DIRECT AND INDIRECT TAXES

 Introduction:
Taxes are sometimes referred to as direct tax or indirect tax. The meaning of
these terms can vary in different contexts, which can sometimes lead to confusion. In
economics, direct taxes refer to those taxes that are collected from the people or
organizations on whom they are ostensibly imposed. For example, income taxes are
collected from the person who earns the income. By contrast, indirect taxes are
collected from someone other than the person ostensibly responsible for paying the
taxes. In law, the terms may have different meanings. In U.S. constitutional law, for
instance, direct taxes refer to poll taxes and property taxes, which are based on simple
existence or ownership. Indirect taxes are imposed on rights, privileges, and activities.
Thus, a tax on the sale of property would be considered an indirect tax, whereas the tax
on simply owning the property itself would be a direct tax. The distinction can be subtle
between direct and indirect taxation, but can be important under the law.

India has a well-developed tax structure with clearly demarcated authority

between Central and State Governments and local bodies. Central Government levies
taxes on income (except tax on agricultural income, which the State Governments can
levy), customs duties, central excise and service tax.

Value Added Tax (VAT), (Sales tax in States where VAT is not yet in force),
stamp duty, State Excise, land revenue and tax on professions are levied by the State
Governments. Local bodies are empowered to levy tax on properties, octroi and for
utilities like water supply, drainage etc.
In last 10-15 years, Indian taxation system has undergone tremendous
reforms. The tax rates have been rationalized and tax laws have been simplified
resulting in better compliance, ease of tax payment and better enforcement. The
process of rationalization of tax administration is ongoing in India. Since April 01, 2005,
most of the State Governments in India have replaced sales tax with VAT.
 Taxes Levied by Central Government

Direct Taxes
A direct tax is one paid directly to the government by the persons on whom it
is imposed. This is a tax that, however oppressive in its nature, and unequal in its
operation, is certain as to its produce and simple in it collection; it cannot be evaded like
the objects of imposts or excise, and will be paid, because all that a man hath will he
give for his head. Examples include some income taxes, some corporate taxes, and
transfer taxes such as estate (inheritance) tax and gift tax. Different direct taxes are as
follows:

1. Tax on Corporate Income

2. Capital Gains Tax
3. Personal Income Tax
4. Tax Incentives
5. Double Taxation Avoidance Treaty

Indirect Taxes
The term indirect tax can be defined from different views. In the colloquial
sense, an indirect tax is the charge that is collected by intermediary (like retail store)
from the individual who holds the actual economic burden of the tax ( like customer).
The intermediary files a tax return and eventually passes to the government.
The indirect tax can be alternatively defined as the charge that is paid by one
individual at the beginning, but the burden of which will be passed over to some other
individual, who eventually holds the burden. Different indirect taxes are as follows:

1. Excise Duty
2. Customs Duty
3. Service Tax
4. Securities Transaction Tax
 Basic concepts
1. Assessment Year
Section 2(9) of the act defines ‘assessment year’ as “the period of twelve
months commencing on the first day of April every year”. An assessment year begins on
1st April of every year and ends on 31st march of next year. For example, the current
assessment year 2006-07 has begun on 1st April, 2006 and will end on 31st March,
2007.

2. Previous Year
Section 3 of the act defines ‘previous year’ as for the purposes of this act,
“previous year means the financial year immediately preceding the assessment year.
Provided that, in the case of a business or profession newly set up, or a source of
income newly coming to existence in the said financial year. The previous year shall be
the period beginning with the date of setting up of the business, or as the case may be,
the date on which the source of income newly comes into existence and ending with the
said financial year.

3. Assessment
Section 2(8) of the Income Tax Act defines this term as “an assessment
includes reassessment. This is an inclusive definition, which indicates that the term
assessment includes reassessment, in addition to its normal meaning. Normally, an
assessment means the process of determining and computing the amount of income
and the tax due of a person. The computation of income and tax is to be done in
accordance with the provisions of the Income Tax Act.

