Tuesday, June 14, 2011

TAX PLANNING IN INDIA - HUF BENEFITS

A tax professional is the last person you would expect to dish out matrimonial advice, but Delhi-based chartered accountant Mahesh Agarwal often tells his bachelor clients to tie the knot. "If they are paying too much tax and all possible deductions have been availed of, the only way to bring down the tax liability is by starting a Hindu Undivided Family (HUF). However, they can do so only after they marry," he says.

Though tax planning must figure in the list of 10 whackiest reasons to say 'I do', there is no doubt about the usefulness of the HUF as a tax planning tool. The taxman treats the HUF as another entity, which is entitled to the same exemptions as any other individual taxpayer and enjoys the same deductions as you and I. This effectively gives the kartaan additional basic tax exemption of 1.8 lakh per year, an additional tax deduction under Sections 80C, 80CCF and 80D, along with the benefit of lower tax slabs.



The enormous tax savings from this arrangement are what led Suresh Bohra to set up an HUF in 1995. It helps this Delhi-based stocks and commodities broker save close to 86,000 a year in taxes. "As the kartaof the HUF, I get a combined basic exemption of 3.6 lakh a year as well as a savings limit of 2.4 lakh a year under Section 80C and 80CCF," he says.
Bohra isn't alone. Lakhs of taxpayers, including salaried professionals, small businessmen, even retirees, use HUFs to save tax. You too can avail of this benefit provided you fulfil the conditions and complete the legal formalities laid down for an HUF.


Who can form HUF?


Any Hindu, Sikh, Jain or Buddhist man can form an HUF, provided he is married. In fact, an HUF is automatically constituted when a couple exchanges wedding vows. Still, there are a few simple formalities to be completed for the HUF to function as a legal entity (see graphic).
The first step is to form a corpus for the HUF. This can be any capital asset (property, gold, jewellery, securities, deposits) or cash. This is not as easy as it may sound. You can't transfer just any asset to your family 'hotchpot'. Any personal funds or property given by an individual to the HUF will lead to clubbing provisions under Section 64 (2) of the Income Tax Act. This means the income from these assets will be treated as that of the individual, thus defeating the very purpose for which the HUF was established.
A husband and wife can form an HUF but a wife can only be a member, not a co-parcener. Therefore, the HUF income will not be assessed separately. A member has equal rights but only a co-parcener can demand the partition of the HUF. "Only the birth of a child will give the unit the status of an HUF for tax purposes," says chartered accountant and legal expert Rakesh Gupta.


The HUF can be formed with money received as gifts from relatives. But there's again a tax implication here. While there is no tax on gifts received by an individual from specified blood relatives, the HUF does not enjoy this exemption. "The HUF is not an individual, so it has no relatives. Any money it gets will be treated as a gift from a stranger. If the value of the assets received as gifts in a year exceeds 50,000, it will be deemed as income of the HUF and taxed accordingly," says Rakesh Gupta.


Even so, an HUF can safely receive gifts of up to 1.8 lakh in a year without incurring any tax liability because of the basic exemption available to it. In fact, if the HUF invests 1.2 lakh in specified tax-saving instruments under Section 80C and 80CCF, it can receive assets worth up to 3 lakh a year without having to pay a paisa as tax. The best way to avoid the tax tangle is to form the HUF corpus with assets received as part of a will.

But here too there are certain conditions to be met. If the property is inherited by the individual, transferring it to the HUF will again lead to clubbing. "A person can give property and other assets to his son's HUF but it should be clearly specified that the asset is for setting up the HUF," says Mukesh Goel, director, Mukesh Raj & Company.
One can also start the HUF with funds received on the dissolution (or full partition) of a larger HUF. If the karta wants to divide the HUF property between the co-parceners, he can transfer the fund to a newly formed HUF. If the ancestral property is sold, the proceeds received can also be transferred to the HUF.

Joining the HUF

There's no need to fill an application form or submit KYC documents for joining an HUF. All lineal descendants of the karta, their spouses and children automatically become members of his family. Wives join the HUF as members, while children join on birth as coparceners. "Even the unborn child of a member or co-parcener has an equal share in the HUF," points out Goel.

Till a few years ago, there was a gender bias in the HUF rules because females did not have an equal share in the ancestral property. A daughter ceased to be a member in the HUF after her marriage. This changed in 2005 when the Hindu Succession Act was amended to give equal rights to daughters even after they were married. "The 2005 amendment was a watershed for female rights," beams chartered accountant Minal Agarwal.

Indeed, the 2005 amendment has changed the equation in favour of women, making them more equal than men. Married women now have rights in two HUFs-their father's as a co-parcener and their husband's as a member. However, they cannot start an HUF on their own. In case, a kartadoes not have male heirs, the HUF property will have to be partitioned among his daughters. Experts say it is best to write a will to this effect to avoid disputes.

Padam Chand Gupta has already willed his HUF property to his two daughters. "Both of them were against me writing the will, but I didn't want to leave anything to chance," says the octogenarian. Gupta's wife Kamlesh Rani is a co-parcener in her father's HUF.

However, while the Mitakshara system, which is followed in most parts of the country, has accepted the change, the Dayabhagaschool, which governs the HUFs in West Bengal and Assam, continues with the bias.

Under the Dayabhagasystem, the father is the sole owner of the joint family property. No other member can enforce the partition of the HUF as long as he is alive. However, the Mitakshara law stipulates that the property belongs to the HUF, not to an individual. It can, therefore, be partitioned even during the lifetime of the karta. Income and tax of HUF

There are five basic heads of income, including salary, capital gains, rent, profit from business, and income from other sources. Except for salary, the HUF can earn from all of these. It can invest the initial corpus as well as the gifts received in subsequent years to earn capital gains. Ancestral property can be let out to earn rental income. It can also start a business and earn profit from it. Interest and royalty incomes are categorised as other sources.

