CU-MCOM-SEM-IV-Tax Planning and Procedure-Second Draft

["10.3 SOURCES OF DIVIDENDS Dividends are an investor's share of a company's profits, given to him as a member of the company. Generally, a company is allowed to pay dividends out of its distributable profits. Distributable profits are a company\u2019s profits available for distribution and includes its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made. The Companies Act 2013 provides dividend be declared or paid by a company for any financial year from the following sources: 10.3.1 Current Profits A company may pay dividends out of current profits of the company arrived at after providing for depreciation in accordance with the law. The profits should be arrived at without including any amount that represents unrealised gains, notional gains or revaluation of assets and any change in carrying amount of an asset or of a liability on measurement of the asset or the liability at fair value. 10.3.2 Accumulated Profits Where the current profits are insufficient for paying dividends, the company may pay dividends out of accumulated profits of the company. The accumulated profits too should have arrived at after providing for depreciation in accordance with the law. The company law uses the term \u2018free reserve\u2019 which means profits accumulated from out of distributable profits. The following conditions are applicable when the company declares dividends out of accumulated profits: \uf0b7 The rate of dividend declared should not be more than the average rate at which dividend was declared in the past three years. Of course, where a company has not declared any dividend during this period, this rule is not applicable. \uf0b7 The maximum amount that can be drawn from accumulated profits should not be more than 10 per cent of the company\u2019s paid-up share capital and free reserves. \uf0b7 The amount drawn from accumulated profits should first be used to set off the current year\u2019s losses. \uf0b7 The balance of reserves after using for paying dividends should not fall below 15 per cent of its paid-up share capital. 10.3.3 Government Grants A company may also declare and pay dividends out of grants provided by the Central Government or a State Government. Such grants are made by the government for the payment of dividend in pursuance of a guarantee given by that government. 151 CU IDOL SELF LEARNING MATERIAL (SLM)","10.4 TAX IMPLICATIONS OF DIVIDENDS Up to Assessment Year 2020-21, a shareholder getting dividend from a domestic company, was not liable to pay any tax on such dividend as it was exempt from tax under the income tax. However, in such cases, the domestic company was liable to pay a dividend distribution tax (DDT). One impact of this provision was that the companies were reluctant to declare dividends to avoid paying the dividend distribution tax, the Finance Act, 2020 has abolished the dividend distribution tax and move to the classical system of taxation wherein dividends are taxed in the hands of the investors (Income Tax Department, 2021). 10.4.1 Current Position Where a domestic company distributes dividends on or after April 1, 2020, it is not liable to pay any dividend distribution tax.Shareholders who receive dividends from domestic company are liable to pay tax on such dividend income. However, the domestic company is required to deduct tax at source at the rate of ten per cent from dividend distributed to the resident shareholders if the aggregate amount of dividend distributed or paid during the financial year to a shareholder exceeds Rs. 5,000.It is hoped that this change would remove the reluctance on the part of domestic companies to declare dividends (Government of India, 2021) 10.4.2 Inter-Corporate Dividend As the taxability of dividend has shifted from companies to shareholders, the Government has removed the cascading effect where a domestic company receives a dividend from another domestic company. To remove the cascading effect, it is provided that inter-corporate dividend shall be reduced from total income of company receiving the dividend if same is further distributed to shareholders one month prior to the due date of filing of return. Dividend received by a domestic company from a foreign company, in which such domestic company has 26 per cent or more equity shareholding, is taxable at a rate of 15 per cent plus surcharge and cess. This tax is computed on a gross basis without allowing deduction for any expenditure.Dividend received by a domestic company from a foreign company, in which equity shareholding of such domestic company is less than 26 per cent, is taxable at normal tax rate. The domestic company can claim deduction for any expense incurred by it for the purposes of earning such dividend income. 10.5 SUMMARY \uf0b7 Dividends are a major component of the total returns that stocks provide over time to investors. Cash dividends and share buybacks are two ways that firms can pay out profits to current shareholders. Dividends are paid from the after-tax profits of a company and are taxed a second time when received by the shareholder. 152 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 The meaning and scope of dividends in income tax law is much broader than in corporate finance and corporate. The income tax law envisages the following six types of dividends: regular dividends, dividends in form of issue of debt instruments, dividends in form of bonus to preference shareholders, dividend in the form of reduction of share capital, liquidating dividend, and loans to holders of substantial shares. \uf0b7 There are several theories of dividend; the following are the prominent ones: irrelevance of dividend (Modigliani-Miller theory), dividend signalling theory, bird in the hand theory, agency theory of dividend, and the residual theory of dividend. Six primary factors affect a company's dividend pay-out policy: investment opportunities, expected volatility of future profits, financial flexibility, tax preference of investors, floatation costs, contractual restrictions, and legal restrictions. \uf0b7 Dividends are an investor's share of a company's profits, given to him as a member of the company. Generally, a company is allowed to pay dividends out of its distributable profits. Distributable profits are a company\u2019s profits available for distribution and includes its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made. \uf0b7 Where a domestic company distributes dividends on or after April 1, 2020, it is not liable to pay any dividend distribution tax. Shareholders who receive dividends from domestic company are liable to pay tax on such dividend income. However, the domestic company is required tax at source at the rate of ten per cent from dividend distributed to the resident shareholders if the aggregate amount of dividend distributed or paid during the financial year to a shareholder exceeds Rs. 5,000. 10.6 KEYWORDS \uf0b7 Accumulated Profit. Accumulated profits are those that are not paid out as dividends but are instead added to the company\u2019s capital base. \uf0b7 Dividend Irrelevancy. This theory proposed by Miller and Modigliani proposes that in ideal circumstances the level of a firm's dividend would not affect the value of the firm, with shareholders being indifferent to an announcement of low or high levels of dividend. \uf0b7 Dividend Signalling. Dividend signalling is a theory that suggests that a company's announcement of an increase in dividend pay-outs is an indication of positive prospects. \uf0b7 Dividend. As applied to a company that is a going concern, dividend ordinarily means the portion of the profits of the company which is allocated to the holders of 153 CU IDOL SELF LEARNING MATERIAL (SLM)","shares in the company. In the case of winding up, dividend means a division of the realized assets among creditors and contributories according to their respective rights. \uf0b7 Floatation Costs. Flotation costs are costs incurred by a company when it issues new securities. These costs include fees of investment banks, lawyers, accountants, advisors, and registration fees paid to regulators and stock exchanges. \uf0b7 Intercorporate Dividend. An intercorporate dividend is dividend received by a company from investments in equity and preference shares held by it in other companies. \uf0b7 Interim Dividend. An interim dividend is a dividend declared by the board of directors of a company before a company's annual general meeting (AGM) and the release of final financial statements. \uf0b7 Liquidating Dividend. A liquidating dividend is a distribution to shareholders during a liquidation. Shareholders are the residual claimants, and as such they will be paid whatever remains after paying out all the other claimants. \uf0b7 Share Buyback. A share buyback refers to the process by which a company repurchases its own shares from its shareholders by paying them cash. 10.7 LEARNING ACTIVITY 1. Explain the concept of liquidating dividend in brief. ___________________________________________________________________________ _____________________________________________________________________ 2. Explain the concept of share buyback in brief. ___________________________________________________________________________ _____________________________________________________________________ 10.8 UNIT END QUESTIONS A. Descriptive Questions 154 Short Questions 1. Explain the concept of accumulated profit in brief. 2. Explain the concept of dividend irrelevancy in brief. 3. Explain the concept of dividend signalling in brief. 4. Explain the concept of final dividend in brief. 5. Explain the concept of interim dividend in brief. Long Questions 1. Enumerate and discuss the different types of dividends. 2. Why do companies declare and pay dividends? CU IDOL SELF LEARNING MATERIAL (SLM)","3. Briefly discuss the various theories of dividend. 4. Briefly discuss the various factors that affect the dividend policy of a company. 5. Briefly discussthe various from which the company can pay dividends. 6. Briefly discuss the tax implications of dividends. B. Multiple Choice Questions 1. The Modigliani-Miller theory states which of the following about dividends? a. Dividends do not have any effect on a company's stock price. b. Dividends have a significant effect on a company's stock price. c. Dividends have some effect on a company's stock price. d. The effect of dividend on a company's stock price depends upon the state of the economy. 2. What is the rate at which a domestic company is required to pay dividend distribution tax where it distributes dividends on or after April 1, 2020, to resident shareholders? a. 15.00 per cent. b. 25.00 per cent. c. 12.50 per cent. d. Nothing. The dividend distribution tax is not applicable. 3. The dividend signalling theory that suggests that a company's announcement of an increase in dividend pay-outs is an indication of which of the following? a. Negative prospects. b. Positive prospects. c. Uncertain prospects. d. Stagnant prospects. 4. What is the maximum amount that a company can draw from reserves for declaring and paying dividends out of accumulated profits? a. The maximum is 10 per cent of the company\u2019s paid-up share capital and free reserves. b. The maximum is 10 per cent of the company\u2019s paid-up share capital. c. The maximum is 10 per cent of the company\u2019s free reserves. d. The maximum is 10 per cent of the company\u2019s market capitalisation. 155 CU IDOL SELF LEARNING MATERIAL (SLM)","5. The bird in hand is a theory of dividend suggests that investors prefer ... compared to potential.... a. Capital gains, dividends from stock investing. b. Stock dividends, cash dividends. c. Share buybacks, cash dividends. d. Dividends from stock investing, capital gains. Answer 1-a, 2-d, 3-b, 4-a, 5-d 10.9 REFERENCES Reference Books \uf0b7 Cruz, A., Deschamps, M., Niswander, F., Prendergast, D., & Schisler, D. (2018). Fundamentals of Taxation. New York: McGraw-Hill Education. \uf0b7 Martin, E. A. (2003). The Dictionary of Law. Oxford: Oxford University Press. \uf0b7 Singhania, V., & Singhania, K. (2021). Direct Taxes Law & Practice. New Delhi: Taxmann. Website \uf0b7 Income Tax Department. (2021, 4 1). Set Off and Carry Forward of Losses Under the Income Tax Act. Retrieved from Tutorials: https:\/\/www.incometaxindia.gov.in\/Tutorials\/21- %20MCQ%20set%20off%20and%20carry%20frwrd.pdf \uf0b7 Institute of Chartered Accountants of India. (2019, February 1). Set off and Carry forward, of Losses. Retrieved from Western India Regional Council: https:\/\/www.wirc-icai.org\/images\/material\/Key-Aspects-Carry-Forward-Set- Losses.pdf \uf0b7 Sirwalla, P. (2012, January 31). Income Tax Deductions That You Should Not Miss. Business Today. Retrieved from https:\/\/www.businesstoday.in\/magazine\/tax\/story\/income-tax-deductions-24273- 2011-12-28 \uf0b7 Directorate of Income Tax. (2021). Salary Income and Tax Implications for AY 2020-21. New Delhi. Retrieved from https:\/\/www.incometaxindia.gov.in\/booklets%20%20pamphlets\/salary-income- tax-implications-ay-20-21.pdf 156 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 KPMG. (2020, January 30). India: Income Tax. Retrieved from Taxation of International Executives: https:\/\/home.kpmg\/xx\/en\/home\/insights\/2011\/12\/india- income-tax.html 157 CU IDOL SELF LEARNING MATERIAL (SLM)","UNIT- 11 BONUS SHARES STRUCTURE 11.0 Learning Objectives 11.1 Introduction 11.2Rationale for Issue of Bonus Shares 11.2.1 Bonus Issues: Company Perspective 11.2.2 Bonus Issues: Shareholders Perspective 11.2.3 Financial Implications of Bonus Shares 11.3Sources for Issue of Bonus Shares 11.3.1 Pre-Conditions for Bonus Issues 11.3.2 Restriction on Listed Companies for Bonus Issues 11.4Tax Implications of Bonus Issues 11.5Summary 11.6Keywords 11.7Learning Activity 11.8Unit End Questions 11.9 References 11.0 LEARNING OBJECTIVES After studying this unit, you will be able to: \uf0b7 Understand the legal, contractual and tax implication of bonus shares. \uf0b7 Expected to work out the impact of bonus issues on the company and shareholders. \uf0b7 Explain the Rationale for Issue of Bonus Shares 11.1 INTRODUCTION Bonus shares are one way in which companies \\\"share the wealth\\\" generated by running the business. Companies still in the rapid growth phase of their life cycle tend to retain all the earnings and reinvest them into the business. Growing companies may not have enough cash in hand or may not wish to part with cash they have; and may issue bonus shares to share wealth with the shareholders without reducing their cash holdings. 