4. Assessee
Section 2(7) defines “assessee” as a person by whom any tax or any other
sum of money is payable under the Act. A person is liable to pay tax as well as interest
(for late payment of tax) or penalty (for concealment of income, fraud) under the
Income Tax Act. Therefore, an assessee basically means a person liable to pay tax or
interest or penalty. Assessee is a person :

• Who is regarded as person in Income Tax Act

• An individual
• Hindu undivided family
• A firm (Partnership)
• Company
• Association of person or body of individuals
• Local authority
• Every judicial person not covered by above.
5. Income tax
Every Government derives revenues by levying taxes. Such taxes can be
either “Indirect” or “Direct”. Indirect taxes are in the form of customs duty, excise duty,
value added tax, service tax, etc. These indirect taxes are levied irrespective of the
level of income of a person.
On the other hand, direct taxes are levied directly based on the income of the
person. The dictionary meaning of the word ‘Income Tax’ is “a tax directly levied on
income or on incomes over a certain period”. Thus, income tax is a direct tax. Of all the
direct taxes, the maximum revenue to the Government is from income tax. The law
relating to it is contained in the Income Tax Act, 1961.
The Income Tax Act is the machinery, which determines which persons are
liable to tax. It also determines in respect of which incomes they are liable to tax. These
incomes are classified under various heads and then taxed. They are as follows:

Different sources of income one can earn Heads of income defined in Sec. 14
from

1) Salary a) Income from salaries

2) Rent b) Income from house property

3) Business Income c) Profits and Gains from business

and profession

4) Sale of property or capital profit d) Capital gains

5) Any other sources of income e) Income from other sources

6. Return
• It is a declaration of income and tax
• Such declaration is by assessee
• Such declaration by assessee is based upon his knowledge and belief
• Such return is filed with income tax authority.
7. Income
As per Section 2(24) of the Act the term “Income” includes:-

• Profits and gains.

• Dividends
• Voluntary contributions received by
a) a charitable or religious trust, or
b) a specified institution (e.g. a scientific research association, a sports
association), except contributions specifically received towards the capital.
• Perquisites taxable under the head “salaries” u/s 17(2) (rent-free accommodation) or
profits in lieu of salary taxable as salaries u/s 17(3) (retrenchment compensation).
• Special allowance or benefit specifically granted to an employee to meet expenses
for the performance of his duties (entertainment allowance).
• Allowance to an employee to meet his personal expenses at office or to compensate
him for the increased cost of living (dearness allowance).
• Benefit or perquisite obtained from a company by a director or a person having
substantial interest in the company or their relatives (provision of motor car).
• Benefit or a perquisite obtained by a representative assessee (a trustee), or a
beneficiary, or any amount paid by the trustee towards the sum due by the
beneficiary.
• Any sum chargeable-
a) under sec 28(ii) and (iii) of the Act (compensation for termination of a
contract for directorship or agency; income from services to members earned
by a trade association)
b) under sec 41 (profits chargeable to tax as income from business e.g.
recovery of bad debts, sale of scientific research asset ) etc. or
c) under sec 59 (profits chargeable to tax as income from other sources e.g.
recovery of expenses claimed earlier).
• Profits on sale of an import license, taxable under sec 28(iiia).
• Export cash assistance received from Government, taxable under sec 28(iiib).
• Refund of customs or excise duty received or receivable against exports, taxable
under sec 28(iiic).
• Benefit or a perquisite from business or profession (e.g. a gift received by a doctor
from a patient), taxable under sec 28(iv).
• Any interest, salary, bonus, commission or remuneration due to or received by a
partner from a firm, to the extent allowed to be deducted under sec 40(b), taxable
under sec 28(v).
• Capital gains chargeable under sec 45 of the act.
• Profits of any business of insurance carried on by a mutual insurance company or a
co-operative society, taxable under sec 44 or the First Schedule to the Act.
• Winnings from lotteries, prizes by draw of lots or by chance, crossword puzzles,
races including horse races, card games, game show, entertainment programme on
television in which people compete to win prizes, gambling or betting.
• Contributions from employees to Provident Fund, or Superannuation fund, or
Employees Insurance Fund etc. deducted by the employer from the salaries of the
employees.
• Any sum received under a Keyman Insurance policy (i.e. a policy taken on the
owner/director etc.), including bonus on such policy.

8. Person
“Person” includes:-
• An individual
• A Hindu Undivided Family
• A Company
• A Firm
• An association of persons or a body of individuals, whether incorporated or not.
• A local authority
• Every artificial judicial person, not falling within any of the preceding sub-clauses.
For the purpose of this clause, an association of persons or a body of individuals
or a local authority or an artificial judicial person shall be deemed to be a person,
whether or not such person or body or authority or judicial person was formed or
established or incorporated with the object of deriving income, profits and gains.

