Explained: What is the tax implication when gifted money is invested?

In continuation with the 'tax on gifts' series, so far we have talked about cases like the tax implications when a person receives and sends a gift. 

Let’s understand the other scenario, with reference to the example mentioned in the last article about a wife who receives Rs 1,00,000 as a gift from her husband. We saw that the husband has to pay tax on his income of Rs 10,00,000 subject to all the benefits as available to him under various sections of the IT act. So let’s say that his total tax after all deductions comes to Rs 75,000/- and his post tax income is Rs 9,25,000. Now he can gift this entire 9,25,000/- to any person without any issue as it his duly taxed income, he can do whatever he wants. But what happens in the hands of the recipient of this gift is the recipient’s liability, except in the third scenario, when the recipient of a gift invests that gifted money and earns a certain income and it may be clubbed back in the hands of a person making the gift, in our example husband.

As explained earlier, there would be no tax implication on her which means that she will not have to pay any tax on this Rs 1 lakh as it is a gift from her husband who comes under the specified list of relatives exempt under the Income Tax Act from gift tax liability. Had it been from a person other than the specified ones, then the gift tax rule will apply as explained in the first article. 

Now the tricky part comes in. What happens when the gifted money is invested in say FDs or shares? Let’s say that the wife invests this Rs 1,00,000 in a bank FD and earns an interest @10% annually i.e. Rs 10 thousand annually. Now who will pay the tax; husband or wife? Ideally, it’s the wife because that is now her money, which she invested and hence needs to pay the tax as per the income tax slab applicable to her. However, since she is a housewife, the only income is this Rs 10 thousand, which is way below the basic exemption limit under the Income Tax Act i.e. Rs 2,50,000 (for current AY 2015-16). Hence she is not supposed to pay any tax and does not even require filing her return of income. 

Because of this whole gifting arrangement, the income generated on that FD is becoming totally tax-free, which otherwise would have been taxable had the same money been invested in the husband’s name only at the first instance; in a situation where the money was not gifted and invested by the husband only. However, IT officials know that people may use these gifting provisions for money laundering and to plug this loophole they have clubbed provisions in place, under certain circumstances.

So in the above example, this interest income of Rs 10,000 would not go tax-free and be clubbed in the hands of the husband. It would be added to his total income and he has to pay the tax based on his tax slab. 

But is there any way out to take advantage of this gifting provision legally? What happens when the wife invests the gifted money in a PPF or tax-free bonds or if that person had gifted a similar amount of money to his parents and children other than his wife? Will the income still be clubbed in his hand out of the investments made by his parents or children? More on this in my next concluding article on gift tax. Till then stay tuned and happy gifting!

Rishabh Parakh is a Chartered Accountant and the Chief Gardener & Founder Director of Money Plant Consulting. He can be reached at rishabhparakh@moneyplantconsulting.net