158 CU IDOL SELF LEARNING MATERIAL (SLM)","The term \u2018bonus\u2019 implies that the share is free. Sometimes, shareholders demand bonus shares instead of cash dividends. This is useful for shareholders who do not need income but want capital growth, and it avoids brokers\u2019 fees. Bonus issues are also known as stock dividends, capitalization issue or a scrip issue. Although, in corporate finance we see authors referring to issue of bonus shares by companies to the holders of their equity shares as stock dividends. Under income tax law however, such issue of bonus shares is not considered as dividends. Issue of bonus shares is also known as a \u2018capitalisation issue\u2019 because instead of distributing all the distributable profit by way of dividend, the company may decide to \u2018capitalise\u2019 the profit and issue bonus shares to members. The profit is transferred to the share capital account, essentially to pay for the bonus shares, which are then issued to the shareholders as fully paid-up. The issued share capital of the company is then increased by that amount. 11.1.1 Definition Bonus shares are shares which are issued with the value paid out of the profits of the company. They are wholly paid for by the company rather than by the member, and yet they confer a right on the member to participate in a share out of capital in the event of the liquidation of the company; they represent a transfer of capital from the company to the member. Bonus shares are allotted to existing members of a company. A decision to issue bonus shares paid for by capital (a capitalisation issue) is to be taken by the directors on the authority of an ordinary resolution of its members. A bonus issue is defined as a pro-rata distribution of additional shares of a company\u2019s stock to holders of the equity shares. A company may opt for stock dividends for several reasons including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity. A bonus issue is a gesture of confidence. The amount available to pay dividends is reduced: therefore, it can be inferred that the management of the company is sure that the amount capitalised will not be needed to pay dividends. A bonus issue moves money from one account that belongs to the shareholders to another. It is therefore basically a book-keeping exercise, and the value of any shareholding is unchanged by a bonus issue despite the increase in the number of shares held.The term capitalization issue is less common but more accurate than the term bonus issue. 11.1.2 Bonus Issues Vs Dividends In corporate finance we see authors referring to issue of bonus shares by companies to the holders of their equity shares as stock dividends. Under income tax law however, such issue of bonus shares is not considered as dividends. 159 CU IDOL SELF LEARNING MATERIAL (SLM)","Bonus shares and dividends have some common features. Both use the free reserves of the company, and both benefit the shareholders. However, there are several differences (Team Savart, 2020). \uf0b7 First, the issue of bonus shares does not involve any cash flows, whereas a dividend involves outflow of cash from the company into the hands of the shareholders. \uf0b7 Second, a dividend once declared as a debt due to the shareholders. No such debt is created when a company announces bonus issues. However, a listed company cannot withdraw a previously announced bonus issue. \uf0b7 Third, a bonus increases the liquidity of shares of a listed company as the number of shares floating in the market increases. This may positively affect the market prices of the company\u2019s shares to a small extent. The payment of dividends is generally welcomed by the shareholders and the impact of this on the market prices of the company\u2019s shares is substantial. \uf0b7 Fourth, bonus shares are always issued by capitalising the free reserves, whereas dividends my be paid from current profits, accumulated profits, or from grants received from the government. \uf0b7 Finally, there are no tax consequences when bonus shares issued, the tax consequences arise only when the bonus shares are disposed. Dividends, however, are taxed in the hands of the shareholders. 11.2 RATIONALE FOR ISSUE OF BONUS SHARES Some of the key reasons why companies issue of bonus shares are as follows: \uf0b7 Bonus issues tends to bring the market price per share within a more popular trading range \uf0b7 Bonus issues increase the number of outstanding shares. This promotes active trading as it increases liquidity \uf0b7 There is an increase in the share capital base of the company. This may achieve a more respectable size in the eyes of the investing community \uf0b7 Investors regard a bonus issue as an indication that the prospects of the company have brightened, and they can reasonably look forward to increase, in total dividends \uf0b7 Bonus issues are enthusiastically received by the market. This improves the prospects of raising additional funds. \uf0b7 The company does not need to part with any cash, bonus issues merely book entries. 11.2.1 Bonus Issues: Company Perspective The following are few of the several advantages of issue of bonus shares by the company: \uf0b7 The company retains the capital to carry on a larger and more profitable business. 160 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 When a company distributes bonus to its shareholders in form of shares and not as cash, the operating capital of the company is not affected. \uf0b7 Issuance of bonus share can somewhat satisfy its investors if the company is not able to pay dividends. \uf0b7 It enables a company to capitalize on its profits on a permanent basis and increases creditworthiness of the company. \uf0b7 Paying abnormally high rate of dividend can be replaced by issuing bonus shares. \uf0b7 The balance sheet of the company will bring out a more truthful picture of the capital structure and the capacity of the company. 11.2.2 Bonus Issues: Shareholders Perspective Advantages \uf0b7 The bonus shares are considered as a permanent source of income for the investors. \uf0b7 Even though the rate of dividend falls, the total amount of dividend may increase because the investor will get the dividend on a larger number of shares. \uf0b7 The investors can easily sell these additional shares and receive immediate cash if they desire to do so. \uf0b7 Shareholders don\u2019t have any liability to pay taxes on bonus shares. Disadvantages \uf0b7 The issue of bonus shares leads to a noticeable reduction in the future dividend rates as the earnings do not usually increase with the bonus issue of shares. \uf0b7 If the rate of profit does not increase over time, the rate of the dividend may be decreased substantially. \uf0b7 The dip in the future dividend rate may result in the fall of the market price of shares. This may also spread unhappiness among the shareholders. \uf0b7 Bonus issue may encourage speculation which is not much desirable for a financially stable company. 11.2.3 Financial Implications of Bonus Shares Considering that a bonus issue is merely a bookkeeping exercise, why does the stock market get so enthusiastic about it? This is because a bonus issue results in dilution in equity as it adds to the total number of company\u2019s shares in the market. As a result: \uf0b7 The earnings per share of the company declines. \uf0b7 Share capital gets increased according to the bonus issue ratio. \uf0b7 Market price gets adjusted on issue of bonus shares. \uf0b7 Free reserves get reduced. 161 CU IDOL SELF LEARNING MATERIAL (SLM)","Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen. This may be because of the following reasons: \uf0b7 The share is now more liquid; more shares available in the market makes it easier to buy and sell; and \uf0b7 A bonus issue is taken as a sign of the good health of the company. In a bonus issue, the shareholders are receiving extra shares rather than cash. However, the individual value of each share may be \u2018watered down\u2019, because, in a case where a company has large reserves of profit and a relatively small number of issued shares, a valuer may place a high value on each share. If the profits are capitalised and bonus shares issued, there are, necessarily, more issued shares, so their individual value is reduced, though the overall value of the members\u2019 total holding will stay more or less the same. 11.3 SOURCES FOR ISSUE OF BONUS SHARES Generally, a company can make a bonus issue by capitalizing any of the following: \uf0b7 Free reserves \uf0b7 Securities premium account \uf0b7 Capital redemption reserve account However, a bonus issue cannot be out of a reserve created by revaluation of fixed assets. For listed companies, SEBI has imposed an additional condition that free reserves, securities premium account or capital redemption reserve account should have been built out of the genuine profits. 11.3.1 Pre-Conditions for Bonus Issues The Companies Act, 2013 imposes the following conditions on all companies for issue of bonus shares: \uf0b7 The articles of association of the company must authorise issue of bonus shares. \uf0b7 The issue of bonus shares should be recommended by the board of director and authorised by the shareholders in the general meeting of the company. \uf0b7 The company should not have defaulted in payment of interest or principal in respect of fixed deposits or debt securities issued by it. \uf0b7 The company should not have defaulted in respect of the payment of statutory dues of the employees, such as, contribution to provident fund, gratuity, and bonus. \uf0b7 The company should make the partly paid-up shares fully paid-up before allotment of bonus shares. For listed companies, SEBI has imposed the following additional conditions (SEBI, 2018). 162 CU IDOL SELF LEARNING MATERIAL (SLM)","11.3.2 Restriction on Listed Companies for Bonus Issues Fugitive Economic Offender A listed company is not allowed to issue bonus shares if any of its promoters or directors is a fugitive economic offender Reservation for Holders of Convertible Securities Before a listed company makes a bonus issue of equity shares it should make a reservation of equity shares of the same class in favour of the holders of outstanding compulsorily convertible debt instruments if any, in proportion to the convertible.The equity shares so reserved for the holders of fully or partly compulsorily convertible debt instruments, shall be issued to the holder of such convertible debt instruments or warrants at the time of conversion of such convertible debt instruments, optionally convertible instruments, warrants, on the same terms or same proportion at which the bonus shares were issued. Bar on Issue of Bonus Share in Lieu of Dividend A listed company is not allowed to issue bonus shares in lieu of dividends. Time Limits for Completion of Bonus Issue SEBI has imposed the following time limits on listed companies for completion of bonus issues: \uf0b7 A company announcing a bonus issue after approval by its board of directors and not requiring shareholders\u2019 approval for capitalisation of profits or reserves for making the bonus issue is required to implement the bonus issue within 15 days from the date of approval of the issue by its board of directors. \uf0b7 Where the issuer is required to seek shareholders\u2019 approval for capitalisation of profits or reserves for making the bonus issue, the bonus issue shall be implemented within 2 months from the date of the meeting of its board of directors wherein the decision to announce the bonus issue was taken subject to shareholders\u2019 approval. \uf0b7 For the purpose of a bonus issue to be considered as \u2018implemented\u2019 the date of commencement of trading shall be considered. Bar on Withdrawal of Bonus Issue \uf0b7 A bonus issue, once announced, cannot be withdrawn. 11.4 TAX IMPLICATIONS OF BONUS ISSUES The tax implication of issue of bonus shares is as follows: \uf0b7 When bonus shares are issued to shareholders there is no tax implications(Price Waterhouse Coopers (PwC), 2016). 163 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 The cost of acquisition of bonus shares is taken as zero (Kaul, 2006). \uf0b7 The period of holding of bonus shares is taken from the date of issue of bonus shares. \uf0b7 Tax implications arise when the shareholder sells or transfers the shares he received as bonus shares. Gain on Sale of Bonus Shares Any gain on the sale of bonus shares is considered as capital gains. The taxability of capital gains depends on the period for which the asset was held before the sale. On this basis we classify capital gains into short-term and long-term. Generally, the tax rates for long-term capital gain and short-term capital gain are different. When a bonus share issued by a listed company is sold after holding it for less than or equal to 12 months, the gain is considered as a short-term capital gain. The period of holding is 24 months in case of bonus shares issued by an unlisted company. When a bonus share issued by a listed company is sold after holding it for more than 12 months, the gain is considered as a long-term capital gain. The period of holding is 24 months in case of bonus shares issued by an unlisted company. 