Planning to earn tax-free income-II

In the wonderland of Investment

Last week we examined a simple yet effective tax planning tool. By way of a background, when the provisions of Sec. 56 (relating to tax on gifts) and the basic exemption limit below which income is tax-free are used in conjunction with each other, there emerges an immense potential to earn tax-free income. We saw, how Mehta who otherwise was in the highest tax bracket could manage to convert the return on almost Rs 1.40 crore of his capital into tax-free income. Note that it is not Rs 1.40 crore of income but the return (interest) on this amount that can be made tax-free. This was essentially done by way of effecting gifts of one’s post tax paid capital to one’s parents and major children who otherwise are not taxpayers. When the recipients of the gifts invest the money, the entire family can earn income free of tax.

Subsequently, several readers wrote in seeking clarifications. While space constraints would preclude replying to each and every query, today’s piece seeks to address issues that readers came up most frequently with in trying to put this tax planning strategy into practice. Most readers, we found were worried that in spite of giving the gifts, eventually the income there from would be clubbed in their hands. Some even expressed concerns about the attraction of gift tax. In this regard, readers ought to know that gift tax has been discontinued in India since October 1, 1998 and hence there is no question of the transaction coming under the purview of gift tax. As far as clubbing is concerned, if you recall, Mehta’s wife wasn’t amongst the recipients. Also, both of Mehta’s children were above eighteen years of age.

In other words, clubbing provisions can and will be attracted in the case of gifts made to spouse and minor children. However, family members (except spouse) who are major (above 18 years of age) can freely be given any amount of money as a gift without the donor coming into the clubbing net.  Another popular clarification requested for was to do with the procedure of making the gift and whether it is necessary to make a gift deed on a stamp paper.

Well, generally, it is better to prepare a gift deed and get it registered (with related stamp duty) but such a precaution is normally needed in the case of high-value gifts, particularly those of real estate. For our purposes, all that is required is an offer by the donor and acceptance thereof by the recipient carried out in black and white. In other words, the donor can offer the gift and the recipient should accept the same in writing (maybe through a thank you note). Only then it would be considered as a gift in India. It is preferable to mention the relationship between the donor and the recipient and both parties concerned should keep this document on file for ready reference whenever needed.

Some readers expressed concerns that giving a gift to parents may require them (the parents) to have to file a tax return. Well — the purpose of the entire strategy is that the income from the gifted money shouldn’t entail earning taxable income. Therefore, care should be taken to ensure that income from the gifted amount doesn’t take the parents’ income above Rs 3 lakh. If the income of a senior citizen is Rs 3 lakh or less, there is no necessity of filing a tax return. In last week’s article, we had taken the example of the parents being gifted an amount of Rs 40 lakh each. This money is invested in a bank FD earning 7.5 per cent per annum interest which translates into an interest income of Rs 3 lakh. Thus the amount is tax-free since it is equal to the basic exemption limit for senior citizens.

Last but not the least, there are some readers who seem to have acquired an impression that the act of giving a gift by itself leads to tax deduction. Consequently, they inquired whether giving a gift, as explained in the article, would lead to a lower deduction of TDS on salary. The answer is a simple no. There is no tax deduction per se for giving gifts to family members.

The tax planning mechanism under consideration seeks to optimize post tax income i.e. left over income after having paid tax. If you recollect the example, Mehta was in the highest tax bracket. Therefore, when he invests in a bank FD from out of his post tax salary, the interest on such FD becomes fully taxable. However, if he were to gift the amount to his parents and they invest the money, the interest that they earn would be tax-free. However none of this would affect the TDS that Mehta’s employer would be deducting.

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