 Scope of Total Income

The following points should be noted in regard to scope of income:

• While Sec 4 makes the total income of the previous year chargeable to tax, Sec 5
defines the scope of the total income so chargeable to tax. It determines the extent
and scope of income, which is chargeable to tax. The term “Scope of Income”
means which items of income are included and which items are excluded while
computing tax liability.
• The scope of income depends upon the residential status of the person. There are
three broad categories of persons:
a) Resident and Ordinary resident
b) Non-resident and
c) Resident but not Ordinarily resident.

• It should be noted that Sec 5 specifically states that the income is to be computed
“subject to the provisions of this Act”. Thus, if any item of income is exempt under
the provisions of the Act, it is to be excluded from the scope of income.
Resident and Ordinary Resident
A Resident and Ordinary Resident is taxable in respect of any income, from
whatever source derived, which:
a) Is received, or deemed to be received in India, in the previous year, by or on behalf
of such person.
b) Accrues or arises, or is deemed to accrue or arise to him, in India. During the
previous year
c) Accrues or arises to him outside India, during the previous year.
Thus, in the case of ‘resident and ordinary resident’, his total income includes
any income received, or accruing or arising in India, and accruing or arising outside
India. In short the entire ‘world income’ (Indian income + Foreign income) of an ordinary
resident is to be included in his total income.

Resident but not Ordinary Resident

A person not ordinarily resident in India, is taxable is respect of any income,
from whatever source derived, which:
a) Is received, or deemed to be received, in India, in the previous year, by or on half of
such person.
b) Accrues or arises, or is deemed to accrue or arise to him, in India, during the
previous year.
c) Accrues or arises to him, outside India, from a business controlled from or a
profession set up in India.
Thus in the case of a ‘not ordinary resident’, while the Indian income is to
be included in the Total Income, the foreign income is to be included only if it is derived
from a business controlled in or a profession set up in India. So, the liability of a ‘not
ordinary resident’ in respect of the foreign income is much less as compared with that of
the ‘ordinary resident’.

Non Resident
A person who is a non resident, is taxable in any respect of any income,
from whatever source derived, which:
a) Is received in India, or is deemed to be received in India, in the previous year, by or
on behalf of such person.
b) Accrues or arises, or is deemed to accrue or arise to him, in India, during the
previous year.
Thus, in case of a ‘non resident’ his taxable income includes only his Indian
income during that year. The foreign income of a non-resident is not taxable under the
Indian Income Tax Act. So, the liability of a non-resident is the lowest among all the
types of residents under the Income Tax Act.

Resident and Resident but

Nature of Income Ordinary not Ordinary Non Resident
Resident Resident
1) Income received in India Taxable Taxable Taxable
2) Income which accrues or arises
Taxable Taxable Taxable
in India
3) Income deemed to be received
Taxable Taxable Taxable
in India
4) Income deemed to accrue in
Taxable Taxable Taxable
India
5) Income which accrues and
arises outside India from a
Taxable Taxable Not Taxable
business controlled from India
or profession setup in India
6) Any other income which
Taxable Not Taxable Not Taxable
accrues or arises outside India
Practical Examples

1) Scope of Total Income

Mr. Akash furnishes you with the following details of his income for the year
ended 31-3-2008. Determine the scope of his total income for assessment year 2008-
2009:
1) Salary from X Ltd. earned in India Rs.25000 of which Rs.10000 was received
abroad.
Salary from Y Ltd. earned abroad Rs.100000 of which Rs.30000 was received in
India.
2) Income from let out hose property
i) Situated in India Rs.40000 of which Rs.12000 was received abroad.
ii) Situated abroad Rs.75000 of which Rs.15000 was received in India.
3) a) Dividend on shares of Indian company
i) Received in India Rs.11000
ii) Received abroad Rs.89000
b) Dividend on shares of foreign company
i) Received abroad Rs.79000
ii) Received in India Rs.21000
4) a) Income from proprietary business earned in India Rs.35000 of which Rs.5000 was
received abroad.
b) Income from foreign business:
i) Controlled from India Rs.50000 of which Rs.9000 was received in India, while
the balance was received abroad.
ii) Controlled from abroad Rs.70000 of which Rs.19000 was received in India
and Rs.51000 was received abroad.
 Resident and Resident but
Non
Nature of Income Ordinary not Ordinary
Resident
Resident Resident
1) a)Salary from X Ltd earned in
India
i) Received in India 15000 15000 15000
ii) Received Abroad 10000 10000 10000
b)Salary from Y Ltd earned
abroad
i) Received in India 30000 30000 30000
ii) Received abroad 70000 NIL NIL
2) Let out House property
a) Situated in India
i) Received in India 28000 28000 28000
ii) Received abroad 12000 12000 12000
b) Situated abroad
i) Received in India 15000 15000 15000
ii) Received abroad 60000 60000 60000
3) a) Dividend on shares of Indian
company
i) Received in India 11000 11000 11000
ii) Received abroad 89000 89000 89000
b) Dividend on shares of foreign
country
i) Received in India 21000 21000 21000
ii) Received abroad 79000 NIL NIL
4) a) Income from property business
earned in India
i) Received in India 30000 30000 30000
ii) Received abroad 5000 5000 5000
b) Income from foreign business
i) Controlled from India
Received in India 9000 9000 9000
Received abroad 41000 41000 NIL
ii) Controlled from Abroad
Received In India 19000 19000 19000
Received abroad 51000 NIL NIL

