earnings per share. However, beyond a limit, it increases the risk and share price may fall because shareholders may assume that their investment is associated with more risk. For an appropriate debt -equity mix, let us discuss some key concepts: - Leverages: There are two leverages associated with the study of capital structure, namely operating leverage and financial leverage. Operating leverage: - Operating leverage exists when a firm has a fixed cost that must be defrayed regardless of volume of business. It can be defined as the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. In simple words, the percentage change in profits accompanying a change in volume is greater than the percentage change in volume. Operating leverage can also be defined in terms of Degree of Operating Leverage (DOL). When proportionate change in EBIT as of result of a given change in sales is more than the proportionate change in sales, operating leverage exists. The greater the DOL, the higher is the operating leverage. Therefore, DOL exists when Percentage change in EBIT/Percentage change in Sales is > 1 Financial leverage: - Financial leverage involves the use of fixed cost of financing and refers to the mix of debt and equity in the capitalisation of a firm. Financial leverage is a superstructure built on the operating leverage. It results from the presence of fixed financial charges in the firm’s income stream. They are to be paid regardless of the amount of EBIT available to pay them. After paying them, the operating profits belong to the ordinary shareholders. In simple words, financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Positive Financial Leverage occurs when the firm earns more on the assets purchased with the funds, than the fixed cost of their use. Financial Leverage is also called as “Trading on Equity”. The degree of financial leverage can be found out as: Percentage change in Earnings before interest and tax (EBIT) Percentage change in Earnings per share (EPS) Positive Financial Leverage occurs when the result of above is greater than 1. Operating Leverage vis-à-vis Financial Leverage: - A company having higher operating leverage should be accompanied by a low financial leverage and vice versa, otherwise it will face problems of insolvency and inadequate liquidity. Thus, a combination of both the leverages is a challenging task. However, the determination of optimal level of debt is a formidable task and is a major policy decision. Determination of optimal level of debt involves equalising between return and risk. EBIT-EPS analysis is a widely used tool to determine level of debt in a firm. Through this 151 CU IDOL SELF LEARNING MATERIAL (SLM)
analysis, a comparison can be drawn for various methods of financing by obtaining indifference point. It is a point to the EBIT level at which EPS remains unchanged irrespective of level of debt-equity mix. The concepts of leverages and EBIT-EPS analysis would be dealt in detail separately for better understanding. Coverage Ratio: The ability of the firm to use debt in the capital structure can also be judged in terms of coverage ratio namely EBIT/Interest. Higher the ratio, greater is the certainty of meeting interest payments. Cash flow Analysis: It is a good supporting tool for EBIT-EPS analysis in framing a suitable capital structure. To determine the debt capacity, cash flow under adverse conditions should be examined. A high debt equity ratio is not risky if the company has the ability to generate cash flows. It would, therefore, be possible to increase the debt until cash flows equal the risk set out by debt. The main drawback of this approach is that it fails to take into account uncertainty due to technological developments or changes in political climate. These approaches as discussed above do not provide solution to the problem of determining an appropriate level of debt. However, with the information available a range can be determined for an optimum level of debt in the capital structure. 8.5 OPTIMAL CAPITAL STRUCTURE The theory of optimal capital structure deals with the issue of the right mix of debt and equity in the long-term capital structure of a firm. This theory states that if a company takes on debt, the value of the firm increases up to a point. Beyond that point if debt continues to increase then the value of the firm will start to decrease. Similarly, if the company is unable to repay the debt within the specified period then it will affect the goodwill of the company in the market and may create problems for collecting further debt. Therefore, the company should select its appropriate capital structure with due consideration to the factors mentioned earlier. 8.6 TAX CONSIDERATIONS i) Interest on debt fund is allowed as deduction as it is a business expenditure. Therefore, it may increase the rate of return on owner’s equity. ii) Dividend on equity fund is not allowed as deduction as it is the appropriate of profit. Dividend is exempt in the hands of shareholders u/s 10(34). However, the company declaring the dividend shall pay dividend distribution tax @ 10% + surcharges + cess. iii)The Cost raising owner’s fund is treated as capital expenditure therefore not allowed as deduction. However, if conditions of Sec. 35D is satisfied then specified expenditures can be amortized. iv)The Cost of raising debt fund is treated as revenue expenditure. It can be claimed as deduction in computing the total income. 152 CU IDOL SELF LEARNING MATERIAL (SLM)
v) Where the assesses is entitled to incentives u/s 10A etc. maximum equity fund should be utilized. vi)Where interest on debt fund is payable outside India, tax should be deducted at source otherwise deduction is not allowed Tax Planning i) If the return on investment > rate of interest, maximum debt funds may be used, since is shall increase the rate of return on equity. However, cost of raising debt fund should be kept in mind. ii) if rate of return on investment < rate of interest, minimum debt funds should be used. iii) Where assessee enjoys tax holidays under various provisions of Income-Tax in such case minimum debt fund should be used, since the profit arising from business is fully exempt from tax which increase the rate of return of equity capital. But the borrowed funds reduce the profits (profits less interest) before tax and to the extent exemption is reduce. iv) The balance of capital structure shall depend upon maximizing the return on capital employed which is computed by using following formula: Distributable Profit/ Equity Capital × 100 8.7 CAPITAL RATIONING Capital rationing is a part of the capital budgeting process of a company in which it places restrictions on the capital it uses for new projects or investments. Companies can also use capital rationing to limit the number of projects that they undertake at a single time. Capital rationing decisions can be difficult to make sometimes. It is because companies may come across several projects that they expect to be profitable. In these conditions, it helps them find the project with the maximum returns. The goal of the capital rationing process of a company is to ensure the most efficient and effective use of its resources. Usually, companies don’t have an infinite pool of resources. Therefore, they must always make decisions related to the best use of those resources and allocate it accordingly. It ascertains that companies not only maximize their returns but also don’t fall short of those resources. To do so, companies must accept a combination of projects and investments with the highest total net present value. One of the top goals of the capital rationing process is to discourage overinvestment in projects. 8.8 SUMMARY 1. Capital structure is the combination of capitals from different sources of finance. 2. A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. 153 CU IDOL SELF LEARNING MATERIAL (SLM)
