CU-MBA-SEM-III-Tax Planning and Management- Second Draft-converted

in respect of any expenditure or allowance shall be allowed in computing such income. Rate of tax on STCG derived The applicable rate of tax is The applicable rate from transfer of a capital asset 25.168% (i.e., tax@22%, of tax is 25.168% on which no depreciation is plus surcharge@10% plus i.e., tax @22%, plus allowable under the Act HEC@4%). surcharge @10% There is, however, no plus cess@4%. restriction regarding There is no claiming of deduction or restriction regarding allowance in this regard. claiming of deduction or allowance in this regard. 7. Conditions to be fulfilled for availing concessional rate of tax and exemption from MAT Conditions to be fulfilled i) The company should be No time limit for availing concessional set-up and registered on specified. Both rate of tax and exemption or after 1.10.2019. existing companies from MAT and new companies can avail benefit. ii) It should commence Need not be a manufacturing or manufacturing or a production of an article or production company thing or business of generating electricity on or before 31.3.2023. iii) It should not be formed by No similar condition splitting up or the has been prescribed reconstruction of a business already in existence (except 101 CU IDOL SELF LEARNING MATERIAL (SLM)

in case of a company, business of which is formed as a result of the re- establishment, reconstruction or revival by the person of the business of any undertaking referred to in section 33B in the circumstances and within the period specified therein) iv) It does not use any No similar condition machinery or plant has been prescribed previously used for any purpose [Refer Note at the end] v) It does not use any building No similar condition previously used as a hotel has been prescribed or a convention centre [meanings assigned in section 80-ID (6)] in respect of which deduction u/s 80-ID has been claimed and allowed. vi) It should not be engaged in No similar condition any business other than the has been prescribed business of manufacture or production of any article or thing and research in relation to, or distribution of, such article or thing manufactured or produced by it. 102 CU IDOL SELF LEARNING MATERIAL (SLM)

Note – Business of manufacture or production of any article or thing does not include business of – (1) Development of computer software in any form or in any media (2) Mining (3) Conversion of marble blocks or similar items into slabs (4) Bottling of gas into cylinder (5) Printing of books or production of cinematograph films (6) Any other business as may be notified by the Central Govt. in this behalf. Note - If difficulty arises regarding fulfilment of conditions listed in (iv) to (vi) above, the CBDT may, with the approval of the Central Government, issue guidelines for 103 CU IDOL SELF LEARNING MATERIAL (SLM)

the purpose of removing difficulty and to promote manufacturing or production of article or thing using new plant and machinery. Every guideline issued by the CBDT has to be laid before each House of Parliament, and shall be binding on the person, and the income-tax authorities subordinate to it. 8 Common conditions for In case of a company opting for either section 115BAA both sections for availing or 115BAB, the total income should be computed - the concessional rate of tax and exemption from MAT i) without providing for deduction under any of the following sections: Section Provision 10AA Exemption of profits and gains derived 32(1)(iia) from export of articles or things or from 33AB services by an assessee, being an entrepreneur from his Unit in SEZ. Additional depreciation @20%, as the case may be, of actual cost of new plant and machinery acquired and installed by manufacturing undertakings. Deduction@40% of profits and gains of business of growing and manufacturing tea, coffee or rubber in India, to the extent deposited with NABARD in accordance with scheme approved by the 104 CU IDOL SELF LEARNING MATERIAL (SLM)

33ABA Tea/Coffee/ Rubber Board. Deduction@20% of the profits of a 35(1)(ii)/ business of prospecting for, or extraction (iia)/(iii) or production of, petroleum or natural 35(2AA) gas or both in India, to the extent deposited with SBI in an approved 35(2AB) scheme or deposited in Site Restoration Account. 35AD Deduction for payment to any research 35CCC association, company, university etc. for 35CCD undertaking scientific research or social 80-IA science or statistical research. 80RRB Deduction of payment to a National Laboratory or University or IIT or approved specified person for scientific research Deduction of in-house scientific research expenditure incurred by a company engaged in the business of bio- technology or in the business of manufacture or production of an article or thing. Investment-linked tax deduction for specified businesses. Deduction of expenditure incurred on notified agricultural extension project Deduction of expenditure incurred by a company on notified skill development project. to Deductions from gross total income under Chapter VI-A under the heading “C- Deductions in respect of certain incomes” other than the 105 CU IDOL SELF LEARNING MATERIAL (SLM)

provisions of section 80JJAA or section 80M. ii) without set-off of any loss or allowance for unabsorbed depreciation deemed so u/s 72A, where such loss or depreciation is attributable to any of the deductions listed in (i) above [Such loss and depreciation would be deemed to have been already given effect to and no further deduction for such loss shall be allowed for any subsequent year] iii) by claiming depreciation u/s 32 determined in the prescribed manner (i.e., in respect of depreciation of any block of assets entitled to more than 40% shall be restricted to 40% on the written down value of such block of assets). However, additional depreciation u/s 32(1) (iia) cannot be claimed. Note – Additional points relevant in the context of section 115BAA: (1) In case of a company opting for section 115BAA, total income should be computed without set-off of any loss carried forward or depreciation from any earlier assessment year, where such loss or depreciation is attributable to any of the deductions listed in (i) above [Such loss and depreciation would be deemed to have been already given effect to and no further deduction for such loss or depreciation shall be allowed for any subsequent year] (2) In the case of a person having a Unit in the IFSC, referred to in section 80LA(1A), which has exercised option for section 115BAA, deduction u/s 80LA would be allowed subject to fulfilment of the conditions specified in that section. (3)Where there is a depreciation allowance in respect of a block of asset from an earlier assessment year attributable to additional depreciation u/s 32(1)(iia), which has not been given full effect to prior to A.Y. 2021-22 and which is not allowed to 106 CU IDOL SELF LEARNING MATERIAL (SLM)

be set-off in the A.Y.2021-22 due to exercise of option u/s 115BAA from that year, corresponding adjustment shall be made to the WDV of such block of assets as on1.4.2020 in the prescribed manner i.e., the WDV as on 1.4.2020 will be increased by the unabsorbed additional depreciation not allowed to be set-off. (4)Since there is no time line within which option under section115BAA can be exercised, a domestic company having brought forward losses and depreciation on account of deductions listed in (i)above may, if it so desires, postpone exercise the option under section115BAA to a later assessment year, after set off of the losses and depreciation so accumulated. Particulars Section 115BAB Section 115BAA 9 Failure to satisfy On failure to satisfy the On failure to satisfy the conditions conditions mentioned in point conditions mentioned in no. (7) and (8) above in any point no.(8) above in any P.Y., the option exercised would P.Y., the option exercised be invalid in respect of the would be invalid in respect assessment year relevant to that of the assessment year previous year and subsequent relevant to that previous assessment years; year and subsequent Consequently, the other assessment years; provisions of the Act would Consequently, the other apply to the person as if the provisions of the Act would option had not been exercised apply to the person as if the for the assessment year relevant option had not been to that previous year and exercised for the assessment subsequent assessment years. year relevant to that Note – Where option exercised previous year and under section 115BAB is subsequent assessment rendered invalid due to violation years. 107 CU IDOL SELF LEARNING MATERIAL (SLM)

of conditions stipulated in point no.7 [(iv) to (vi)] above, such person may exercise option under section 115BAA. 10 Availability of set- Since it is a new company, there Brought forward MAT off of MAT credit would be no brought forward credit cannot be set-off brought forward MAT credit against income u/s from earlier years 115BAA. Note - If a company has b/f MAT credit, it can first exhaust the MAT credit, and thereafter opt for section 115BAA in a subsequent previous year. 11 Adjustments for If the Assessing Officer opines No such requirement to transactions with that the course of business make any adjustment persons having between the company and any close connection other person having close connection therewith is so arranged that the business transacted between them produces more than the ordinary profits to the company, he is empowered to take into account the amount of profits as may be reasonably deemed to have been derived therefrom, while computing profits and gains of such company. In case the arrangement referred above involves a specified domestic transaction referred to in section 92BA, then, the 108 CU IDOL SELF LEARNING MATERIAL (SLM)

amount of profits from such transaction would be determined by considering the arm’s length price (ALP). The amount, being profits in excess of the amount of the profits determined by the Assessing Officer, shall be deemed to be the income of the person. The income-tax on the income so deemed shall be subject to [email protected]% (i.e., tax@30% + surcharge @10% +HEC@4%). Note – The scope of “specified domestic transaction” referred to in section 92BA has been expanded to include within its ambit, any business transacted between such persons with close connection, where one such person is a company claiming benefit under section 115BAB. 12 Exercise of option The beneficial provisions of this The beneficial provisions of by the company section would apply only if this section would apply if within the option is exercised in the option is exercised in the prescribed time prescribed manner on or before prescribed manner on or the due date u/s 139(1) for before the due date u/s furnishing the first of the returns 139(1) for furnishing the of income for any previous year return of income for any relevant to assessment year or previous year relevant to any subsequent assessment year. assessment year or any Such option, once exercised, subsequent A.Y. 109 CU IDOL SELF LEARNING MATERIAL (SLM)

