income tax

In this article, Aashish Ahuja, a student of B.A.LL.B. Hon’s at University Institute of Legal Studies, Shimla, Himachal Pradesh University discusses legal provisions relating to income tax laws which every entrepreneur should know about

Few fundamental facts about Income Tax

Income tax can be defined as an annual charge which is levied on both earned income i.e. wages, salaries, and commission as well as unearned income i.e. dividends, interests, rents, etc. The two basic types are as follows:

  • Personal Income Tax which is levied on personal income of individuals, sole-proprietorships, households, and partnerships; and
  • Corporation Income Tax which is levied on profits of the incorporated firms. However, due to the presence of some loopholes, wealthy persons escape higher taxes without violating the tax laws.
  • According to Section 2(13) of Income Tax Act, 1961, business includes any trade, commerce or manufacture or any adventure or concern in the nature of trade, commerce or manufacture.
  • Section 28 of the Income Tax Act, 1961 deals with the income to be chargeable to income-tax under the head “Profits and Gains of business and profession.”

Tax exemption to startups for upto three initial years

  • Finance Minister, Arun Jaitley while announcing Union Budget 2016-2017 in Parliament proposed to exempt the tax for three years to give a much-needed boost to the budding entrepreneurs and promote the growth of startups. It was declared that startups would not incur any taxes on profits in the first three years.
  • However, innovation is the essence of every startup, and young minds kindle new ideas every day to think beyond conventional strategies of the existing corporate world. In the initial years, entrepreneurs struggle to evaluate the feasibility of their business idea, and capital investment is made to fight with the rising competition and navigate through unique challenges.
  • Also, the small and growing entrepreneurs have limited alternate financial resources, leading to constrained cash funds.

Thus, for three initial years, the profits of a startup are exempted from the income tax to facilitate their growth and development and given them a competitive platform.

Scope of income tax

Income Tax Act, 1961 contains the income tax laws and covers the following matters:

  • The basis of charging income tax.
  • Computation of income tax under various heads
  • Exempted incomes
  • Permissible deductions from income.
  • Rebates and relieves from income tax.
  • Clubbing of income.
  • Set off and carry forward of losses.
  • Double taxation relief.
  • Special provision for avoidance of tax.
  • General Anti-Avoidance Rules.
  • Determination of Tax.
  • Determination of residential status.
  • Special Provisions relating to companies.
  • Special Provisions for limited liability partnership.
  • Tax on dividend distributed by domestic companies.
  • Income tax authorities and their powers.
  • The survey, search, and seizures.
  • An assessment of income tax liabilities of assesses.
  • Tax Deduction at Sources.
  • Advance taxes.
  • Refunds.
  • Appeal and revisions.
  • Acquisition of immovable properties.
  • Penalty and Prosecutions.

The income tax rules prescribe the procedures, time limits, conditions and return form, etc. for implementation of various provisions of the act.

Income tax returns

Income tax return is considered as the most authentic proof of the income earned. In India, there is a system of self-declaration, wherein one is required to file income tax returns within the due date showing the income details, but due to some reasons, many people do not file tax returns because of the following reasons:

  • Tax at source has been deducted at source.
  • Filing of income tax return is considered as a time-consuming process.
  • Deadline for filing a tax return is far away.
  • The deadline has already passed away, so it is irrelevant to file income tax return.

Benefits of filing income tax returns

  • Tax refunds can only be claimed if the tax returns are filed. Unless one files income tax return, they will not get the extra taxes refund.
  • One can be saved from proceedings and assessments of income by income tax officials by filing timely and fair returns. A person may end up having to pay tax with interest and penalty if the IT department picks up his case.
  • If a business is having losses and want to carry forward it and set off with the future profits, then it is possible only if it files the tax return within due dates.
  • For making an investment, income tax return is essential, and it proves that you have a valid source of income for making the investment.

The different tax forms available for filing of tax returns

Form ITR-4

This form is used by the individuals who conduct a business or who earn through a profession and applies to any business, undertaking or profession on no limit of the income earned. The taxpayers can also club any income from salaries, speculation, lotteries, housing properties, etc. with the income earned from business.

