Basic Concepts and Residential Status notes — Unit 1

The power to levy a tax is an attribute of sovereignty. In India, this power is strictly regulated by the Constitution.

⇒Article 265: The Golden Rule

'No tax shall be levied or collected except by authority of law.'

• This means the government cannot arbitrarily demand money. Every tax must be backed by a validly enacted statute.
• If an executive officer levies a tax without legislative backing, it is illegal and can be challenged in the High Court.

⇒Distribution of Taxing Powers (Schedule VII)

• Union List (Entry 82): Taxes on income other than agricultural income. (This is the source of the Income Tax Act).
• State List (Entry 46): Taxes on agricultural income. (This is why the Central Govt cannot tax agricultural income).
• Concurrent List: Unlike general subjects (like criminal law), taxing entries are generally NOT put in the concurrent list to avoid double taxation by both center and state. (GST is a special constitutional exception).

To understand tax law, you must master its specific vocabulary.

⇒Assessee (Sec 2(7))

An assessee is a person by whom any tax or any other sum of money (like penalty or interest) is payable under the Income Tax Act.

• Ordinary Assessee: A person liable to pay tax on their own income.
• Deemed Assessee: A person liable to pay tax on someone else's income (e.g., a legal representative of a deceased person, or the guardian of a minor).
• Assessee in Default: A person who fails to fulfill a statutory duty (e.g., an employer who forgets to deduct TDS before paying a salary).

⇒Person (Sec 2(31))

Income tax is levied on a 'person'. The definition is inclusive and very broad:

• 1. An Individual (human being).
• 2. A Hindu Undivided Family (HUF).
• 3. A Company.
• 4. A Firm (Partnership/LLP).
• 5. An Association of Persons (AOP) or Body of Individuals (BOI).
• 6. A Local Authority (Municipality).
• 7. Every Artificial Juridical Person (e.g., a University, an Idol in a temple).

Income is earned in one year, and taxed in the next year. This creates two distinct timelines.

⇒Previous Year (PY) - Section 3

The financial year in which the income is actually earned. It always begins on 1st April and ends on 31st March of the following year.

• Exception for New Business: If a new business starts on Oct 1st, its first 'Previous Year' will be from Oct 1st to March 31st (less than 12 months). But subsequent years will always be exactly 12 months.

⇒Assessment Year (AY) - Section 2(9)

The period of 12 months commencing on the 1st day of April immediately following the Previous Year. This is the year in which the income earned in the PY is evaluated and taxed.

General Rule: Income of the Previous Year is taxed in the Assessment Year.

Exceptions: In certain urgent situations, the government cannot wait for the Assessment Year to collect the tax. In these cases, the income is taxed in the same year it is earned.

• 1. Shipping business of non-residents (Sec 172): A foreign ship leaves an Indian port carrying passengers/goods. It might never return. The tax must be collected before the ship leaves.
• 2. Persons leaving India permanently (Sec 174): If someone is relocating abroad with no intention of returning, they must clear their tax dues for the current year before leaving.
• 3. Bodies formed for a short duration (Sec 174A): An Association of Persons formed for a specific 3-month project and then dissolved.
• 4. Persons likely to transfer property to avoid tax (Sec 175): If the tax officer suspects someone is selling off assets to run away without paying tax.
• 5. Discontinued Business (Sec 176): If a business shuts down permanently, the tax officer has the discretion to tax its income in the same year it closes.

What exactly is 'Income'? The Income Tax Act does not define it strictly; it only provides an inclusive list. Over the years, the Supreme Court has laid down several principles to identify income.

⇒Key Characteristics of Income

• Definite Source: Income must have a definite source (like a job, a house, a business). A random windfall (like finding money on the street) was historically not income, though laws have changed to tax lotteries.
• Periodicity: Income is usually a periodic return (weekly, monthly). However, even a lump sum (like winning KBC) is now taxed as income.
• Receipt from Outside: A person cannot earn income from themselves. (e.g., A club collecting subscriptions from members and spending it on members is 'mutuality'—not taxable income).
• Legality is Irrelevant: Income earned from smuggling, bribery, or extortion is fully taxable. The tax department does not care if the money is black; they just want their cut. (Though the earner will separately face criminal charges).

⇒Capital Receipt vs. Revenue Receipt

This is a fundamental accounting and tax principle.

• Revenue Receipt: Taxable (e.g., Rent received, Salary, Profit from selling goods). It is the fruit of the tree.
• Capital Receipt: Generally NOT taxable, unless specifically mentioned under 'Capital Gains' (e.g., Selling the house itself, receiving a loan, getting life insurance maturity amount). It is the sale of the tree itself.

Citizenship has absolutely NOTHING to do with Income Tax in India. You are taxed based on your 'Residential Status' (how many days you spend in India).

⇒Why is Residential Status important?

It determines the 'Scope of Total Income' (Section 5). An Indian resident pays tax on their global income. A non-resident pays tax only on the income earned within India.

⇒Categories of Individuals

An individual can be:

• 1. Resident and Ordinarily Resident (ROR)
• 2. Resident but Not Ordinarily Resident (RNOR)
• 3. Non-Resident (NR)

To be classified as a 'Resident' in India for a particular Previous Year, an individual must satisfy ANY ONE of the following two basic conditions:

⇒Basic Condition (a) [The 182-Day Rule]

The person is in India during the relevant Previous Year for a total period of 182 days or more.