would apply to subsequent Such option, once assessment years. exercised, would apply to Further, once the option has subsequent assessment been exercised for any previous years. year, it cannot be subsequently Further, once the option has withdrawn for the same or any been exercised for any other previous year. previous year, it cannot be Notes – (1) The option has to be subsequently withdrawn for exercised at the time of the same or any other furnishing the first of the returns previous year. of income for any previous year. Note – The option can be If a person fails to so exercise exercised even in a later such option, it cannot be year, but once exercised, exercised thereafter for any cannot be withdrawn subsequent previous year. subsequently. (2) In case of amalgamation, the Further, where the person option exercised u/s 115BAB exercises option under shall remain valid in the case of section 115BAA, the option the amalgamated company only under section 115BA may and if the conditions mentioned be withdrawn. in point no. (7) and (8) are continued to be satisfied by such company. Note - For the purpose of point no.7(iv) in column (3) of the above table in relation to a company exercising option under section 115BAB, any machinery or plant which was used outside India by any other person shall not be regarded as machinery or plant previously used for any purpose, if all the following conditions are fulfilled, namely: — (a) such machinery or plant was not, at any time previous to the date of the installation, used in India; (b) such machinery or plant is imported into India from any country outside India; (c) no deduction on account of depreciation in respect of such machinery or plant has been allowed or is allowable under the provisions of the Income-tax Act, 1961 in computing the 110 CU IDOL SELF LEARNING MATERIAL (SLM)

total income of any person for any period prior to the date of installation of the machinery or plant by the person. Further, where in the case of a person, any machinery or plant or any part thereof previously used for any purpose is put to use by the company and the total value of the machinery or plant or part so transferred does not exceed 20% of the total value of the machinery or plant used by the company, then, the condition specified that the company does not use any machinery or plant previously used for any purpose would be deemed to have been complied with. 4. Concessional rate of tax on dividends received by Indian companies from specified foreign companies [Section 115BBD] i) Concessional rate - Dividends received by Indian companies from specified foreign companies to be subject to a concessional rate of 15% (plus surcharge, if applicable, and health and education cess) (as against the general rate of 30% applicable to Indian companies). ii) No expenditure is allowed - This rate of 15% would be applied on gross dividend, in the sense, that no expenditure would be allowable in respect of such dividend. iii) Meaning of specified foreign company - Specified foreign company means a foreign company in which the Indian company holds 26% or more in nominal value of the equity share capital of the company. Therefore, this concessional rate would not be applicable in respect of dividend received from a foreign company in which the holding of the Indian company is less than 26% of the nominal value of the equity share capital. 5. Minimum Alternate Tax on companies [Section 115JB] Discussed elaborately in Unit 2. 6. Levy of additional income-tax on distributed income of a domestic company on account of buy-back of shares [Chapter XII-DA] i) In case of buyback of shares (whether listed or unlisted) by domestic companies, additional income-tax @20% (plus surcharge@12% and cess@4%) is leviable in the hands of the company. [Section 115QA (1)] Consequently, the income arising to the shareholders in respect of such buyback of shares by the domestic company would be exempt under section 10(34A) since the domestic company is liable to pay additional income-tax on the buyback of shares. As per section 115QA (2), a domestic company is liable to pay additional income-tax on buy-back of shares, irrespective of the fact that no income-tax is payable by such 111 CU IDOL SELF LEARNING MATERIAL (SLM)

domestic company on its total income computed in accordance with the provisions of this Act. ii) Such tax should be paid to the credit of the Central Government within 14 days from the date of payment of any consideration for such buyback to the shareholder. Meaning of buyback and distributed income Buyback Purchase by a company of its own shares in accordance with the provisions of any law for the time being in force to companies [clause (i) of Explanation to section 115QA] Distributed The consideration paid by the company on buy-back of shares as income reduced by the amount which was received by the company for issue of such shares, determined in the manner as may be prescribed [clause (ii) of Explanation to section 115QA] Accordingly, the CBDT has, vide Notification no. 94/2016 dated 17-10-2016, inserted Rule 40BB to provide the manner of determination of the amount received by the company for issue of shares being bought back in various circumstances including shares being issued under tax neutral reorganisations and in different tranches as follows: Sub-rule Circumstance Manner of determination of amount received No. 2 by the company in respect of issue of shares 3 being bought back 4 Where shares have been Amount actually received by the company in issued by a company to respect of such share including any amount any person way of actually received by way of premium. subscription Where the company had The amount actually received in respect of such at any time, prior to the shares as reduced by the sum so returned buy-back of the share, returned any sum out of the amount received in respect of such share Where the share has been The fair market value of the share is computed issued by a company in accordance of Rule 3(8), to the extent under any plan or scheme credited to the share capital and share premium 112 CU IDOL SELF LEARNING MATERIAL (SLM)

under which an account by the company shall be deemed to be employees’ stock option the amount received by the company for issue of has been granted or as said share. part of sweat equity “Sweat equity shares” means equity shares shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called [Clause (b) of Explanation to section 17(2)(vi)]. 5 Where the share has been The amount received by the amalgamating issued by a company company in respect of such share or shares being an amalgamated determined in accordance with this rule, shall be company, under a deemed to be the amount received by the scheme of amalgamation, amalgamated company in respect of the share so in lieu of the share or issued by it. shares of an amalgamating company 6 Where the Shares are Amount received by the resulting company in issued by resulting respect of shares issued by it under a scheme of company under a scheme demerger: of demerger Amount received by the demerged co. in respect of the original shares (determined as per this rule) × Net book value of assets transferred in a demerger / Net worth of the demerged company immediately before demerger. Amount received in respect of the original shares issued by the demerged company post demerger: 113 CU IDOL SELF LEARNING MATERIAL (SLM)

The amount received by the demerged company in respect of the original shares (-) the amount as so arrived under sub-rule (6) 7 Where the share has been The amount received by the company for issue issued or allotted by the of such share shall be determined in accordance company as part of with the following formula- consideration for Amount received = A/B acquisition of any asset Where, or settlement of any A = an amount being lower of the following liability amounts- a) Fair market value of the assets and liabilities as determined by a merchant banker × The part of consideration being paid by issue of shares / the total consideration b) The amount of consideration for acquisition of the asset or settlement of the liability to be paid in the form of shares, to the extent credited to the share capital and share premium account by the company. B = the number of shares issued by the company as part of consideration: 8 Where the shares have The amount received by the company for issue been issued or allotted by of shares shall be determined in accordance with a company on succession the following formula- or conversion, as the case Amount received = (A-B)/C may be, of a firm into the A = book value of the assets in the balance- company or succession sheet as reduced by any amount of tax paid as of sole proprietary deduction or collection at source or as advance 114 CU IDOL SELF LEARNING MATERIAL (SLM)

concern by the company tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act and any amount shown in the balance-sheet as asset including the unamortized amount of deferred expenditure which does not represent the value of any asset; For determining book value of the assets, any change in the value of the assets consequent to their revaluation shall be ignored. B = book value of liabilities shown in the balance-sheet, but does not include the following amounts, namely: - (a) capital, by whatever name called, of the proprietor or partners of the firm, as the case may be; (b) reserves and surpluses, by whatever name called, including balance in profit and loss account; (c) any amount representing provision for taxation, other than amount of tax paid, as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act, if any, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto; (d) any amount representing provisions made for meeting liabilities, other than ascertained liabilities; and (e) any amount representing contingent liabilities, C = number of shares issued on conversion or succession. 115 CU IDOL SELF LEARNING MATERIAL (SLM)

9 Where the share has been The consideration in respect of such share shall issued or allotted, be deemed to be “Nil” without any consideration, on the basis of existing shareholding in the company 10 Where the shares have The amount received by the company in respect been issued on of such instrument as so converted. conversion of preference shares or bond or debenture, debenture- stock or deposit certificate in any form or warrants or any other security issued by the company 11 Where the share being The amount received by the company in respect bought back is held in of such share shall be the amount received for dematerialised form and the issue of share determined in accordance with the same cannot be this rule on the basis of the first-in-first-out distinctly identified method. 12 In any other case The face value of the share shall be deemed to be the amount received by the company for issue of the share. iii) No credit or deduction under the Act in respect of such income or additional income-tax: The additional income-tax payable by the company shall be the final payment of tax on such income. No credit or deduction shall be claimed by the company or any other person in respect of such tax paid. 116 CU IDOL SELF LEARNING MATERIAL (SLM)

Further, no deduction under any provision of the Income-tax Act, 1961 shall be allowed to the company or the shareholder in respect of income, which has been subject to additional income-tax, or tax thereon. iv) Interest payable for non-payment of additional income-tax by the company [Section 115QB] The principal officer of the domestic company and the company will be liable to pay simple interest on the amount of additional income-tax not paid within the specified time. Such interest is leviable at the rate of 1% for every month or part of the month on the amount of such tax not paid or short paid for the period beginning on the date immediately after the last date on which such tax was payable and ending with the date on which the tax is actually paid (Tax to be paid within 14 days from the date of payment of any consideration for such buyback to the shareholder). v) Deemed Assessee-in-default [Section 115QC] The principal officer of the domestic company and the company will be deemed to be an assessee-in-default in respect of amount of tax payable by him or it, in case the additional income-tax is not paid to the credit of Central Government within the specified time. In such a case, all the provisions of the Act for the collection and recovery of income-tax would apply. ILLUSTRATION XYZ Ltd., a domestic company, purchases its own listed shares on 4th July 2020. The consideration for buyback amounted to ₹ 21 lakh, which was paid on the same day. The amount received by the company two years back for issue of such shares determined in the manner specified in Rule 40BB was ₹ 13 lakh. Compute the additional income-tax payable by XYZ Ltd. Compute the interest, if any, payable if such tax is paid to the credit of the Central Government on 29th September 2020. SOLUTION XYZ Ltd is liable to pay ₹ 1,86,368 as additional income-tax, which is the amount calculated @23.296% (20% plus surcharge@12% plus health and education cess@4%) on ₹ 8 lakh, being its distributed income (i.e., ₹ 21 lakh – ₹ 13 lakh). The additional income-tax was payable on or before 18th July 2020. However, the same was paid only on 29th September 2020. Period for which interest@1% per month or part of a month is leviable – 117 CU IDOL SELF LEARNING MATERIAL (SLM)