3. Cost Principle: According to this principle, an ideal pattern or capital structure is one that minimizes cost of capital structure and maximizes earnings per share (EPS). 4. Risk Principle: According to this principle, reliance is placed more on common equity for financing capital requirements than excessive use of debt. 5. 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). 6. Financial risk: It is a risk associated with the availability of earnings per share caused by use of financial leverage. 7. Control Principle: While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed. 8. 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. 9. The capital structure decisions are so significant in financial management, as they influence debt – equity mix which ultimately affects shareholders return and risk. 10. Operating leverage exists when a firm has a fixed cost that must be defrayed regardless of volume of business. 11. Financial leverage involves the use of fixed cost of financing and refers to the mix of debt and equity in the capitalization of a firm. 8.9 KEYWORDS • EBIT-Earnings before interest and tax • EPS- Earnings per share • DOL – Degree of Operating Leverage 8.10 LEARNING ACTIVITY 1. Learn about benefits of investment in ELSS Scheme as provided in Income Tax Act ___________________________________________________________________________ _______________________________________________________________ 8.11 UNIT END QUESTIONS A. Descriptive Questions 154 Short Questions 1. How debt funds increase rate of return on equity? 2. Explain briefly about optimal capital structure. 3. What are the factors governing Capital structure? 4. Explain briefly about impact of debt funds on Tax planning for a company? CU IDOL SELF LEARNING MATERIAL (SLM)
5. Explain briefly about Operating and Financial Leverage Long Questions 1. Explain the key concepts in designing optimal capital structure. 2. An Indian company is considering three different proposals of raising Rs. 1200000 for project where earning before tax estimated as 36% of the capital employed. The company can raise this entire amount either by issue of equity share entirely or combination along with borrowing from a bank @12% p.a. or by issuing of debentures and any capital mix of three sources, which of the following three alternatives should it opt for: a) Entire Rs. 1200000 to be raised through equity share capital b) Rs. 600000 from equity shares and Rs. 300000 from each other sources available. c) Rs. 400000 from each source available. Assume the company shall distribute the entire amount of profits as dividend and applicable corporate tax rate is 30.9%. What will be your answer, if return on capital employed before tax is 12% instead of 36%, other things reaming the same? 3. Explain in detail about capital rationing, capital structure and tax considerations with respect to the same 4. Explain in detail about tax planning relating to financial management decisions 5. A Ltd. wants to acquire a machine on 1st April 2020. It will cost Rs 1, 50,000. It is expected to have a useful life of 3 years. Scrap value will be Rs 40,000. If the machine is purchased through borrowed funds, rate of interest is 15% p.a. The loan is repayable in three annual instalments of Rs 50,000 each. If machine is acquired through lease, lease rent would be `60,000 p.a. Profit, before depreciation and tax is expected to be Rs 1, 00,000 every year. Rate of depreciation is 15%. Average rate of tax may be taken at 33.99%. A ltd. seeks your advice whether it should: (i) Acquire the machine through own funds, or borrowed funds; or (ii) Take it on lease. Advice whether asset should be taken on lease or on purchase. Whether it should be acquired through own funds or borrowed funds? Present value factor shall be taken @ 10%. B. Multiple choice Questions 1. Positive financial leverage occurs when the result is a. >1 b. <1 c. =1 d. =0 2. The main drawback of cash flow analysis approach is that it fails to take into account a. Uncertainty due to technological developments 155 CU IDOL SELF LEARNING MATERIAL (SLM)
b. Changes in political climate c. Both (a) and (b) d. None of these 3. _________ from a domestic company is exempt in the hands of shareholders. a. Interest b. Dividend c. Both (a) and (b) d. None of these 4. The cost of raising fund is treated as _______________ a. Revenue Expenditure b. Capital Expenditure c. Both (a) and (b) d. None of these 5. Capital rationing is a part of __________________process a. Tax planning b. Tax evasion c. Capital budgeting d. Tax management Answers 1-a 2-c 3-b 4-a 5-c 8.12 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. 156 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 9: FINANCIAL MANAGEMENT Structure 9.0 Learning objectives 9.1 Introduction 9.2 Long term Finance 9.3 Factors affecting long term finance 9.4 Borrowed capital 9.5 Cost of capital 9.6 Importance of cost of capital 9.7 Factors determining cost of capital 9.8 Summary 9.9 Keywords 9.10 Learning activity 9.11 Unit End Questions 9.12 References 9.0 LEARNING OBJECTIVES After studying this unit students will be able to • State about Long term Finance • Appreciate factors affecting long term finance • Learn about Borrowed capital • Explain concept about cost of capital and its importance • Describe Factors determining cost of capital 9.1 INTRODUCTION Finance is the life blood of business. It is of vital significance for modern business which requires huge capital. Funds required for a business may be classified as long term and short term. In this chapter we will discuss about long term sources of finance. Finance for a long period is required for purchasing fixed assets like land and building, machinery etc. Even a portion of working capital, which is required to meet day to day expenses, is of a permanent nature. To finance it we require long term capital. The amount of long-term capital depends upon the scale of business and nature of business. Features of Long-term finance • It involves financing for fixed capital required for investment in fixed assets 157 CU IDOL SELF LEARNING MATERIAL (SLM)
• it is obtained from Capital Market • Long term sources of finance have a long-term impact on the business • Generally used for financing big projects, expansion plans, increasing production, funding operations. 9.2 LONG TERM FINANCE – ITS MEANING AND PURPOSE A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture etc. These assets may be regarded as the foundation of a business. The capital required for these assets is called fixed capital. A part of the working capital is also of a permanent nature. Funds required for this part of the working capital and for fixed capital is called long term finance. Purpose of long-term finance: Long term finance is required for the following purposes: 1. To finance fixed assets: Business requires fixed assets like machines, building, furniture etc. Finance required to buy these assets is for a long period, because such assets can be used for a long period and are not for resale. 2. To finance the permanent part of working capital: Business is a continuing activity. It must have a certain amount of working capital which would be needed again and again. This part of working capital is of a fixed or permanent nature. This requirement is also met from long term funds. 3. To finance growth and expansion of business: Expansion of business requires investment of a huge amount of capital permanently or for a long period. 9.3 FACTORS DETERMINING LONG-TERM FINANCIAL REQUIREMENTS The amount required to meet the long-term capital needs of a company depend upon many factors. These are: (a) Nature of Business: The nature and character of a business determines the amount of fixed capital. A manufacturing company requires land, building, machines etc. So it has to invest a large amount of capital for a long period. But a trading concern dealing in, say, 158 CU IDOL SELF LEARNING MATERIAL (SLM)