11.5 SUMMARY \uf0b7 Bonus shares are one way in which companies share the wealth generated by running the business. Companies still in the rapid growth phase of their life cycle tend to retain all the earnings and reinvest them into the business. Growing companies may not have enough cash in hand or may not wish to part with cash they have; and may issue bonus shares to share wealth with the shareholders without reducing their cash holdings. \uf0b7 A bonus issue is defined as a pro-rata distribution of additional shares of a company\u2019s stock to holders of the equity shares. \uf0b7 Some of the key reasons why companies issue of bonus shares are as follows: bonus issues tend to bring the market price per share within a more popular trading range; bonus issues increase the number of outstanding shares. This promotes active trading as it increases liquidity; there is an increase in the share capital base of the company. This may achieve a more respectable size in the eyes of the investing community, investors regard a bonus issue as an indication that the prospects of the company have brightened, and they can reasonably look forward to increases in total dividends, bonus issues are enthusiastically received by the market. This improves the prospects of raising additional funds, and the company does not need to part with any cash, bonus issues merely book entries. 164 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 Generally, a company can make a bonus issue by capitalizing any of the following: (1) free reserves, (2) securities premium account, (3) capital redemption reserve account. However, a bonus issue cannot be out of a reserve created by revaluation of fixed assets. For listed companies, SEBI has imposed an additional condition that free reserves, securities premium account or capital redemption reserve account should have been built out of the genuine profits. \uf0b7 The tax implications of issue of bonus shares is as follows: (1) when bonus shares are issued to shareholders there is no tax implications; (2) the cost of acquisition of bonus shares is taken as zero; (3) the period of holding of bonus shares is taken from the date of issue of bonus shares, and (4) tax implications arise when the shareholder sells or transfers the shares he received as bonus shares. 11.6KEYWORDS \uf0b7 Bonus Share. A bonus issue is defined as a pro-rata distribution of additional shares of a company\u2019s stock to holders of the equity shares. \uf0b7 Capitalising Dividend. A capitalising dividend is another term for bonus shares. This is because bonus shares are issued by capitalising the free reserves of the company. \uf0b7 Convertible Security. A convertible security is one which offers a choice to the holder either to be repaid cash on the due date or be issued equity shares in the company. \uf0b7 Free Reserves. Free reserves are accumulated profits of the company that have been accumulated from the normal profits of the company over the years. The free reserves are available distribution as dividends to the shareholders. \uf0b7 Stock Dividend. A stock dividend is a dividend payment to shareholders that is made in shares rather than as cash. The stock dividend has the advantage of rewarding shareholders without reducing the company's cash balance, although it can dilute earnings per share. 11.7 LEARNING ACTIVITY Based on the learning from this unit (1) identify the 30 companies which are part of the S&P BSE SENSEX; (2) find out which of the companies issued bonus shares in the last five years; (3) try to find reasons why some of these companies issued bonus shares. ___________________________________________________________________________ ___________________________________________________________________________ 11.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 165 CU IDOL SELF LEARNING MATERIAL (SLM)","1. Explain the concept of bonus shares in brief. 2. Explain the concept of free reserves in brief. 3. Explain the concept of convertible security in brief. 4. Explain the concept of stock dividend in brief. 5. Explain the concept of capitalising dividend in brief. Long Questions 1. Explain the rationale of bonus shares from the perspective of the issuing company. 2. Explain the rationale of bonus shares from the perspective of the shareholders. 3. Briefly discuss financial implications of issue of bonus shares. 4. Enumerate and discuss sources from which a company may issue bonus shares. 5. Briefly discussthe restrictions placed on listed companies in issuing bonus shares. 6. Briefly discuss the tax implications of bonus shares. 7. Enumerate the differences between bonus issues and dividends. B. Multiple Choice Questions 1. Which of the following is NOT a difference between bonus issues and dividend payments? a. A dividend once declared as a debt due to the shareholders. No such debt is created when a company announces bonus issues. b. The issue of bonus shares does not involve any cash flows, whereas a dividend involves outflow of cash from the company into the hands of the shareholders. c. The shareholder are liable to pay tax when bonus shares issued, whereas in case of dividends the tax is paid by the company. d. Bonus shares are always issued by capitalising the free reserves, whereas dividends my be paid from current profits or from accumulated profits. 2. Which of the following is FALSE with regard to issue of bonus issues? a. Bonus issues tends to bring the market price per share within a more popular trading range b. Bonus issues decreases the number of outstanding shares. c. Investors regard a bonus issue as an indication that the prospects of the company have brightened, and they can reasonably look forward to increase, in total dividends d. The company does not need to part with any cash, bonus issues merely book entries. 3. Which of the following is NOT a consequence of issue of bonus issues? a. The earnings per share of the company declines. b. Share capital gets increased according to the bonus issue ratio, although the amount of shareholders' equity remains unchanged. 166 CU IDOL SELF LEARNING MATERIAL (SLM)","c. Market price gets adjusted on issue of bonus shares. d. Free reserves remain unchanged. 4. Theoretically, on the issue of bonus shares, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen. Which of the following is NOT a reason for the slight increase in the market price of the shares of the company making a bonus issue? a. The share is now more liquid; more shares available in the market make it easier to buy and sell. b. Investors perceive bonus issue as a sign of the good health of the company. c. After the bonus issue, it becomes harder for corporate raiders to do a hostile takeover of the company. d. The price of the share adjusts downward making it possible for more people to buy the shares. 5. Which of the following is a precondition for issue of bonus shares? a. The company should not have defaulted in respect of the payment of statutory dues of the employees, such as, contribution to provident fund, gratuity, and bonus. b. The company should have earned operating profit in three out of the last five financial years. c. The company should have net tangible assets of at least Rs. 100 lakhs at the end of each of the last three years. d. The company should have net worth of at least Rs. 300 lakhs at the end of each of the last three years. Answer 1-c, 2-b, 3-d, 4-d, 5-a 11.9 REFERENCES Reference Books \uf0b7 Cruz, A., Deschamps, M., Niswander, F., Prendergast, D., & Schisler, D. (2018). Fundamentals of Taxation. New York: McGraw-Hill Education. \uf0b7 Martin, E. A. (2003). The Dictionary of Law. Oxford: Oxford University Press. \uf0b7 Singhania, V., & Singhania, K. (2021). Direct Taxes Law & Practice. New Delhi: Taxmann. Website 167 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 Income Tax Department. (2021, 4 1). Set Off and Carry Forward of Losses Under the Income Tax Act. Retrieved from Tutorials: https:\/\/www.incometaxindia.gov.in\/Tutorials\/21- %20MCQ%20set%20off%20and%20carry%20frwrd.pdf \uf0b7 Institute of Chartered Accountants of India. (2019, February 1). Set off and Carry forward, of Losses. Retrieved from Western India Regional Council: https:\/\/www.wirc-icai.org\/images\/material\/Key-Aspects-Carry-Forward-Set- Losses.pdf \uf0b7 Sirwalla, P. (2012, January 31). Income Tax Deductions That You Should Not Miss. Business Today. Retrieved from https:\/\/www.businesstoday.in\/magazine\/tax\/story\/income-tax-deductions-24273- 2011-12-28 \uf0b7 Directorate of Income Tax. (2021). Salary Income and Tax Implications for AY 2020-21. New Delhi. Retrieved from https:\/\/www.incometaxindia.gov.in\/booklets%20%20pamphlets\/salary-income- tax-implications-ay-20-21.pdf \uf0b7 KPMG. (2020, January 30). India: Income Tax. Retrieved from Taxation of International Executives: https:\/\/home.kpmg\/xx\/en\/home\/insights\/2011\/12\/india- income-tax.html 168 CU IDOL SELF LEARNING MATERIAL (SLM)","UNIT- 12 MERGERS AND AMALGAMATIONS 169 STRUCTURE 12.0 Learning Objectives 12.1 Meaning of Mergers and Amalgamations 12.1.1 M&A Terminology 12.1.2 Tax Definition of Amalgamation 12.2 Rationale for Mergers and Amalgamations 12.2.1 Synergy 12.2.2 Strategic Realignment 12.2.3 Market Power 12.2.4 Diversification 12.5.5 Tax Considerations 12.3 Modes of M&A transactions in India 12.3.1 Share Purchase 12.3.2 Asset Purchase 12.3.3 Merger 12.4 Types of Mergers and Amalgamations 12.4.1 Classification Based on Industry 12.4.2 Classification Based on Motives 12.5 Process of Mergers and Amalgamations 12.6 Tax Implications of Mergers and Amalgamations 12.7 Summary 12.8 Keywords 12.9 Learning Activity 12.10 Unit End Questions 12.11 References 12.0 LEARNING OBJECTIVES After studying this unit, you will be able to: CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 Learn the rationale why companies enter merger and acquisition transactions, \uf0b7 The process of mergers, and the different modes for merger and acquisition transactions. \uf0b7 State the Expected to work out the tax implications of mergers and acquisitions. 12.1 MEANING OF MERGERS AND AMALGAMATIONS Mergers and acquisitions (M&A) is an important strategic option that companies can leverage to make necessary leaps in the competitive marketplace. It can help companies to obtain a higher market share and a broader customer base, and gain access to new technology, products, and distribution channels. Yet, at the same time, M&A is risky, and many deals fail, sometimes bringing companies to the brink of failure. Reasons for failure vary and range from opportunistic M&A and overpayment to poor integration (Kotak, 2017). 12.1.1 M&A Terminology In this section we describe some of the important terms one comes across in this field. Merger In a merger, one company is absorbed into the other, so it ceases to exist as a separate entity once the merger is complete. A merger is said to take place when two or more companies agree to combine, resulting in a new entity or with the resulting firm maintaining the identity of the acquiring company. The firm that attempts to acquire or merge another company with it is called an acquiring company, acquirer, or bidder. The target company is the firm being solicited by the acquiring company. Absorption In an absorption, one company absorbs the business of another company in such a way that at the after the conclusion of the transaction, only one company survives, and the other company ceases to exist. Absorption is a form merger where the undertaking, property, and liabilities of one or more companies are to be transferred to another existing company. We can under an absorption with the equation, A + B = A, where company B is merged into company A. Consolidation In a consolidation, a new company is formed to absorb the business of two or more existing companies. The original companies cease to exist, and their shareholders become shareholders in the new company. The law defines consolidation as follows: 170 CU IDOL SELF LEARNING MATERIAL (SLM)","Consolidation is form merger where the undertaking, property, and liabilities of one or more companies are to be transferred to a new company. We can under a consolidation with the equation, A + B = C, where C is an entirely new company. Thus, in a consolidation, all of the combining companies are dissolved and only the new entity continues to operate. Demerger A demerger is a transaction in which a business is broken into components, either to operate on their own, or to be sold or to be liquidated as a divestiture. In India, a demerger is called as division. The law defines divisions as follows: Division is a form of merger where the undertaking, property and liabilities of the company are to be divided among and transferred to two or more companies. A division can be a spin off or an equity carves out. \uf0b7 A spinoff is a transaction in which a parent creates a new legal subsidiary, with the spun-off subsidiary now independent of the parent. A company creates a spinoff expecting that it will be worth more as an independent entity. A spinoff is also known as a spin out or starburst. \uf0b7 A split-off is similar to a spin-off, in that a firm\u2019s subsidiary becomes an independent firm, and the parent firm does not generate any new cash. However, unlike a spin-off, the split-off involves an offer to exchange parent stock for stock in the parent firm\u2019s subsidiary. \uf0b7 An equity carve-out is a transaction in which the parent creates a new legal subsidiary with the intention of making selling a minority interest of a subsidiary to outside investors to generate cash. Acquisition An acquisition occurs when a company takes a controlling interest in another firm. In contrast to a merger, where one or entities cease to exist, in an acquisition, all the entities continue to exist. For example, Flipkart\u2019s acquisition of Myntra. What Flipkart has acquired is the control of the board of directors of Myntra. The \u2018acquired\u2019 entity Myntra continues to carry out its business as earlier. The only thing that has changed is the Myntra is now a subsidiary of Flipkart. An acquisition are also referred to as takeovers. Takeovers may be friendly or hostile. \uf0b7 Friendly takeovers occur when the target company expresses its agreement to be acquired. Friendly takeoversare negotiated deals struck voluntarily by both buyers and sellers. The vast majority of acquisitions are of this variety. They are based on mutual accommodation of the interests of two or more parties 171 CU IDOL SELF LEARNING MATERIAL (SLM)","that believe they will be better off together than apart if they can just work things out. \uf0b7 Hostile takeovers occur when the target company does not consent to the acquisition. In this case, the acquiring company must attempt to gather a majority stake to force the acquisition to go forward. Merger Vs Acquisition Acquisition is the generic term used to describe a transfer of ownership. Merger is a narrow, technical term for a particular legal procedure that may or may not follow an acquisition (Reed, Lajoux, & Nesvold, 2007). 