Period No. of months/part of 19th July – 18th August 2020 (whole of first month) month 1 19th August – 18th September 2020 (whole of second 1 month) 1 19th September – 29th September 2020 (part of third month) 3 Total number of months Interest under section 115QB is payable @1% per month for 3 months on the amount of additional tax payable i.e., ₹ 1,86,300 (rounded off as per Rule 119A). Therefore, interest payable under section 115QB is ₹ 5,589. 6.3 CARRY FORWARD AND SET OFF OF BUSINESS LOSSES [SECTION 72] Under the Act, the assessee has the right to carry forward the losses under the business and profession in cases where such loss cannot be set-off due to the absence of inadequacy of income under any other head in the same year. The loss so carried forward can be set-off against the profits of subsequent previous years. Section 72 covers the carry forward and set-off of losses arising from a business or profession. Conditions The assessee’s right to carry forward business losses under this section is, however, subject to the following conditions: - (1) The loss should have been incurred in business, profession or vocation. (2) The loss should not be in the nature of a loss in the business of speculation. (3) Loss from one business can be carried forward & set-off against the income from any other business: The loss may be carried forward and set-off against the income from business or profession though not necessarily against the profits and gains of the same business or profession in which the loss was incurred. 118 CU IDOL SELF LEARNING MATERIAL (SLM)

However, a loss carried forward cannot, under any circumstances, be set-off against the income from any head other than “Profits and gains of business or profession”. (4) Person who incurred the loss alone is entitled to carry forward & set-off the loss: The loss can be carried forward and set off only against the profits of the assessee who incurred the loss. That is, only the person who has incurred the loss is entitled to carry forward or set off the same. Consequently, the successor of a business cannot carry forward or set off the losses of his predecessor except in the case of succession by inheritance. (5) Maximum period for carry forward & set-off of losses: A business loss can be carried forward for a maximum period of 8 assessment years immediately succeeding the assessment year in which the loss was incurred. (6) Rehabilitation of business [Proviso to section 72(1)] If there is a loss sustained in a business which is discontinued in the circumstances mentioned under section 33B and such business is re-established, reconstructed or revived by the assessee within 3 years from the end of previous year of discontinuation, the loss attributable to such business (i) shall be allowed to be set off against the profits and gains, if any, of that business or any other business carried on by him and assessable for that assessment year, and (ii) if the loss cannot be wholly so set off, the amount of balance loss to be carried to the following assessment year and so on for 7 assessment years immediately succeeding provided such re-established business is continued to be carried by the assessee. Note: Circumstances referred to in section 33B The business is formed as re-establishment, reconstruction or revival by the assessee of the business of such industrial undertaking which is discontinued by reason of extensive damage to or destruction of, any building, machinery, plant or furniture owned by the assessee and used for the purpose of such business. Such damage or destruction should be affected as a direct result of flood, typhoon, hurricane, cyclone, earthquake or other convulsion of nature or riot or civil disturbance or accidental fire or explosion or action by an enemy or action taken in combating an enemy. CARRY FORWARD AND SET OFF OF ACCUMULATED BUSINESS LOSSES AND UNABSORBED DEPRECIATION IN CERTAIN CASES OF AMALGAMATION/ DEMERGER, ETC. [SECTION 72A] (1) Amalgamation Applicability: This section applies where there has been an amalgamation of – (i) a company owning an industrial undertaking or a ship or a hotel with another company; or (ii) an amalgamation of a banking company with a specified bank; or 119 CU IDOL SELF LEARNING MATERIAL (SLM)

(iii) public sector companies engaged in the business of operation of aircrafts. Allowability of carry forward and set-off of accumulated loss and unabsorbed loss by amalgamated company in case of amalgamation: It provides that the accumulated loss and unabsorbed depreciation of the amalgamating company shall be deemed to be the loss or unabsorbed depreciation, as the case may be, of the amalgamated company for the previous year in which the amalgamation took place. Other provisions of the Act relating to set off and carry forward shall also apply accordingly. Conditions for availing benefit under this section i) Conditions to be fulfilled by the amalgamating company a) The amalgamating company should have been engaged in the business, in which the accumulated loss occurred or depreciation remains unabsorbed, for 3 or more years. b) The amalgamating company has held continuously as on the date of amalgamation, at least 3/4th of the book value of the fixed assets held by it, 2 years prior to the date of amalgamation. ii) Conditions to be fulfilled by the amalgamated company a) The amalgamated company should hold at least 3/4th of the book value of fixed assets of the amalgamating company acquired as a result of amalgamation for a minimum period of 5 years from the effective date of amalgamation. b) The amalgamated company continues the business of the amalgamating company for at least 5 years. c) The amalgamated company must also fulfil such other conditions prescribed under Rule 9C for the revival of the business of the amalgamating company or to ensure that the amalgamation is for genuine business purpose - (1) The amalgamated company shall achieve the level of production of at least 50% of the installed capacity (capacity of production as on the date of amalgamation) of the said undertaking before the end of 4 years from the date of amalgamation and continue to maintain the said minimum level of production till the end of 5 years from the date of amalgamation. Central Government has the power to modify this requirement on an application made by the amalgamated company. (2) The amalgamated company shall furnish to the Assessing Officer a certificate in the prescribed form verified by a Chartered Accountant in this regard. Consequences of non-fulfilment of specified conditions: In case the above specified conditions are not fulfilled, that part of carry forward of loss and unabsorbed depreciation 120 CU IDOL SELF LEARNING MATERIAL (SLM)

remaining to be utilized by the amalgamated company shall lapse and such loss or depreciation as has been set-off shall be treated as the income in the year in which there is a failure to fulfil the conditions. (2) Demerger Allowability of carry forward and set-off of accumulated loss and unabsorbed loss by resulting company in case of demerger: Where there has been a demerger of an undertaking, • the accumulated loss and the unabsorbed depreciation directly relatable to the undertaking transferred by the demerged company to the resulting company shall be allowed to be carried forward and set off in the hands of the resulting company. • if the accumulated loss or unabsorbed depreciation is not directly relatable to the undertaking, the same will be apportioned between the demerged company and the resulting company in the same proportion in which the value of the assets retained by the demerged company and have been transferred to the resulting company. Conditions for availing benefit under this section: The Central Government is empowered to notify such conditions as it considers necessary to ensure that the demerger is for genuine business purpose. (2) Re-organisation of business Allowability of carry forward and set-off of accumulated loss and unabsorbed loss by company in case of succession: In case of re-organisation of business, whereby a firm is succeeded by a company as per the provisions of section 47(xiii), or a sole proprietary concern is succeeded by a company as per the provisions of section 47(xiv), then the accumulated business loss and the unabsorbed depreciation of the firm / proprietary concern, as the case may be, shall be deemed to be the loss or depreciation allowance of the successor company for the previous year in which the business re-organisation took place. Other provisions of the Act relating to set-off and carry forward will apply accordingly. Consequences of non-fulfilment of specified conditions: If it is found that any of the conditions laid down in the corresponding sub-sections (xiii) or (xiv) of section 47 have not been complied with, the set-off of loss or allowance of depreciation made in any previous year in the hands of the successor company shall be deemed to be the income of the company chargeable to tax in the year in which the conditions have been violated. 121 CU IDOL SELF LEARNING MATERIAL (SLM)

CARRY FORWARD AND SET OFF OF ACCUMULATED BUSINESS LOSSES AND UNABSORBED DEPRECIATION IN A SCHEME OF AMALGAMATION IN CERTAIN CASES [SECTION 72AA] (1) Applicability: This section provides for carry forward and set off of accumulated loss and unabsorbed depreciation allowance where there has been an amalgamation of - (i) one or more banking company with any other banking institution under a scheme sanctioned and brought into force by the Central Government under section 45(7) of the Banking Regulation Act, 1949 or (ii) one or more corresponding new bank or banks with any other corresponding new bank under a scheme brought into force by the Central Government under section 9 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 or under section 9 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980, or both, as the case may be, or (iii) one or more Government company or companies with any other Government company under a scheme sanctioned and brought into force by the Central Government under section 16 of the General Insurance Business (Nationalisation) Act, 1972. (2) Allowability of carry forward and set-off of accumulated loss and unabsorbed depreciation in case of amalgamation: The accumulated loss and unabsorbed depreciation of such banking company or companies or amalgamating corresponding new bank or banks or amalgamating Government company or companies shall be deemed to be the loss or the allowance for depreciation of such banking institution or amalgamated corresponding new bank or amalgamated Government company for the previous year in which the scheme of amalgamation is brought into force. Accordingly, all the provisions contained in the Income- tax Act, 1961, relating to set off and carry forward of loss and unabsorbed depreciation would be applicable. (3) Meaning of certain terms: Term Meaning Accumulated So much of the loss of the amalgamating banking company or loss companies or amalgamating corresponding new bank or banks or amalgamating Government company or companies under the head \"Profits and gains of business or profession\" (not being a loss sustained in a speculation business) which such amalgamating banking company or companies or amalgamating corresponding new bank or 122 CU IDOL SELF LEARNING MATERIAL (SLM)

