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Sunday, July 21, 2013

Clubbing of Income(spouse, children, parents) in India under Income Tax Act

Most savings instruments allow investment in the name of spouse, children or parents, but with some restrictions. It is common to open a fixed deposit or buy life insurance in the name of spouse or minor children. One can even open a Public Provident Fund (PPF) account or buy stocks in the name of spouse or children. But, beware of the clubbing of income clause...Read on...

What is clubbing of income ?
Most savings instruments allow investment in the name of spouse, children or parents, but with some restrictions. It is common to open a fixed deposit or buy life insurance in the name of spouse or minor children. One can even open a Public Provident Fund (PPF) account or buy stocks in the name of spouse or children. Many seem to think opening fixed deposits in their spouse's name or minor child’s name will reduce their tax liability. Unfortunately this is not so. The tax man has laid specific rules with regard to taxation arising from income clubbing. This is a diverse area and has its own complexities and is termed as "Clubbing of Income".

Can i gift / give money to my close relatives?

Any transfer of assets to close relatives (parent, spouse, sibling, lineal ascendant/descendant) is not taxed. You can transfer this money or assets as a gift. (Refer Gift Tax in India). Many people use this rule to transfer assets to others who are either in a lower tax bracket or do not pay tax at all and save tax on income from these assets. But the tax laws do not allow you to give these gifts for the purpose of avoiding taxation.

What are the rules governing clubbing of income?
Since some people try to take undue advantage of a liberal gift tax rule, To check this, Section 64 of the Income Tax Act contains clubbing provisions as per which any income from investment made or assets purchased in the name of close relatives (spouse, minor child or daughter-in-law) is clubbed with the income of the person making the investment and taxed accordingly. This applies to all types of investments such as shares, fixed deposits, land, building, post office savings and mutual funds.

Let us look at the rules governing Section 60 to 64 of IT Act which related to Clubbing of Income. Income from assets transferred directly or indirectly "other than for adequate consideration" to a person or association of persons who may benefit the individual's spouse or son's wife is also clubbed with the transferor's earnings.

(1) Investing in the name of a minor child (less than 18 years of age)

  • If we invest in the name of our minor child we still need to pay tax on the entire interest income. 
  • if the income is from the child's own skills, manual work, etc, such income will be directly taxed in the hands of the child. All other income will be clubbed in the parent's hands.
  • The parent may claim an exemption of Rs 1,500 per minor child if the clubbing provisions come into play.
  • Income of a minor child is added to husband or wife’s Income depending on whose total income is greater. So if the child earns Rs. 1 Lacs and wife is earning Rs. 5 Lacs and the husband is earning Rs. 4 Lacs, then the income of the child will be added to the wife’s income, which will become Rs. 6 Lacs, and it will be taxed accordingly.
  • Income of a minor child shall not be clubbed and is taxable in the child's hand if the child is suffering from a disability (under Section 80U) such as physical disability, complete blindness or if he earns the income through manual work or any activity involving application of his skills or talent or if both his parents are not alive.

(2) Investing in the name of your spouse or daughter-in-law(D-I-L)

  • If we invest in our spouses / D-I-L's name, we will need to pay tax on the income generated from the sum transferred. 
  • Also, if a person buys a property in the name of his wife, who has not contributed any money, the rental income will be clubbed with his income.

What if the spouse / daughter-in-law re-invests the interest?
Now, we know that the income generated by my wife on the money that i gifted her, is fully taxable on me. But ultimately, the income generated is hers. What if i pay the tax on that income and then she re-invests that income for further profits? This is termed as "interest on interest" and is a little complicated, but very important to understand from taxation perspective.

Illustration of Interest on Interest
A simple illustration will hopefully make this clear:

  • I transfer Rs. 100 to my wife. 
  • She opens a fixed deposit offering 10% interest per year.
  • After a year the balance with her is Rs. 110. "She has earned" Rs. 10.
  • I will have to pay tax on Rs. 10, because this is the income generated from the sum I transferred to her. 
  • At the end of the second year the balance is Rs. 121 (Rs. 110 plus 10% interest on Rs. 110). 
  • Out of the interest income of Rs. 11, Rs.10 is the interest from (my) Rs. 100 and Rs. 1 is the interest from (her) Rs. 10.
  • Rs. 10 is the income generated by my spouse from the Rs. 100 I gave her. I don’t need to pay tax on any subsequent interest generated from this Rs. 10 (he/she will have to if applicable).  I only need to pay tax on the income generated from Rs. 100, the sum I transferred. 
  • Trouble is, as long as the sum remains invested, I always need to pay this tax. This scenario is also applicable if I had gifted the Rs. 100 to my daughter-in-law. Thus the tax liability on income clubbing with spouse (and daughter-in-law) is not zero but is not 100% either

