Chapter - 1

Introduction to Income Tax

OBJECTIVES
After going through this chapter you will be able to understand
• The meaning and definition of Tax
• Types of Taxes
• Brief History of Indian Income Tax
• The Canons of Taxation
• Charge of Income Tax
• Assessment, Assessment Year and Previous Year
• Assessee and person
• Casual Income, Income, Gross Total Income and Total Income
• Average Rate of Tax and Maximum Marignal Rate
• Tax Planning, Tax Avoidance and Tax Evasion
• Agricultural income and Non-agricultural income

STRUCTURE
• Introduction
• Meaning and Types of Taxes
• Brief History of Income Tax in India
• Legal Frame Work
• Canons of Taxation
• Important Definitions
— Assessment
— Assessment Year
— Previous Year (including Exceptions),
— Assessee
— Person
— Income
— Casual Income
— Gross Total Income
— Agricultural Income (including Scheme of Partial Integration)
• Scheme of taxation
• Tax Planning, Tax Avoidance and Tax Evasion
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INTRODUCTION
Income tax is one of the most important source of revenue to the Central
Government. The Government needs money to meet the various public expenditure
such as maintaining law and order in the country, to safeguard the country from
foreign power, to develop agriculture, to develop industries, infrastructure development,
to provide education, to maintain hospitals, and to promote the welfare of the
people. For all these, the Government needs to mobilise funds from different sources.
These sources may be direct or indirect. Income tax is one of the most important
direct tax.

MEANING AND DEFINITION OF TAX

The Tax Revenue is the most important source of public revenue. A tax is a
complusory payment levied by the government on individual or companies to meet
the expenditure which is required for public welfare.
According to Hugh Dalton, “A Tax is a compulsory contribution imposed by
public authority, irrespective of the exact amount of services rendered to the tax
payer in return, and not imposed as penalty for any legal offence.”
Thus, tax is a compulsory payment made by every citizen to the Government for
the purpose of availing certain benefits from the Government which are not directly
related to the payment of tax.
Types of Taxes
There are two types of taxes namely
1. Direct tax, and
2. Indirect tax.
1. Direct Tax
A tax that is paid directly by an individual or an organisation to the imposing
entity is called Direct Tax. In otherwords, the impact and incidence of tax fall on the
same person, is known as direct tax. The impact means the burden and the
incidence of tax means the responsibility. For example: Income tax, property tax,
etc.
2. Indirect Tax
An indirect is a tax collected by an intermidiary from the person who bares the
ultimate economic burden of the tax. The intermidiary later files a tax return and
forwards the tax proceeds to government with the return. In otherwords, impact
falls on one person and the incidence of tax fall on some other person is known as
indirect tax. For example: Goods and Services Tax, Custom Duty, etc.
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BRIEF HISTORY OF INCOME TAX IN INDIA

In India, this tax was introduced for the first time in 1860, by Sir James Wilson in
order to meet the losses sustained by the Government on account of the Military
Mutiny of 1857. Thereafter, several amendments were made in it from time to time.
At last in 1886, a separate Income tax act was passed. This act remained in force
up to 1917, with various amendments from time to time. In 1918, a new income tax
was passed and again it was replaced by another new act which was passed in
1922. This Act remained in force up to the assessment year 1961-62 with numerous
amendments
The Income Tax Act of 1922 had become very complicated on account of
innumerable amendments. The Government of India therefore referred it to the law
commission in1956 with a view to simplify and prevent the evasion of tax.. The law
commission submitted its report-in September 1958, but in the meantime the
Government of India had appointed the Direct Taxes Administration Enquiry Committee
submitted its report in 1956.In consultation with the Ministry of Law finally the
Income Tax Act, 1961 was passed.
The Income Tax Act 1961 has been brought into force with 1 April 1962.It
applies to the whole of India and Sikkim (including Jammu and Kashmir). Since 1962
several amendments of far-reaching nature have been made in the Income Tax Act
by the Union Budget every year, which also contains Finance Bill. After it is passed
by both the houses of Parliament and receives the assent of the President of India,
it becomes the Finance act. Besides this ,amendments have also been made by
various Amendment acts, for instance, Taxation laws Amendment Act, 1984, Direct
Taxes Amendment Act, 1987, Direct Taxes Law (Amendment) Acts of 1988 and 1989,
Direct Tax Law (Second amendment) Act, 1992 and 1993, are mostly based on the
recommendation of Chelliah Committee Report.
As a matter of fact, the Income Tax Act 1961, which came into force on 1st
April, 1962, has been amended and re-amended drastically. It has therefore become
very complicated both for the administering authorities and the tax-payers.
Income Tax Act, 1961 is a comprehensive act and consists of 298 sections and
innumerous sub-sections, schedules, rules, etc.
Persons Liable to Pay Income Tax
Every person, whose taxable income for the previous year exceeds the minimum
taxable limit is liable to pay tax to the Central Government during the assessment
year at the rates in force during the relevant previous year.
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LEGAL FRAME WORK