washing machines will require a smaller amount of long-term fund because it does not have to buy building or machines. (b) Nature of goods produced: If a business is engaged in manufacturing small and simple articles it will require a smaller amount of fixed capital as compared to one manufacturing heavy machines or heavy consumer items like cars, refrigerators etc. which will require more fixed capital. (c) Use of Technology: In heavy industries like steel the fixed capital investment is larger than in the case of a business producing plastic jars using simple technology or producing goods using labour intensive technique. SOURCES OF LONG-TERM FINANCE The two main sources of long-term finance are as follows: (A) Ownership Capital • Equity share capital • Preference share capital • Retained earnings (B) Borrowed capital • Debentures • Term loans • Others Owner’s capital 1. Equity share capital It represents the investment made by the owners of the business. They enjoy the rewards and bear the risks of the ownership. They are paid dividend only after paying dividend to preference shareholders and after meeting the future investment needs of the organisation. 2. Preference share capital It represents the investment made by preference shareholders. Preference shareholders as the name suggests enjoy preference over payment of dividend. The dividend paid on these shares is generally at a fixed rate. 3. Retained earnings It represents the earnings not distributed to shareholders. A firm may retain a portion or whole of its profits and utilize it for financing its projects. 9.4 BORROWED CAPITAL 1. Debentures 159 CU IDOL SELF LEARNING MATERIAL (SLM)
Debenture capital is a financial instrument for raising long term debt capital. A debenture holder is a creditor of the company. A fixed rate of interest is paid on debentures. It may be convertible or Non-convertible. Non-convertible debentures - these are straight debt instrument carrying a fixed rate and have a maturity period of 5-9 years. If interest is accumulated, it has to be paid by the company by liquidation of its assets. It is an economical method of raising funds. Debenture holders do not have any voting rights and there is no dilution of ownership. They cannot be converted into equity shares. Convertible debentures - convertible debentures are debentures which are convertible wholly or partly into equity shares after a fixed period of time. 2. Term loans from banks: Many industrial development banks, cooperative banks and commercial banks grant medium term loans for a period of three to five years. Commercial banks usually provide short-term finance to business firms in the form of loans and advances, cash credit, overdraft etc. But nowadays, most of the commercial banks have also started term lending (long and medium term) and providing need-based finance of different time periods to firms of all sizes. 3. Loan from financial institutions: There are many specialised financial institutions established by the Central and State governments which give long term loans at reasonable rate of interest. Some of these institutions are: Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), Industrial Investment Bank of India (IIBI), Infrastructure Development Finance Company Ltd. (IDFC), Small Industries Development Bank of India (SIDBI), State Industrial Development Corporations (SIDCs), Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India (UTI), State Finance Corporations (SFCs) etc. The main functions of these institutions are: (i) To grant loans for a longer period to industrial establishment. (ii) To help the establishment of business units that require large amount of funds and have long gestation period. (iii) to provide support for the speedy development of the economy in general and backward regions in particular. (iv) to offer specialized services operating in the areas of promotion, project assistance, technical assistance services and training and development of entrepreneurs. (v) to provide technical and professional management services and help in identification, evaluation and execution of new projects. 4. Foreign Sources: 160 CU IDOL SELF LEARNING MATERIAL (SLM)
Foreign Sources also play an important part in meeting the long-term financial needs of the business in India. These usually take the form of (1) external borrowings; (2) foreign investments and; (3) deposits from NRIs. 9.5 COST OF CAPITAL The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. Meaning of Cost of Capital Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders. Definitions of the Term ‘Cost of Capital’ The following important definitions are commonly used to understand the meaning and concept of the cost of capital According to the definition of John J. Hampton “Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place” According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”. According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for the allocation of capital to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”. According to the definition of William and Donaldson, “Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the cost elements of the burden at the time, they are due”. Assumption of Cost of Capital Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts: A. It is not a cost as such. It is merely a hurdle rate. B. It is the minimum rate of return. C. It consists of three important risks such as zero risk level, business risk and financial risk. Cost of capital can be measured with the help of the following equation. K = rj + b + f. 161 CU IDOL SELF LEARNING MATERIAL (SLM)
Where, K = Cost of capital. rj = The riskless cost of the particular type of finance, b = The business risk premium. f = The financial risk premium. 9.6 IMPORTANCE OF COST OF CAPITAL Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern. 1. Importance to Capital Budgeting Decision: Capital budgeting decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to make capital budgeting decision. 2. Importance to Capital Structure Decision: Capital structure is the mix or proportion of the different kinds of long-term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure. 3. Importance to Evolution of Financial Performance: Cost of capital is one of the important factors in determining claim which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm. 4. Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc.; hence, it plays a major part in the financial management. 9.7 FACTORS DETERMINING THE FIRM’S COST OF CAPITAL Cost of capital, like all other costs, is a variable term, subject to changes in a number of factors. The various factors that play a part in determination of cost of capital are described below. There are four main factors which mainly determine the cost of Capital of a firm 1. General Economic Conditions General economic conditions determine the demand for and supply of capital within the economy, as well as the level of expected inflation. This economic variable is reflected in the risk less rate of return. This rate represents the rate of return on risk- free investments, such as the interest rate on short-term government securities. In principle, as the demand for money in the economy changes relative to the supply, investors alter their required rate of return. For example, if the demand for money increases without an equivalent increase in the supply, 162 CU IDOL SELF LEARNING MATERIAL (SLM)