12.1.2 Tax Definition of Amalgamation The income tax law defines an amalgamation as follows: An amalgamation is merger of one or more companies with another company or merger of two or more companies to from one company in such a manner that: \uf0b7 All the property of the amalgamating company or companies immediately before the amalgamation becomes the property of the amalgamated company by virtue of the amalgamation. \uf0b7 All the liabilities of the amalgamating company or companies immediately before the amalgamation becomes the liabilities of the amalgamated company by virtue of the amalgamation \uf0b7 Shareholders holding at least three-fourths in value of the shares in the amalgamating company or companies (other than shares already held therein immediately before the amalgamated company or its nominee) becomes the shareholders of the amalgamated company by virtue of the amalgamation. 12.2 RATIONALE FOR MERGERS AND AMALGAMATIONS Companies buy other companies for several reasons. Some of the common reasons for M&A are to benefit from synergies, to realign strategy to keep up with the changes in business environment, to achieve market power, to diversify into new product lines or new markets, and also to take advantage of tax incentives for acquiring loss-making companies. These reasons for M&A are discussed below (Motis, 2007). 12.2.1 Synergy Synergy is the interaction or cooperation of two or more organizations, substances, or other agents to produce a combined effect greater than the sum of their separate effects. In the context of mergers and acquisitions, synergy is the value realized from the incremental cash flows generated by combining two businesses. That is, if the market value of two firms is Rs. 100 million and Rs. 75 million, respectively, and their combined market value is Rs. 200 172 CU IDOL SELF LEARNING MATERIAL (SLM)","million, then the implied value of synergy is Rs. 25 million. The two basic types of synergy are operating and financial. Operating synergy consists of economies of scale, economies of scope, and the acquisition of complementary technical assets and skills, which can be important determinants of shareholder wealth creation. Gains in efficiency can come from these factors and from improved managerial operating practices. Financial synergy refers to the reduction in the acquirer\u2019s cost of capital due to a merger or acquisition. This could occur if the merged firms have cash flows that are relatively uncorrelated, realize cost savings from lower securities\u2019 issuance and transactions costs, or experience a better matching of investment opportunities with internally generated funds. 12.2.2 Strategic Realignment Strategic realignment process of aligning an organization\u2019s decisions and actions such that they support the achievement of strategic goals. Firms use M&As to make rapid adjustments to changes in their external environmentsuch as regulatory changes and technological innovation. Those industries that have beensubject to significant deregulation in recent years\u2014financial services, healthcare, utilities,media, telecommunications, and defense\u2014have been at the centre of M&A activity, becausederegulation breaks down artificial barriers and stimulates competition. Firms in highlyregulated industries often are unable to compete successfully following deregulation andbecome targets of stronger competitors. As such, deregulation often sparks a flurry of M&Aactivity resulting in a significant reduction in the number of competitors in the formerlyregulated industry. 12.2.3 Market Power One theory suggests that firms merge to improve their ability to set product prices at levels not sustainable in a more competitive market. There is evidence that increased industry concentration can force suppliers to lower their selling prices. 12.2.4 Diversification Diversification is the process of a business enterprise enlarging or varying its range of products or field of operation. Diversification may create financial synergy that reduces the cost of capital as noted earlier, or it may allow a firm to shift its core product lines or target markets to ones that have higher growth prospects. The new product lines or target markets may be related or unrelated to the firm\u2019s current products or markets. A firm facing slower growth in its current markets may accelerate growth through related diversification by selling its current products in new markets that are somewhat unfamiliar and, therefore, riskier. A firm also may attempt to achieve higher growth rates by acquiring 173 CU IDOL SELF LEARNING MATERIAL (SLM)","new products with which it is relatively unfamiliar and then selling them in familiar and less risky current markets. 12.5.5 Tax Considerations Acquirers of firms with accumulated losses and tax incentives may use them to offset future profits generated by the combined firms. However, the taxable nature of the transaction often plays a more important role in determining whether a merger takes place than do any tax benefits accruing to the acquirer. The seller may view the tax-free status of the transaction as a prerequisite for the deal to take place. A properly structured transaction can allow the target shareholders to defer any capital gain until the acquirer\u2019s stock received in exchange for their shares is sold. 12.3 MODES OF M&A TRANSACTIONS IN INDIA A M&A transaction may be structured in several ways. The three most common structures are: share acquisition, asset acquisitions, and mergers. 12.3.1 Share Purchase In a share purchase, the buyer-company purchases the equity shares of the target company directly from the shareholders of the target company. The buyer-company usually pays for the target company\u2019s shares in the form of cash. However, stock swap deals have also been structured. In a stock swap deal the buyer-company pays for the target company\u2019s shares by issuing its own shares. A share acquisition is one of the most common modes of M&As that have happened in India. From a target company shareholder\u2019s perspective, a share purchase structure has the following key implications: Tax on Transfer of Shares of Listed Company In the case of shares listed on stock exchanges, if the shares have been held for a period exceeding 12 months and the shares are sold on the floor of the stock exchange after payment of securities transaction tax (STT), any profits on such sale are exempt from payment of any income taxes. In the event such listed shares have been held for a period not exceeding 12 months and STT has been paid on the sale, profits on such sale will attract capital gains tax at the rate of 15 per cent (excluding any surcharge and cess). Tax on Transfer of Shares of Unlisted Company If the shares are not listed, the minimum period of holding required for availing the benefits of a beneficial rate of tax on long-term capital gains increases to 24 months. This means that if the shares are sold after a period of 24 months from the date they were acquired, the profits from the sale are taxed at the rate of 20 per cent. While computing profits, indexation of cost 174 CU IDOL SELF LEARNING MATERIAL (SLM)","of acquisition is allowed to factor in the inflation effect. In case the seller is a non-resident, the applicable tax rate is 10 per cent. However, for non-residents, no benefit of indexation or exchange rate fluctuations is allowed while computing the taxable profits. 12.3.2 Asset Purchase In an asset purchase, the buyer-company acquires all or selected assets of the target company and assumes all, a portion, or none of the liabilities of the target company pursuant to an asset purchase agreement. This transaction requires shareholder approval of a sale of \u201call or substantially all\u201d of the assets of the target company. There are a number of reasons why a deal may be structured as an asset purchase. In some cases, such as where the buyer-company is acquiring only a division or a product line from an established business with multiple divisions and product lines that are not separately incorporated, an asset purchase is the only practical way to accomplish this objective (Johnson, 2020). 12.3.3 Merger In a merger, as discussed in paragraph 12.1.1, one company is absorbed into the other, so it ceases to exist as a separate entity once the merger is complete. A merger can take three forms: absorption, consolidation, and division. In India, the buy-company and the target company are required to enter an agreement covering the terms of the merger. This agreement, called a scheme of arrangement, first by the shareholders of both and companies and finally sanctioned by the National Company Law Tribunal (NCLT). 12.4 TYPES OF MERGERS AND AMALGAMATIONS Mergers and acquisitions may be classified based on the industry or based on the motive of M&A (Coates IV, 2014). 12.4.1 Classification Based on Industry Based on industry, we can classify mergers into horizontal mergers, vertical mergers, and conglomerate mergers. Horizontal Merger A horizontal merger is a merger between two or more firms in the same industry that are both at the same stage in the production cycle; that are two or more competitors. Vertical Merger A vertical merger is a merger in which one firm acquires another firm that is in the same industry but at another stage in the production cycle. For example, the firm being acquired serves as a supplier to the firm doing the acquiring. Conglomerate Merger 175 CU IDOL SELF LEARNING MATERIAL (SLM)","A conglomerate merger is a merger involving two or more firms that are in unrelated businesses. 12.4.2 Classification Based on Motives Based on motives, we can classify mergers as strategic mergers, financial mergers, reverse mergers, and defensive mergers. Strategic Mergers Strategic mergers are mergers which are motivated by some strategic purpose. For example, the buyer-company may be motivated to absorb the target company to achieve some strategic objectives such as expansion of business, or obtain market power, or to spread into new markets, etc.This type of a merger is also called as \u2018buy-to-hold\u2019 merger. Financial Mergers Financial mergers are mergers which are motivated by financial goals. Financial mergers are often initiated by private equity funds and similar financial institutions. For example, a financial institution may \u2018buy\u2019 a poorly performing company whose market price has fallen substantially with the goal of improving performance and ultimately selling the company at a higher price. This type of a merger is also called as \u2018buy-to-sell\u2019 merger. Reverse Mergers A reverse merger is a merger in which a private company may go public by merging with an already public company that often is inactive or a corporate shell. The combined company may then choose to issue securities and may not have to incur all of the costs and scrutiny that normally would be associated with an initial public offering. The private-turned-public company then has greatly enhanced liquidity for its equity. Another advantage is that the process can take place quickly and at lower costs than a traditional initial public offering (IPO). Defensive Mergers Sometimes businesses are acquired because the buying-company may be facing a severe downturn in its business, and they think an acquisition will alleviate the cause of the severe downturn. An example is a pharmaceutical company that has massive marketing power but is running out of patent protection on its key drugs. It may acquire a promising new drug and put it into its powerful marketing channel. 