ADMINISTRATION OF INCOME TAX ACT

CENTRAL BOARD OF DIRECT TAXES

ADMINISTRATIVE JUDICIAL

Director General Chief Commissioner High Court

of Income Tax of Income Tax Appellate Tribunal

Directors Commissioner Commissioner Supreme Court

of Income Tax of Income Tax of Income Tax (Appeals)

Additional Directors Additional Commissioner

of Income Tax of Income Tax

Joint Directors Joint Commissioner

of Income Tax of Income Tax

Deputy Directors Deputy Commissioner

of Income Tax of Income Tax

Assistant Directors Assistant Commissioner

of Income Tax of Income Tax

Income Tax Officer

Tax Recovery Officer

Income Tax
Inspector

CANONS OF TAXATION
Canons of Taxation are the main basic principles (i.e. rules) set to build a 'Good
Tax System'.
Canons of Taxation were first originally laid down by economist Adam Smith in his
famous book "The Wealth of Nations".
In this book, Adam smith only gave four canons of taxation. These original four
canons are now known as the "Original or Main Canons of Taxation".
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As the time changed, governance expanded and became much more complex
than what it was at the Adam Smith's time. Soon a need was felt by modern
economists to expand Smith's principles of taxation and as a response they put
forward some additional modern canons of taxation.

ADAM SMITH'S FOUR MAIN CANONS OF TAXATION

A good tax system is one which is designed on the basis of an appropriate set of
principles (rules). The tax system should strike a balance between the interest of
the taxpayer and that of tax authorities. Adam Smith was the first economist to
develop a list of Canons of Taxation. These canons are still regarded as characteristics
or features of a good tax system.
Adam Smith gave following four important canons of taxation.
1. Canon of Equity
The principle aims at providing economic and social justice to the people.
According to this principle, every person should pay to the government depending
upon his ability to pay. The rich class people should pay higher taxes to the
government, because without the protection of the government authorities (Police,
Defence, etc.) they could not have earned and enjoyed their income. Adam Smith
argued that the taxes should be proportional to income, i.e., citizens should pay the
taxes in proportion to the revenue which they respectively enjoy under the protection
of the state. Adam Smith has defined the canon of Equality as follows. “The subject
of every state ought to contribute towards the support of the government, as nearly
as possible to their respective abilities, that is, in proportion to the revenue which
they respectively enjoy under the protection of the state.”
2. Canon of Certainty
According to Adam Smith, the tax which an individual has to pay should be
certain, not arbitrary. The tax payer should know in advance how much tax he has
to pay, at what time he has to pay the tax, and in what form the tax is to be paid to
the government. In other words, every tax should satisfy the canon of certainty. At
the same time a good tax system also ensures that the government is also certain
about the amount that will be collected by way of tax. This canon is meant to
protect the tax payer from unnecessary harassment by the tax officials.
3. Canon of Convenience
According to this canon, the taxes should be imposed and collected in such a
manner that it provides the maximum convenience to the tax payer. The mode and
timing of tax payment should be as far as possible, convenient to the tax payers. For
example, land revenue is collected at time of harvest, income tax is deducted at
source and so on. Convenient tax system will encourage people to pay tax and will
increase tax revenue.
4. Canon of Economy
According to this canon, the cost of administration of the tax shall be kept
minimum. This principle states that there should be economy in tax administration.
The cost of tax collection should be lower than the amount of tax collected. It may
not serve any purpose, if the taxes imposed are widespread but are difficult to
administer. Therefore, it would make no sense to impose certain taxes, if it is difficult
to administer.
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ADDITIONAL CANONS OF TAXATION

Activities and functions of the government have increased significantly since
Adam Smith's time. Government is expected to maintain economic stability, full
employment, reduce income inequality & promote growth and development. Tax
system should be such that it meets the requirements of growing state activities.
Accordingly, modern economists gave following additional canons of taxation.
1. Canon of Productivity
It is also known as the canon of fiscal adequacy. According to this principle, the
tax system should be able to yield enough revenue for the treasury and the government
should have no need to resort to deficit financing. This is a good principle to follow in
a developing economy.
2. Canon of Elasticity
According to this canon, every tax imposed by the government should be elastic
in nature. In other words, the income from tax should be capable of increasing or
decreasing according to the requirement of the country. For example, if the government
needs more income at time of crisis, the tax should be capable of yielding more
income through increase in its rate.
3. Canon of Flexibility
It should be easily possible for the authorities to revise the tax structure both
with respect to its coverage and rates, to suit the changing requirements of the
economy. With changing time and conditions the tax system needs to be changed
without much difficulty. The tax system must be flexible and not rigid.
4. Canon of Simplicity
The tax system should not be complicated. That makes it difficult to understand
and administer and results in problems of interpretation and disputes. In India, the
efforts of the government in recent years have been to make the system simple.
5. Canon of Diversity
This principle states that the government should collect taxes from different
sources rather than concentrating on a single source of tax. It is not advisable for
the government to depend upon a single source of tax, it may result in inequity to
the certain section of the society; uncertainty for the government to raise funds. If
the tax revenue comes from diversified source, then any reduction in tax revenue on
account of any one cause is bound to be small.