Government banks or amalgamating Government company or companies, would company have been entitled to carry forward and set off under the provisions of section 72, if the amalgamation had not taken place Unabsorbed It means a Government company as defined in section 2(45) of the depreciation Companies Act, 2013, which is engaged in the general insurance business and which has come into existence by operation of section 4 or section 5 or section 16 of the General Insurance Business (Nationalisation) Act, 1972 It means so much of the allowance for depreciation of the amalgamating banking company or companies or amalgamating corresponding new bank or banks or amalgamating Government company or companies which remains to be allowed and which would have been allowed to such banking company or companies or amalgamating corresponding new bank or banks or amalgamating Government company or companies, if the amalgamation had not taken place. LOSSES IN SPECULATION BUSINESS [SECTION 73] The meaning of the expression ‘speculative transaction’ as defined in section 43(5) and the treatment of income from speculation business has already been discussed under the head “Profits and gains of business or profession”. (1) Set-off and Carry forward & set-off of loss from speculation business: Since speculation is deemed to be a business distinct and separate from any other business carried on by the assessee, the losses incurred in speculation can be neither set off in the same year against any other non-speculation income nor be carried forward and set off against other income in the subsequent years. Therefore, if the losses sustained by an assessee in a speculation business cannot be set-off in the same year against any other speculation profit, they can be carried forward to subsequent years and set-off only against income from any speculation business carried on by the assessee. (2) Maximum period for carry forward & set-off of losses: The loss in speculation business can be carried forward only for a maximum period of 4 years from the end of the relevant assessment year in respect of which the loss was computed. Loss from the activity of trading in derivatives, however, is not to be treated as speculative loss. 123 CU IDOL SELF LEARNING MATERIAL (SLM)

(3) When a business of a company deemed to be carrying on a speculation business: The Explanation to this section provides that where any part of the business of a company consists in the purchase and sale of the shares of other companies, such a company shall be deemed to be carrying on speculation business to the extent to which the business consists of the purchase and sale of such shares. However, this deeming provision does not apply to the following companies – i) A company whose gross total income consists of mainly income chargeable under the heads “Income from house property”, “Capital gains” and “Income from other sources”; ii) A company, the principal business of which is – (a) the business of trading in shares; or (b) the business of banking; or (c) the granting of loans and advances. Thus, these companies would be exempted from the operation of this Explanation. Accordingly, if these companies carry on the business of purchase and sale of shares of other companies, they would not be deemed to be carrying on speculation business. CARRY FORWARD & SET OFF OF LOSSES BY SPECIFIED BUSINESSES [SECTION 73A] (1) Set-off and Carry forward & set-off of losses of specified business: Any loss computed in respect of the specified business referred to in section 35AD shall be set off only against profits and gains, if any, of any other specified business. The unabsorbed loss, if any, will be carried forward for set off against profits and gains of any specified business in the following assessment year and so on. (2) Loss can be set-off indefinitely: There is no time limit specified for carry forward and set-off and therefore, such loss can be carried forward indefinitely for set-off against income from specified business. Note - The loss of an assessee claiming deduction under section 35AD in respect of a specified business can be set-off against the profit of another specified business under section 73A, irrespective of whether the latter is eligible for deduction under section 35AD. An assessee can, therefore, set-off the losses of a hospital or hotel which begins to operate after 1st April, 2010 and which is eligible for deduction under section 35AD, against the profits of the existing business of operating a hospital (with at least 100 beds for patients) or a hotel (of two-star or above category), even if the latter is not eligible for deduction under section 35AD. 124 CU IDOL SELF LEARNING MATERIAL (SLM)

6.4 SUMMARY • The Companies Act, 2013 provides for the kinds of companies that can be promoted and registered under the Act. • Sec 2(17) of the Income Tax Act, 1961 defines the term company under IT Act. • A company would be resident in India in any previous year, if- a. it is an Indian company; or b. its place of effective management, in that year, is in India • Place of effective management (POEM) means a place where key management and commercial decisions that are necessary for the conduct of the business of an entity are, in substance made. • Place of effective management' (POEM) is an internationally recognized test for determination of residence of a company incorporated in a foreign jurisdiction. • The POEM concept is one of substance over form. It may be noted that an entity may have more than one place of management, but it can have only one place of effective management at any point of time. • The income-tax rate on foreign companies is higher at 40% plus surcharge @2%. • Certain tax incentives available to domestic companies are not available to foreign companies like amortization of preliminary expenses. 6.5 KEYWORDS • RBI – Reserve Bank of India • AY – Assessment Year • CBDT – Central Board of Direct Taxes • MAT – Minimum Alternate Tax 6.6 LEARNING ACTIVITY 1. Study closely section 179 of income tax act and compare with unlimited liability. ___________________________________________________________________________ _____________________________________________________________________ 2. Compare between sections 115JB and 115BAA of Income Tax Act ___________________________________________________________________________ _____________________________________________________________________ 6.7 UNIT END QUESTIONS 125 CU IDOL SELF LEARNING MATERIAL (SLM)

A. Descriptive Questions Short Questions 1. Explain the concept of carry forward and set off of business losses. 2. Briefly discuss the concept of carry forward and set off in case of specified businesses. 3. Mr. Cheran who is in the business of selling electronics goods incurred a loss of ₹ 4,00,000 in the FY 2020-21. In the FY 2021-22, he started another business of trading in FMCG. He earned a profit of ₹ 1,50,000 and ₹ 70,000 from electronics and FMCG business respectively in FY 2021-22. Compute the business income which is taxable in the year 2021- 22. 4. A Ltd., a domestic company, purchases its own listed shares on 4th January 2021. The consideration for buyback amounted to ₹ 21 lakh, which was paid on the same day. The amount received by the company two years back for issue of such shares determined in the manner specified in Rule 40BB was ₹ 13 lakh. Compute the additional income-tax payable by XYZ Ltd. Compute the interest, if any, payable if such tax is paid to the credit of the Central Government on 29th September 2021. 5. Explain briefly the provisions relating to Set off carry forward of losses relating to speculation business Long Questions 1. Briefly explain the classification of companies. 2. Elaborately discuss the provisions of Sections 115BAB and 115BAA. 3. Briefly discuss the concessional rate of tax on dividends received by Indian Companies under section 115BBD. 4. Explain the provisions relating to levy of additional income tax on distributed income on account of buy back of shares. 5. Discuss provisions relating to Set off and carry forward of losses relating to specified business. B. Multiple Choice Questions 1. Companies in which public are substantially interested are called a. Closely held companies b. Widely held companies c. Both (a) and (b) d. None of these 2. Specified foreign company means a foreign company in which the Indian company holds ____ or more of the nominal value of the Equity share capital. a. 26% b. 25% 126 CU IDOL SELF LEARNING MATERIAL (SLM)

c. 20% d. 10% 3. Purchase by a company of its own shares is known as a. Buyback of shares b. Dividend c. Both (a) and (b) d. None of these 4. A business loss can be carried forward for a maximum period of ____ assessment years immediately succeeding the assessment year in which the loss was incurred. a. 7 b. 5 c. 8 d. None of these 5. The loss in speculation business can be carried forward for a maximum period of ______ a. 3 years b. 4 years c. 5 years d. 8 years Answers 1-b 2-a 3-a 4-c 5-b 6.8 REFERENCES • Prasad, Bhagabati: Direct Tax Law & Practice, New Age Publ., N. Delhi. • H.C. Mehrotra –Income Tax Law & Practice • H.P. Ranina: Corporate Taxation: A Hand Book (Tax Mann). • V.S. Datey: Indirect Taxes – Law and Practice (Tax Mann Publications Limited) • Ahuja, Girish & Gupta, Ravi: Systematic Approach to Income Tax; Central Sales Tax, Bharat Law House, N. Delhi. 127 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 7: AREAS OF TAX PLANNING Structure 7.0 Learning Objectives 7.1 Introduction 7.2 Tax planning considerations in respect of salary income 7.3 Tax planning considerations in relation to business income 7.4 Summary 7.5 Keywords 7.6 Learning Activity 7.7 Unit End Questions 7.8 References 7.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • State the tax planning considerations in case of salary income • Explain the various deductions which are available from salary income • Explain the various forms of organisations • State the tax planning aspects in case of business income 7.1 INTRODUCTION Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax efficient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success. 7.2 TAX PLANNING CONSIDERATIONS IN RESPECT OF SALARY INCOME The scope for tax planning from the angle of employees is limited. The definition of salary is very wide and includes not only monetary salary but also benefits and perquisites in kind. The only deductions available in respect of salary income are the standard deduction up to ₹ 50,000, deduction for entertainment allowance and deduction for professional tax. Therefore, the scope for tax planning in respect of salary income is severely limited. However, the following are some ideas of tax planning in regard to salary income. 128 CU IDOL SELF LEARNING MATERIAL (SLM)