Form ITR-4S

The form is also known as ‘Sugam’ form and can be used by the individuals who earn their income from any business. This form is used in special circumstances and applies to businesses where income earned is based on the presumptive method of calculation.

Form ITR-6

It is to be used by the companies other than the companies claiming exemption under section 11 of Income Tax Act, 1961.

Form ITR-7

It is to be used by the persons including companies required to furnish a return of income under section 139 (4A), 139 (4B), 139 (4C) or 139 (4D). The form can be filled either electronically or in the paper form.

Capital Gains

  • Capital Gain can be defined as any profit or gain which arises from the sale of a capital asset and is charged to tax in the year in which the transfer of the asset takes place. When an asset is inherited, then there is no capital gain as there is no sale but only a transfer.
  • Capital gain is applicable only if the asset is sold by the person who inherits it. Assets received as gifts by way of inheritance or by will are exempted from the Income-tax Act.

The difference between short-term capital gains and long-term capital gains

Short-term capital gain Long-term capital gain
Short term capital gains are obtained by sale or exchange of capital assets held for one year or less than one year. Long-term capital gains are obtained by the sale or exchange of capital assets held for more than one year.
The tax rates for short-term capital gains are higher than the tax on long-term capital gains. The tax rates are less in long-term capital gains.
Such gains are obtained by sale or exchange of shares. Such gains are obtained by sale of long-term assets such as real estate.
  • The difference between short-term capital gains and long-term capital gains depends upon the time frame for which they are held. Their nature and structure are very similar to each other.
  • The longer the assets are held, higher is the risk of fluctuation in the value, and this is the reason why long-term gains are taxed at a lower rate than short-term capital gains.

Tax on short-term and long-term capital gains

Tax on long-term capital gain

 Long-term capital gain is taxable at 20% along with surcharge and education cess.

Tax on short-term capital gain

Short-term capital gain is taxable at 15% along with surcharge and education cess if securities transaction tax is not applicable.

Exemptions on capital gains

  • The Finance Ministry has introduced in sections 53 to 54H to provide exemptions on capital gains if sale proceeds realized are invested into assets specified in the respective sections.
  • For example, Section 53 of the Income Tax Act, 1961 says that the capital gains arising out of the sale of the residential house are exempted if sale proceeds realised from the sale are reinvested in the purchase or construction of the new residential house.
  • Furthermore, section 54 EC provides that the capital gains arising from the sale of capital assets are exempted if such sale proceeds are invested in bonds of government companies notified by the government from time to time.

The appropriate ITR form

One needs to fill ITR form 2 as it declares the income from capital gains, all house properties, and other sources. (Including lottery)

Tax on ESOPs (Employees Stock Ownership Plans)

  • ESOPs stands for Employees Stock Ownership Plans. ESPOs are similar to profit-sharing plans and allow the owners of private companies to share their ownership with their employees. These are the good ways to motivate the employees and increase the distribution of shares of the company and create a market for them.
  • ESOPs can be defined as contribution employee benefit plans that invest in the stock of the employer company. However, ESOPs distribute the stock of the company to employees as a benefit instead of selling the shares to employees.
  • Employees Stock Ownership Plans gives way for the retiring owners to cash out their holdings without selling the entire company. As such, to raise funds for expansion, creating a market for shares can also be used.
  • These are the stock options granted over a vesting period to employees where they are given the right to purchase the company’s shares at a predetermined price or exercise price, and if the employee does not exercise the option within the prescribed time of the company, the option automatically expires.
  • ESOPs benefits received by the employee are taxable as a prerequisite for tax purposes. It is the difference between the fair market value of the shares on the date of exercise of options less the exercise price, and however, it shall be taxable only if shares are allotted under ESOPs.

Ways of reducing income tax liability

Proper recording of cash expenses

Most of the businesses in the country are labour intensive, and the wages of the unorganized labour are generally paid in cash. Improper recording of payments results in higher profits as a consequence of under-recording of expenses and results in higher amount of taxes. A proper register should be maintained along with the cash receipts to avoid extra taxes.

