Financial planning has been best defined as a strategy to channelise personal savings and investments to maximise personal income and wealth and minimise personal taxation.
In a system that taxes income and wealth at a flat rate, without giving any exemptions, deductions or reliefs, tax planning is pointless. Tax planning assumes significance in a tax system like ours which has graded rates of tax and provides the taxpayer the opportunity to avail of incentives as exemptions, deductions and reliefs.
Some 35 years ago, the Indian taxpayer had to live with a system of direct taxes, where the maximum rate of income tax was 97.5 per cent, wealth tax 5 per cent, estate duty 85 per cent and gift tax 75 per cent. Over the years, we have seen the total abolition of estate duty, and considerable reduction of gift tax and wealth tax. Current Indian income tax rates, for both personal and corporate taxation, can be favourably compared with some of the most progressive economies in the world.
If in FY 2004-05, the basic income tax exemption limit was Rs50,000 and taxable income exceeding Rs1.5 lakh attracted the maximum tax rate of 30 per cent, in FY 2014-15, the basic income tax exemption limit is Rs2.5 lakh (Rs2 lakh for FY 2013-14) and the maximum tax rate of 30 per cent is attracted only if the taxable income exceeds Rs10 lakh.
THE GOLDEN SECRETS
The two golden secrets of tax planning are:
Share your income and lower your tax rate
Avail of incentives and augment your tax savings
Imagine yourself on Kaun Banega Crorepati’s hot seat and Big B asking you this rapid fire question: 'How much income tax would you need to pay in FY 2014-15 on taxable family income of Rs34,50,000?’ You are given your four choices A—Rs3,86,250; B—Rs4,01,700; C—Rs5,68,560; and D—Rs7,83,250.
Your would be tempted to go for the lowest figure, though you would have no clue how to justify it? To your delight, your answer is correct! It is now possible for an individual, his wife and his Hindu Undivided Family (HUF) to earn collectively a taxable income of Rs34,50,000 and pay an income tax of just Rs3,86,250, at an average rate of around 11.20 per cent.
Take a look at the following illustration.
Mr TP, Mrs TP and the HUF of the TPs plan to earn Rs11.5 lakh each, totalling Rs34.5 lakh. They plan to make savings and allocations of Rs1.5 lakh in each case and get the benefit of deduction under section 80C. On the taxable balance of Rs10 lakh in the three cases, as per the tax rates effective for FY 2014-15, the income tax (including 3 per cent education cess) payable would be Rs1,28,750 each. Thus the total tax would be Rs3,86,250, at an average rate of just around 11.20 per cent.
Even after allocating the resources of Rs4.5 lakh for deduction under section 80C and the tax payment of Rs3,86,250, the TP family would still enjoy a liquidity of Rs26,13,750, giving them the freedom to spend more than Rs2,17,813 a month.
The illustration has not taken into consideration other commonly availed deductions such as payment of premium for medical insurance (up to Rs15,000 under section 80D) and deduction of up to Rs2,00,000 under section 24 (effective from FY 2014-15) for payment of interest on housing loan. It has also not taken into consideration the scope of earning additional incomes by way of PPF interest, dividends and long-term capital gains from listed securities, which are totally exempt from income tax under section 10.
TAX PLANNING OF GIFTS
Gift tax was abolished in 1998. But, in 2004, taxing of gifts as income was introduced. Section 56(2)(vi) of the Income Tax Act provides that, “where any sum of money aggregating to more than Rs50,000 is received without consideration by an individual or HUF from one or more persons, the whole of such sum shall be chargeable to tax as income from other sources.”
However, exceptions have been carved out in respect of any sum of money received from any relative or on the occasion of the marriage of the individual or under a will or by way of inheritance or in contemplation of death of the payer or receipts from any local authority as defined in section 10(20) or fund, foundation, university, educational institution, hospital or other medical institution referred to under section 10(23C) or receipt from any trust or institution registered under section 12AA and accordingly such receipts will be exempt from tax.
The term ‘relative’ has been defined to include the individual’s spouse, brother or sister of the individual or spouse, brother or sister of either of the parents of the individual, any lineal ascendant or descendant of the individual or spouse and, finally, the spouse of any of the above-referred persons.