Total amount 595000 335000 294000

2) Residential Status
A person is classified, on the basis of legal status, into Individual, Hindu
Undivided Family, Firm, Association of Persons, Body of Individuals, or Artificial Judicial
Person. A person may be further classified, on the basis of residential status
Into:
a) A Resident in India
b) A Non-Resident in India
c) Ordinarily Resident
d) Not Ordinarily Resident.
It should be noted that:
1) Residential status is to be determined for every previous year as it may change from
year to year. It depends upon the number of days a person is in India during the
concerned previous year.
2) Residential status is different from citizenship. An individual may be the citizen of
Britain, but a resident in India. Similarly, an Indian citizen may be a non-resident in
India.
3) Residential status is important in deciding whether foreign income of a person is
taxable or not.

Basic Conditions
Basic Conditions for individual whether he is resident/non-resident in India
Sec 6(6):
A) He/she should be resident in India for a period of 182 days or more during previous
year
OR
B) He/she should be in India for a period of 60 days or more during previous year and
365 days during last 4 previous year.
Note: The condition of 60 days will be enhanced or increased in following cases:
1) When an Indian citizen leaves India for a period of 60 days or more will be increased
to182 days if he/she is there for employment / working as a member of crew of
Indian Ship.
2) If an Indian citizen or a person of Indian origin comes to India for a visit during
previous year.
 An individual can be ordinarily resident in India:
C) If he is resident for any 2 years out of 10 preceding previous year
AND
D) If he is in India for a period of 730 days out of last preceding 7 years.

Therefore, if an individual is satisfying either A or B of basic condition and satisfying

both the condition C and D then he will be regarded as resident and ordinarily resident.
If an individual is satisfying A or B but he fails to satisfy either both the
conditions of C and D then he will be regarded as resident but not ordinarily resident.

Practical Example:
Mr. X an Indian Citizen has settled abroad for the last twenty-five years. His
stay in India in the last few years was as under:

Year Days Year Days

1991-1992 170 1997-1998 125

1992-1993 59 1998-1999 105
1993-1994 110 1999-2000 121
1994-1995 39 2000-2001 157
1995-1996 210 2001-2002 183
1996-1997 196

He did not come to India prior to 1991. Determine his residential status for the
Assessment Year 2002-2003. Would your answer change if his stay in India in the
previous year 2001-2002
Solution:
A) Ascertaining whether a resident
1) Mr. X is a citizen of India coming to India on a visit.
2) Mr. X will be a resident only if he is in India from 1-4-2001 to 31-3-2002 for 182 days
or more.
3) He is in India for 183 days from 1-4-2001 to 31-3-2002.

Conclusion: Mr. X is a resident as he satisfies the conditions.

B) Ascertaining whether an ordinary resident.
1) Mr. X will be an ordinary resident if:-
a) He is a resident for 9 out of 10 preceding years and
b) He is in India between 1-4-1994 and 31-3-2001 for 730 days.
2) Mr. X is a non-resident in the preceding 3 previous years 1998-99, 1999-2000, and
2000-2001 as his stay in each of these years is less than 182 days. Hence, he
cannot be a resident for 9 out of 10 years. Since he fails to satisfy condition 1(a),
there is no need to check the next condition 1(b).

Conclusion: Mr. X is a resident but not ordinarily resident.

C) Stay of 63 days in 2001-2002:

If X stays in India in the previous year 2001-2002 for 63 days only then he
would become a Non-resident in India for the assessment year 2002-2003. As per the
exception to the 2nd condition in Sec 6(1), an Indian citizen settled abroad becomes
resident in India only when his stay in India during the previous year is 182 days or
more.
Conclusion: As X does not satisfy this condition, he will be Non-resident for the
assessment year 2002-2003.

