses, or Rs 1,50,000 (Rs 2,00,000 – Rs 50,000). This amount will now be treated for tax purposes according to your applicable tax bracket.

• Capital gains: Capital gains refer to the gains that you may make, by investing your capital in assets like shares, immovable property, gold, mutual funds, bonds, debentures etc.  Let us take an example: the purchase price for an equity mutual fund in Jan 2016 was Rs 100 and the redemption price in Dec 2018 was Rs 180. The capital gains you would have earned are Rs 180 - Rs 100 = Rs 80 {However, you would need to pay 10% on Rs 80 as the Finance Bill, 2018 has proposed to introduce tax on Long term capital gains made by investing in equity oriented mutual funds and shares at the rate of 10% on capital gains in excess of INR 1 lakh without indexation (12 months is treated as a ‘long term’ cut off period for equity oriented investments)}. If on the other hand the value of your investment increased by Rs 20 but you withdrew your investment as early as Nov 2016 itself, you would need to pay a 15% tax on it, as per the tax laws.

  Debt mutual funds are taxed differently and this has been explained with an example slightly later in this article.

  In computing long term capital gain, the benefit of cost inflation index is also available. (for meaning of indexation see later in this part)

• Income from other sources: Any other income that does not fit into the above mentioned heads would get taxed under this head. For example, Interest income, Dividend Income, gift received in excess of Rs.50,000/- other than from relatives, income earned by winning a lottery is taxable.

It is therefore important that you classify your income carefully as the tax treatment of the same could be different under each head.

Do also note that a certain part of your income is designated as tax-free: for instance, interest earned on Provident Fund, Medical Reimbursement (up to Rs 15,000), Gratuity (up to Rs 10 lakh), Provident Fund withdrawals (which are tax free provided you have completed 5 years of membership), Employers contribution to Provident Fund, Employers contribution to National Pension Scheme (up to 10% of basic salary), and so on. Consult your tax advisor for more information.

How can you create a statement of total income?

To prepare your statement of total income, you just need to add your income under all the above heads, after considering any deductions within each head that you are eligible for. Once you do this, deduct the exemption that you are eligible for, under various sections of income tax regulation (e.g. section 80C, 80D, etc to derive your total taxable income. If you are confident that you possess adequate knowledge to do this, you may go ahead and do it on your own. Otherwise you would do well to seek the service of a Chartered Accountant or Tax Return Preparer (TRP).

Investments that can fetch you tax deductions under section 80C

It is not that you can’t save on your income tax liability. By making certain specified investments of up to Rs 1.50 lakh in a financial year, you can save tax every year. Which will depend on your total taxable income and the tax slab under which your income fall. The investments that qualify are:

• ELSS schemes/Tax Saving mutual fund schemes 

• Life insurance premium

• National Savings Certificate offered by the post office

• 5-year bank deposits

• Senior Citizens Savings Scheme

• Sukanya Samridhi Scheme offered by the post office

• Public Provident Fund

Tax-free Income: Long Term Capital Gains and Dividend

You may also save tax by making smart decisions that can enable you to achieve tax-free gains. These are:

• Long Term Capital Gains (LTCG):The Finance Bill, 2018 has proposed to introduce tax on long term capital gains made by investing in equity oriented mutual funds and shares at the rate of 10% on capital gains in excess of INR 1 lakh without indexation (12 months is treated as a ‘long term’ cut off period for equity oriented investments). This is however not the case when you invest in debt oriented funds or fixed income securities. If you hold the investment for more than 36 months, Long term capital gains will be taxed at 20% with indexation benefits.Indexation, when it comes to debt mutual funds, refers to the practice of adjusting your original investment purchase price for inflation, which helps reflect the true value of the profit you’ve earned.

  To understand this better, let’s assume that the purchase price for a fixed income fund in 2010 was Rs 100 and the redemption price was Rs 180. If the inflation index for 2016-17 is 1125 and for 2010-11 was 711, your investment’s true purchase cost today would be= Rs 100 X (1125/711), or Rs 158. The 20% tax you need to pay will now be calculated on Rs 180- Rs 158, or Rs 22 and not on Rs 180 - Rs 100, or Rs 80.

• Dividends: As per Finance Bill, 2018, 10% Dividend Distribution Tax (DDT) is proposed to be levied on dividends distributed by equity oriented mutual fund schemes. Dividends distributed by debt oriented funds are also subject to DDT. Dividends received from shares of companies are exempt from income-tax in your hand upto Rs. 10,00,000/-( balance being taxable at flat rate of 10% to be increased by applicable surcharge and cess).

Tax slabs and tax rates

Your tax liability would depend on the size of your income with higher income being subject to progressively higher taxation. The table below explains it in detail:

*In addition deduction will be available as explained above, If invested in any of the instruments mentioned in the “Investments that can fetch you tax deductions under section 80C”.

Health and Education cess at 4% is applicable on the tax computed as above. If your taxable income is between 50 lakhs and 1 crores, you would be liable to a surcharge of 15% and if taxable income is between 1 crores and 10 crores (in case of individuals/ HUF/ BOIs/ AOPs and Artificial juridical persons) of the tax amount.

Tax is a fairly important consideration while making investments. You need to consider post-tax returns on your investments. You should also know if your investment qualifies for tax breaks.