Always deduct tax at source

Tax which is deducted at source is deducted from an individual’s income on a periodical basis and is applicable to income which is either regular or irregular. Income Tax Act, 1961 regulates TDS in India through Central Board of Direct Taxes under Indian Revenue Services. It is applicable for salary, commission, interest, rent, professional fees, etc.

File your income tax return on time

To avail the benefits, income tax department suggests filing the income tax return on time. Carry forward of losses in the business income is one of the main benefits. The losses in the business income can be carried forward for a consecutive period of 8 years and hence can be set off against the income of the coming years if it is not set off with the income of the current year. As such, the benefits can only be availed if the income tax return is filed on time.

Depreciation

Depreciation is the decrease in value of assets and reduces the amount of taxes paid in the form of depreciation expense on the income statement. The depreciation expense of a company is recognized on the income statement after all revenue, the cost of goods sold and operating expenses have been paid. A company’s tax expense is calculated from the income statement reflecting the earnings before interest and taxes.

MAT (Minimum Alternate Tax)

MAT stands for “Minimum Alternate Tax.” This concept was introduced for companies, and it has been made applicable to all other taxpayers in the form of AMT (Alternate Minimum Tax).

  • At times it may happen that a company may have generated income during the year, but it may have reduced its tax liability or may not have paid the tax at all by taking the advantages of various provisions of income tax law such as exemptions, deductions, depreciation, etc.
  • The Finance Act, 1987 introduced MAT with effect from the assessment year 1988-89 due to increase in a number of zero-tax companies and later on, it was withdrawn by the Finance Act, 1990 and re-introduced by Finance Act, 1996 with effect from 1st April 1997.
  • The main objective of MAT is to bring into tax net “zero tax companies” which do not pay any tax due to various tax concessions and incentives provided under income tax law even after earning substantial profits and paying handsome dividends.

MAT Credit

The provisions related to the adjustment of MAT credit and carry forward are given in section 115JAA. A company is liable to pay as per MAT provisions or has to pay higher of normal tax liability, and if in any year it pays liability as per MAT then it is entitled to claim credit of MAT paid over and above the normal tax liability in the subsequent year. 

Period for which MAT credit can be carried forward

The MAT credit can be carried forward for adjustment in the subsequent year; however, it can be carried forward for a period of 10 years after which it lapses. In other words, if the company does not utilise it within ten years, MAT credit lapses. As such, the taxpayer is not paid any interest in respect of such credit.

LLP Vs Private Limited Company tax implications

On January 9, 2009, the Limited Liability Partnership Act, 2008 was published in the Official Gazette of India. The Act has been notified with limited sections only, and the rules have been notified in the Official Gazette on 1st April 2009. In the first week of April 2009, the first LLP was incorporated.

  • An LLP is treated like any other partnership firm in India.
  • There is no joint liability created by the partners, and no partner is liable on account of unauthorized actions of other partners.
  • LLP is a body corporate and a legal entity separate from its partners and has perpetual succession.
  • Indian Partnership Act, 1932 is not applicable to LLPs and there is no upper limit on the number of partners in an LLP unlike other partnership firms where the number of partners cannot exceed 20.
  • The provisions are made for corporate actions like mergers, amalgamations, etc.
  • The existing partnership firm, private limited company and unlisted public company can be converted into an LLP by registering with the Registrar of Companies.

Tax Implications on LLP

Limited Liability Partnership is a new type of business entity in India. The income of the LLPs is taxed at the rate of 30%. The taxation policy of an LLP is similar to that of partnership firm. The income of a partnership firm is taxed at the rate of 30% plus 2% education cess and 1% secondary and higher education cess, which is similar to that of private limited company.

Taxation on LLP Partner Remuneration and Interest

Deduction for remuneration and interest on capital provided to the LLP can be claimed by a partner while arriving at taxable income of Limited Liability Partnership. There must be a specific provision in the LLP agreement to claim partner remuneration and interest on capital. The clauses must be clearly specified in the LLP agreement that allows for payment of remuneration and interest on capital and the loan provided by the partners.