The Finance Act, 2012, widened the definition of relative under section 56(2)(vii) by providing that in case of a HUF, any member thereof shall be treated as a relative. Therefore, an HUF can also make or receive gifts, to or from any of its members. It is important to note that this amendment has been made retrospectively with effect from October 1, 2009. However, in case of any gift being made by an individual to his HUF, the impact of the clubbing provisions under Section 64(2) needs to be borne in mind.
Section 56(2)(vi), as originally introduced, had cast income tax liability only in respect of a ‘gift of any sum of money exceeding Rs50,000’. In view of this clear language, any gift received in kind (not being any sum of money) clearly fell outside the liability for income tax, irrespective of the value of such gift. However, as per the provisions of section 56(2)(vii), in case of nine specified properties received by an Individual or HUF, either by way of gift or for a purchase consideration that is treated by the assessing officer as inadequate, the market value of such gift or the differential value of such purchase is also taxed as income from other sources. The properties are land and building, shares and securities, jewellery, archaeological collections, drawings, paintings, sculptures, any work of art and bullion.
The continuance of the clubbing provisions under section 64 of the Income Tax Act, which are aimed at serving as a deterrent for gift-tax planning, should also be kept in mind. As per the provisions of section 64, the income arising out of assets gifted by an individual to his/her spouse or son’s wife is liable to be clubbed while computing the taxable income of the individual. Similarly, any income arising to the minor child is also liable to be included in the total income of the father or mother, whosoever’s income is greater. However, such clubbing would be attracted only when the child is minor.
The clubbing provisions also cover within its scope the income arising out of assets gifted by an individual to an HUF of which he or she is a member. Keeping in view the graded tax rates for computing income tax, the greatest benefit of saving in income tax through planning of gifts can be derived, when a gift is made to a person not covered within the scope of the clubbing provisions and in whose case the income from the gifted assets would be either totally exempt, or would attract tax at a lower rate as compared to that of the person making the gift.
With effect from the assessment year 1993-94, the basic exemption limit for wealth tax applicable for individuals, HUFs and companies was raised from Rs2.5 lakh to Rs15 lakh and the rate of tax was fixed at a flat 1 per cent. It took another 17 years to review this basic exemption limit. From March 31, 2010, relevant to assessment Year 2010-11, the said exemption limit has been revised to Rs30 lakh.
The following six kinds of assets, considered to be unproductive, have been made liable to wealth tax:
Any building or land appurtenant thereto, including a residential house, guest house or farm house. However, a residential house allotted by a company to an employee, any house for residential or commercial purpose held as stock in trade, any house occupied by the taxpayer for the purpose of his business or profession, any residential property let out for a minimum period of 300 days, any property in the nature of commercial establishments or complexes have been exempted from wealth tax.
Motor cars, excluding those used for the business of running them on hire or held as stock in trade.
Jewellery and ornaments, including articles made of precious metals or stones, but excluding items held as stock in trade.
Yachts, boats and aircraft, excluding those used for commercial purposes.
Urban land. That is land situated in any area within the municipal limit.
Cash in hand in excess of Rs50,000 in the case of individuals and HUFs. In other cases, any amount not recorded in the books of account would be treated as liable to wealth tax.
Under section 5 of the Wealth Tax Act, a special exemption has been granted in respect of one house property or a plot of land not exceeding 500sq.m belonging to an individual or an HUF.
Keeping in view the joint family system prevailing in India where the financial affairs of the family are generally managed and controlled by the male head of the family, it is common to come across situations where the family head plans holding of assets and deriving income in the hands of his wife or son’s wife (daughter-in-law), thus availing the advantage of tax planning under the Income Tax Act.
The abolition of gift tax in 1998 threw open several opportunities for planning to reduce a taxpayer’s income tax and wealth tax liabilities. Moreover, even under the provisions of section 56(2) seeking to treat gifts exceeding Rs50,000 as income, gifts made to ‘a relative’ have been duly exempted. However the ‘clubbing provisions’ under both the Income Tax and Wealth Tax Acts seek to guard against tax-avoidance through the route of gifts to close members of the family such as spouse and son’s wife.