Not a good idea to invest in your spouse / D-I-L / minor child's name
It does not look like a good idea to invest in the name of spouse or D-I-L or even a minor child.
  • If I gift my spouse (or daughter-in-law) Rs. 50,000 and they subsequently invest this amount in a FD offering 8.5% interest (compounded quarterly) for say, 5 years, I need to figure out my tax liability (on Rs. 50,000) each financial year.  
  • My spouse (or daughter-in-law) will have to figure out their tax liability (interest on interest earned) each financial year. 
  • Surely this is a headache for a law abiding tax paying citizen. It is a terrible idea to open a fixed deposit in your spouse’s name with your money. In general, this arrangement is a terrible idea with any taxable instrument. 
  • This is terrible, because of the complex way in which the interest income will be taxed. 
  • Not only that, this becomes more complex if the spouse is in 10% or 20% tax bracket, and you are in 30% tax bracket.
  • This complexity further increases because your spouse liability may not be even 10% on her share of income (from interest on interest) but the bank would deduct at least 10% TDS, which then needs to be asked for refund during ITR filing.

How to legally prevent Clubbing of Income?
Given all the above constraints, is there any way i can benefit from the investments in my family member's name and that too legally? Yes, there are. Simplest way of saving tax is by investing through parents, parent in laws, wife and children. If you invest in the right instrument, the rate of return may be higher as well. Here is how we can save tax through our family members.

(1) Invest in the name of a major child

  • Tax liability on income clubbing with a major child is zero, which essentially means that any such income will be taxable in the hands of the major child. If your major child (above 18 years of age) is still not in a high tax bracket, you can take the tax bracket differential benefit. Unfortunately in this case, the parent’s access to the transferred sum and income generated is at the discretion of the child.
  • If, however, due to some reasons you do not feel inclined to make huge gifts to your major children, then you may give interest-free loans to your adult children so as to legally reduce your taxable income. It is lawful to grant interest-free loans to adult children from your own funds.
(2) Loan Money

  • If a person is in the higher tax bracket than his wife, he can transfer a certain sum to his wife in exchange for her jewelry. She can open a fixed deposit so that the interest is taxed in her hands at a lower rate.
  • Its a fact that your own parents as well as your own in-laws can become legal tools of tax planning for you and your family. If you want to achieve this dictum then all you are need to do is just to give away a portion of your funds, either as a gift or a loan, to your parents as well as your parents in law so that in years to follow your income tax burden becomes lighter as the income on funds transferred by you to them which would bring in income, would be taxed in their hands (which might be lower than yours)
(3) Time Your Gifts

  • Plan ahead and gift before the wedding. Since clubbing applies only when the other person is your wife or daughter-in-law, you can plan a little ahead and smartly gift assets before the marriage. (of course there is a cap to the non taxable gift amount that you can give to non-relatives - refer Gift Tax rules in India).
  • Gift even if the income is clubbed. Since income on income is not clubbed, this might still be advantageous to you if you earn a lot and your spouse doesn't. (you are in different tax brackets). Same planning can be done for parents in laws.
(4) Invest in Tax Exempt Income

  • One can also avoid clubbing of income by opting for tax exempt investments. As an example, there is no tax on income from the Public Provident Fund . There is also no tax on gains from shares and equity mutual funds if held for more than a year. So, if one invests in these options in the name of the spouse, there is no additional tax liability.

If you are resorting to roundabout ways to save tax, be careful not to rub law the wrong way. The government has upped the ante against transactions intended at avoiding tax.If you are careful, you can use your family to save a lot of taxes.

Like the article? Do not hesitate to share. It can make a positive impact on someone's life.

The book "From the Rat Race to Financial Freedom" has many such investment concepts explained in a very simple and uncomplicated manner.


Manoj Arora
Freedom can buy you.... what money cannot !!

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