12.5 PROCESS OF MERGERS AND AMALGAMATIONS A typical M&A transaction passes through a number of steps. The following 13 steps are common (KPMG, 2019). Acquisition Strategy 176 CU IDOL SELF LEARNING MATERIAL (SLM)","At the stage the company considers what strategic goalsit wants to pursue in the future. These goals may be growth and expansion, diversification, entering a new market, or developing a new product. Then it identifies various ways in which these strategic objectives and whether M&A is the means through which the strategic objectives of the company would be achieved. Acquisition Criteria Having decided that the company should pursue M&A as a means of achieving its strategic achievements, now the company would decide the acquisition criteria, that is the broad type of Target Company that company would like to acquire. These criteria may include size of the target, market share in the industry, the target\u2019s strengths weakness, and vulnerabilities, and its corporate culture. Identifying Targets At this stage, the company would start the process of identifying target companies which satisfy the broad criteria decided in step #2. The company would do this on its own and it may also seek the help of investment bankers. At the end of this step, the company would have identified a pool of target companies. Screening Targets At the end of step 3, the company would have identified a large pool of target companies. At this stage the company would apply some screening criteria to prune this pool to a small number of targets. The rationale for this step is that the company need to study this small group closely so as to make them an offer. The screening criteria may be on the same lines of the acquisition criteria only at this stage the criteria would be more stringent. Courtship At this stage the company informally approaches the small number of companies which has come through the screening criteria. The approach is a tricky affair as it is possible that the target may not be interest and there is risk of being rebuffed. Companies often seek help of investment bankers to find out whether the target company is interested so that a formal offer can be made. Due Diligence After making a formal offer to the target company and receiving a positive signal, the company would seek information from the target. The target may insist on entering a confidentiality agreement to safeguard its information. The buyer-company would also collect information from independent sources to validate the information provided by the target. Based on this information the buyer-company carry out a due diligence exercise to ensure that the target company is the right candidate for acquisition. The due diligence exercise would cover several areas of the business including financial due diligence, commercial due diligence, and legal due diligence. 177 CU IDOL SELF LEARNING MATERIAL (SLM)","Valuation Valuation is the process of estimating the intrinsic value, or worth, of an asset or investment. The company has to make an offer to the target about the price it is willing to pay for the acquisition. Alternatively, the target may have made an offer of the price it expects for the sale. In either case, the company has to work out the \u2018right\u2019 price. This process of finding out the right price is called as corporate valuation. Companies often seek help of investment bankers to value the company. The three common approaches to valuation are the discounted cash flow approach (DCF), the relative valuation approach, and the net asset value approach. Negotiations At this stage formal negotiations are carried out to work out detail of transfer of business. The two parties may have a lot of difference of opinion about the quality of assets, the business prospects, and the value of the target company. Negotiations are carried out to resolve these differences of opinion and finalise the terms of transfer of business. At the end of the negotiation process the two parties, the buy-company, and the target company, come up with an agreement. This agreement is called as the draft definitive agreement or a draft scheme of arrangement. Internal Approvals The draft scheme of arrangement is then considered by the board of directors of both the companies and duly approved. The is then placed on the agenda of the shareholders\u2019 general meeting. The draft scheme of arrangement is then duly approved by the shareholders of the two companies by passing a resolution. Legal Sanction The draft scheme of arrangement is then filed with the National Company Law Tribunal (NCLT) for its sanction. The NCLT generally ask for convening a meeting of the creditor and seek the opinion of tax authorities and regulators like the registrar of companies and the SEBI. It may also hear the view of dissenting shareholders of the two companies. After considering the view of lenders, creditors, government authorities, regulators, and the dissenting shareholders, the NCLT will apply its own mind to determine if the draft scheme of arrangement is fair and reasonable and grant its legal sanction. Transfer of Control and Satisfaction of Purchase Consideration At this stage the target company hands over the control of the company to the buy-company. In return the buyer-company satisfies the purchase consideration. The purchase consideration may be satisfied by pay cash, or by issue of equity shares or other securities, or a combination of all of these. Immediate Integration 178 CU IDOL SELF LEARNING MATERIAL (SLM)","At this stage, the buyer-company would now take the first steps of integrating the business of the target company with its own business. This may involve harmonising various business systems such as accounting and financial reporting system, management information system, human resource information system, and the information technology system. The buy- company would also start the process of integrating the business planning, marketing, and operations functions. Final Integration Final integration is achieved when not only are the business systems harmonised, and business functions integration, but when the cultures of the two businesses become integration. This may happen in several ways. For example, the buyer-company may impose its culture on that acquired business, or it may be the other way round. However, the best scenario is for the two cultures to come together and create a new culture which contains the best features of the two previous cultures. 12.6 TAX IMPLICATIONS OF MERGERS AND AMALGAMATIONS The tax implication of mergers and amalgamations depends upon whether the M&A is a tax compliant one or not.A tax compliant merger or amalgamation is one which satisfies the conditions laid out by the Income Tax Act, 1961. 12.6.1 Tax Compliant Merger A tax compliant merger or amalgamation is one which satisfies the following conditions: \uf0b7 All the property of the target company immediately before the amalgamation becomes the property of the acquiring company by virtue of the amalgamation. \uf0b7 All the liabilities of the target company immediately before the amalgamation becomes the liabilities of the acquiring company by virtue of the amalgamation \uf0b7 Shareholders holding at least three-fourths in value of the shares in the target company becomes the shareholders of the acquiring company by virtue of the amalgamation(Nishith Desai Associates, 2020). 12.6.2 Tax Relief to Target Company Exemption from Capital Gains Tax Any capital gain arising from the transfer of assets by the target companies to an Indian acquiring company is exempt from tax as such transfer is not regarded as a transfer for the purpose of capital gain. Exemption from Capital Gains Tax in case of International Restructuring 179 CU IDOL SELF LEARNING MATERIAL (SLM)","In case of amalgamation of foreign companies, transfer of shares held in Indian company by target foreign company to acquiring foreign company is exempt from tax, if the following two conditions are satisfied: \uf0b7 At least 25 per cent of the shareholders of the target foreign company continue to remain shareholders of the acquiring foreign company, and \uf0b7 Such transfer does not attract tax on capital gains in the country, in which the target company is incorporated. 12.6.3 Tax Relief to Shareholders of Target Company Any capital gains arising from the transfer of shares by a shareholder of the acquiring companies are exempt from tax as such transactions will not be regarded as a transfer for capital gain purpose. This is subject to the following conditions: \uf0b7 The transfer is made in consideration of the allotment to him of shares in the acquiring company; and \uf0b7 The acquiring company is an Indian company. 12.6.4 Tax Relief to Acquiring Company Tax benefits are available to acquiring companies only if the followings conditions are fulfilled: \uf0b7 The target company should be: (a) a company owning an industrial undertaking; or (b) ship or a hotel with another company, or a banking company; (c) one or more public sector company or companies engaged in the business of operation of aircraft with one or more public sector company or companies engaged in similar business. \uf0b7 The acquiring company should be an Indian company. \uf0b7 The target company should be engaged in the business, in which the accumulated loss occurred, or depreciation remains unabsorbed, for 3 years or more. \uf0b7 The target company should have held continuously as on the date of amalgamation at least three-fourth of the book value of the fixed assets held by it two years prior to the date of amalgamation. \uf0b7 The acquiring company holds continuously for a minimum period of five years from the date of amalgamation at least three-fourths in the book value of fixed assets of the target company acquired in a scheme of amalgamation \uf0b7 The acquiring company continues the business of the target company for a minimum period of five years from the date of amalgamation. \uf0b7 The acquiring company fulfils such other conditions as may be prescribed to ensure the revival of the business of the amalgamating company or to ensure that the amalgamation is for genuine business purpose. Tax benefits are available to acquiring companies are as follows: 180 CU IDOL SELF LEARNING MATERIAL (SLM)","Carry forward of the target company\u2019s accumulated losses With a view to encourage the mergers of the sick companies with healthy companies, the acquiring company is allowed the advantage of the carry forward of accumulated losses and unabsorbed depreciation of the target company. This benefit is allowed subject to several stringent conditions. Carry forward of the target company\u2019s unabsorbed expenditure on scientific research When target company transfers any asset represented by capital expenditure on the scientific research to the acquiring Indian company in a scheme of amalgamation the following tax benefits: \uf0b7 Unabsorbed expenditure on scientific research of the amalgamating company will be allowed to be carried forward and set off in the hands of the amalgamated company, \uf0b7 If such asset ceases to be used in the previous year for scientific research related to the business of acquiring company and is sold by the target company the sale price to the extent of cost of asset shall be treated as business income and the excess of sale price over the cost shall be subject to the provisions of capital gain. Amortization of expenditure of amalgamation Amortization of expenditure in case of amalgamation incurred in connection with the amalgamation the assessee is allowed a deduction of an amount equal to one-fifth of such expenditure for each of the five successive previous years beginning with the previous year in which the amalgamation takes place. Amortization of Preliminary Expenses When and target company merges with an acquiring company under a scheme of amalgamation, the amount of preliminary expenses of the target company to the extend not yet written off is allowed as deduction to the acquiring company in the same manner as would have been allowed to the amalgamating company. Bad Debts When due to amalgamation debts of the target company has been taken over by acquiring company, and subsequently, such debts turn out to be bad, it is allowed as deduction to the acquiring company. 12.7 SUMMARY \uf0b7 Mergers and acquisitions (M&A) is an important strategic option that companies can leverage to make necessary leaps in the competitive marketplace. It can help 181 CU IDOL SELF LEARNING MATERIAL (SLM)","companies to obtain a higher market share and a broader customer base, and gain access to new technology, products, and distribution channels. Yet, at the same time, M&A is risky, and many deals fail, sometimes bringing companies to the brink of failure. Reasons for failure vary and range from opportunistic M&A and overpayment to poor integration. \uf0b7 Companies buy other companies for several reasons. Some of the common reasons for M&A are to benefit from synergies, to realign strategy to keep up with the changes in business environment, to achieve market power, to diversify into new product lines or new markets, and also to take advantage of tax incentives for acquiring loss-making companies. \uf0b7 A M&A transaction may be structured in several ways. The three most common structures are: share acquisition, asset acquisitions, and mergers. \uf0b7 Mergers and acquisitions may be classified based on the industry or based on the motive of M&A. Based on industry; we can classify mergers into horizontal mergers, vertical mergers, and conglomerate mergers. Based on motives, we can classify mergers as strategic mergers, financial mergers, reverse mergers, and defensive mergers. \uf0b7 A typical M&A transaction passes through a number of steps. The following steps are common: acquisition strategy, acquisition criteria, identifying targets, screening targets, courtship, due diligence, valuation, negotiations, obtaining internal approvals, legal sanction, transfer of control and satisfaction of purchase consideration, immediate integration, and final integration. \uf0b7 The tax implications of mergers and amalgamations depend upon whether the M&A is a tax compliant one or not. A tax compliant merger or amalgamation is one which satisfies the conditions laid out by the Income Tax Act, 1961. 12.8KEYWORDS \uf0b7 Absorption. Absorption is a form merger where the undertaking, property, and liabilities of one or more companies are to be transferred to another existing company. \uf0b7 Acquisition. Acquisition means the transaction of one company taking over controlling interest in another company. \uf0b7 Amalgamation. Amalgamation is the action, process, or result of combining two or more companies. \uf0b7 Consolidation. Consolidation is form merger where the undertaking, property, and liabilities of one or more companies are to be transferred to a new company. 