IMPORTANT DEFINITIONS – BASIC CONCEPTS

Charge of income tax [sec. 4]
The following basic principles are followed while charging tax.
(a) Annual Tax: Income tax is an annual tax on income.
(b) Tax rate of assessment year: Income of previous year is chargeable in the
following assessment year at the tax rates applicable for that assessment
year.
(c) Rates Fixed by Finance Act: Tax Rates are fixed by the Annual Finance Act
and not by the Income Tax Act.
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(d) Tax on Person: Tax is charged on every person.

(e) Tax on Total Income: The tax is levied on the “total income”, of every
assessee computed in accordance with the provisions of the act.
Section 2 and Section 3 of Income Tax Act, 1961 deals with important definitions.

ASSESSMENT[Sec.2 (8)]
According section 2(8) of Income Tax Act, 1961 the term assessment means-
(1) Computation of total income or taxable income;
(2) Computing the tax on that income and
(3) Imposition of tax liability.

ASSESSMENT YEAR [Sec.2(9)]

Assessment year means the period of twelve months commencing on 1st April
every year and ending on 31st March of the next year. For instance, the current
assessment year is 2021-22 which will commence on 1st April 2021, and will end on
31st March 2022. It is fixed by law and never changes. Income of the previous year
will be assessed to tax during the following assessment year at the rates prescribed
for such assessment year by the relevant finance act.

PREVIOUS YEAR [Sec.3]

Previous year means a financial year immediately preceding the assessment year.
In other words, the year in which income is earned is known as previous year. The
income earned in the previous year is taxed in the following assessment year. The
previous year is also known as income year or accounting year.
Previous Year in Case of Newly Established Business or profession [Sec. 3(1)]
The first previous year of any newly established business or profession will be
the period from the date of setting up of a new business or profession till the end of
that financial year.
Illustration: 1
As assessee commences his business on
a) 1st June 2020
b) 1st October 2020
c) 1st December 2020
d) 1st January 2021
e) 1st March 2021
In each case what period will be treated as his first previous year for the
assessment year 2021-22?
Solution
For the assessment year 2021-22. the following period will comprise of the first
previous year in each case
a) Period from 1st June 2020 to 31st March 2021
b) Period from 1st October 2020 to 31st March 2021
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c) Period from 1st December 2020 to 31st March 2021

d) Period from 1st January 2021 to 31st March 2021
e) Period from 1st March 2021 to 31st March 2021
Illustration: 2
Which period will be treated as previous year for income tax purposes for the
assessment year 2021-22 in the following cases?
a) Anand starts a new business on 1st July 2020 and prepares his final accounts
on 30th June 2021.
b) Bhaskar joined service in a company on 1st January 2021 at a salary of
` 25,000 per month; his annual increment in salary will fall on 1st January
2022.
c) Chandrashekar maintain his accounts on the basis of calender year.
d) Darshan is a registered doctor and keeps his books of accounts on the basis
of financial year.
e) Edward bought a house on 1st August 2020 and let out at ` 10,000 per
month from 1st October 2020.
Solution
In each case, the following period will comprise of the first previous year for the
Assessment Year 2021-22.
a) Period from 1st July 2020 to 31st March 2021.
b) Period from 1st January 2021 to 31st March 2021.
c) Period from 1st April 2020 to 31st March 2021.
d) Period from 1st April 2020 to 31st March 2021.
e) Period from 1st August 2020 to 31st March 2021.
Exceptions to the General Rule of Previous Year
The income of the previous year will be assessed to tax in the following
assessment year. However, there are certain exceptions to this general rule of
previous year. In the following cases, the income of the previous year is assessed to
tax in the same year at the rates applicable to that year.
(a) Income of a non-resident from shipping business (sec.172): In the case
of a non-resident shipping company any income earned from carrying
passengers from Indian port will be taxed in the year of its earnings
(b) Income of persons leaving India (sec. 174): When an individual may leave
India during the current assessment year for the purpose of employment and
he has no intention of returning to India, the total income of such an individual
for the period from the expire of the previous year till the date of his departure
from India shall be chargable to tax in the same assessment year.
(c) Income of an association of person or body of individuals formed for a
particular purpose or event (sec. 174A): Where any association of person
or body of individuals is formed for a particular event or purpose and is likely
to be dissolved in the assessment year in which it is formed, the total income
of such AOP or BOI shall be chargable to tax in the same assessment year.