lenders will raise their required interest rate. At the same time, if inflation is expected to deteriorate the purchasing power of money, investors require a higher rate of return to compensate for this anticipated loss. 2. Market Conditions When an investor purchases a security with significant risk, an opportunity for additional returns is necessary to make the investment attractive. Essentially, as risk increases, the investor requires a higher rate of return. This increase is called a risk premium. When investors increase their required rate of return, the cost of capital rises simultaneously. If the security is not readily marketable when the investor wants to sell, or even if a continuous demand for the security exists but the price varies significantly, an investor will require a relatively high rate of return. Conversely, if a security is readily marketable and its price is reasonably stable, the investor will require a lower rate of return and the company’s cost of capital will be lower. 3. Operating and Financing Decisions Risk, or the variability of returns, also results from decisions made within the company. Risk resulting from these decisions is generally divided into two types: business risk and financial risk. Business risk is the variability in returns on assets and is affected by the company’s investment decisions. Financial risk is the increased variability in returns to common stockholders as a result of financing with debt or preferred stock. As business risk and financial risk increase or decrease, the investor’s required rate of return (and the cost of capital) will move in the same direction. 4. Amount of Financing The last factor determining the corporation’s cost of funds is the level of financing that the firm requires. As the financing requirements of the firm become larger, the weighted cost of capital increases for several reasons. For instance, as more securities are issued, additional flotation costs, or the cost incurred by the firm from issuing securities, will affect the percentage cost of the funds to the firm. Also, as management approaches the market for large amounts of capital relative to the firm’s size, the investors’ required rate of return may rise. Suppliers of capital become hesitant to grant relatively large sums without evidence of management’s capability to absorb this capital into the business. This is typically “too much too soon”. Also, as the size of the issue increases, there is greater difficulty in placing it in the market without reducing the price of the security, which also increases the firm’s cost of capital. Controllable Factors affecting Cost of Capital These are the factors affecting cost of capital that the company has control over: (1) Capital Structure Policy A firm has control over its capital structure, and it targets an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases. 163 CU IDOL SELF LEARNING MATERIAL (SLM)
(2) Dividend Policy Given that the firm has control over its pay-out ratio, the breakpoint of the marginal cost of capital schedule can be changed. For example, as the pay-out ratio of the company increases, the breakpoint between lower-cost internally generated equity and newly issued equity is lowered. (3) Investment Policy It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change. Uncontrollable Factors affecting the Cost of Capital These are the factors affecting cost of capital that the company has no control over: (1) Level of Interest Rates The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital. (2) Tax Rates Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital. TAX PLANNING THROUGH ISSUE OF BONUS SHARES When Bonus Shares are issued to the equity shareholders, the value of the shares is not taxed as dividend distributed. However, where redeemable preference shares are issued as Bonus shares, on their redemption, the amount shall be taxed as dividend distributed. Where Bonus Shares are issued to the Preference Shareholders, on their issue it is deemed to be dividend and liable to tax. Expenses on issue of Bonus Shares is not allowed as deduction since capital expenditure. TAX PLANNING THROUGH PURCHASE OF OWN SHARES Purchase of Own Shares: 1. Where the company purchase its own shares, the payment refund by shareholders is not treated as dividend. 2. However as per Sec. 64A, when a company purchases its own shares from a Shareholders, the capital gain arising to shareholders is chargeable to Tax. 3. The Capital Gain shall be computed u/s 48. 4. The Shareholders shall pay Tax on LTCG. Thus, if a company purchases its own shares instead of distributing dividend, it can reduce its tax liability. 9.8 SUMMARY 164 CU IDOL SELF LEARNING MATERIAL (SLM)
• The capital required for Financing Fixed Assets is called fixed capital. • The two main sources of long-term finance are as follows: • Ownership Capital • Borrowed Capital • Equity share capital represents the investment made by the owners of the business. • Preference share capital represents the investment made by preference shareholders. • Retained earnings represents the earnings not distributed to shareholders. • Debenture capital is a financial instrument for raising long term debt capital. A debenture holder is a creditor of the company. • Foreign Sources also play an important part in meeting the long-term financial needs. • Types of Foreign Sources of investment are: • External borrowings • Foreign Investments and • Deposits from NRIs. • The cost of capital is the required rate of return that a firm must achieve to cover the cost of generating funds in the marketplace. • Cost of capital, like all other costs, is a variable term, subject to changes in several factors. 9.9 KEYWORDS • LTCG-Long term capital gains • STCG-short term capital gains • IFCI – Industrial Finance Corporation of India • IDBI – Industrial Development Bank of India • IIBI – Industrial Investment Bank of India • ICICI – Industrial Credit and Investment Corporation of India 9.10 LEARNING ACTIVITY 1. What is meant by buy back of securities? Learn how it affects the capital structure ___________________________________________________________________________ ___________________________________________________________________________ 2. What is the impact of issue of bonus shares on the capital structure of the company? ___________________________________________________________________________ ___________________________________________________________________________ 9.11 UNIT END QUESTIONS 165 CU IDOL SELF LEARNING MATERIAL (SLM)
A. Descriptive Questions 166 Short Question 1. Define and explain the term ‘cost of capital’. 2. Explain about debentures as a source of borrowed capital 3. Explain about Tax planning through purchase of own shares 4. Discuss briefly about controllable factors affecting cost of capital. Long Questions 1. Explain the term long term finance in detail. 2. Explain in detail about different sources of borrowed capital? 3. Discuss Elaborately about factors determining Firm’s cost of capital? 4. Discuss in detail factors determining Firm’s cost of capital. 5. Explain what is cost of capital and its importance. B. Multiple choice Questions 1. Which of the following is a purpose served by long-term finance? a. To finance fixed assets b. To finance the permanent part of working capital c. To finance growth and expansion of business. d. All of these 2. Which of the following is not a part of ownership capital? a. Equity share capital b. Retained earnings c. Term loans d. None of these 3. Which of the following is a form of foreign source? a. External borrowings b. Foreign investments c. Deposits from NRIs. d. All of these 4. Which of the following is not a controllable factor affecting cost of capital? a. Capital structure policy b. Tax rates c. Dividend policy d. Investment policy 5. __________ plays a major part in the financial management. CU IDOL SELF LEARNING MATERIAL (SLM)