182 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 Demerger. A demerger is a transaction in which a business is broken into components, either to operate on their own, or to be sold or to be liquidated as a divestiture. In India, a demerger is called as division. \uf0b7 Diversification. Diversification is the process of a business enterprise enlarging or varying its range of products or field of operation. \uf0b7 Horizontal Merger. A horizontal merger is a merger between two or more firms in the same industry that are both at the same stage in the production cycle; that is two or more competitors. \uf0b7 Merger. A merger is said to take place when two or more companies agree to combine, resulting in a new entity or with the resulting firm maintaining the identity of the acquiring company. \uf0b7 Reverse Merger. A reverse merger is a merger in which a private company may go public by merging with an already public company that often is inactive or a corporate shell. \uf0b7 Strategic Realignment. Strategic realignment process of aligning an organization\u2019s decisions and actions such that they support the achievement of strategic goals. \uf0b7 Synergy. Synergy is the interaction or cooperation of two or more organizations, substances, or other agents to produce a combined effect greater than the sum of their separate effects. \uf0b7 Valuation. Valuation is the process of estimating the intrinsic value, or worth, of an asset or investment. \uf0b7 Vertical Merger. A vertical merger is a merger in which one firm acquires another firm that is in the same industry but at another stage in the production cycle. For example, the firm being acquired serves as a supplier to the firm doing the acquiring. 12.9 LEARNING ACTIVITY 1. In a tax compliant merger, what tax relief is available to the shareholders of the target company? ___________________________________________________________________________ _____________________________________________________________________ 2. In a tax compliant merger, what tax relief is available to the acquiring company? ___________________________________________________________________________ _____________________________________________________________________ 12.10UNIT END QUESTIONS A. Descriptive Questions 183 Short Questions CU IDOL SELF LEARNING MATERIAL (SLM)","1. Explain the concept of absorption in brief. 2. Explain the concept of acquisition in brief. 3. Explain the concept of amalgamation in brief. 4. Explain the concept of consolidation in brief. 5. Explain the concept of demerger in brief. 6. Explain the concept of diversification in brief. 7. Explain the concept of horizontal merger in brief. 8. Explain the concept of merger in brief. 9. Explain the concept of reverse merger in brief. 10. Explain the concept of strategic realignment in brief. 11. Explain the concept of synergy in brief. 12. Explain the concept of valuation in brief. 13. Explain the concept of vertical merger in brief. Long Questions 1. Explain the concept of an acquisition and enumerate the types of acquisitions. 2. Explain the concept of a demerger and enumerate the types of demergers. 3. Enumerate discuss the various reasons why companies acquire other company. 4. Enumerate discuss the various types of mergers when they are classified on the basis of industry. 5. Enumerate discuss the various types of mergers when they are classified on the basis of the motive for mergers. 6. Enumerate discuss the steps involved in the process of a merger. 7. Explain the concept of a tax compliant merger. 8. In a tax compliant merger, what tax relief is available to the target company? B. Multiple Choice Questions (MCQs): 1. Which of the following reasons for mergers and acquisition creates value for the company? a. Managers' Personal Incentives b. Synergy c. Tax Benefits d. Bootstrapping Profits 2. The acquisition of Dharma Ports by Adani Ports from Tata Steel, it is an example of \u2026 which of the following? a. Conglomeritic merger b. Horizontal merger 184 CU IDOL SELF LEARNING MATERIAL (SLM)","c. Vertical merger d. Financial merger 3. When a company which is predominantly engaged in manufacture of cigarettes, like ITC, acquires a paper company, like Bhadrachalam paper, it is an example of which of the following types of mergers? a. Conglomeritic merger b. Horizontal merger c. Vertical merger d. Financial merger 4. When a new company is formed to absorb the business of two or more existing companies, it is called which of the following? a. Division b. Consolidation c. Friendly takeover d. Management buyout 5. Boisar Enterprises is a company whose shares are listed on the Bombay Stock Exchange (BSE) however; the company has fallen on bad times. Bandra Private Equity Fund acquires Boisar Enterprises with the intention of infusing more capital and improving its operational efficiency and ultimately selling it off to another entity. Which of the following best describes this transaction? a. Strategic merger b. Financial merger c. Reverse merger d. Conglomerate merger Answer 1-b, 2-a, 3-c, 4-b, 5-b 12.11 REFERENCES Reference Books \uf0b7 Cruz, A., Deschamps, M., Niswander, F., Prendergast, D., & Schisler, D. (2018). Fundamentals of Taxation. New York: McGraw-Hill Education. \uf0b7 Martin, E. A. (2003). The Dictionary of Law. Oxford: Oxford University Press. 185 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 Singhania, V., & Singhania, K. (2021). Direct Taxes Law & Practice. New Delhi: Taxmann. Website \uf0b7 Income Tax Department. (2021, 4 1). Set Off and Carry Forward of Losses Under the Income Tax Act. Retrieved from Tutorials: https:\/\/www.incometaxindia.gov.in\/Tutorials\/21- %20MCQ%20set%20off%20and%20carry%20frwrd.pdf \uf0b7 Institute of Chartered Accountants of India. (2019, February 1). Set off and Carry forward, of Losses. Retrieved from Western India Regional Council: https:\/\/www.wirc-icai.org\/images\/material\/Key-Aspects-Carry-Forward-Set- Losses.pdf \uf0b7 Sirwalla, P. (2012, January 31). Income Tax Deductions That You Should Not Miss. Business Today. Retrieved from https:\/\/www.businesstoday.in\/magazine\/tax\/story\/income-tax-deductions-24273- 2011-12-28 \uf0b7 Directorate of Income Tax. (2021). Salary Income and Tax Implications for AY 2020-21. New Delhi. Retrieved from https:\/\/www.incometaxindia.gov.in\/booklets%20%20pamphlets\/salary-income- tax-implications-ay-20-21.pdf \uf0b7 KPMG. (2020, January 30). India: Income Tax. Retrieved from Taxation of International Executives: https:\/\/home.kpmg\/xx\/en\/home\/insights\/2011\/12\/india- income-tax.html 186 CU IDOL SELF LEARNING MATERIAL (SLM)","UNIT- 13 DIRECT TAX PLANNING 187 STRUCTURE 13.0 Learning Objectives 13.1 Managerial Decisions of Make or Buy 13.1.1 Definition 13.1.2 Decision Factors 13.1.3 Tax Implications of Make or Buy Decision 13.2 Managerial Decisions of Own or Lease 13.2.1 Decision Factors 13.2.2 Tax Implications of Own or Lease Decision 13.3 Managerial Decisions of Close or Continue 13.3.1 Decision Factors 13.3.2 Tax Implications of Close or Continue Decision 13.4 Managerial Decisions of Export or Local Sales 13.4.1 Sales Mix Decision 13.4.2 Special Order Decision 13.4.2 Tax Implications of Export or Local Sales 13.5 Managerial Decisions of Replace or Repair 13.5.1 Decision Factors 13.5.2 Tax Implications of Replace or Repair Decision 13.6 Foreign Collaborations and Joint Ventures 13.6.1 Foreign Collaborations 13.6.2 Joint Ventures 13.6.2 Tax Implications of Foreign Collaborations and Joint Ventures 13.7 Summary 13.8 Keywords 13.9 Learning Activity 13.10 Unit End Questions 13.11 References CU IDOL SELF LEARNING MATERIAL (SLM)","13.0 LEARNING OBJECTIVES After studying this unit, you will be able to: \uf0b7 State the tax implications of corporate finance decision areas \uf0b7 Explain the make or buy, own or lease, close or continue, export or local sales, replace or repair, foreign collaborations, and joint ventures \uf0b7 Expected to work out the tax implications of mergers and acquisitions. 13.1 MANAGERIAL DECISIONS OF MAKE OR BUY A make-or-buy decision is any decision by a company to acquire goods or services internally or externally. A steel company that mines its own iron ore and processes it into pig iron makes; one that purchases it for further processing buys. The make-or-buy decision is often part of a company\u2019s long-run strategy. Some companies choose to integrate vertically (own the firms in the supply chain) to control the activities that lead to the final product; others prefer to rely on outsiders for some inputs and specialize in only certain steps of the total manufacturing process. Aside from strategic issues, the make-or-buy decision is ultimately a question of which firm in the value chain can produce the product or service at the lowest cost. 13.1.1 Definition Nowadays, the make-or-buy decision is also known as outsourcing, which is defined as follows: Outsourcing refers to having work performed for one company by an off-site, non-affiliated supplier; it allows a company to buy a product (or service) from an outside supplier rather than making the product or perform the service in-house. Whether to rely on outsiders for a substantial amount of materials depends on both differential cost comparisons and other factors that are not easily quantified, such as suppliers\u2019 dependability and quality control. Although make-or-buy decisions sometimes appear to be simple one-time choices, frequently they are part of a more strategic analysis in which top management makes a policy decision to move the company toward more or less vertical integration. 13.1.2 Decision Factors The outsourcing decision (or make-or-buy decision) is made after performing an analysis that compares internal production and opportunity costs to external purchase cost and then assesses the best use of facilities. Having an insourcing (make) option implies that the company has the capacity available for that purpose or has considered the cost of obtaining the necessary capacity. 188 CU IDOL SELF LEARNING MATERIAL (SLM)","Relevant information for this type of decision includes both quantitative and qualitative factors. Most outsourcing is not related to an organization\u2019s strategic core but to the management of operating costs and the desire to free personnel from \u201cdrudge work.\u201d Thus, routine activities such as information processing are more often outsourced than activities that constitute core competencies or new strategies. Numerous factors should be considered in the outsourcing decision. Several quantitative factors, such as incremental directmaterial and direct labour costs per unit, are known with a high degree of certainty. Other factors, such as the variable overhead per unit and the opportunity cost associated with production facilities, must be estimated. The qualitative factors should be evaluated by more than one individual so personal biases do not distort business judgment. 13.1.3 Tax Implications of Make or Buy Decision Outsourcing has a tax effect. A manager has to consider the tax benefits and tax detriments of outsourcing in structuring the transaction, pricing the services, and negotiating the terms of an outsourcing services agreement. Because the tax costs of an outsourcing transaction can be significant, they must be addressed early on in a transaction (Hirshman & Zablotney, 2005). For example: \uf0b7 The company may be manufacturing the product in a tax-advantaged location and must be enjoying a tax holiday or a special deduction for this reason. The company stands to lose these tax benefits if it decides to outsource the manufacturing. \uf0b7 The company may be manufacturing the product which has been singled out by the government for an advantageous tax treatment. The company stands to lose these tax benefits if it decides to outsource the manufacturing. \uf0b7 Certain tax deductions, set off and carry forward of losses are available to an entity only if it continues to carry on its business,the company stands to lose these tax benefits if it decides to outsource the manufacturing. Thus, the cost savings and other benefits of outsourcing should be considered in the light of the tax detriments discussed above. 13.2 MANAGERIAL DECISIONS OF OWN OR LEASE When a company pursues a strategy of rapid growth and expansion, it may need a large amount of cash to buy equipment, set up plants, and other capital expenditure. Although, some part of the capital expenditure may be met from internal resources, the company may have to seek funding from external sources for the remaining funds. Obtaining external funding is not only expensive, but it may also require the company to enter restrictive debt 189 CU IDOL SELF LEARNING MATERIAL (SLM)","covenants which would hamper the company\u2019s freedom in running its business. There is an alternative to external funding to buy expensive property, plant, and equipment: leasing. 13.2.1 Definition Leasing, like long-term debt, requires the firm to make a series of periodic, tax-deductible payments that may be fixed or variable. The lessee uses the underlying asset and makes regular payments to the lessor, who retains ownership of the asset. Leasing is defined as follows: Leasing is an agreement between two parties to rent an asset is a leasing arrangement. The owner of the leased asset, the lessor, receives a set of fixed payments for the term of the contract from the lessee (Paxson & Wood, 1998). Leasing can take a number of forms. Two forms are most common operating lease and financial lease. Operating Lease An operating lease is defined as follows: An operating lease is one that contains a provision that allows the lessee to cancel at any time or if the lessor is responsible for insurance and maintenance (Paxson & Wood, 1998). Financial Lease A financial lease is defined as follows: Financial leases are long term, carry no cancelation options, and the lessee is responsible for all insurance and maintenance (Paxson & Wood, 1998). 