How income is calculated under Income Tax Act ?

basics of income tax

What is Income tax in India?

The major source of revenue of any country is through a collection of taxes on income and other transactions. Income tax is a direct tax that is collected from the person who is liable to pay, the person who makes the payment to the government, and the person who is liable to pay taxes are the same. For efficient tax management, in some cases, the taxes will be collected by the person making the payment to the person in case of certain transactions through tax deduction and tax collection at the source (TDS/TCS). Even though TDS/ TCS is remitted by the person making the payment, it is not the final liability.

Power to collect Income tax and tax administration is given to the central government through “entry no 82 list I, seventh schedule article 246 of the constitution of India. Any changes to the act or amendments can be done only with the approval of the parliament. Income tax rules facilitate the smooth implementation of the act, and it cannot override the provisions of the Income Tax Act.

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

The computation of income, exemption, deduction, and assessment of income tax income under the income tax act is divided into 5 heads of income. The nature of income, frequency of income, and activity giving rise to the income determine the head 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 benefit 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.

Income tax salary return filing is mandatory even though the employer deducts TDS from 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 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 char gable under the head of 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 of the house property ownership of each joint owner.

A standard deduction of 30 %, along with property taxes, other local municipality taxes, and interest on the housing loan alone is available as a deduction in this head of income.

3. Capital Gains

Computation of Income from capital gains requires enormous knowledge of income tax provisions, valuation rules, and other income tax rules. Considering other heads of income, the challenge starts from the stage of classification of income as a capital gain.

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.

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 results in reduced tax liability due to the availability of indexation benefit and more exemptions compared to short-term capital gain. 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, is some of the major transaction which gives rise to capital gain income with high value.

Transactions involving the sale of jewellery, 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, income under this head is calculated with the application of income tax rules frequently.

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.

Various benefits and exemptions are given to the person based on capacity 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, will be prepared before the application of income tax provisions, which is mandatory in nature when the benefit of presumptive taxation is availed or applicable.

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 the 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 e.g, 80C, and 80D are reduced from gross total income to arrive at total income. 

After total income is computed, income tax is calculated on the total income by application of income tax rates applicable to the person. Tax will be paid if there is an additional liability in excess of TDS deducted, before filing the income tax return.