(1) Salary Structure: The employer should plan the salary structure keeping in view the deductions and exemptions available under the Act. If salary is paid as a consolidated amount, without any break-up, the amount of salary after providing standard deduction of ₹ 50,000, would become taxable without any further exemption and deduction. Therefore, the employer should split the same and pay it as basic salary plus various allowances and perquisites, so as to reduce the tax implication in the hands of the employee. For example, the employer may include allowances as part of the salary structure of the employees for which exemption can be claimed under Rule 2BB, e.g., Children education allowance, hostel allowance, house rent allowance. The employer will get a deduction of all the above amounts paid while computing his profits and gains of business or profession. Further, the employer can give such allowances like special compensatory allowance, border area allowance or remote area allowance or difficult area allowance or disturbed area allowance depending upon the posting of the employee. Some exemptions are available in respect of these allowances. In this connection, Rule 2BB specifies the exempt allowances. The employer has to make a careful study and fix the salary structure in such a manner that it will include allowances which are exempt. Standard deduction of ₹ 50,000 or the amount of gross salary, whichever is less, is allowed as deduction under section 16(ia). (2) Employees’ welfare schemes: There are several employees’ welfare schemes such as recognised provident fund, approved superannuation fund, gratuity fund. Payments received from such funds by the employees are totally exempt or exempt up to significant amounts. For example, gratuity received by an employee covered under the Payment of Gratuity Act, 1972 is exempt up to ₹ 20 lakh. The entire provident fund received by the employee from recognised provident fund is exempt. The employer is well advised to institute such welfare schemes for the benefit of the employees. Such amount contributed by the employer towards the above funds is deductible. However, a note of caution is necessary here in view of the restrictive provisions of section 40A (9) which disallows any contribution made to any welfare funds except where such contributions are covered by section 36(1)(iv)/(iva)/(v) or as required by or under any other law for the time being in force. In this connection, it may be noted that section 10(23AAA) exempts any income of a staff welfare fund subject to the satisfaction of certain conditions. However, in the absence of an amendment to section 40A (9), contribution to such welfare trusts can be disallowed by the Assessing Officer. Further, the employer can contribute to recognized provident fund account of the employee up to 12% of salary, and the same would not be taxable in the hands of the employees. (3) Insurance policies: Any payment made by an employer on behalf of an employee to maintain a life policy will be treated as perquisite in the hands of the employee. Further, payments received from the employer in respect of keyman insurance policies constitute income in the hands of the employees. However, the payment of premium by the employer 129 CU IDOL SELF LEARNING MATERIAL (SLM)

on behalf of the employee will not be treated as a perquisite in the case of accident insurance policies. This is due to the fact that the employer has a vested interest in the safety of the life of his employee who is engaged in such dangerous occupations. [CIT v Lala Shri Dhar (1972) 84 ITR 192 (Del) and CIT v Vinay Bharat Ram (1981) 129 ITR 128 (Del)]. Further, any sum paid by the employer in respect of any Mediclaim premium paid by the employee to keep in force an insurance on his health or the health of any member of his family under any scheme approved by the Central Government or IRDA for the purpose of section 80D is not a perquisite in the hands of the employee. (4) Dearness allowance, dearness pay: The employer should ensure that dearness allowance and dearness pay should form part of “salary”. This is because certain items like entertainment allowance, gratuity, commuted pension and the employer’s contribution to the recognised provident fund etc. are calculated on the basis of salary. Therefore, if dearness allowance, dearness pay etc. are included in salary, the above benefits will also increase leading to higher exemption in the hands of the employee. (5) Commission: The Supreme Court, in Gestetner Duplicators Pvt. Ltd. v. CIT 117 ITR 1, has held that if, under the terms of employment, commission is payable at a fixed percentage of turnover achieved by an employee such commission should be taken into account for calculating “salary” for the purpose of gratuity etc. The employer will be well advised to provide for such commission. (6) Leave travel facility: The employer should extend leave travel facility to the employees at all levels. Under section 10(5) of the Income-tax Act, 1961, exemption is provided in the hands of the employee in respect of leave travel concession. Such exemption is available for the employee, spouse, children (to a maximum of 2 children), dependent parents, dependent brothers and dependent sisters. (7) Rent free accommodation / House Rent Allowance (HRA): An employee should analyse the tax incidence of a perquisite and an allowance, whenever he is given an option, in order to choose the one which is more beneficial to him. In the case of Rent-Free Accommodation vs. HRA, it must be noted that the perquisite of rent-free accommodation is taxed as per Rule 3(1) of the Income-tax Rules, 1962 and HRA is exempt to the extent mentioned in section 10(13A) read with Rule 2A. The employee should therefore work out his tax liability and net cash flow under both the options and then, decide on whether to receive HRA or choose a rent-free accommodation. (8) Uncommuted/Commuted pension: Uncommuted pension is fully taxable. Therefore, the employees should get their pension commuted. Commuted pension is fully exempt from tax 130 CU IDOL SELF LEARNING MATERIAL (SLM)

in the case of government employees and partly exempt from tax in the case of non- government employees. (9) Provident Fund: Where an employee who is a member of a recognised provident fund and who resigns before completing five years of continuous service should ensure that he joins a firm which maintains a recognised provident fund. The accumulated balance of the provident fund with the previous employer will be exempt from tax provided the same is transferred to the new employer who also maintains a recognised provident fund. (10) Retirement benefits: Incidence of tax on retirement benefits like gratuity, commuted pension, accumulated balance of unrecognized provident fund is lower if they are paid in the beginning of the financial year. The employer and the employees should mutually plan their affairs in such a way that retirement takes place in the beginning of a financial year. (11) Pension received by non-residents: Pension received in India by a non-resident assessee from abroad is taxable in India. If, however, such pension is first received by or on behalf of the employee in a foreign country and later on remitted to India, it will be exempt from tax. (12) Accident insurance: In respect of accident insurance policies, the decision of the Supreme Court in CIT v. L.W.Russel (1964) 53 ITR 91 points out that the term perquisite applied to only such sums in regard to which there was an obligation on the part of the employer to pay and a vested right on the part of the employee. If the employee has no vested interest in the policy, it cannot be considered as a perquisite. In view of this position, in cases where an employer takes out accident insurance policy covering all workmen and staff members and pays insurance premium and whenever any worker/staff member meets with an accident and the amount of claim is received from the insurance company and the same is paid away by the employer to the said worker or his family members, the premium paid by the employer in respect of group accident policies could not be considered as a perquisite, under section 17 to be added in the salary income of any employee [CIT v. Lala Shri Dhar (1972) 84 ITR 192 (Delhi)]. The amount received from insurance company on accident or death by employee or his dependents will not also be in the nature of income but a capital receipt and therefore the same will not be taxable. (13) Tax free perquisites: The following are the perquisites which are exempt from tax– (i) Use of computers and laptop by employee. (ii) Medical facility in employer’s own hospital or a public hospital or Government or other approved hospital. 131 CU IDOL SELF LEARNING MATERIAL (SLM)

(iii) Educational benefit in a school run by employer provided value of benefit does not exceed ₹ 1,000 per month per child. (14) Considerations for salary structuring: The perquisite valuation rules prescribe the method for valuing the various perquisites provided by the employer to his employees on the basis of the cost of such perquisites to the employee. For a detailed study, students are advised to refer to the chapter on ‘Salaries’. Accordingly, the entire salary structuring for employees will have to be done after carefully weighing the pros and cons of paying salary in monetary terms or allowing the benefit of perquisites in kind to the employees. It may be noted that a salaried person can opt for concessional rates of tax under section 115BAC in respect of his total income (other than income chargeable to tax at special rates under Chapter XII), if he does not avail certain exemptions/deductions like Leave Travel Concession, standard deduction under the head “Salaries”, interest on housing loan on self- occupied property, deductions under Chapter VI-A [other than 80CCD (2) and section 80JJAA] etc. So, a salaried taxpayer not availing the above deductions/exemptions or availing a lesser amount of such deductions/exemptions can analyse his tax liability under the regular provisions of the Income-tax Act, 1961 vis-à-vis Special provisions under section 115BAC. He can choose whether or not to exercise the option in each previous year. An employee intending to opt for concessional rate of tax under section 115BAC has to intimate the same to the employer. ILLUSTRATION 1 Mr. A, aged 32 years, is employed with XYZ (P) Ltd. on a basic salary of ₹ 50,000 p.m. He has received transport allowance of ₹ 15,000 p.m. and house rent allowance of ₹ 20,000 p.m. from the company for the P.Y. 2020-21. He has paid rent of ₹ 25,000 p.m. for an accommodation in Delhi. Mr. A has paid interest of ₹ 2,10,000 for housing loan taken for the construction of his house in Mumbai. The construction of the house is completed in March, 2021 and the house is vacant. Other Information - Contribution to PPF - ₹ 1,50,000 - Contribution to pension scheme referred to in section 80CCD - ₹ 50,000 - Payment of medical insurance premium for father, who is of the age of 65 - ₹ 55,000 - Payment of medical insurance premium for self and spouse - ₹ 32,000 Compute the total income and tax liability of Mr. A for the A.Y. 2021-22 SOLUTION Computation of total income and tax liability of Mr. A for A.Y. 2021-22 132 CU IDOL SELF LEARNING MATERIAL (SLM)

Particulars ₹ Salaries 6,00,000 Basic Salary [₹ 50,000 x 12] 1,80,000 - Transport allowance [₹ 15,000 x 12] 7,80,000 HRA received 2,40,000 (50,000) 7,30,000 Less: Least of the following exempt u/s 10(13A) 2,40,000 HRA Received 2,40,000 Actual rent paid – 10% of salary [₹3,00,000 – ₹ 60,000] 2,40,000 50% of salary 3,00,000 Gross salary Less: Standard deduction u/s 16(ia) Income from house property [Annual Value is Nil. Deduction u/s 24(b) for interest on housing loan would (2,00,000) be restricted to ₹ 2,00,000, in case of self-occupied property, which would represent loss from house property] Gross Total Income 5,30,000 Less: Deductions under Chapter VI- A Section 80C 1,50,000 Contribution to PPF 133 CU IDOL SELF LEARNING MATERIAL (SLM)

Section 80CCD(1B) 50,000 Own contribution to pension scheme 75,000 Section 80D Mediclaim insurance premium For self and spouse, restricted to 25,000 For father, who is a senior citizen, restricted to 50,000 Total Income 2,55,000 Tax liability 250 Tax @ 5% on ₹ 5,000 [₹ 2,55,000 - ₹ 2,50,000] 250 Less: Rebate u/s 87A Total Tax Liability - Computation of total income and tax liability of Mr. A for A.Y. 2021-22 in accordance with the provisions of section 115BAC Particulars ₹ Salaries Basic Salary [₹ 50,000 x 12] 6,00,000 Transport allowance [₹ 15,000 x 12] 1,80,000 HRA received 2,40,000 10,20,000 Income from house property - Interest on housing loan Gross Total Income 10,20,000 Less: Deductions under Chapter VI- A 134 CU IDOL SELF LEARNING MATERIAL (SLM)