The karta will have to maintain the books of accounts of the HUF and file tax returns on its behalf. The date of filing tax returns and the tax rate are no different from that of individual taxpayers. He also needs to invest to save tax under Section 80C and 80CCF.

Through intelligent planning, an individual can shift some of the taxinefficient investments to the HUF hotchpot so that the tax burden is lowered. Given the intricacies involved, it is best to take the help of a professional. This is also because the taxman looks at HUF tax returns with a degree of scepticism. "The income pattern of an HUF is often questioned by income tax officers," says Bohra. The general belief is that the HUF has been formed to evade tax and that its accounts have been fudged.
However, if your chartered accountant is good, he can help you cross these hurdles without putting you on the wrong side of the law or inviting a notice from the tax department. "One must do a cost-benefit analysis. If by paying a fee of 8,000-10,000 to the chartered accountant you can save 1 lakh in tax, it would be money well spent," says Goel.

Smart strategies

Insure the family's health: The tax savings apart, the HUF arrangement can be used to optimise the benefits on other fronts. Take health insurance. If there are enough people in the HUF (say 20-25), a karta can get a group health insurance cover at a lower price than that of an ordinary plan. Some recent innovations by insurance companies may also prove useful.

The Family First plan from Max Bupa Health Insurance Max Bupa Health Insurance covers not just an individual and his family but even extended families including 13 relationships. This policy is eminently suitable for HUFs because there is no upper limit on the number of people it can cover. In case the proposer (the kartaof the HUF) dies, a new proposer can take his place.

The plan offers a family floater cover of up to 15 lakh and the premium paid for the health insurance is fully deductible under Section 80D. This will help bring down the taxable income of the HUF while offering insurance cover for the entire family.

Pay kartafor services: If the karta does not have a high income, the HUF can pay him a salary for his services. This salary will be taxed as his income and will be fully deductible from the HUF income.

But experts warn that this should be a reasonable amount and should be commensurate with the karta's skills, the time taken for HUF work and the nature of the business it is engaged in. "If the income tax authorities feel that this is being done to gain a tax arbitrage, they might disallow the expense," says Agarwal.

Use HUF income for expenses: The income earned by the HUF can be used for the household expenses of the family. This will not only prevent the HUF kitty from bloating, but also allow individual co-parceners to use their own incomes optimally. For instance, a co-parcener can take a larger home loan to reduce his personal tax liability because the HUF income is enough to take care of his living expenses.

Tax officials can seek an explanation if a taxpayer does not withdraw from his bank account too often. It is an indication that the person has income from other sources as well. However, if he is a co-parcener in the HUF, the taxpayers will be able to explain why the salary flowing into his bank account has not been withdrawn for months.

Distribute income to co-parceners: The karta can gift money to the coparceners from the income earned by the HUF. This income is tax-free in the hands of the co-parceners. In this manner, a person with a high income will be able to get tax-free income.

Give loan for business: The HUF can also give loans to the kartaor coparceners for setting up a business. The HUF can charge interest on the loan. Interest paid on any business loan is fully deductible. Therefore, for the borrower, it will be like taking money from one pocket and putting it in another and getting tax deduction on the interest.The HUF can also give loans to the karta or co-parceners for setting up a business.

A caveat is in order here. If the coparcener borrows money to start the same business in which the HUF is engaged, the tax authorities may raise an objection. It will be seen as an attempt to evade tax. There have been cases where income from businesses started by coparceners after borrowing funds from the HUF have been treated as HUF income.
Should you go for HUF?

The HUF arrangement especially suits taxpayers who also have income from ancestral property and expect to inherit financial assets. Such taxpayers will be able to divert the inheritance to the HUF, thus preventing their personal tax liability from shooting up. It may not be as advantageous for someone whose income is not very high and who does not have any ancestral property.

Similarly, it will be particularly useful for taxpayers with a very high savings rate. There are many taxpayers in the high income bracket, whose Section 80C limit is quickly exhausted by the Provident Fund and children's school fee. They will be able to get tax benefits on other investments, such as insurance premium, equity-linked saving schemes and fixed deposits. However, somebody who is not able to save the 1 lakh under Section 80C will not benefit from the additional deduction available to his HUF.

It is a fallacy that HUF is only meant for small businessmen and traders. BL Gupta (see picture) is the director of finance in a listed company. He started his HUF in 1997 to lower his tax liability from the ancestral property. Bohra, a stock broker, uses the additional deduction to bring down his tax.

Even so, keep in mind that once an HUF is established and assets are transferred to the family hotchpot, the income from these assets would continue to be assessed as HUF income till the HUF is partitioned completely. This would amount to the individual giving up control over the assets.

For the same reason, it is essential that all coparceners of the HUF act in the best interest of the family. Even if one decides to part ways, it will have implications for the entire HUF. "Every co-parcener can demand the partition of the HUF property. Even if one asks for his share, the entire HUF will have to be partitioned," points out Priyambada Sen, senior manager with Deloitte India .

Then again, not all tax benefits enjoyed by an individual are applicable to the HUF. Experts warn that the clubbing provisions should especially be kept in mind when you transfer personal assets to the HUF. It's possible that the income you think can be shifted to the HUF will actually be clubbed with your income and taxed in your hands.




Thanks to ET for the article

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