Profit Remuneration Deductible
On the first Rs. Three lakhs of book-profit or in case of loss Rs. 1.5 lakhs or at the rate of 90% of book profit
On the balance of book profit At the rate of 60% of book profit

LLP Partner Income

  • Interest from LLP or the receipt of remuneration is taxed as business income in the hands of LLP partner. For business purposes like interest payments and business loss of proprietary business, the expenses incurred can be set off against receipt of interest and remuneration.
  • While making payment of interest and remuneration to LLP partners, no TDS deduction is necessary. A designated partner signs the income tax filing return of LLP, and if he is unable to sign for unavoidable reasons, then it is signed by other partners.

Private Limited Company

A private limited company can be defined as a voluntary association of persons of not less than two and not more than fifty members, whose liability is limited and the transfer of whose shares is limited to its members and the general public is not invited to subscribe to its shares or debentures.

  • The liability of the members is limited.
  • The shares allotted to the members are not freely transferable between them.
  • Its existence continues even if all the members die or desert it.
  • Shares are not freely transferable.
  • The general public is not invited to subscribe to its shares.

A company is liable to pay tax on the income of the corporate. The income tax is levied on the private limited company at the rate of 30%.

Dividend distribution tax is charged at the rate of 16%. When a company pays a dividend, it is subjected to dividend distribution tax.

  • Minimum Alternate Tax is the third kind of tax applicable to a company. Using a straight line method, many companies charge depreciation in their books and the accounts maintained for the company law purposes shows that the profits are higher and declare as dividend. For the purpose of income tax, depreciation is charged on the written down value which is higher, and the company may show
  • For the purpose of income tax, depreciation is charged on the written down value which is higher and the company may show low profit or even loss. Such companies are known as zero tax companies.
  • If the income tax payable on the total income as calculated under the Act is less than minimum, then a company has to pay minimum alternate tax on its book profit which is accessed at the rate of 18% according to latest Finance Act.

Transfer Pricing

A transfer price is defined as the price at which the divisions of a company transact with each other, such as the trade of supplies or labour within departments. These prices are used when individual entities of a larger multi-entity firm are treated and measured as separate run entities.

  • India has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same group due to increase in participation of multinational groups in economic activities.
  • Hence, in the case of such multinational enterprises, there was a need to introduce a uniform and internationally accepted mechanism of determining reasonable, fair and equitable profits and tax in India. As such, the Finance Act, 2001 introduced
  • As such, the Finance Act, 2001 introduced law of transfer pricing in India through sections 92A to 92 F of Income Tax Act, 1961 which guides the computation of transfer price and suggests detailed documentation procedures.
  • The regulations of transfer pricing apply to all enterprises that enter into an international transaction with an associated enterprise and to all cross-border transactions entered into between associated enterprises. The main aim is to arrive at a comparable price as available to an unrelated party in open market conditions and is known as Arm Length’s Price.

Tax Deducted at Source (TDS)

TDS stand for ‘Tax Deducted at Source.’ It is a type of tax which is deducted from an individual’s income on a periodical basis and can be applicable to income that is regular as well as irregular in nature. TDS is regulated by Income Tax Act, 1961 through Central Board of Direct Taxes under the Indian Revenue Services and directs the employer to deduct a certain amount of tax before making full payment to the receiver. It is applicable for salary, commission, professional fees, etc.

Any source which withholds a small percentage of overall payment while making payments is known as deductor. A person whose payment is deducted is known as deductee. For example, when a deductor is an employer paying salary to the employee who is a deductee.

Advantages of TDS

  • Responsibility sharing for deductor and tax collection agencies.
  • Prevents tax evasion.
  • Widens the tax collection base.
  • A steady source of revenue for the government.
  • Easier for a deductee as tax gets automatically collected and deposited to the credit of the central government.