a. Cost of capital b. Cost of equity c. Cost of debt d. None of these Answers 1-d 2-c 3-d 4-b 5-a 9.12 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. 167 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 10: BUSINESS AND TAX PLANNING Structure 10.0. Learning Objectives 10.1. Introduction 10.2. Setting up of business and tax planning 10.3. Business deductions 10.4. Interest on borrowed capital 10.5. Specific deductions 10.6. Capital or revenue 10.7. Specifically allowed Expenditure 10.8. Summary 10.9. Keywords 10.10. Learning activity 10.11. Unit End Questions 10.12. References 10.0 LEARNING OBJECTIVES After studying this unit students will be able to • State about business deductions • Learn the impact of interest on borrowed • Differentiate between capital or revenue • Discuss specifically allowed expenditure for business 10.1 INTRODUCTION Setting up of business in the context of the Income-tax Act, 1961 is a concept entirely confined to that Act. It is not the same as the commencement of the business and these two concepts have been clearly distinguished for income-tax purpose. Between the date of the setting up and date of commencement, there may be an interregnum during which the assessee may be incurring expenses of a revenue nature. Under the taxation laws, the expenditure incurred prior to the date of setting up is not normally admissible for income-tax purposes. But if those are incurred on and from the date of setting up, but before commencement of the business, they may be allowed as deduction for tax purposes provided of course they are revenue in nature and are incurred wholly and exclusively for the purposes of business. 168 CU IDOL SELF LEARNING MATERIAL (SLM)
It is now practically well settled by various judicial rulings that a business is set up as soon as it is ready to commence production and it is not necessary that actual production should be so commenced. Thus, in the case of a company established for manufacturing cement, the business is set up as soon as acquiring of limestone is commenced even if at that time the plant and machinery may not have been installed so that actual manufacturing operations may commence. 10.2 SETTING UP OF BUSINESS AND TAX PLANNING A tax planner should fix the setting up date in such a manner that the company gets the maximum scope for allowability of expenses incurred contemporaneously to the date of setting up remembering that if those are incurred prior to the setting up date those are inadmissible as direct deductions while, if such expenses are of a revenue nature and they are wholly and exclusively incurred for business purpose, and are incurred subsequent to the date of setting up, they will be admissible as normal deductions. The following examples may be noted: (a) Such expenditure may be allowed as revenue expenditure. Expenditure by way of brokerage, legal charges, etc. for arranging long term loans, interest on borrowing— India Cement Ltd. vs. CIT 60 ITR 52 (SC). (b) Such expenditure may form part of the cost of assets on which depreciation may be available – Challapalli Sugars Ltd. vs. CIT 98 ITR 167 (SC). In this context, the provisions of Explanation 8 to Section 43(1) to the effect that any interest paid or payable in connection with the acquisition of an asset, which is relatable to any period after such asset is first put to use cannot be capitalised, are relevant. (c) Such expenditure may constitute preliminary expenditure and may be eligible for amortisation over a five-year period under section 35D. (d) Such expenditure, if being of a capital nature and if not falling under any of the three categories noted above may be disallowed and there may not be relief either on account of depreciation or amortisation. 10.3 TAX PLANNING FOR BUSINESS DEDUCTIONS — SOME GENERAL CONSIDERATIONS: There are several matters which affect the assessee’s ability to deduct various expenses for income-tax purposes. Some of the principal considerations to be borne in mind planning for business deductions, are given below: 169 CU IDOL SELF LEARNING MATERIAL (SLM)
Successful tax planning for business deductions pre-supposes a clear and thorough understanding of the various statutory provisions governing the deductions and an awareness of the statutory rights as well as various restrictions and conditions governing such rights. The general considerations applicable to tax planning in the field of business deductions, revolve round their- (a) allowability. (b) year of allowability (c) extent of allowability (disallowing provisions if any), and (d) carry-forward to future years. Often, the question of expenditure being capital or revenue and the consequences attaching to the likely treatment eventually may also be an important part of the tax planning exercise. This aspect has been discussed at a later stage. One of the important aspects of tax planning would be to see that the maximum deduction or allowance is obtained in the earliest possible time for the purpose of determination of taxable income. Therefore, while deciding about incurring of capital and revenue expenditure, the assessee should consider the tax treatment of such expenditures and the period within which the benefit of deduction or amortisation would be obtained so that he can estimate and work out cash flow position over a period of time. While tax considerations play a major role in investment decisions, the general principles of financial management and their effect on investment decisions should not be ignored. The tax planner should keep in mind the advantage arising out of minimising the expenditure, especially in the initial years of a business, so that the profits may be maximised and the assessee may be in a position to avail of the various tax incentives like depreciation as also the tax holiday provisions. Normally, deduction for expenditure is allowable in the year in which it is incurred or paid depending on the method of accounting followed, viz, mercantile or cash. In other words, the expenditure to be claimed as deduction should be claimed in the relevant year. Where the assessee follows the cash system of accounting, the allowance in respect of expenses would be available only when the moneys in respect of them are actually paid by the assessee. Whereas in the case of mercantile system of accounting, if a business liability has definitely arisen in the accounting year, a deduction should be allowed. Where accounts are kept on a mercantile basis, if an expenditure is claimed on the ground that it is legally deductible, it can be claimed in the year in which the liability for the expenditure is incurred even though the payment itself is made in a subsequent year. If an assessee following mercantile system fails to claim an expense in the year in which it accrues he loses the right to claim it as a deduction 170 CU IDOL SELF LEARNING MATERIAL (SLM)
