Direct Tax: Meaning, Types, Significance & Criticisms

Direct Taxes form a key component of a country’s Taxation System as well as Fiscal Policy. Vital for government revenue generation, wealth redistribution, and economic regulation, they play a crucial role in ensuring the equitable distribution of resources and funding essential public services. This article of NEXT IAS aims to study in detail the Direct Tax, including its meaning, types, significance, and criticisms. Various types of direct taxes such as Income Tax, Corporate Tax, Wealth Tax, Securities Transaction Tax, and others are dealt with in detail in the article.

What is Tax?

• Taxes are involuntary fees levied on individuals, businesses, or corporations that are enforced by a government entity, whether local, regional, or national.
  • Thus, they are compulsory levies payable by an entity to the government.
• Taxes are the basic source of revenue for the government which is utilized by the government for its various expenses such as Defence, Healthcare, Education, and different infrastructure facilities like roads, dams, highways, etc.

Read our detailed article on the Taxation System.

Direct Tax

• Direct Tax refers to the type of tax that is borne by a person/entity on whom it is levied.
• Thus, in this case, the Impact of Tax and the Incidence of Tax fall on the same person or entity.
  • In other words, the burden of a Direct Tax cannot be shifted to another person or entity.
• Direct Taxes in India is administered by the Central Board of Direct Taxes (CBDT), which is a part of the Department of Revenue (under the Ministry of Finance).

Indirect Tax – Indirect Tax refers to the type of tax for which the Impact of Tax and Incidence of Tax fall on different persons or entities. – They are, generally, imposed on goods and services.

Read in detail about the Types of Taxes.

Features of Direct Tax

Some of the prominent characteristics of Direct Taxes can be seen as follows:

• Tax on Income: They are levied directly on the income of individuals or businesses, rather than on the consumption of goods and services.
• Paid Directly: Unlike indirect taxes, which are collected by intermediaries such as sellers and paid indirectly to the government, direct taxes are paid directly by the taxpayer to the government
• Progressive Nature: They tend to be progressive, meaning the tax rate increases as the income level increases.
• Narrow Base: They typically have a narrow tax base, as they are imposed only beyond a certain threshold value of income.

Types of Direct Tax

• Some prominent examples of Direct Taxes in India include:
  • Income Tax (IT)
  • Corporate Tax
  • Minimum Alternate Tax (MAT)
  • Alternate Minimum Tax (AMT)
  • Capital Gains Tax (CGT)
  • Securities Transaction Tax (STT)
  • Dividend Distribution Tax (DDT)
  • Wealth Tax
  • Banking Cash Transaction Tax (BCTT)
  • Digital Tax – Google Tax or GAFA Tax or Equalization Levy
• Each of these taxes is discussed in detail in the sections that follow.

Income Tax

• It is a type of direct tax that is charged directly on the income of an entity such as Individuals, Hindu Undivided Families (HUFs), Cooperative Societies, Trusts, Partnership Firms, Companies, etc.
• Income tax is charged on “taxable income”, which depends on the total income and exemptions applicable.

Taxable Income = Total Income – Applicable Deductions and Exemptions.

• Income Tax is of two types – Personal Income Tax and Corporate Income Tax.
  • Each of these taxes is discussed in the sections that follow.

Personal Income Tax

• It is often referred to as simply Income Tax, though it is a sub-type of Income Tax.
• Personal Income Tax is the income tax levied on the incomes of Individuals, Households, Hindu Undivided Families (HUF), Partnership Firms, Sole Proprietorships, etc.
• Various types of income covered under Personal Income Tax are – salary, profits from business/profession, rental income, income from interest, royalty, etc.
• It is governed by the Income Tax Act, 1961 (IT Act, 1961).

Corporate Income Tax or Corporate Tax

• It is often referred to as simply Corporate Tax.
• Corporate Income Tax is the income tax levied on profits earned by the incorporated firms or companies.
  • Thus, similar to Personal Income Tax, Corporate Tax is also a type of Income Tax. But, since the contribution of Corporate Tax to the overall tax revenue is significantly high, so it has been made a separate category of income tax.
• Companies, both public and private, which are registered in India under the Companies (Amendment) Act, 2019 are liable to pay Corporate Tax.
• It is also governed by the Income Tax Act, 1961 (IT Act, 1961).

Minimum Alternate Tax (MAT)

Minimum Alternate Tax (MAT) refers to the tax imposed on “Zero Tax Companies”, which escape the Corporate Tax net or pay very low taxes by using the provisions of exemptions, deductions, incentives, etc.

Zero Tax Companies

• Zero Tax Companies are companies that, despite earning significant profits, manage to pay little or no Corporate Tax by making use of various tax deductions, exemptions, credits, and loopholes in the tax system.
• Such companies, although show book profits and may even declare dividends to the shareholders, they do not pay any tax.
• In order to bring such companies under the Income Tax net, Minimum Alternate Tax (MAT) was introduced in 1997-98.
  • Now, a company must pay at least either Corporate Tax or Minimum Alternate Tax (MAT), whichever is higher.

