Jun 14, 2009

Income Tax - 3 Other Sources of Confusion

Photo by onkel wart

Some of the most common tax confusions were discussed in the previous post, 5 Common Tax Confusions. Here’s another three:

1. Difference between exemption, deduction and rebate
Do you know the difference between the three different methods of providing tax concessions: exemption, deduction and rebate? Actually, most people get confused between the three and use them interchangeably. Broadly speaking, exemptions and deductions both reduce your taxable income, while rebate reduces your tax.

Now, tax exemptions and tax deductions both reduce your taxable income. But the manner of reduction is different. Exemption doesn’t form part of your total income whereas deduction first forms part of your total income and later deducted from it. For instance, while PPF interest is exempt, NSC interest is taxable but deduction is allowed under section 80C. To understand how it affects your tax planning, check out – PPF vs NSC.

The most common example to illustrate the difference between deduction and rebate is the benefit of long term savings given to individuals. Up to AY 2005-06, rebate was allowed under section 88 which got replaced by deduction under section 80C by the Finance Act 2005.

2. Difference between AY, FY and PY
The other basic tax confusion is about Assessment Year (AY), Financial Year (FY) and Previous Year (PY).

Unlike calendar year which starts on January 1 and ends on December 31, a financial year (FY) is considered to be from April 1 to March 31.

Under the Income Tax Act, income earned in a financial year (FY) is taxed in the next FY. The FY to which the income belongs is called the previous year (PY) and the FY in which the income is taxed is called the assessment year (AY).

For instance, the income earned during FY 2007-08 is assessed for tax in the FY 2008-09. Here, FY2007-08 is called PY and FY 2008-09 is called AY.

3. Difference between tax planning and tax evasion
First, tax planning is your right and is perfectly legal. Every tax payer has a right to plan his finances in such a way as to minimize the payment of taxes without violating the legal provisions. Put simply, through tax planning you can reduce your tax burden, by taking advantage of exemptions, deductions and reliefs provided under the Income Tax Act, 1961. But the moment it crosses the threshold of law, it becomes tax evasion and is prohibited. Tax evasion involves unfair methods and malafide intention (intention to deceit) to conceal income which is otherwise taxable.

Furthermore, there is another term called ‘tax avoidance’ which falls between tax planning and tax evasion. It is an attempt to dodge tax in legally permissible ways by taking advantage of certain loopholes in law. Technically, it is legal (i.e., there is no breach of law) but is against the legislative intent. Anyhow, tax avoidance has also got the judicial sanction as per the ruling of the Supreme Court of India in UOI vs. Azadi Bachao Andolan (2003).

For example, while designing your salary structure in such a way as to claim maximum HRA exemption is tax planning, making a false claim for HRA exemption without paying any rent is tax evasion, and paying rent to a spouse just to avail HRA tax exemption is tax avoidance.

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