altogether. He cannot claim or make any attempt to reopen the accounts of the earlier year to which the expense relates. The Supreme Court’s decision in C.I.T. vs. Gemini Cashew Sales Corporation (1967) 65 ITR 643 emphasizes the principle that if the liability to make the payment has arisen during the previous year, it must be appropriately regarded as the expenditure of that year and merely because the payment in respect of the expenditure is made in the subsequent year, the assessee would not be entitled to claim deduction in respect thereof in the subsequent year. As pointed out earlier, this is subject to the provisions of section 43B. Normally, deduction can be claimed by the assessee only in respect of those expenses and losses which have been actually incurred by the assessee during the previous year, i.e. after the business is set up. However, there are some exceptions to this rule and a tax planner should be aware of the exceptions and make use of them in appropriate cases. For example, expenditure incurred on scientific research before the commencement of the business — capital or revenue during the three years immediately preceding the commencement of the business and coming within the scope of the Explanation to sections 35(1)(i) and 35(1)(ii), capital expenditure incurred prior to commencement of specified business allowed as deduction in the year of commencement of business, in case capitalized under section 35AD, preliminary expenses incurred before commencement of the business and coming within the scope of section 35D, expenditure on prospecting for minerals coming within the scope of section 35E, are cases where the assessee could claim deduction in respect of the expenditure even though the expenditure was not incurred during the previous year. Similarly, the expenditure in respect of which deduction is claimed by the assessee should not be in the nature of capital expenditure. This is again subject to the statutory exceptions contained in provisions like section 35 and 35AD. Again, subject to the statutory exceptions, the expenditure should be incurred wholly and exclusively for the purpose of the business. 10.4 INTEREST ON BORROWED CAPITAL Under clause (iii) of section 36(1), deduction of interest is allowed in respect of capital borrowed for the purposes of business or profession in the computation of income under the head \"Profits and gains of business or profession\". As per the proviso to section 36(1)(iii), any amount of interest paid, in respect of capital borrowed for acquisition of an asset for any period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such asset was first put to use, shall not be allowed as deduction. 171 CU IDOL SELF LEARNING MATERIAL (SLM)
ICDS IX on Borrowing Costs deals with the treatment of borrowing costs. It requires borrowing costs which are directly attributable to the acquisition, construction or production of a qualifying asset to be capitalized as part of the cost of that asset. Qualifying asset has been defined to mean – • land, building, machinery, plant or furniture, being tangible assets; • know‐how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, being intangible assets; • inventories that require a period of twelve months or more to bring them to a saleable condition. This ICDS requires capitalization of specific borrowing costs (in respect of funds borrowed specifically for the purpose of acquisition, construction or production of a qualifying asset) and general borrowing costs. In case of qualifying assets being tangible and intangible assets, the capitalization shall commence from the date on which funds were borrowed and cease when such asset is first put to use. This ICDS also provides the formula for capitalization of borrowing costs when funds are borrowed generally and used for the purpose of acquisition, construction or production of a qualifying asset. For this restricted purpose, a qualifying asset shall be such asset that necessarily require a period of 12 months or more for its acquisition, construction or production. In this case, the capitalization of borrowing costs shall commence from the date on which funds were utilized. 10.5 SPECIFIC DEDUCTIONS UNDER THE INCOME-TAX ACT, 1961 The Income-tax Act, 1961 lists several specific deductions. A deduction falling under each category is allowable subject to the conditions and limitations, if any which may be specified. At times the restrictive conditions apply to expenditure which is prima facie suspect as, for example, transactions with relatives or associates or within the same group coming within the scope of section 40A (2). While planning for business deductions, due regard must be had to these limitations. In addition to the specific provisions the omnibus provision in section 37 also enables an assessee to claim deduction in respect of expenditure laid out ‘wholly and exclusively for the purpose of the business’ the tax planner has to take into consideration the principles emerging from the innumerable relevant judicial rulings while availing of the facility of deduction under this provision. Any expenditure incidental to business, may be deducted except those prohibited by any provision of the Act. 172 CU IDOL SELF LEARNING MATERIAL (SLM)
Ordinarily, an expenditure which is specifically provided for should be claimed under the relevant section rather under the omnibus provision. To justify the deduction under the residual clause, all that is required is that the expenditure must have been incurred wholly and exclusively and it is not necessary to prove that the expenditure was also incurred ‘necessarily’ or ‘reasonably”. The expenditure must have been incurred ‘for the purpose of businesses. These words are wider than the phrase “for the purpose of earning profits”. A specific quid pro quo is not essential. It is not necessary to show that the expenditure resulted in commensurate benefit or advantage either during the same year or subsequently. An expenditure is liable to be disallowed if it is either of a personal nature or of a capital nature. The question whether a particular expenditure is of a personal nature must be judged by reference to the assessee himself and not any other person. 10.6 CAPITAL OR REVENUE: Generally speaking, expenditure is regarded as being of a capital nature, if it results in the acquisition of an asset or of an advantage or benefit of an enduring nature. The test with regard to the nature of the expenditure-capital or revenue - is to be applied with reference to its purpose rather than its effect. The test must be applied by reference to the assessee himself and not any other person. For instance, a company must be obliged to construct pipelines for the purpose of its business but under conditions whereby the pipelines ultimately become the property of a municipal corporation rather than the company itself. In such a case, although the pipelines undoubtedly constitute tangible assets the expenditure may not be regarded as of a capital nature, since the assets do not belong to the company but to some other person. There are many judicial rulings to support this view. A leading case that maybe referred to in this context is Lakshmiji Sugar Mills Co. P. Ltd. vs. CIT (1971) 82 ITR 376 (SC)]. If the purpose of the expenditure is to secure a commercial advantage, rather than acquisition of a capital asset, it is likely to be allowed as revenue expenditure even though the advantage may endure for an indefinite period. However, this rule is by no means inflexible or capable of universal application. Conversely, if the purpose of the expenditure is the acquisition of an advantage or benefit of an enduring nature the expenditure is liable to be treated as capital expenditure even if the period or durability of the asset acquired as the result of the expenditure is very short. For example, if a company making shoes acquires knives and lasts, whose life is only three years, the expenditure may nevertheless be regarded as capital expenditure. In applying the various case laws on the subject of distinction between capital and revenue, it should be recognised that circumstances do change, and the law normally keeps pace with such changing circumstances. The expenditure that was regarded as capital expenditure resulting in long-term benefit during the relatively laissez faire days of the 19th century may not perhaps, be regarded as capital expenditure in the context of the rapid technological changes which are the feature of industrial life today. The decision of the Supreme Court in Shahzada Nund & Sons vs. CIT 108 ITR 358 also supports this view. A tax 173 CU IDOL SELF LEARNING MATERIAL (SLM)
