How income tax is calculated under Income Tax Act?

basics of income tax

What is Income tax in India?

Income tax is a tax collected on the income of a person earning income in India or income source in India or income earned by a person in India. All incomes are not chargeable to income tax, only incomes that are considered as income under the Income Tax Act are charged to income tax at the rates of income tax applicable for the financial year.

A person who is required to file an income tax return is required to make payment of income tax before filing the income tax return, income tax act has specified a list of conditions for a person and a list of persons who are required to file income tax return.

For the calculation of income tax income is first classified under any of the five heads of income, The classification of income under different heads enables the application of specific rules and provisions for the category of income.

For example, capital gains income cannot be charged to tax as it is because of the nature of the capital asset, period of holding, and high scope for generating black money.

Income tax will be calculated on the total income of the person, for calculation of total income, a step-by-step process is required as below.

Steps in calculating income tax

  1. Charging of income.
  2. Classification of income.
  3. Allowing exemption and deduction under each head of income.
  4. Arriving at taxable income head-wise
  5. Allowing deduction on gross total income etc.
  6. Thereafter income tax will be calculated on total income using the rate of income tax applicable to the person.

What are the different heads or types of income under the Income Tax Act 1961?

The computation of income under the Income Tax Act is divided into 5 heads of income, the classification enables to granting of exemptions, and deductions and to implementation computation methodology based on the nature of income.

1. Income from salaries

Under this head of income, salary income received by the individual is taxable, and this head is practically applicable only to the individual. The salary of the directors in a limited company is assessable under this head of income. The computation of income under this head is much more straightforward in terms of exemptions, deductions, etc.

All amounts including allowances, bonuses, commission, leave encashment, gratuity, advance salary, and terminal benefits are chargeable as salary under this head.

For classification of the income under this head of income, there should be an employer and employee relationship between the person making the payment and the person receiving the payment respectively.

Form 16 issued by the employer is considered a base document for filing income tax returns, any income not included in Form 16 such as capital gains on the sale of shares, etc can be added, and deductions like housing loan interest shall be considered apart from the date in Form-16.

Income tax return filing is mandatory even if the employer deducts TDS from the salary and remits it to the government account, the final liability of tax on salary is determined, and an income tax return shall be filed with payment of any excess taxes, in case of excess TDS is deducted it will be refunded only on filing the income tax return.

2. Income from house property –

Under this head of income, income is charged to tax if it is earned through renting of immovable property, rent received from commercial complexes is chargeable under “Income from House property” with certain exceptions.

In case the property is held in joint ownership, income from the property of each joint owner is calculated in proportion to the share in ownership in the property of each joint owner.

A standard deduction of 30 %, along with property taxes, and other local municipality taxes, is available on gross rental income received.

Interest on the housing loan alone is available as a deduction in this head of income up to Rs.2,00,000 for self-occupied property and with no limits on interest deduction against interest income.

3. Capital gains

Computation of Income from capital gains requires enormous knowledge of income tax provisions, valuation rules, and other income tax rules. Comparing other heads of income, for computation of income under the head capital gains, the challenge starts from the stage of classification of income.

Use of historical data, data published by registration departments, etc are used for the computation of income, hence care should be given in using the right and authentic data for inputs from third parties.

Due to the high-value transactions involved, tax liability will be high, and submission of wrong data or improper use of income tax provisions invites notices from the income tax department. Through the periodical returns applicable to registration departments, banks, and other financial institutions, details of the capital gains transaction are shared with the income tax department.

The value declared by the buyer of property for deduction of TDS on the sale of property in FORM 26QB will be reflected in the AIS and TIS of the taxpayer.

Income classified under this head of income is further classified into short-term or long-term capital gain, and exemptions are available based on the classification of income as short-term or long-term.

Generally, long-term capital gains result in reduced tax liability due to the availability of indexation benefits and more exemptions compared to short-term capital gains. Exemptions from capital gain shall be claimed by income tax return filing for capital gain.

The sale of immovable property, such as the sale of land, the sale of a flat, the sale of a residential building, or the sale of a commercial complex, are some of the major transaction which gives rise to capital gain income of high value.

Transactions involving the sale of jewelry, shares, and mutual funds, as also offered to income as a capital gain.

Special rates of taxes are applicable in case of long-term capital gain, and slab rates applicable to the person are applicable for short-term capital gain with certain exceptions.

4. Profits and gains from business or profession

Profits and gains by undertaking the business or profession are computed under this head of income, and income under this head is calculated with the application of an enormous number of tax rules and provisions.

Income under this head is classified based on the routine nature of the transactions, the relationship between the parties, and the nature of income.

Most of the litigations relating to this head of income are due to non-compliance with certain procedural aspects, for example, disallowance of certain expenses made as cash.

For computing business income, turnover data from all GST registration numbers applied using the same PAN should be clubbed together.

Various benefits and exemptions are given to the person based on the status of the person and amount of turnover, one such notable benefit is section 44AD presumptive taxation, under which profits can be declared as a minimum of 8% for eligible businesses.

Detailed financial statements such as profit and loss accounts, balance sheets, and notes to accounts, depreciation statements, are required to be prepared before filing income tax returns for business income.

The remuneration of partners from a partnership firm is classified under profits and gains from business or profession.

5. Income from other sources

All incomes which cannot be classified under the first four heads of income are offered to income tax under the head income from other sources, this head is technically called a residuary head by professionals.

Interest received from a savings account, interest received from the fixed deposit and other deposits, dividend income, and interest income received from a partnership firm are always classified as income from other sources if they cannot be classified under the head profits and gains from business or profession.

What is gross total income and total income?

Numerous exemptions and deductions are available for each head of income, before arriving at the income under the relevant head the effect of the exemptions and deductions should be made.

After arriving at income under each head, setoff of losses should be done on the intra-head level and inter-head level, loss under certain heads can be set off only against the same head, and for some heads of income, the loss can be set off with the other heads subject to income tax provisions relating to carry forward and set off of a loss.

Once the loss is set off, the total of all heads is called gross total income, Chapter VI-A deductions for example, 80C, and 80D are reduced from gross total income to arrive at total income. 

For example, to complete the filing of the income tax returns for an individual for the financial year 2023-2024, after total income is computed, income tax is calculated on the total income by application of income tax rates for the financial year 2023-2024. Tax will be paid along with interest for delay in filing, interest on delay in payment and deferment of advance tax, penalty for late filing of income tax return, etc, if there is an additional liability over TDS deducted, before filing the income tax return.