Section 80C - Contribution in PPF Section 80CCD - Contribution to pension scheme Section 80D - Mediclaim insurance premium for self and parents Total Income 10,20,000 Tax liability 4,000 79,000 Tax@20% on ₹ 20,000 [₹ 10,20,000 – ₹ 10,00,000] 37,500 Tax @15% on ₹ 2,50,000 [₹ 10,00,000 - ₹ 7,50,000] 25,000 Tax @10% on ₹ 2,50,000 [₹ 7,50,000 - ₹ 5,00,000] 12,500 Tax @5% on ₹ 2,50,000 [₹ 5,00,000 - ₹ 2,50,000] Add: Health & Education cess @ 4% 3,160 Total Tax Liability 82,160 Since tax payable as per the regular provisions of the Act is lower than the tax payable under the provisions of section 115BAC, it would be beneficial for Mr. A not to opt for section 115BAC. Note: In this case, Mr. A is entitled to exemption u/s 10(13A), benefit of interest on housing loan in respect of self-occupied property and Chapter VI-A deductions, owing to which his total income is reduced by ₹ 7,65,000. His total income under the regular provisions of the Act is less than ₹ 5,00,000, owing to which he becomes entitled to rebate u/s 87A. Hence, in this case, it is beneficial for Mr. A not to opt for section 115BAC. 7.3 TAX PLANNING CONSIDERATIONS IN RELATION TO 135 BUSINESS INCOME CU IDOL SELF LEARNING MATERIAL (SLM)

The scope of income liable to tax under the head “Profits and gains of business or profession” covered by sections 28 to 44D of the Income-tax Act, 1961 has been discussed earlier. The object of this part of the study material is to discuss from the angle of tax planning the various areas in which taxpayer will have to take appropriate decisions to ensure that the incidence of tax in respect of his income chargeable under this head is reduced to the extent possible, by taking advantage of the various allowances, deductions and other tax concessions provided under the law. For a new business, the spheres in which the question of tax planning is relevant are as follows: i) Form of the organization ii) Nature of the business iii) Financial Structure iv) Acquisition of plant and machinery and other fixed assets v) Setting up and commencement of business Each of these aspects will be considered briefly in the following paragraphs. In addition, there is lot of scope for planning with reference to the method of accounting to be employed and the various deductions and special incentives provided under the Income-tax Act, 1961. Certain special tax planning considerations relevant to specific management decisions, foreign collaboration agreements and other related matters are also discussed. (1) Form of Business Organization: The choice of the appropriate form of business organization will have to be thought of and decided by the person who intends to carry on business or profession at the beginning itself, because a change in the form of business organization after the commencement of the business, may attract liability to tax. A new business can be organized under any of the following forms: i) Sole proprietorship ii) Hindu undivided family iii) Association of persons or Body of Individuals iv) Partnership firm/LLP v) Company vi) Co-operative society The selection of a particular form of organization would depend not only on the tax aspect but on other considerations also, e.g., financial requirements and resources, requirement of limited liability and many other practical considerations. 136 CU IDOL SELF LEARNING MATERIAL (SLM)

However, depending upon the taxable status and level of tax liability of the owners, a selection can be made from the various forms available for setting up a new unit. Sole Proprietorship: In the case of a sole proprietorship concern, one of the important tax disadvantages would be that no allowance or relief would be available to the tax payer in computing his income from business in respect of even a reasonable amount of remuneration attributable to the services rendered by him for carrying on the business. As a result, the taxable income arrived at would be a larger amount than what it would have been if it had been the case of, say, a firm paying remuneration to partners, such remuneration is allowable subject to the limits specified in section 40(b)(v). The taxable income from business would get reduced and correspondingly, the incidence of tax would also be reduced. Under sole proprietorship, the entire income of a business unit gets assessed in the hands of the same person along with other income, while the entire loss and other allowances shall be available for set off in his hands against other income. This may have some advantage in the initial years, after which the possibility of converting it into company/firm may be considered; on such conversion, the questions of possible capital gains tax, etc., will have to be considered. Hindu Undivided Family: The Hindu undivided family as a unit of taxation continues to exist for the purpose of carrying on business as well and there is a large number of cases where business is carried on by the members of the family on behalf on the family. Since the law does not specifically provide for the disallowance of such expenses, it is advantageous to carry on a business through the HUF wherever possible. The income of the family is computed and first taxed in the hands of the family at the rates applicable to it. The income of the family may, thereafter, be divided amongst the members of the family and the members, in such cases, do not attract any liability to tax in view of the specific exemption granted under section 10(2) of the Income-tax Act, 1961. Thus, if a business is carried on by a Hindu undivided family, the advantages which are available in the case of a company could be fully availed of and in addition, the members of the family would not become liable to tax when they receive any portion of the family’s income. Option under section 115BAC for availing concessional tax slab rates As per section 115BAC, individuals and HUF have an option to pay tax in respect of their total income (other than income chargeable to tax at special rates under Chapter XII) at following concessional rates, if they do not avail certain exemptions/deductions like Leave Travel Concession, standard deduction under the head “Salaries”, interest on housing loan on self-occupied property, deductions under Chapter VI-A [other than 80CCD (2) and section 80JJAA] etc. – 137 CU IDOL SELF LEARNING MATERIAL (SLM)

i) Up to ₹ 2,50,000 Nil ii) From ₹ 2,50,000 to ₹ 5,00,000 5% iii) From ₹ 5,00,000 to ₹ 7,50,000 10% iv) From ₹ 7,50,000 to ₹ 10,00,000 15% v) From ₹ 10,00,000 to ₹ 12,50,000 20% vi) From ₹ 12,50,000 to ₹ 15,00,000 25% vii) Above ₹ 15,00,000 30% Individuals and HUFs exercising option u/s 115BAC are not liable to alternate minimum tax u/s 115JC. Partnership Firm/LLP: All firms and LLPs will be taxed at a flat rate of 30%. If the total income exceeds ₹ 1 crore, surcharge @12% would be attracted. Further, health and education cess @4% would be applicable. There will be no initial exemption and the entire income will be taxed. In computing the taxable income of a firm, certain prescribed deductions in respect of interest and remuneration have to be allowed. The share income of a firm in the hands of the partners of the firm which is separately assessed as such is fully exempt under section 10(2A). Note: An Individual, HUF or a partnership firm (but not an LLP), who is a resident carrying on eligible business can declare income on presumptive basis as per the provisions of section 44AD @8% of gross receipts [6% in case gross receipts are received by an account payee cheque/bank draft/use of ECS through bank account/through any other electronic mode as may be prescribed on or before the due date of filing return of income]. The prescribed electronic modes are credit card, debit card, net banking, IMPS (Immediate payment Service), UPI (Unified Payment Interface), RTGS (Real Time Gross Settlement), NEFT (National Electronic Funds Transfer), and BHIM (Bharat Interface for Money) Aadhar Pay [CBDT Notification No. 8/2020 dated 29.01.2020]. An assessee, being a resident in India, carrying on notified profession can declare income on presumptive basis@50% of gross receipts as per the provisions of section 44ADA. In such a case, they need not get their books of account audited as per section 44AB. Company: For any large venture requiring substantial investment and recourse to borrowed funds from banks and institutions, ordinarily the form of a limited company will have to be adopted. Within the company form of organisation, however, several alternatives exist. On the basis of the ownership and control, a company can be organised as a widely held company, i.e., a company in which the public are substantially interested within the meaning 138 CU IDOL SELF LEARNING MATERIAL (SLM)

of section 2(18) of the Income-tax Act, 1961. Alternatively, it can be organised as a closely held company. Depending upon the choice of the form of organisation of the company, the following important tax consequences would have to be considered from the viewpoint of tax planning: (i) The provisions of section 79 regarding restrictions on carry forward of losses in the event of substantial change in the shareholding of the company also become applicable if the company is one in which the public are not substantially interested. This aspect would assume particular significance in the case of closely held companies where losses are made, and shareholdings are transferred before such losses are fully absorbed. (ii) Also, MAT provisions are applicable to companies. It so happens that in case of companies enjoying tax holiday benefits still have to pay tax under MAT provisions, credit of which also cumulated for number of years without being used causing significant outflow of funds in the initial years. Thus, it can be seen that the concept of deemed dividend under section 2(22)(e) and the provisions of section 79 do not apply to a widely held company. Place of Effective Management (PoEM) framework is introduced to determine the tax payable by a foreign company that for all purposes is managed from India and yet does not pay tax domestically. Many Indian companies that have traditionally used holding companies and subsidiaries overseas for various reasons are assessing how they may be affected and are racing to put new structures in place before they come under scrutiny. These provisions provide for a foreign company to be a resident of India, if the company’s place of effective management is in India. If a company’s POEM is situated in India; it will be treated as Indian resident. Its global income will be taxable in India. Rate of tax: The income-tax rate on foreign companies is higher at 40% plus surcharge @2% (if total income exceeds ₹ 1 crore but does not exceed ₹ 10 crore) and @ 5%, if the total income exceeds ₹ 10 crore as against 30% (plus surcharge @7%, if total income exceeds ₹ 1 crore but does not exceed ₹ 10 crore and @12%, if total income exceeds ₹ 10 crore) on domestic companies. Note – The Taxation Laws (Amendment) Act, 2019 has inserted two sections, section 115BAA and 115BAB, in the Income-tax Act, 1961 with effect from A.Y.2020-21. Section 115BAA provides for concessional rate of tax @22% (plus surcharge@10% and HEC@4%) for domestic companies, subject to certain conditions, like non-availability of 139 CU IDOL SELF LEARNING MATERIAL (SLM)