planner would do well to keep track of the various cases reported from time to time so as to keep himself informed of the trend of judicial thinking in this regard. In this context, the requirements spelt out in the various income computation and disclosure standards have also to be kept in mind while considering the point in time of deductibility of expenditure. 10.7 EXPENDITURE SPECIFICALLY ALLOWED: The Income-tax Act, 1961 specifically allows many types of expenditure such as depreciation, expenditure on scientific research, expenditure on know-how, preliminary expenses, bad debts etc. The Act prescribes several conditions and restrictions for the allowance of such expenditure. The tax-planner should take care to see that all the prescribed conditions are complied with so that deductions may not be denied. Note - A company opting for the special provisions under section 115BAA or 115BAB would, however, not be eligible to claim deduction on account of, inter alia, additional depreciation and contribution for scientific research to companies/research association/IITs. Other business expenses: As already explained earlier, section 37(1) deals with the various items of expenses which are otherwise not covered by the provisions of Section 30 to 36 of the Income-tax Act, 1961 and specifically provides that all expenses which are incurred wholly and exclusively (though not necessarily) for the purpose of the business or profession carried on by the assessee would be deductible in computing the assessee’s business income. In order to qualify for deduction under this provision, the following important conditions will have to be fulfilled: (i) The expenditure should have been incurred by the assessee in the ordinary course of his business or profession. (ii) The expenditure should be of a revenue nature and should not be of capital nature. (iii) The expenditure should not be of a personal nature. (iv) The expenditure should not be covered by any other provisions of sections 30 to 36 for purposes of allowance, and it should not also be covered by any of the provisions of disallowance contained in sections 40 to 44D; and (v) The expenditure should not be one which is in the nature of an appropriation of income or diversion of profits by an overriding title. It should not also be one in respect of which deduction is permissible under Chapter VI-A of the Income-tax Act, 1961 from the gross total income of the assessee. Commercial expediency: The concept of ‘commercial expediency’ helps a tax payer in insisting that a reasonable view is taken of his right to deduct normal expenditure. The trend in judicial thinking has also 174 CU IDOL SELF LEARNING MATERIAL (SLM)
recognised this concept. This concept reflects the fact that it is virtually impossible for the legislation to list all possible deductions to which an assessee would be entitled in computing his taxable income and therefore the fact that a business has to be run by the assessee himself under normal commercial conditions must be recognised in determining the allowability of certain expenditure. The test of commercial expediency should be applied from the point of view of a normal prudent businessman, by reference to modern concepts of business responsibility and not by reference to the subjective standards of the revenue department. A claim on the ground of commercial expediency is subject to the under-noted conditions and limitations: (a) If the expenditure is covered by one of the express provisions in the Act, it must conform to the requirements stipulated therein. (b) An expenditure which is expressly disallowed under the Act cannot be claimed on grounds of commercial expediency. (c) An expenditure cannot be claimed on grounds of commercial expediency if it is improper or illegal. It may be commercially expedient to pay a bribe or incur a penalty, but this does not mean that the bribe or penalty would be normally deductible for tax purposes. There is also a distinction between a payment made for a violation or breach of law and payment made for a breach of contract. Courts have taken the view that where the payments are not in the nature of penalties for infraction of any law but made in pursuance of the exercise of an option given in a particular scheme and where the assessee opts for it out of commercial expediency and business consideration, it could be allowed as deduction. Deduction in respect of profits and gains from newly established small-scale industrial undertakings in certain areas. (Sec 80HHA). (1) Where the gross total income of an assessee includes any profits and gains derived from a small-scale industrial undertaking to which this section applies, there shall, in accordance with and subject to the provisions of this section, be allowed, in computing the total income of the assessee, a deduction from such profits and gains of an amount equal to twenty per cent thereof. (2) This section applies to any small-scale industrial undertaking which fulfils all the following conditions, namely: — (i) it begins to manufacture or produce articles after the 30th day of September 1977 but before the 1st day of April 1990, in any rural area; (ii) it is not formed by the splitting up, or the reconstruction, of a business already in existence: Provided that this condition shall not apply in respect of any small-scale industrial undertaking which is formed as a result of the re-establishment, reconstruction or revival by the assessee of the business of any such industrial undertaking as is referred to in section 33B, in the circumstances and within the period specified in that section ; 175 CU IDOL SELF LEARNING MATERIAL (SLM)