Section 64(1) of the I-T Act provides that in computing the total income of an individual, the income arising to the spouse or son’s wife from assets gifted to them by the individual would be clubbed with the total income of the individual. Similarly, section 4 of the Wealth Tax Act provides for inclusion of such gifted assets by the individual to the spouse or son’s wife in the computation of net wealth.
If the transferee continues to accumulate the income arising from the gifted asset and further income is generated from such accumulated income, such income is not liable for clubbing under section 64. Similarly, for purposes of wealth tax, such accretions to the gifted asset are also not liable for clubbing. If the husband gifts equity shares of a company to his wife and thereafter the wife is allotted bonus shares by the company, the bonus shares cannot be treated as assets transferred by the husband. In such a case, although the capital gains from the equity shares gifted would be liable for clubbing under section 64, such income arising from the bonus shares would be outside the scope of the clubbing provisions.
The impact of the clubbing provisions under section 64 can be effectively blunted by investing the gifted funds in avenues that are totally free from income tax under section 10 of the Income Tax Act. The accumulated income from such tax-free investments can be reinvested in taxable investments.
Section 64 also provides that where remuneration is received by the spouse of an individual from ‘a concern in which the individual has substantial interest,’ such remuneration would be liable to be clubbed with the income of the individual. ‘Substantial interest’ has been defined to mean holding of equity shares either individually or along with the relatives, carrying 20 per cent or more of the voting power in the case of a company and deriving 20 per cent or more of the profit in the case of a concern, other than a company. For this purpose, a relative would mean, the husband, wife, brother or sister or any lineal ascendant or descendant of the individual. Accordingly, if remuneration is given to the spouse from a concern in which the individual does not have substantial interest, the clubbing provisions would not be attracted.
However, an exception in this regard provides that if the spouse possesses professional or technical qualifications, and the remuneration concerned is solely attributable to the application of his/her technical or professional knowledge and experience, the clubbing provisions would not be attracted. In this context, it needs to be borne in mind that if the spouse is professionally or technically qualified, there would be no clubbing if the remuneration is paid from a concern even where the individual does have a substantial interest. It is common to come across cases where remuneration is paid to a professional spouse such as a lawyer, engineer, architect, chartered accountant or doctor.
However, in a host of judicial pronouncements, various High Courts have held that the words ‘technical or professional qualifications’ do not necessarily relate to such qualification acquired by obtaining a certificate, diploma or degree or in any other form, from a recognised body like university or an institute. The term ‘qualification’ must be given a wide meaning as referring to the qualities which are required to be possessed by a person performing the work that he/she does.
TAX BENEFITS FOR HUF
The income or wealth of an HUF is taxed separately in the hands of the HUF itself and no part thereof is subject to tax in the hands of any member of the family by virtue of section 10(2) of the Income Tax Act and section 5(1)(ii) of the Wealth Tax Act.
Since an HUF has been granted the status of an independent tax entity just like an individual, it would also enjoy the advantages of separate personal income tax exemption limit of Rs2.5 lakh (effective from FY 2014-15) and graded tax structure up to the maximum income level of Rs10 lakh, deductions from gross total income under section 80 family of the Income Tax Act. Similarly, an HUF would also be entitled to a separate personal wealth tax exemption of Rs30 lakh and other benefits of exemption under section 5 of the Wealth Tax Act.
Suppose an individual earns taxable income of Rs15 lakh in his personal capacity. He has the scope of earning additional investment income of Rs11.5 lakh, which if earned in his personal capacity, would attract the maximum tax of Rs3,55,350, at the rate of 30.9 per cent. If this investment income is earned in the status of his HUF, which does not have any other taxable income, the HUF can avail the benefit of deduction of Rs1.5 lakh (effective from FY 2014-15) under section 80C and on the net taxable income of Rs10 lakh, the tax payable would work out to Rs1,28,750. Thus, by getting the benefit of the HUF as a separate tax entity in his case, the individual would be in a position to net a clear tax saving of Rs2,26,600.
Mukesh Patel is an international tax and investment consultant, columnist and author. Jigar Patel is an international tax attorney and professor.