3) Income from House Property

Sec 22 of the Income Tax Act defines the basis of charge of income under the head –
Income from house Property. It states that “Annual value of the property, consisting of
any building or lands appurtenant thereto, of which the assessee is the owner, shall be
chargeable to Income Tax under the head “Income from House Property”. This is
however not applicable to the property occupied for the purpose of any business or
profession carried on by the owner, profits of which are chargeable to income-tax. On
further analysis of this provision, we will see that four conditions must be satisfied
before a particular income is taxed under this head. These are:

1) The property must contain of a building or a land attached to or connected with such
building.
2) The assessee must be the owner of the house property.
3) The property should not have been occupied by the assessee for the purpose of
carrying on his business or profession.
 4) The Annual Value of the House Property is to be taxed under the head “Income from
House Property”

Pre-Construction Interest:

1) Where property has been constructed or purchased with borrowed funds, the
interest payable for the period prior to acquisition or construction, can be deducted in
5 equal installments beginning with the previous year in which property is acquired
or constructed and 4 succeeding years.
2) However, any amount already allowed as deduction any other provision of the Act
cannot be claimed again.
3) Interest is to be aggregated from the date of borrowing till the end of the previous
year prior to the year in which the house is completed.
4) It should be noted that:
(a) A fresh loan can be taken specifically to repay the original loan taken for
purchase/construction of a house. The interest on such fresh loan ca also be
deducted.
(b) If interest is not paid on time the late payment charges or interest on interest
cannot be deducted.
(c) Brokerage paid for arranging the housing loan cannot be deducted.
(d) Only simple, and not compound, interest can be deducted.

Annual Value:
The income from house property is determined on the basis of ‘Annual Value’. It
is the Annual Value of the house property, which is charged to tax, after allowing certain
deductions therefrom.
Sec 2(2) define ‘Annual Value’ in relation to any property, as its annual value
determined by Sec 23. Thus, the annual value is always in relation to some property.
i) Under Sec 23, the annual value of any property is deemed to be:
The sum for which the property might reasonably be expected to be let from year
to year
ii) Where the property or any part of it is let and the actual rent received or
receivable by the owner in respect thereof is in excess of the amount received or
receivable.
iii) Where the property or any part thereof is let and was vacant during the whole or
any part of the previous year due to which the actual rent received or receivable
is less than the amount, the amount so received or receivable whichever is more.
Practical Example:
Mr. X owns a house at Delhi, which is let out. Fair rent of the house is Rs.24000
whereas actual rent received is Rs30000. He also received Rs.10000 from the tenant
for charges towards lift, generator and security. He makes the following expenditure in
respect of the house property:

Particulars Amount Particulars Amount

1) Municipal taxes paid 5) Land revenue. 3800

by Mehra. 6) Ground rent paid.
2) Fire insurance. 4000 2000
3) Collection charges.
2400
4) Repairs.
500
2000

Interest on borrowed capital during the previous year 2001-2002 is Rs.4000. Funds
borrowed on April 1, 1998, Rs.40000 @ 10% interest p.a. were used for construction of
the house which was completed on March 31, 2002. Compute the income earned by Mr.
Mehra from his let-out house property during the assessment year 2002-2003.
Solution:
Name of the owner: Mr. Mehra
Previous year: 2001-2002.
Assessment year: 2002-2003.
Computation of Income of House Property

Particulars Amount Amount

Gross Annual Value

Higher of RLV (Rs.24000) or Rent received
(Rs.30000) 30000

Less: Municipal taxes paid 4000

Net Annual Value (A-B)
26000
Less: Deductions u/s 24
1) Standard Deduction (30% of 26000)
2) Interest on borrowed funds during previous year. 7800
3) Interest on borrowed funds during pre-construction 4000
period.

2400 14200

E) Net Income from House Property (C-D)

11800

Working Notes:
‘Rent’ includes only charges for house property. Charges received for lift etc. are taxed
not as ‘income from house property’ but as ‘income from other sources’.
1) Pre-construction interest is computed as follows:
a) Construction completed in previous year 2001-2002.
b) Pre-construction period = Period from date of borrowing to end of Preceding
Financial Year = 1-4-1998 to 31-3-2001.
c) Pre-construction Interest = Rs.40000 x 10% x 3 years = Rs.12000.
d) Pre-construction Interest Allowance during current previous year = 1/5 x 12000 =
Rs.2400.