Tax Concepts: Complete Guide to India's Tax System

Tax can be defined as a charge that the government levies on various economic activities such as sale/purchase of goods/service, income earned, investment profits, etc. The government uses the funds collected through taxes for various purposes ranging from public welfare to paying off loans taken from other countries.

Perhaps the most common type of tax in India is income tax, a type of direct tax applicable to income earned by individuals. The other common type of tax in India is Goods and Services Tax (GST), an indirect tax that is payable when any of us purchases goods or services. Tax is a legal obligation that citizens need to follow to help in the development of the country.

One of the key tax concepts is that the funds received as tax are designed to help grow and diversify the economy. Since the reliance on any single type of tax can adversely impact this, the government of India imposes a variety of taxes at both the central and state levels. The central government primarily collects income tax, corporate tax, and customs duties. While, state governments in India handle taxes such as state GST, land revenue, value added tax (VAT), etc. Over time the tax system in India has evolved with implementation of reforms such as GST implementation and faceless assessments that are aimed at making tax compliance/collection easier as well as increasing the tax base.

Without adequate finances, no country can progress and the Indian taxation system is designed to ensure that sufficient revenue is generated the meet the financial needs of the country. Moreover, to ensure that the burden of taxes is less on individuals with a low income, direct taxes such as income tax are collected only if one has crossed a specified income threshold, known as the basic exemption limit.Similarly, in the case of indirect taxes such as GST, a lower tax rate and even nil tax rate is applicable in the case of essential goods and services, while luxury items typically feature a higher GST slab rate.

The money collected through taxes are then used to fund development. For example, to enhance education and literacy, the government introduced various schemes, like the “Beti Bachao Beti Padhao”, “Sarva Shiksha Abhiyan”, while other government initiatives such as widow pension scheme and Ujwala Yojana are designed to uplift other key segment of society. Typically, the funds collected through taxes are used by the government of India for a variety of purposes including but not limited to:

The tax system seeks to balance revenue collection while maintaining transparency. It is based on constitutional ideas that grant the central and state governments the power to levy and collect taxes. This system features different types of taxes and they have unique characteristics. Additionally, another key tax concept to remember is that there are various rules regarding how and when a specific tax can be levied and enforced by the relevant tax authorities. Read on to learn about the different types of taxes in India.

In India, depending on the type of tax, it can be collected by different types of authorities - local municipal bodies, state government, and central government. Moreover, taxes in India can be classified into two broad categories - direct tax and indirect tax. Let’s take a closer look at the key differences between direct and indirect tax:

Direct Taxes: Direct taxes in India are levied on income or profits earned by individuals as well as non-individual taxpayers such as companies, Hindu Undivided Family (HUF), Association of Persons (AoP), Body of Individuals (BoIs), etc. Common examples of direct taxes in India include income tax, property tax, capital gains tax,professional tax, etc. While a majority of direct taxes are governed and administrated by the central board of direct taxes, some direct taxes are administered by local bodies e.g. property tax, while others like professional tax are subject to state government laws.

Indirect taxes: Indirect tax is levied by the government on services and goods. As the name suggests this tax is not directly payable to the government by the end-user. So, this type of tax can be shifted from one taxpayer to another. For example, the wholesaler may transfer it to retailers, who may then pass it to consumers. In India, indirect tax are governed and administrated by the central board of indirect taxes and customs. Below table illustrates the most common types of direct and indirect taxes payable in India:

Let's take a look at the table below to explore the advantages and disadvantages of two primary categories of taxes i.e. direct vs. indirect tax:

In order to understand the basic tax concepts better, it is essential that you understand the concepts of gross income and taxable income. Gross Income can be defined as the total income that the tax payer has earned from various sources such as:
●Salary
●Rental income
●Profits from Business or Profession
●Investment returns (like dividends, interest, and capital gains)
●Income from other sources such as - Winnings from the lottery or contests

On the other hand, taxable income refers to the portion of a tax payer’s income that is subject to taxation after considering all permissible deductions and exemptions. So, the relationship between gross income and taxable can be summed up using the following formula:

Taxable Income = (Gross Income) – (All permissible deductions)

Do keep in mind that tax is calculated on an annual basis, hence, taxable/gross income as well as deductions are also considered on an annual basis.

In India, tax exemptions and deductions are terms you often hear during tax season. They both reduce your taxable income and are often used interchangeably, but they are different and have distinct purposes.