profit-linked deductions and investment-linked tax deduction under the Act, non-availability of deduction for contribution to research and development, additional depreciation etc. Section 115BAB provides for concessional rate of tax @15% (plus surcharge@10% plus HEC@4%) to new manufacturing or electricity generating domestic companies set up and registered on or after 1.10.2019, and commences manufacturing on or before 31.3.2023, subject to certain conditions, like non-availability of profit-linked deductions and investment- linked tax deduction under the Act, non-availability of deduction for contribution to research and development, additional depreciation etc. Domestic Companies have to exercise the option to be governed by these special provisions of the Act. The option for section 115BAB has to be exercised in the very first year in which the eligible company is set up, failing which it cannot exercise such option in the future years. However, a company eligible to exercise option u/s 115BAA can defer exercise of such option to a future year, if it is availing sizable profit-linked or additional depreciation in the previous year. However, once the company exercises such option under section 115BAA or 115BAB, as the case may be, in a year, it would continue to be governed by the special provisions u/s 115BAA or 115BAB, as the case may be, thereafter and cannot opt for regular provisions in any subsequent year. It may be noted that companies exercising option under section 115BAA or section 115BAB are not liable to minimum alternate tax under section 115JB. Also, certain tax incentives available to domestic companies are not available to foreign companies like amortisation of preliminary expenses. It is advantageous, from tax angle, for foreign corporations intending to do business in India to do so through a subsidiary instead of directly through a branch. Co-operatives: The co-operative form of business organisation, i.e., a co-operative society would also be advantageous from the tax angle and, in addition to the general benefits flowing from the co-operative form the society, can claim deduction in respect of the reasonable amount of remuneration payable to the members of the society for their services rendered, including the amount of commission, if any, payable to them and the interest on the deposits or loans given by them. The co-operative society is entitled to a further tax benefit arising from section 80P under which the income of a co-operative society is exempted from tax under different circumstances depending upon the nature of the income and/or the amount thereof. In addition to the various tax concessions which are available to all assessees, the co- operative society stands to gain substantially by virtue of the special benefits available to it under section 80P. The profits of the society remaining after payment of tax would be distributed by it amongst its members in the form of dividends subject to the relevant legislation. 140 CU IDOL SELF LEARNING MATERIAL (SLM)

However, it may be noted that benefit under section 80P has been withdrawn w.e.f. A.Y.2007-08 in respect of all co-operative banks, other than primary agricultural credit societies (i.e. as defined in Part V of the Banking Regulation Act, 1949) and primary co- operative agricultural and rural development banks (i.e. societies having its area of operation confined to a taluk and the principal object of which is to provide for long-term credit for agricultural and rural development activities). This is for the purpose of treating co-operative banks at par with other commercial banks, which do not enjoy similar tax benefits. From the above analysis of various forms of the organisation and their treatment for income- tax purposes, it may be appreciated that the provisions of the taxation laws have a considerable influence on the entrepreneurs in their choice of particular form of the organisation that they should establish. Note - Co-operative society, resident in India, can opt for concessional rate of tax @25.168% [i.e., tax@22% plus surcharge@10% plus health and education cess (HEC)@4%] under section 115BAD in respect of its total income computed without giving effect to deduction under section 10AA, 33AB, 33ABA, 35(1)(ii)/(iia)/(iii), 35(2AA), 35AD, 35CCC, additional depreciation under section 32(1)(iia), deductions under Chapter VI-A (other than section 80JJAA) etc. and set off of loss and depreciation brought forward from earlier years relating to the above deductions. The provisions of alternate minimum tax under section 115JC would not be applicable to co-operative society opting for section 115BAD. ILLUSTRATION 2 Mr. Gavaskar sought voluntary retirement from a Government of India Undertaking and received compensation of ₹ 40 lacs on 28th February, 2020. He is planning to use the money as capital for a business dealership in electronic goods. The manufacturer of the product requires a security deposit of ₹ 15 lacs, which would carry interest at 8% p.a. Gavaskar’s wife is a graduate and has worked as marketing manager in a multinational company for 15 years. She now looks for a change in employment. She is willing to join her husband in running the business. She expects an annual income of ₹ 5 lacs. Mr. Gavaskar would like to draw a monthly remuneration of ₹ 40,000 and also interest @ 10% p.a. on his capital in the business. Mr. Gavaskar has approached you for a tax efficient structure of the business. Discuss the various issues, which are required to be considered for formulating your advice. Computation of income or tax liability is not required. SOLUTION The selection of the form of organisation to carry on any business activity is essential in view of the differential tax rates prescribed under the Income-tax Act, 1961 and specific 141 CU IDOL SELF LEARNING MATERIAL (SLM)

concessions and deductions available under the Act in respect of different entities. For the purpose of formulating advice as to the tax efficient structure of the business, it is necessary for the tax consultant to consider the following issues: i) In the case of sole proprietary concern, interest on capital and remuneration paid to the proprietor is not allowable as deduction under section 37(1) as the expenditure is of personal nature. On the other hand, in the case of partnership firm, both interest on capital and remuneration payable to partners are allowable under section 37(1) subject to the conditions and limits laid down in section 40(b). The partnership should be evidenced by an instrument and the individual share of partners should be specified in the instrument. Remuneration and interest should however, be authorised by the instrument of partnership and paid in accordance with such instrument. Such interest and salary shall be taxable in the hands of partners to the extent the same is allowed as deduction in the hands of the firm under section 40(b). Interest to partners can be allowed up to 12% on simple interest basis, while the limit for allowability for partners' remuneration is based on book profit under section 40(b). As per section 40(b)(v), partners’ remuneration shall be allowed to the extent of aggregate of – a) On the first ₹ 3,00,000 of book profit or in case of loss – ₹ 1,50,000 or at the rate of 90% of book profits, whichever is more b) On the balance of book profit – at the rate of 60% Note – However, if the firm is eligible to opt for presumptive taxation under section 44AD, 8% of gross receipts or 6% of gross receipts, as the case may be, would be deemed as its income. All deductions under section 30 to 37 are deemed to be allowed. No deduction is allowable, including deduction for partner’s remuneration and interest on capital. ii) Partner's share in the profits of firm is not taxed in the hands of the partners by virtue of section 10(2A). iii) If a proprietary concern is formed, the salary of Mrs. Gavaskar shall be allowed as deduction under section 37(1). iv) The possibility of invoking section 40A (2) cannot be ruled out as salary is payable to a relative, who is an interested person within the meaning of section 40A (2). However, it can be argued successfully that salary of ₹ 5 lacs is justified in view of her long experience as marketing manager of a multinational company and the fair market value of services to be rendered by her to the concern. 142 CU IDOL SELF LEARNING MATERIAL (SLM)

v) An issue arises as to whether remuneration of Mrs. Gavaskar would be includible in the total income of Mr. Gavaskar. Under section 64(1)(ii), remuneration of the spouse of an individual working in a concern in which the individual is having a substantial interest shall be included in the total income of the individual. However, the clubbing provision does not apply if the spouse possesses technical or professional qualification, and the income is solely attributable to the application of his or her technical or professional knowledge and experience. Further, technical or professional qualification would not necessarily mean the qualifications obtained by degree or diploma of any recognized body [Batta Kalyani vs. CIT (1985) 154 ITR 0059 (AP)]. The experience of Mrs. Gavaskar as a marketing manager in a multinational company for 15 years may reasonably be considered as a professional qualification for this purpose. vi) If Mrs. Gavaskar joins the proprietary concern or partnership concern of her husband as employee, remuneration of ` 5 lacs shall be taxed in her hands under the head \"salary\". vii) If she joins as partner in the business, remuneration shall be taxed in her hand as business income under section 28 to the extent such remuneration is allowed in the hands of the firm under section 40(b). viii) The tax rate applicable to an individual depends on the level of his/her income, whereas for partnership firms it is flat rate at 30%. Surcharge @12% would be attracted only if total income exceeds ₹ 1 crore. For individuals, the rate of tax is 5% on income exceeding ₹ 2.50 lakhs but not exceeding ₹ 5 lakhs; 20% for total income exceeding ₹ 5 lakhs but not exceeding ₹ 10 lakhs and @ 30% in respect of income exceeding ₹ 10 lakhs for the assessment year 2021-22. The surcharge for total income exceeding ₹ 50 lakhs but not exceeding ₹ 1 crore is 10% of tax payable; for total income exceeding ₹ 1 crore but not exceeding ₹ 2 crore is 15% of tax payable; for total income exceeding ₹ 2 crore but not exceeding ₹ 5 crore is 25% of tax payable and for total income exceeding ₹ 5 crore is 37% of tax payable. Health and Education cess @ 4% on income-tax plus surcharge, if applicable, is attracted in all the cases. ix) If a sole proprietary concern is formed, Mr. Gavaskar has an option to pay income-tax in respect of his total income (other than income chargeable to tax at special rates under Chapter X-II) at concessional rates under section 115BAC. However, if he exercises such option in the P.Y. 2020-21, the said provisions will apply for all subsequent previous years. 143 CU IDOL SELF LEARNING MATERIAL (SLM)