13.2.2 Tax Implication of Buy-or-Lease Decision The decision of whether to purchase an item of property, plant, and equipment outright or acquire it on lease is taken by calculating the net advantage to leasing (NAL). The net advantage to leasing is the present value of the benefits that are provided by leasing an asset instead of purchasing it via other financing alternatives. If the net advantage to leasing of a lease is positive, leasing is preferred over the purchase. In the absence of transaction costs, savings in taxes is considered to be the paramount benefit of leasing. It has been shown that a necessary condition for the net advantage to leasing to be positive for both lessee and lessor, is that their tax brackets must differ. The intuition is that an organization that is non-tax-paying or even in a low tax bracket would be better off by transferring its depreciation and interest tax shields to a company that pays taxes at a higher tax rate. This can be easily accomplished by entering into a leasing arrangement (either for assets that are newly put into use or for existing assets \u2013 by entering into a sale and leaseback). In return for the tax shields, the lessee receives consideration in the form of lower lease payments relative to its outflows under other financing alternatives. 190 CU IDOL SELF LEARNING MATERIAL (SLM)","The pertinent points to be noted are that when an entity purchases an item of property, plant, and equipment outright it is able to claim depreciation as a tax-deductible expense. The operating expenses as well as the interest paid on obtaining external funding to buy the item are tax deductible. This benefit should be compared with the fact that only the lease rent is tax deductible. Thus, the cost savings and other benefits of outsourcing should be considered in the light of the tax detriments discussed above. 13.3 MANAGERIAL DECISIONS OF CLOSE OR CONTINUE Managers often must decide whether to add or drop a product line or close a business unit. Product lines that were formerly profitable may be losing market share to newer products. Companies abandon a product, product line, business unit, or the business enterprise as a whole, when it is unprofitable either because revenues no longer exceed costs or because another company offers to buy the rights to theproduct, product line, business unit, or the business enterprise. Because the focus is on unit-level profitability, the relevant cost analysis involves comparing the costs saved by abandoning the unit with the revenues forgone (Deal Room, 2021). 13.3.1 Decision Factors The analysis of what costs are avoided when a unit is dropped can be very difficult. The various costs involved in closing a unit may include paying workers severance pay and incurring environmental clean-up and many other costs. Dropping a product line in some companies is equivalent to closing a business unit. Although, managers predominantly focus primarily on the financial aspects of the decision, when a business unit is closed, important nonfinancial impacts need to be considered (Onsight, 2021). Plant closures, for example, have serious effects for the employees and communities involved. These nonfinancial considerations are often so important that they outweigh the financial issues. 13.3.2 Tax Implications of Close or ContinueDecisions The tax implications of business closure depends upon the mechanism use to dispose of the business. For example, the entity may sell of assets separately waiting for the \u2018right\u2019 price, or it may sell all the assets as a whole, called as a slump sale, or the entity may dispose off the business as a part of a merger (KPMG, 2019). These alternatives are discussed below: Piecemeal or Itemised Sale of Assets Sometimes, the entity shutting down a business unit decides to sell the assets of the unit piecemeal waiting for the most opportune time and price. In such a case the entity would be liable to pay capital gains tax. The nature of capital gains depend upon the period for which the assets were held from the date of acquiring the asset to the date of its disposal. Generally, 191 CU IDOL SELF LEARNING MATERIAL (SLM)","if the period of this holding is less than 36 months, the gain would be classified as short-term capital gain, otherwise it would be treated as long term capital gain. The two types of capital gains are taxed at different rates. However, if the asset being sole is a depreciable asset, the gains are taxable as short-term capital gains irrespective of the period of holding the asset Slump Sale As opposed to piecemeal or itemised sale, an entity may sell its business unit as a whole for a lump sum consideration. Slump sale means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales. In such a case too, the entity would be liable to pay capital gains tax as in case of piecemeal or itemised sale. However, the major difference between tax implications of piecemeal sale versus slump sale lies in the method of calculation of capital gains. \uf0b7 Ordinarily, capital gains is calculated by subtracting acquisition cost of asset from the full consideration of the sale net of transaction cost. In a slump sale the cost of acquisition is taken as the net worth of the business unit being sold. Where the net worth of the business unit has eroded and has become negative, the cost of acquisition is taken as zero. \uf0b7 Generally, if the period of an asset holding is less than 36 months, the gain is classified as short-term capital gain; otherwise it would be treated as long term capital gain. Ordinarily, the assessee is given the benefit of subtracting the indexed cost of acquisition from the sale consideration. However, this benefit of indexation is not available for slump sale. Sale in a Merger The third possibility in a business closure is that the unit may be sold in a merger transaction. The tax implications of this sale depends upon whether the merger satisfies the conditions contained in the income tax law. If the merger does satisfy the tax law conditions, it is called as a tax-compliant merger otherwise it is termed as non-compliant merger. Several tax benefits are available to the seller-company as well as the shareholders of the seller-company in case of a tax compliant merger (Deloitte, 2014). These tax implications are discussed in Unit XII of this course. 13.4 MANAGERIAL DECISIONS OF EXPORT OR LOCAL SALES The decision choice between export and local sales is not mutually exclusive. Ideally, managers would like to maximise both export sales as well as domestic sales. The choice become relevant only where the company has short operational capacity, and it is unable to satisfy both domains. Managers call this choice as the sales mix decision. 13.4.1 Sales Mix Decision 192 CU IDOL SELF LEARNING MATERIAL (SLM)","Managers continuously strive to achieve a variety of company objectives such as maximization of profit, maintenance of or increase in market share, and generation of customer goodwill and loyalty. Managers must be effective in selling products or performing services to accomplish these objectives. Regardless of whether the company is a retailer, manufacturer, or service organization, sales mix refers to the relative product quantities composing a company\u2019s total sales. Some important factors affecting a company\u2019s sales mix between export or domestic sales are as follows: \uf0b7 Product selling prices \uf0b7 Sales force compensation, and \uf0b7 Advertising expenditures Because a change in one or all of these factors could cause sales mix to shift, managing these factors is fundamental to managing profit. 13.4.2 Special Order Decision For a company that is predominantly engaged in the domestic market, the decision to enter export markets is analysed as a special order. Similarly, for a company that is predominantly engaged in the export market, the decision to enter domestic markets is analysed as a special order. While dealing with a special-order companies depart from their price-setting routine and offer \u201clow-ball\u201d selling prices. A low-ball price could cover only costs and produce no profit or even be below cost. The rationale of low-ball bids is to obtain the job and have the opportunity to introduce company products or services to a particular market segment. Special pricing of this nature could provide work for a period of time, but it cannot be continued over the long run. To remain in business, a company must set selling prices to cover total costs and provide a reasonable profit margin. 13.4.3 Tax Implications of Export or Local Sales There was a time when the balance of trade position of the country was precarious and the foreign exchange reserves were meagre. At this time several tax incentives were offered to entities engaged in export trade and those earning income in convertible foreign currencies. However, with the improvement in the balance of trade position and ever-expanding foreign exchange reserves these incentives for exporters and foreign exchange earners have been gradually withdrawn. In view of this, the decision of export or local sales is taken on the basis of strategic goals of the company, extent of unused or under-used capacity, and competitive strengths and weaknesses of the company. 193 CU IDOL SELF LEARNING MATERIAL (SLM)","13.5 MANAGERIAL DECISIONS OF REPLACE OR REPAIR The repair or replace decision is the final phase of the life cycle of an asset. This decision can influence operations, quality, and performance.Managing the forever evolving plant infrastructure is a commitment and challenging job especially with business drivers such as: reduce downtime, improve plant reliability, lower operation costs and regulatory compliance in areas of safety and environmental issues. The pros and cons of both repair and replace should be considered when making the major repair or replace decision.Knowing that there are costs and risks associated with both options, it\u2019s important to be educated when pondering the \u201cend of the road.\u201d 13.5.1 Decision Factors Several factors are considered by companies while making the decision to either replace an item of equipment or repair it. Repair Decision The following are some of the factors considered in decided whether or not to repair items: \uf0b7 Maintenance history \uf0b7 Age of the asset \uf0b7 Availability and cost of spare parts \uf0b7 Technology or capability of the asset \uf0b7 Labour cost \uf0b7 Critical nature of the asset \uf0b7 Equipment downtime Replacement Decision A decision to replace is much easier than the actual work of procuring, checking, installing and commissioning the new asset. Depending on the process and the specific application, the issues and process of decommissioning a device might include: \uf0b7 Review, planning, engineering, purchasing, calibration, configuration, and documentation of the new device. \uf0b7 Asset removal and replacement. \uf0b7 Environmental handling of a device that has been in contact with certain fluids. \uf0b7 Cleaning and disposal of a device that was in contact with hazardous material. \uf0b7 Safety of employees and the environment if the device needs to be decontaminated. \uf0b7 Installation work required for the new device - new wires, form and fit of the replacement device, new mounting or piping requirements, etc. 194 CU IDOL SELF LEARNING MATERIAL (SLM)","\uf0b7 Skill and experience with the removal and disposal of certain devices. 13.5.2 Tax Implication of Replace or RepairDecisions Repair implies the existence of an asset has malfunctioned and can be set right by effecting repairs which may involve replacement of some parts, thereby making the thing as efficient as it was before or close to it as possible. After repair, the asset continues to be available for use. Current repair implies the expenditure incurred to \u2018preserve and maintain\u2019 an already existing asset and the object of the expenditure is not to bring a new asset into existence of for obtaining a new advantage. The amount paid on account of current repairs of machinery, plant or furniture used for the purposes of the business or profession is allowed as a deduction. Further, any premium paid in respect of insurance against risk of damage or destruction is also allowed as a deduction. What is allowed as a deduction is the cost of current repairs and not any expenditure in the nature of capital expenditure. 