When TDS is not deducted

On payments made to the Reserve Bank of India, the Government of India, etc. TDS is not collected. TDS will not be collected when interest is credited or paid to:

  • Central or State Financial Corporations.
  • Banking companies.
  • Interest paid under Direct Taxes or refund from the IT department.
  • UTI, LIC and other insurance or co-operative societies.
  • Interests earned from recurring deposit or savings account in cooperative societies or banks.
  • Interest in Indira Vikas Party, KVP, or NSC.
  • Interest earned in NRE account.
  • All institutions notified under no-TDS.

TDS Certificate

  • It can be difficult to keep track of deductions by an individual as TDS is collected on an ongoing basis. According to section 203 of the Income Tax Act, the deductor has to furnish a certificate of TDS payment to the deductee/payee.
  • This certificate is also offered by banks making deductions on pension payments etc. At the deductor’s own letterhead, the certificate is issued. Individuals are advised to request for TDS certificate wherever applicable, and if not already provided.

Provisions of Audit

Tax Audit means a close examination of a tax return by internal revenue system to verify that the income and deductions are accurate. The taxpayers have to get the audit of accounts of their business or profession according to the provisions of income tax law.

Section 44AB of the Income Tax Act, 1961 covers the provisions of tax audits in India. According to the requirement of this section, an audit of accounts of the taxpayer is done by chartered accountant. The chartered accountant prepares the audit report and submits his findings.

Objective of Tax Audit

  • To ensure that the records of the assessee and the books of accounts are properly maintained.
  • The income of the taxpayer and deductions must be clearly mentioned in the books of accounts.
  • Proper presentation of accounts before the tax authorities facilitates proper administration of tax laws and save the time of assessing officers in carrying out routine verification.

Who should get their books audited

As per section 44AB, a person has to get his books of accounts audited by chartered accountant if he satisfies the following conditions:

  • An individual is carrying on any business and his turnover or total sales for the financial year exceeds 1 crore.
  • A person is carrying on any profession and his gross receipts for the financial year exceed 25 lakhs.
  • Where profits and gains from the business are determined on a presumptive basis under section 44AD and who has claimed his income lower than the profits of the business, yet exceeds the amount which is not chargeable as income tax.
  • Where profits and gains from the business are determined on a presumptive basis under section 44AE, 44BB and 44BBB and have claimed his income to be lower than the profits of the business.

Form 3CA, 3CB and 3CD

  • The chartered accountant must furnish the tax audit reports before income tax authorities in a prescribed form.
  • If the books of accounts of a person, carrying on any business or profession, are required to be audited under any law, form 3CA must be chosen and if not, then form 3CB must be used. Form 3CD must be accompanied by forms 3CA/3CB where prescribed particulars are reported.

Speculative Transactions

Speculation is considered as an act of trading in an asset or conducting a financial transaction that has a significant risk of losing most or all of the initial outlay with the expectation of a substantial gain.

Section 43 (5) of the Income Tax Act, 1961 deals with the speculative transactions. A speculative transaction is a transaction of purchase or sale of a commodity including stocks and shares settled otherwise than by actual delivery or transfer of a commodity.

Speculative Business Income

Income generated from intra-day trading is considered as speculation income. According to section 43 (5) of Income Tax Act, 1961, intra-day trading is considered as speculation business transactions and the income generated would be either speculation gains or speculative losses. The income generated from speculation gains is taxed at normal rates.

Intra-day trading means trading of shares within the same day. Delivery is not taken in such trading and thus, are said to be speculative transactions. The shares enter and exit on the same day from the trading account and does not enter DEMAT account at all.

Tax Treatment

Tax treatment is similar to the business income tax.The profit earned from intra-day trading is categorised under speculative business income and is taxed as per the tax slab you fall in while losses can be offset only against speculative gains.

Conclusion

It is vital to discuss with your tax accountant or attorney, no matter which legal form you choose, to make sure that you are operating legally and getting the best deal on your taxes. Thus, the statute of income tax in India is the Income Tax Act, 1961 and provides for levy, administration, collection and recovery of income tax.

Hope the article added value to your knowledge. Feel free to share more such unique provisions of income tax laws by commenting below and don’t forget to share. 

Read more on income tax laws

E-filing of Income Tax Returns

Taxation System in India

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