Tax Exemptions in India

Tax exemptions are designed to provide relief to specific groups of tax payers by reducing their tax burden. The Income Tax Act includes different types of tax exemptions, such as:

1- HRA (House rent allowance) Exemption

If you are a salaried employee and get House Rest Allowance (HRA) as a part of your salary, then under section 10(13A) of the Income Tax Act, you can claim an exemption for it. The amount of exempt HRA is the lesser among the following:

● Actual HRA received
● Rent paid over 10% of basic salary
● 50% of salary for metro cities or 40% for non-metros

Once the exempt HRA amount has been calculated, this amount is deducted from the total HRA received during the year to determine the taxable portion of the HRA. You can also use a HRA Calculator to get instant accurate results regarding your tax-exempt and taxable HRA.

2- Exemption on Agriculture income
Agriculture income is exempt from income tax under Section 10(1). If agriculture is the primary source of your income, you do not have to pay any tax on income from agricultural activities.

3 – Exemption on Maturity Proceeds from ULIPs and Death Benefits from Life Insurance Plans
Section 10(10D) of the Income Tax Act, maturity proceeds from Unit Linked Insurance Plans (ULIPs) and traditional life insurance policies as well as death benefit payout from life insurance plans are tax exempt in the hands of the investor. However, ULIP maturity proceeds can be taxable if annual premium payments of the plan exceed Rs. 2.5 lakh. Similarly, in the case of traditional life insurance policies, maturity proceeds are taxable, if such plans feature an annual premium in excess of Rs. 5 lakh.

Tax deductions refer to various investments or expenses that can reduce your taxable income. These can help lower the amount of taxable income and reduce the overall tax payable. Here are a few common examples tax deductions in India:

1- Section 80C Deductions

Many people who file individual income tax returns use Section 80C to save money on taxes. You can reduce your gross total income by up to ₹1.5 lakh each financial year.

Section 80C deductions may be claimed for:

●Investments in Public Provident Fund (PPF)
●Contributions made into Employee Provident Fund (EPF) and Voluntary Provident Fund (VPF)
●Investing in National Savings Certificates (NSC)
●Investing in equity linked savings scheme (ELSS) i.e. tax saver mutual funds
●Premiums paid for life insurance plans
●Principal repayment of home loans
●Payment of children’s tuition fees for full-time education

In order to take this deduction, individuals must invest or pay qualified amounts in the same financial year. You should remember that, these deductions from Section 80C investments are only available under the old tax regime currently and those opting for the new tax regime are not currently eligible for Section 80C tax benefits.

2- Home loan interest

According to Section 24(b) of the Income Tax Act, if you have taken a home loan then the interest repaid on the home loan is tax deductible. You can claim deductions of up to ₹2 lakh annually on the interest paid on your home loan. This benefit is also available only if the tax payer has opted for the old tax regime, as the new tax regime does not currently offer this tax deduction benefit.

3- Medical expenditure and insurance premiums:

Under Section 80D of the Income Tax Act, you can claim deductions on premiums paid for health insurance policies purchased for self, family, and dependent parents. The maximum deduction allowed under Section 80D are as follows:

● Up to ₹25,000 annually for health premiums paid for self (aged less than 60 years) and family
● Up to ₹50,000 annually for health premiums paid for self (aged 60 years or older) and family
● Up to ₹50,000 annually for health premiums paid for senior citizen parents
● Up to cumulative limit of ₹1 lakh annually for senior citizen tax payer (self), family and dependent parents
● Preventive health checkups up to ₹5,000 are also allowed and covered within the overall limit.

This benefit u/s 80D for health insurance plans is also available only if one has opted for the old tax regime and not applicable under the new tax regime.

Note:The above list of tax exemptions and deductions are illustrative and not exhaustive. Tax rules are subject to periodic change, so do consider the help of a tax expert in order to get the latest information.

Also read: New Tax Regime vs. Old Tax Regime

GST can be defined as a tax on consumption that is imposed when once purchases goods or services. This is currently the single most common type of indirect tax is India that was introduced to replace a complex system of multiple taxes, previously levied by both the central and state governments.

What is GST?

In terms of tax concept, the key feature of Goods and Services Tax (GST) is that it is based on the “One Nation, One Tax” principle, aimed at streamlining indirect taxation across the country. In the pre-GST era, there were multiple indirect taxes that were applied at different levels of the value chain. With the introduction of GST, the government of India brought a large number of indirect taxes under one umbrella.

Consumers pay the tax at the end, and businesses receive credit for the tax they have already paid in order to purchase raw materials/services at a previous stage. However, some goods such as alcohol for human consumption and petrol/diesel are currently not in the ambit of GST hence state-level taxes such as VAT (Value Added Tax), service tax, etc. are applicable to these.

GST Slabs in India (5%, 12%, 18%, 28%)

GST is applicable on different products and services at different GST slab rates, such as:

• ● 5%: Essential items like packaged food, and footwear.
• ● 12%: For intermediate goods such as processed foods and garments.
• ●18%: Applied on standard services and industrial products like phones and toiletries.
• ● 28%: Luxury goods such as cars.