Generally, Income Tax is computed as per the provisions of the Income Tax Act. However, companies compute their book profit as per provisions of the Companies (Amendment) Act, 2019. But, as the Income Tax Act allows several kinds of exemptions, depreciations, and deductions from gross income or book profit, companies are able to show their taxable income as very low. Thus, the amount of tax comes out to be very low.

Alternate Minimum Tax (AMT)

Alternate Minimum Tax (AMT) is the same as Minimum Alternate Tax (MAT) but is imposed on commercial establishments other than companies, like partnership firms, etc.

Capital Gains Tax (CGT)

• Capital Gains Tax (CGT) is a tax levied on the profit one makes from selling a Capital Asset.
• In other words, it’s a tax on the gains one earns from investments or property sales.

Capital Asset

• A ‘Capital Asset’ is officially defined as any kind of property held by an assessee, excluding goods held as stock-in-trade, agricultural land, and personal effects.
• Some examples of Capital Assets include – Land, Buildings, House Property, Vehicles, Patents, Trademarks, Leasehold Rights, Machinery, and Jewellery.
• The following are not considered Capital Assets:
  • Stock in trade.
  • Consumable stores or raw materials held for the purpose of business or profession.
  • Personal effects that are movable except jewelry, archaeological collections, drawings, paintings, sculptures, or any artwork held for personal use.
  • Agricultural Land: The land must not be located within 8 km from a municipality, Municipal Corporation, notified area committee, town committee, or cantonment board with a minimum population of 10,000.
  • 6.5 percent Gold Bonds, National Defence Gold Bonds, and Special Bearer Bonds.
  • Gold Deposit bonds under the Gold Deposit Scheme.
• Broadly, there are two types of Capital Assets:

Short-Term Capital Asset

Short-Term Capital Asset refers to a capital asset that is held for equal to or less than a specified period (say 36 months).

Long-Term Capital Asset

Long-Term Capital Asset refers to a capital asset that is held for more than a specified period (say 36 months).

Securities Transaction Tax (STT)

• Securities Transaction Tax (STT) is a tax levied on every purchase or sale of securities listed on recognized stock exchanges such as shares, bonds, mutual funds, etc.
• It is levied on the value of the transaction of securities.
  • Thus, it is distinct from Capital Gains Tax, which applies to the profit you earn on the sale of securities.
• STT was introduced in the Budget of 2004.
• The primary purpose for introducing the Securities Transaction Tax (STT) is to curb tax evasion on capital gains as the STT is taxed at source.

Dividend Distribution Tax (DDT)

• Dividend Distribution Tax (DDT) is a tax imposed on dividends paid by a corporation to its shareholders.
• It is a withholding tax, meaning the company deducted the tax before paying out the dividends to shareholders.
• In India, only domestic companies as defined under the IT Act had to pay Dividend Distribution Tax (DDT).
  • However, DDT has been abolished in India w.e.f. 1st April, 2020.

Wealth Tax

• Wealth Tax is a tax levied on the net wealth or assets of Individuals, Hindu Undivided Families (HUFs), or Companies.
• Unlike Income Tax, which is based on earnings, Wealth Tax targets the value of owned assets.
• In India, Wealth Tax was governed by the Wealth Tax Act, 1957.
  • However, it has been abolished w.e.f. 1st April, 2016.

Banking Cash Transaction Tax (BCTT)

• Banking Cash Transaction Tax (BCTT) is a tax levied on cash withdrawals exceeding a specified amount (say ₹25,000) in a day by an Individual or HUF from a non-saving bank account (i.e. bank accounts other than savings bank accounts).
• In India, it was introduced in 2005. However, later, it was withdrawn in 2009.
• In 2017, the Committee of Chief Ministers on Digital Payments recommended the re-introduction of BCTT to promote digital payments.
  • However, it has not been re-introduced as of now.
• BCTT helps the government prevent tax evasion by taxing at the source itself.
  • However, the flip side is that any such tax adds to the burden of the customer and may receive a backlash.

Professional Tax

• Professional Tax is a tax levied on individuals earning an income from salary or practicing a profession such as chartered accountants, lawyers, doctors, and other similar professions.
• Unlike other direct taxes, it is levied and collected by State Governments.

Digital Tax – Google Tax or GAFA Tax or Equalization Levy

• Digital Tax, also known as Digital Services Tax (DST), is a levy imposed on the earnings of digital companies from digital services provided in jurisdictions where they do not have a significant physical presence.
• This tax aims to address the challenges of taxing digital and online activities in the global economy.
• The rationale behind the tax can be seen as follows.

Rationale Behind Digital Tax Traditional tax systems rely on a company’s physical presence in a country to determine tax liability. However, most digital businesses operate primarily online with minimal physical presence, allowing them to potentially avoid taxes in jurisdictions where they earn a significant portion of their profits. This, ultimately, has the effect of Base Erosion and Profit Shifting and puts a dent in the tax revenue of the countries where such companies make significant earnings.

