A 5 step guide on calculation of Income Tax

The law of the land is that when we earn income, we need to pay a portion of that as tax towards government treasury. How that portion is arrived at is a mystery uncovered in close to 300 sections of the Income Tax Act, over 100 Income Tax Rules,  further supported by several guidance notes, circulars, notifications, and court rulings on various cases.( It’s complicated!)  It makes sense to leave these details for the experts to comprehend. However, as a taxpayer, we need to be familiar with the broad structure and understand the implications of a few terms used in the normal Income tax parlance. These are some basics that all of us must know:

Step 1- Heads of Income

Any income that we earn, has to classify under one of the five categories – >>We may earn a salary

>>Receive a rental income from a house that we own

>>Get a profit (or suffer loss) from a business activity or from a professional practice

>>Enjoy capital gains(or suffer a capital loss) by selling an asset

>>Or an income from other source that doesn’t fall in any of the categories above.

The first step is to classify all that you earn into one or more of the above heads of income. However, not all of what you earn shall be taxed (Smile). The next step is to calculate the “Taxable” income under each head.

Step 2- Taxable Income

Under each head, some part of income is excluded or not counted at all.  These are called “exemptions”.  It is not necessary that the exemption enjoyed by us is also enjoyed by our neighbour. The benefit amount varies from person to person. We must analyse the exemptions that we specifically enjoy. Incomes under each head so arrived at after applying these exemptions are then summed up. Income from capital gains is calculated and taxed in a different way and therefore it is excluded from this total.

The sum total of all these taxable incomes is called the “gross total income”.

Step 3- Deductions

Apart from the exemptions under each head of income, certain amounts are also enjoyed as “Deductions” (Cheers to that!). These amounts are in the nature of investments that we make, insurance premiums we pay or even the principal amounts we repay on housing loans. We may look up for sections 80C to 80U to get an idea of what kind of investments or contributions we must make to avail the benefit. These amounts are deducted from gross total income and we are left with what is called the “Net Taxable Income”.

Step 4 -Tax amount

Tax amount is then calculated by applying the appropriate tax rate to the net taxable income. Education cess and additional education cess amounts are added to this.

For incomes above Rs. 1cr, a surcharge is also added. Amounts for ‘rebate’ and ‘relief’ are then reduced. We thus, get the final tax liability.


Deductions, exemptions, rebates and reliefs

Many a time we use the word ‘deduction’, ‘exemption’,’rebates’ and ‘reliefs’ interchangeably. We must realize that these are terms with different implications. As seen above, an exemption is excluded while calculating the taxable income under each head whereas, a deduction is the amount reduced from the gross total income. The impacts of deduction and exemption are similar. They ultimately reduce the net taxable income and thus indirectly reduce the tax amount. Rebates and reliefs go to reduce the tax amount directly. 

Step 5 – Refund or Tax payable

The government collects taxes beforehand in the form of TDS and advance taxes. Tax deducted at source (TDS) is an amount that is deducted from our incomes directly by the person who pays us the income. They then deposit this tax amount on our behalf, with the government. Advance tax is paid to the government by the taxpayers themselves usually every quarter.

TDS and advance taxes are calculated on the basis of projected incomes and hence it is unlikely that it would exactly match the tax liability that is later calculated on the actual incomes. There would in most cases be a difference. If the TDS/ advance tax amount is higher, we are eligible for a refund. If not, then we must pay the difference amount.

These 5 steps in a nutshell, is nothing but all the information required for our ‘Income tax return’. Once we understand this structure, it is easy to see its applicability to our individual case. We may then dig deeper to understand areas where we need to exercise caution or areas where we could exploit the benefits to the maximum. Happy tax planning!