How Strategic Tax Planning via Interest-Free Loans to Spouse or HUF can be lawfully safeguarded?
Tax exemption for Gifts by an individual to close members of his family like spouse or son’s wife or even to his Hindu Undivided Family (HUF) can quite naturally provide an attraction to transfer assets and create income and capital in the hands of such close family entities.
However, the clubbing of income provisions under Section 64 of the Income-tax Act seek to guard against escapement of tax through the route of gifts to such close family entities.
Lawfully Scrubbing the Clubbing Provisions
In the backdrop of the above tax scenario, how can a taxpayer in the top tax bracket, strategically plan to build up capital for such entities covered by the clubbing provisions? If the taxpayer prefers to give an interest-free loan out of his self-owned funds, can the Taxman raise any tax hurdle for such planning?
An interesting case study with logical analysis supported by judicial reasoning helps provide the right answer.
Case-Study: Mr. Goyal, a taxpayer in the tax bracket of 30%, plans to advance interest-free loans, from out of his personal savings to his wife and HUF, who are in the 5% tax bracket. This money is proposed to be invested in interest earning deposits in their names, which would obviously reap valuable tax benefit, keeping in view the differential tax brackets.
In such a case can an Assessing Officer propose to invoke the provisions of Section 60 of the Income-tax Act alleging that this is a case of transfer of income where there is no transfer of assets? Alternatively, can it be argued by him that such interest earned by the wife or HUF should be taxed in Mr. Goyal’s hands as notional interest income, on the ground that he has not earned interest, which he could have so earned?
Mr. Goyal can take comfort that none of the above stands, even if sought to be taken by the Taxman, can hold legal ground.
On the aspect of applicability of Section 60 it has been held that an interest-free loan cannot be treated as a case of transfer of income without transfer of assets.
On the other issue relating to whether any notional income can be taxed in his hands in relation to the interest-free loans, the ratio of a number of Supreme Court decisions is clear and unequivocal. The Apex Court has in the celebrated cases of Godhra Electricity Co. and A. Raman & Co. held that income chargeable to tax is the income that is received or which has accrued during the previous year. Where there is no ‘real income’ earned by the taxpayer, there can be no levy of tax. Income, which a taxpayer could have, but has not earned, cannot be made taxable as income accrued to him.
Thus, the settled legal position in the above regard is that if a taxpayer advances an interest-free loan from his own funds or even from borrowed funds on which he is under no obligation to pay any interest, the Income-tax Department cannot question his decision as to why he has not charged any interest on such loan advanced.