• Digital Tax is known by different names in different jurisdictions and assumes shape accordingly.
  • Some of the most prominent forms of Digital Tax are discussed in the sections that follow.

Google Tax

• Google Tax is a form of Digital Tax or Digital Services Tax (DST).
• Though it is named after just one internet giant Google, it aims to levy a Digital Tax on all digital companies.

GAFA Tax

• GAFA Tax is also a form of Digital Tax.
• GAFA Tax is named after Google, Apple, Facebook, and Amazon – the 4 largest technology and internet companies.
• Several countries across the world have introduced their own versions of the GAFA Tax.

Equalization Levy

• Equalization Levy is a form of Digital Tax introduced in India in 2016.
• It is levied on the amount paid to non-resident companies (i.e. without permanent establishment) by Indian companies on 12 digital services, including online advertisement provided by them.
• It is applicable on payments exceeding ₹1 lakh during a financial year.
• It is a withholding tax, meaning that the Indian Company making payment to a non-resident digital service provider deducts the amount at the time of payment itself.

Merits of Direct Tax

Some of the major advantages of Direct Tax are as follows:

• Social and Economic Equity: They are, mostly, progressive in nature i.e. levied on the basis of ability to pay. Thus, they help in containing income inequalities and ensure social justice.
• Relatively Elastic: They are relatively elastic as an increase in the income of individuals and companies leads to an increase in the revenue from these taxes.
• Certainty: As the tax rates for these taxes are decided in advance, they have an element of certainty. The taxpayers are certain as to how much tax is to be paid, while the government can estimate the tax revenue from these taxes.
• Low Cost of Collection: Collection of these taxes is generally economical as compared to other forms of taxes. For example, Personal Income Tax can be deducted at source (TDS) from the income or salaries of the individuals.
• Checks Inflation: They can help control inflation. When inflation is on the rise, the government may increase the tax rate. This reduces the money supply, and hence demand and inflation.

Demerits of Direct Tax

Some of the major disadvantages of Direct Tax are as follows:

• Tax Evasion: By its very nature, these types of taxes face the issues of tax evasion. This issue is largely not faced in the case of Indirect Taxes.
• Impacts Capital Formation: They directly affect savings. This, in turn, has an impact on savings and investments and hence capital formation.
• Arbitrariness in Rates and Exemptions: There is no objective defined for determining the tax rates of direct taxes. Also, the exemption limits in most of these taxes such as Personal Income Tax are determined in an arbitrary manner.
• Imbalance in Sectoral Taxation: In India, there is a sectoral imbalance in the levying of these taxes. Certain sectors like the corporate sector are heavily taxed, whereas, the agriculture sector is 100% tax-free.

Conclusion

Direct Taxes are a crucial aspect of a nation’s tax system, playing a vital role in revenue generation, economic redistribution, and influencing economic behavior. While they offer significant benefits in terms of equity and fiscal stability, they also present challenges related to compliance, economic distortion, and political feasibility. Effective management and continuous reforms in the direct tax system are necessary to address the evolving economic landscape and societal needs.

Direct Tax Code (DTC)

• Direct Tax Code (DTC) is a tax reform step, which aims at simplifying the tax laws and regulations in India into a single legislation.
• In simple terms, it aims to bring a single Direct Tax Code (DTC) for various types of direct taxes.
• For this purpose, a Direct Tax Code (DTC) Bill, 2010 has been brought, which aims to replace the Income Tax Act, 1961 and Wealth Tax, 1957.

Expected Provisions of Direct Tax Code

• Simplified Law: Expected to contain less than 400 sections (vis-a-vis 700 earlier), with an easier compliance mechanism.
• Changes in Personal Tax Slabs: to benefit middle and upper-middle-class Indians.
• Uniform Corporate Tax: across-the-board 25% tax rate for both local and foreign companies.
• Removal of Surcharges and Cesses on personal and corporate taxes.
• ‘Assessing Unit’ to replace ‘Assessing Officer’: To check harassment by tax officials, individual ‘assessment officers’ are likely to be replaced with ‘assessment units’.
• Removal of Dividend Distribution Tax: To allow for dividends to be taxed only in the hands of shareholders.
• Repatriation Tax or “Branch Profit Tax”: for foreign companies on the earnings they repatriate to their overseas parent. This will be over and above the corporate tax.
• Mediation: The draft DTC might announce a new concept of settling disputes through mediation between the taxpayer and a Collegium of Commissioners, to help avoid tax litigation.
• Litigation Management Unit: to deal with the tax litigation process under the new income tax law.
• A slew of incentives for start-ups.

Central Board of Direct Taxes (CBDT)

• The Central Board of Direct Taxes (CBDT) is the apex body responsible for administering direct taxes in India.
• It is a part of the Department of Revenue in the Ministry of Finance, Government of India.
• The CBDT provides essential inputs for policy and planning of direct taxes in India and is also responsible for the administration of direct tax laws through the Income Tax Department.