(2) Nature of the business: Besides the form of organisation, the choice of the nature of the business also calls for appropriate planning with reference to the various special benefits available under the taxation laws to the particular kinds of industries which are not available to other kinds. Some of these benefits are of such a substantial nature that they constitute one of the major factors in the determination of the nature of the business. Broadly, business for this purpose may be divided into two categories - trading and manufacturing business. There could be a third category involving combination of both. Deduction is available under section 10AA to units established in SEZ. Deduction is available to newly units established in Special Economic Zones during P.Y. 2020-21 where letter of approval, required to be issued in accordance with the provisions of the SEZ Act, 2005, has been issued on or before 31st March 2020 and the manufacture or production of articles or things or providing services has begun on or before 31st March, 2021 or such other date after 31st March, 2021, as notified by the Central Government. In such case, the SEZ has deemed to have commenced manufacture or production in the P.Y.2019-20 and would be eligible for benefit of deduction under section 10AA. A taxpayer carrying on manufacturing or industrial activities would be in a position to avail of the various concessions such as depreciation allowance, benefit of amortisation under sections 32, 35ABA, 35ABB, 35D and 35E. Tax holiday benefit under section 80-IAC would be available in case of eligible start-up, under section 80-IBA in case of developing and building housing projects and under section 80LA in case of offshore banking unit and IFSC located in Special Economic Zone. Section 35AD of the Act also extends investment linked tax deduction to taxpayers with respect to the capital expenditure incurred for setting up and operation of specified businesses. While deciding the nature of the business, the benefit of tax exemption or concessional treatment available in respect of certain types of income such as agricultural income, new industrial undertakings, ships, business of repairs to ocean going vessels, business of exploration, etc. of mineral oils, etc. should also be taken into account. 7.4 SUMMARY • The scope for tax planning from the angle of employees is limited. • The definition of salary is very wide and includes not only monetary salary but also benefits and perquisites in kind. • The employer should plan the salary structure keeping in view the deductions and exemptions available under the Act. 144 CU IDOL SELF LEARNING MATERIAL (SLM)

• There are several employees’ welfare schemes such as recognized provident fund, approved superannuation fund, gratuity fund. Payments received from such funds by the employees are totally exempt or exempt up to significant amounts. • Any payment made by an employer on behalf of an employee to maintain a life policy will be treated as perquisite in the hands of the employee. 7.5 KEYWORDS • HRA – House Rent Allowance • CIT – Commissioner of Income Tax • LLP – Limited Liability Partnership • HUF – Hindu Undivided Family 7.6 LEARNING ACTIVITY 1. Download Form 16 (Part A and Part B) from internet and notice closely on various Payroll Components. ___________________________________________________________________________ _____________________________________________________________________ 2. Study about Setup of Cooperative society for farmers of nearby village and understand the taxation impact in comparison with Producer Company. ___________________________________________________________________________ _____________________________________________________ 7.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. List out a few circumstances where corporate form of organization is more suitable than other forms of organization. 2. Benjamin enterprises is a partnership firm earned a total income of ₹ 1,25,000 for the FY 2020-21. Compute the tax payable by the firm for the FY 2020-21. 3. Milton Traders, a partnership firm paid ₹ 5,50,000 as salary to Partners. The firm earned a book profit of ₹ 4,00,000. Compute the salary allowable as deduction under section 40 (b) of the Income Tax Act, 1961. 4. Describe briefly about POEM and its relevance to Tax Planning 5. Explain briefly about presumptive Taxation. 145 CU IDOL SELF LEARNING MATERIAL (SLM)

Long Questions 1. Explain the various components of salary and its tax implications. 2. Explain the taxation of leave travel facility. 3. Briefly explain a few deductions from the gross total income. 4. Briefly explain about the various forms of organizations. 5. Explain briefly about Tax planning in relation to a partnership Firm, Private Limited company and HUF B. Multiple Choice Questions 1. Maximum deduction under section 80C is a. ₹ 1,20,000 b. ₹ 1,50,000 c. ₹ 2,00,000 d. None of these 2. Which form of organisation is more suitable for an individual having a minimal investment who wants to do at a very small scale? a. Company b. Partnership firm c. LLP d. Proprietorship 3. All firms and LLPs will be taxed at a flat rate of ___ a. 20% b. 22% c. 25% d. 30% 4. Interest on capital can be allowed to partners at the rate of ___ as per sec 40(b). a. 11.5% b. 12% c. 12.5% d. None of these Answers 1-b 2-d 3-d 4-b 146 CU IDOL SELF LEARNING MATERIAL (SLM)

7.8 REFERENCES • Prasad, Bhagabati: Direct Tax Law & Practice, New Age Publ., N. Delhi. • H.C. Mehrotra –Income Tax Law & Practice • H.P. Ranina: Corporate Taxation: A Hand Book (Tax Mann). • V.S. Datey: Indirect Taxes – Law and Practice (Tax Mann Publications Limited) • Ahuja, Girish & Gupta, Ravi: Systematic Approach to Income Tax; Central Sales Tax, Bharat Law House, N. Delhi. 147 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 8: TAX PLANNING AND FINANCIAL MANAGEMENT Structure 8.0 Learning Objectives 8.1 Introduction 8.2 Meaning of Capital Structure 8.3 Designing Capital Structure 8.4 Concepts for designing optimal capital structure 8.5 Optimal capital structure 8.6 Tax considerations 8.7 Capital rationing 8.8 Summary 8.9 Keywords 8.10 Learning activity 8.11 Unit End Questions 8.12 References 8.0 LEARNING OBJECTIVES After studying this unit students will be able to • State the meaning of capital structure • Learn about design of capital structure • Explain the meaning of capital rationing 8.1 INTRODUCTION Broadly speaking, the choice in the matter of financing a new unit or business would be between capital and borrowings. New units being set up by existing units or companies would have the possibility of using retained profits. In the case of a company, the means of finance are as follows: (i) Share capital. (ii) Debentures. (iii) Other borrowed moneys. (iv) Generation of funds through profits. While the return on share capital is a charge on the profits after tax, the return on loans to the lenders is a charge on the profits before tax. Thus, recourse to borrowings would offer a tax advantage which will be reflected in a higher rate of return on the owner’s capital. 148 CU IDOL SELF LEARNING MATERIAL (SLM)

8.2 MEANING OF CAPITAL STRUCTURE Capital structure is the combination of capitals from different sources of finance. The capital of a company consists of equity share holders’ fund, preference share capital and long-term external debts. The source and quantum of capital is decided on the basis of need of the company and the cost of the capital. However, the objective of a company is to maximise the value of the company and it is prime objective while deciding the optimal capital structure. Capital Structure decision refers to deciding the forms of financing (which sources to be tapped); their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalisation. Whenever funds are to be raised to finance investments, capital structure decision is involved. A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing. 8.3 DESIGNING CAPITAL STRUCTURE A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. It can: a) Exclusively use debt (in case of existing company), or b) Exclusively use equity capital, or c) Exclusively use preference share capital (in case of existing company), or d) Use a combination of debt and equity in different proportions, or e) Use a combination of debt, equity and preference capital in different proportions, or f) Use a combination of debt and preference capital in different proportion (in case of existing company). The choice of the combination of these sources is called capital structure mix. But the question is which of the pattern should the firm choose? Factors Governing Capital Structure While choosing a suitable financing pattern, certain fundamental principles should be kept in mind, which are discussed below: (a) Cost Principle: According to this principle, an ideal pattern or capital structure is one that minimises cost of capital structure and maximises earnings per share (EPS). For e.g. Debt capital is cheaper than equity capital from the point of its cost and interest being deductible for income tax purpose, whereas no such deduction is allowed for dividends. (b) Risk Principle: According to this principle, reliance is placed more on common equity for financing capital requirements than excessive use of debt. Use of more and more debt means higher commitment in form of interest pay-out. This would lead to erosion of 149 CU IDOL SELF LEARNING MATERIAL (SLM)

shareholders value in unfavourable business situation. There are two risks associated with this principle: i) Business risk: It is an unavoidable risk because of the environment in which the firm has to operate and it is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm products, variations in prices and proportion of fixed cost in total cost. ii) Financial risk: It is a risk associated with the availability of earnings per share caused by use of financial leverage. It is the additional risk borne by the shareholders when a firm uses debt in addition to equity financing. Generally, a firm should neither be exposed to high degree of business risk and low degree of financial risk or vice-versa, so that shareholders do not bear a higher risk. (c) Control Principle: While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed. Issue of new equity will dilute existing control pattern and also it involves higher cost. Issue of more debt causes no dilution in control, but causes a higher degree of financial risk. (d) Flexibility Principle: By flexibility it means that the management chooses such a combination of sources of financing which it finds easier to adjust according to changes in need of funds in future too. While debt could be interchanged (If the company is loaded with a debt of 18% and funds are available at 15%, it can return old debt with new debt, at a lesser interest rate), but the same option may not be available in case of equity investment. (e) Other Considerations: Besides above principles, other factors such as nature of industry, timing of issue and competition in the industry should also be considered. Industries facing severe competition also resort to more equity than debt. Thus, a finance manager in designing a suitable pattern of capital structure must bring about satisfactory compromise between the above principles. The compromise can be reached by assigning weights to these principles in terms of various characteristics of the company. 8.4 KEY CONCEPTS FOR DESIGNING OPTIMAL STRUCTURE The capital structure decisions are so significant in financial management, as they influence debt – equity mix which ultimately affects shareholders return and risk. Since cost of debt is cheaper, firm prefers to borrow rather than to raise from equity. So long as return on investment is more than the cost of borrowing, extra borrowing increases the 150 CU IDOL SELF LEARNING MATERIAL (SLM)