13.6 FOREIGN COLLABORATIONS AND JOINT VENTURES 13.6.1 Foreign Collaborations The past few decades have seen a rapid growth in foreign collaboration agreements between firms. This trend is particularly evident in those industries where consumption patterns are more homogeneous across countries, and which show a high level of capital intensity as well as knowledge intensity in terms of investment in innovation and technology. Firms have always needed external partners (suppliers, competitors, customers, universities, technological research centres or institutes) to collaborate with on different, specific activities along their value chain, but the extent to which firms in the twenty-first century systematically exploit cooperative networks and agreements is quite breath-taking (Bagchi, 1986). Nowadays, knowledge-intensive firms from both advanced and developing countries are globally dispersing and disintegrating their value chains to control costs and leverage their capabilities. Through foreign collaborations, firms have found a way not only to be more efficient or flexible, but also to benefit from the distinctive capabilities of specialized partners located worldwide, even in emerging countries. Foreign collaboration agreements cover a wide array of different activities (Eylean, 2019). It is important to distinguish between horizontal cooperation and vertical cooperation. Each has different primary motivations. Horizontal Collaboration 195 CU IDOL SELF LEARNING MATERIAL (SLM)","Horizontal collaboration occurs among enterprises operating in the same industry, engaged in roughly the same kinds and types of value-adding activities. The opportunities for economies of scale and scope are here maximized, but there is also the possibility of conflict and leakage of intellectual property from one partner to the other. The cooperation between two biotechnology enterprises or between a human biotechnology enterprise and a pharmaceutical manufacturer would be considered a horizontal alliance. These are strategic in nature, and in general occur between large firms and organizations that are leaders in their field. They are commonly used to establish standards, and may often be seen by regulators as anticompetitive, as they involve some degree of collusion. Vertical Collaboration Vertical collaborations occur among enterprises operating in related industries along the same value chain, where one partner produces inputs for the other. The latter may be a larger enterprise assembling or sub-assembling products from parts and components acquired from different suppliers, including SMEs. It may also be a small systems integrator close to markets and obtaining equipment from larger suppliers. Vertical collaborations are less problematic, as the partners possess complementary but not competing capabilities and opportunities. Their primary (but not the only) motivation is toward reducing costs.Vertical alliances are especially important within global production networks and global value chains. Importance of Foreign Collaboration Collaboration is critical in international business. A firm sometimes has no choice but to partner with other companies to gain access to resources and capabilities unavailable within its own organization. In addition, occasionally a government will restrict companies from entering its national market through wholly owned FDI. For example, the Government of India does not allow foreign firms from attaining full ownership of ventures in its retail industry. Where such restrictions exist, the firm may have no choice but to collaborate with a foreign partner to enter the market. A collaborative venture can give a company access to foreign partners\u2019 expertise, capital, distribution channels, marketing assets, or the ability to overcome government-imposed obstacles. By collaborating, the firm can position itself better to create new products and enter new markets. For example, Starbucks now boasts more than 1,000 coffee shops in India, thanks to a collaboration with its local partner, the house of Tatas. The collaboration allowed Starbucks to internationalize and navigate the marketplace with the help of a knowledgeable local partner. 13.6.2 Joint Venture A joint venture is a business organization established by two or more companies that combines their skills and assets. It may have a limited objective (research or production) and be short lived. It may also be multinational in character, involving cooperation among several 196 CU IDOL SELF LEARNING MATERIAL (SLM)","domestic and foreign companies. Joint ventures differ from mergers in that they involve the creation of a new business firm, rather than the union of two existing companies (Ernst & Young Global Limited, 2021). Justification for Joint Ventures Several reasons have been advanced to justify the creation of joint ventures. Some functions such as research and development can involve costs too large for any one company to absorb by itself. Many of the world\u2019s largest copper deposits have been owned and mined jointly by the largest copper companies on the grounds that joint financing is required to raise enough capital. The exploitation of oil deposits is often done by a consortium of several oil companies. Exploratory drilling projects typically involve several companies united in a joint venture, and several refining companies traditionally own long distance crude oil pipelines. Another factor that encourages the formation of international joint ventures is the restrictions some governments place on the foreign ownership of local businesses. Governments in developing nations often close their borders to foreign companies unless they are willing to take on local partners. The Government of India require that their own national companies represent a major interest in any foreign company conducting business within their borders. The foreign investor is forced to either accept local equity participation or forgo operation in the country. Such government policies are defended on the grounds that joint ventures result in the transfer of managerial techniques and know-how to the developing nation. Joint ventures may also prevent the possibility of excessive political influence on the part of foreign investors. Also, joint ventures help minimize dividend transfers abroad and thus strengthen the developing nation\u2019s balance-of-payments. International joint ventures are also viewed as a means of forestalling protectionism against imports. Disadvantages of International Joint Venture There are disadvantages to forming an international joint venture. A joint venture is a cumbersome organization compared with a single organization. Control is divided, creating the problem of \u201ctwo masters.\u201d Success or failure depends on how well companies can work together despite having different objectives, corporate cultures, and ways of doing things. The action of corporate chemistry is difficult to predict, but it is critical, because joint venture agreements usually provide both partners an ongoing role in management. When joint venture ownership is divided equally, as often occurs, deadlocks in decision making can take place. If balance is to be preserved between different economic interests, negotiation must establish a hierarchical command. Even when negotiated balance is achieved, it can be upset by changing corporate goals or personnel. 13.6.3 Tax Implications of Foreign Collaborations and Joint Ventures The tax implications of foreign collaborations and international joint ventures are complex as they involve an intersection of Indian income tax law, foreign tax laws and tax treaties. The 197 CU IDOL SELF LEARNING MATERIAL (SLM)","complexity of the tax laws in the area is so high that there were complaints that different assessing officers were applying the differently and the Central Board of Direct Taxes had to intervene to provide guidelines to ensure uniform application of the law. Payment for Providing Technical Service One area of the law in this regard has received a lot of attention. That is the tax treatment of technical service fees. When a non-resident entity has entered a foreign collaboration or joint venture with a resident entity, generally, the non-resident entity would provide technical know-how to the resident entity. In return for these services the resident entity pays technical service fees. In CIT v. Union Carbide Corporation (1994)the court observed that if the amount received by the foreign participant is a revenue receipt in his hands and the amount is received by him outside India, then the taxability of the receipt will depend on place where the services were rendered. Where the technical services are rendered in India then the receipt is taxable in India, otherwise not. Payment of Royalty Apart from fees for providing technical services, resident assessees also pay royalty to their foreign collaborators. On the taxability of royalty income in the hands of the foreign collaborators the court held that the entire income would be taxable in India where the intellectual property for which the royalty is paid is exploited in India. 13.7 SUMMARY \uf0b7 A make-or-buy decision, or outsourcing decision, refers to having work performed for one company by an off-site, non-affiliated supplier; it allows a company to buy a product (or service) from an outside supplier rather than making the product or perform the service in-house. \uf0b7 Outsourcing has a tax effect. A manager has to consider the tax benefits and tax detriments of outsourcing in structuring the transaction, pricing the services, and negotiating the terms of an outsourcing services agreement. Because the tax costs of an outsourcing transaction can be significant, they must be addressed early on in a transaction. \uf0b7 When a company pursues a strategy of rapid growth and expansion, it may need a large amount of cash to buy equipment, set up plants, and other capital expenditure. Although, some part of the capital expenditure may be met from internal resources, the company may have to seek funding from external sources for the remaining funds. Obtaining external funding is not only expensive, but it may also require the company to enter restrictive debt covenants which would hamper the company\u2019s freedom in 198 CU IDOL SELF LEARNING MATERIAL (SLM)","running its business. There is an alternative to external funding to buy expensive property, plant, and equipment: leasing. \uf0b7 Companies abandon a product, product line, business unit, or the business enterprise as a whole, when it is unprofitable either because revenues no longer exceed costs or because another company offers to buy the rights to the product, product line, business unit, or the business enterprise. Because the focus is on unit-level profitability, the relevant cost analysis involves comparing the costs saved by abandoning the unit with the revenues forgone. \uf0b7 The tax implications of business closure depends upon the mechanism use to dispose of the business. For example, the entity may sell off assets separately waiting for the \u2018right\u2019 price, or it may sell all the assets as a whole, called as a slump sale or the entity may dispose of the business as a part of a merger. \uf0b7 There was a time when the balance of trade position of the country was precarious and the foreign exchange reserves were meagre. At this time several tax incentives were offered to entities engaged in export trade and those earning income in convertible foreign currencies. However, with the improvement in the balance of trade position and ever-expanding foreign exchange reserves these incentives for exporters and foreign exchange earners have been gradually withdrawn. In view of this, the decision of export or local sales is taken on the basis of strategic goals of the company, extent of unused or under-used capacity, and competitive strengths and weaknesses of the company. \uf0b7 The repair or replace decision is the final phase of the life cycle of an asset. This decision can influence operations, quality, and performance. Managing the forever evolving plant infrastructure is a commitment and challenging job especially with business drivers such as: reduce downtime, improve plant reliability, lower operation costs and regulatory compliance in areas of safety and environmental issues. \uf0b7 The tax implications of foreign collaborations and international joint ventures are complex as they involve an intersection of Indian income tax law, foreign tax laws and tax treaties. Two areas of payment for providing technical service and payment of royalty. Where the amount received by the foreign participant is a revenue receipt in his hands and the amount is received by him outside India, and then the taxability of the receipt will depend on place where the services were rendered. Where the technical services are rendered in India then the receipt is taxable in India, otherwise not. On the taxability of royalty income in the hands of the foreign collaborators the court held that the entire income would be taxable in India where the intellectual property for which the royalty is paid is exploited in India. 199 CU IDOL SELF LEARNING MATERIAL (SLM)","13.8KEYWORDS \uf0b7 Collaboration. Collaboration is a working practice whereby individual business entities work together for a common purpose. \uf0b7 Divestiture. Divestiture is the action or process of selling off subsidiary business interests or investments. \uf0b7 Financial Lease. Financial leases are long term, carry no cancelation options, and the lessee is responsible for all insurance and maintenance. \uf0b7 Foreign Collaboration. Foreign collaboration refers to an agreement between two or more companies from different countries to joint run any business operations. \uf0b7 Joint Venture. Joint venture is a commercial enterprise undertaken jointly by two or more parties who otherwise retain their distinct identities. \uf0b7 Leasing. Leasing is an agreement between two parties to rent an asset is a leasing arrangement. The owner of the leased asset, the lessor, receives a set of fixed payments for the term of the contract from the lessee. \uf0b7 Operating Lease. An operating lease is one that contains a provision that allows the lessee to cancel at any time or if the lessor is responsible for insurance and maintenance. \uf0b7 Outsourcing. Outsourcing refers to having work performed for one company by an off-site, non-affiliated supplier; it allows a company to buy a product (or service) from an outside supplier rather than making the product or perform the service in- house. \uf0b7 Slump Sale. Slump sale means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales. 13.9 LEARNING ACTIVITY Based on the learning from this unit (1) identify the 30 companies which are part of the S&P BSE SENSEX; (2) find out which of the companies have a collaboration or joint venture with a foreign entity; (3) try to find reasons why the collaborate and joint venture agreement were entered. ___________________________________________________________________________ ___________________________________________________________________________ 13.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 200 CU IDOL SELF LEARNING MATERIAL (SLM)"]