⇒Basic Condition (b) [The 60 + 365 Rule]

The person is in India for 60 days or more during the relevant Previous Year, AND has been in India for 365 days or more during the 4 Previous Years immediately preceding the relevant Previous Year.

The government realized that the '60 day' limit in Condition (b) was too harsh for certain Indians who travel abroad. For the following specific categories of people, Condition (b) is totally ignored. They are only judged by Condition (a) (the 182-day rule):

• 1. Leaving for Employment: An Indian citizen who leaves India during the PY for the purpose of employment outside India.
• 2. Crew Member: An Indian citizen who leaves India as a member of the crew of an Indian ship.
• 3. Visiting India: An Indian citizen, or a Person of Indian Origin (PIO), who comes on a visit to India during the PY. (Note: A recent amendment restricts this if their total Indian income exceeds ₹15 Lakhs, reducing the 182-day limit to 120 days for them).

Definition of PIO: A person whose parents or grandparents were born in undivided India.

If an individual is found to be a 'Resident' (Step 1), we must further classify them as ROR or RNOR. To become 'Resident and Ordinarily Resident (ROR)', the person must satisfy BOTH of the following Additional Conditions:

⇒Additional Condition (a) [The 2-out-of-10 Rule]

The person has been a Resident in India (by satisfying the basic conditions) in at least 2 out of the 10 Previous Years immediately preceding the relevant Previous Year.

⇒Additional Condition (b) [The 730-Day Rule]

The person has been in India for a total of 730 days or more during the 7 Previous Years immediately preceding the relevant Previous Year.

The rules for artificial entities depend on 'Control and Management'.

⇒Hindu Undivided Family (HUF), Firm, and AOP

They are considered Resident in India if the Control and Management of their affairs is situated wholly or partly in India.

• If the control is situated wholly outside India, they are Non-Resident.
• (Note: An HUF can further be classified as ROR or RNOR depending on the residential status of its Karta. Firms and Companies are never classified as ROR/RNOR, they are simply Resident or Non-Resident).

⇒Company

A company is considered Resident in India in any previous year if:

• 1. It is an Indian Company (registered under the Companies Act in India) -> ALWAYS Resident.
• 2. For foreign companies: If its Place of Effective Management (POEM) in that year is in India.

POEM means the place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance, made.

This is the ultimate reason we calculate residential status. It determines exactly which incomes the Indian government has the jurisdiction to tax.

⇒Three Categories of Income

Income is generally divided into three types based on geography:

• 1. Indian Income: Income received/deemed to be received in India, OR income accruing/arising (earned) in India. (e.g., Salary earned by working in Mumbai; Rent from a house in Delhi).
• 2. Foreign Income (Business controlled from India): Income earned and received outside India, BUT derived from a business controlled from India or a profession set up in India.
• 3. Pure Foreign Income: Income earned outside India, received outside India, from a business controlled outside India. (e.g., Rent from a house in London, received in a London bank account).

Based on Section 5, here is how the three categories of income apply to the three residential statuses:

Sometimes, people try to route transactions through foreign countries to avoid Indian tax. Section 9 creates a legal fiction. Even if an income is technically earned and received outside India, the law 'deems' it to be earned in India if it has a strong Indian connection.

⇒Examples of Section 9

• Business Connection: Any income arising through a business connection in India.
• Property in India: Income from any property, asset, or source of income in India (e.g., a foreigner selling shares of an Indian company in New York—the capital gains are deemed to accrue in India).
• Salary for Services in India: A US citizen works for a US company but comes to India for a 3-month project. The salary for those 3 months is deemed to accrue in India.
• Interest, Royalty, and Technical Fees: If paid by the Indian Government, or paid by a resident Indian (unless the loan/knowledge was used strictly for a foreign business).

⇒Summary of Master Concepts

• PY vs AY: Earn in Previous Year, Pay in Assessment Year. Exceptions exist (shipping, leaving India, closing business).
• Income vs Capital: Revenue receipts are taxable, capital receipts generally aren't.
• Residential Status (Basic): 182 days OR (60 days + 365 in 4 years). Exceptions for employment/crew ignore the 60-day rule.
• Residential Status (Additional): 2 out of 10 years Resident AND 730 days in 7 years.
• Scope of Income: ROR pays on everything. NR pays only on Indian income.

⇒University Exam Tips for this Unit (Premium Advice)

• The Practical Problem: You will almost certainly get a 10-mark practical problem calculating the residential status of a person (e.g., 'Mr. X left for Germany on...'). Always solve it step-by-step: Step 1 (Basic Conditions), Step 2 (Additional Conditions). State the conclusion clearly.
• The Exceptions to PY: 'Income of PY is taxed in AY. Discuss exceptions.' This is a highly repeated 5-mark short note. Memorize the 5 exceptions.
• The Taxability Matrix: If asked about 'Scope of Total Income', literally draw the 3x3 table provided on Page 12. Examiners give maximum marks for clear tabular representations.