(iii) it is not formed by the transfer to a new business of machinery or plant previously used for any purpose; (iv) it employs ten or more workers in a manufacturing process carried on with the aid of power, or employs twenty or more workers in a manufacturing process carried on without the aid of power. Explanation. —Where in the case of a small-scale industrial undertaking, any machinery or plant or any part thereof previously used for any purpose is transferred to a new business and the total value of the machinery or plant or part so transferred does not exceed twenty per cent of the total value of the machinery or plant used in the business, then, for the purposes of clause (iii) of this sub-section, the condition specified therein shall be deemed to have been fulfilled. (3) The deduction specified in sub-section (1) shall be allowed in computing the total income of each of the ten previous years beginning with the previous year in which the industrial undertaking begins to manufacture or produce articles: Provided that such deduction shall not be allowed in computing the total income of any of the ten previous years aforesaid in respect of which the industrial undertaking is not a small-scale industrial undertaking within the meaning of clause (b) of the Explanation below sub-section (4) Where the assessee is a person, other than a company or a co-operative society, the deduction under sub-section (1) shall not be admissible unless the accounts of the small-scale industrial undertaking for the previous year relevant to the assessment year for which the deduction is claimed have been audited by an accountant as defined in the Explanation below sub-section (2) of section 288 and the assessee furnishes, along with his return of income, the report of such audit in the prescribed form duly signed and verified by such accountant. (5) The provisions of sub-sections (6) and (7) of section 80HH shall, so far as may be, apply in relation to the computation of the profits and gains of a small-scale industrial undertaking for the purposes of the deduction under this section as they apply in relation to the computation of the profits and gains of an industrial undertaking for the purposes of the deduction under that section. (6) In a case where the assessee is entitled also to the deduction under section 80-I or section 80J in relation to the profits and gains of a small-scale industrial undertaking to which this section applies, effect shall first be given to the provisions of this section. 176 CU IDOL SELF LEARNING MATERIAL (SLM)
(7) Where a deduction in relation to the profits and gains of a small-scale industrial undertaking to which section 80HH applies is claimed and allowed under that section for any assessment year, deduction in relation to such profits and gains shall not be allowed under this section for the same or any other assessment year. (8) Nothing contained in this section shall apply in relation to any small-scale industrial undertaking engaged in mining. Explanation. —For the purposes of this section, — (a) \"rural area\" means any area other than— (i) an area which is comprised within the jurisdiction of a municipality (whether known as a municipality, municipal corporation, notified area committee, town area committee, town committee or by any other name) or a cantonment board and which has a population of not less than ten thousand according to the last preceding census of which the relevant figures have been published before the first day of the previous year; or (ii) an area within such distance, not being more than fifteen kilometres from the local limits of any municipality or cantonment board referred to in sub-clause (i), as the Central Government may, having regard to the stage of development of such area (including the extent of, and scope for, urbanisation of such area) and other relevant considerations specify in this behalf by notification in the Official Gazette; (b) an industrial undertaking shall be deemed to be a small-scale industrial undertaking which is, on the last day of the previous year, regarded as a small-scale industrial undertaking under section 11B of the Industries (Development and Regulation) Act, 1951 (65 of 1951). 10.8 SUMMARY • Successful tax planning for business deductions pre-supposes a clear and thorough understanding of the various statutory provisions governing the deductions and an awareness of the statutory rights as well. • One of the important aspects of tax planning would be to see that the maximum deduction or allowance is obtained in the earliest possible time for the purpose of determination of taxable income. • ICDS IX on Borrowing Costs deals with the treatment of borrowing costs. It requires borrowing costs which are directly attributable to the acquisition, construction, or production of a qualifying asset to be capitalized as part of the cost of that asset. • An expenditure is regarded as being of a capital nature if it results in the acquisition of an asset or of an advantage or benefit of an enduring nature. • The concept of ‘commercial expediency’ helps a taxpayer in insisting that a reasonable view is taken of his right to deduct normal expenditure. 177 CU IDOL SELF LEARNING MATERIAL (SLM)
10.9 KEYWORDS • ICDS- Income computation and disclosure standards • CIT- Commissioner of Income Tax • Capitalization - the conversion of income or assets into capital 10.10 LEARNING ACTIVITY 1. List the ICDS issued in India. ___________________________________________________________________________ ___________________________________________________________________________ 10.11 UNIT END QUESTIONS A.Descriptive Questions Short Questions 1. In order to qualify for deduction under the provisions of Sec 37 of Income tax Act 1961, certain important conditions have to be fulfilled Explain. 2. Explain the term “Qualifying Asset” 3. Explain the concept of commercial expediency’ Long Questions 1. Elaborately discuss about various business deductions given in Income Tax Act 2. Discuss the provisions of Sec 80HHA of the Income Tax Act 1961 3. Discuss about General considerations for in Tax planning for business deductions 4. Explain what are capital and revenue items and its impact on Tax planning B. Multiple choice Questions 178 1. Interest on borrowed capital till the date on which the asset is put to use shall be a. Allowed as deduction b. Added to the cost of the asset c. Both (a) and (b) d. None of these 2. Qualifying asset means a. Land and Building b. Know-how, patents, copyrights CU IDOL SELF LEARNING MATERIAL (SLM)
c. Inventories that require a period of 12 months to bring them to saleable condition d. All of these 3. ICDS IX deals with a. Construction contracts b. Inventories c. Borrowing costs d. None of these 4. An expenditure is liable to be disallowed if it is a. Personal nature b. Capital nature c. Both (a) and (b) d. None of these 5. Under mercantile system, the expenditure is claimed as deduction when a. It is incurred b. It is paid c. In the subsequent year d. None of these Answers 1-d 2-d 3-c 4-c 5-a 10.12 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. 179 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 11: SPECIAL PROVISIONS Structure 11.0. Learning Objectives 11.1. Introduction 11.2. SEZ Zones 11.3. EOU 11.4. Set off and Carry forward of losses in case of Amalgamation and demerger 11.5. Summary 11.6. Keywords 11.7. Learning activity 11.8. Unit End Questions 11.9. References 11.0 LEARNING OBJECTIVES After studying this unit students will be able to: • Explain about SEZ and EPZ Zones • Learn about Tax benefits of SEZ and EOU • Describe the special provisions in IT Act relating to SEZ and EOU • Describe provisions relating to Set off and Carry Forward of losses in case of Amalgamation and demerger 11.1 INTRODUCTION In India Special Economic Zones (SEZ) Act were passed during the year 2005. The Act intended to make SEZs an engine for economic growth supported by quality infrastructure complemented by an attractive fiscal package, both at the Centre and the State level, with the minimum possible regulations. Export Processing Zones are specified areas in a country where quotas and tariffs are eliminated in the hope of attracting foreign investments and new business. It can also be defined as production centres which is labour intensive, and which involve the import of raw materials and the export of finished products. The government of India offers many tax incentives to the Export Processing Zones that have been set up in the country 11.2 SPECIAL PROVISIONS IN RESPECT OF NEWLY ESTABLISHED UNITS IN SPECIAL ECONOMIC ZONES. (SEC 10AA.) 180 CU IDOL SELF LEARNING MATERIAL (SLM)
(1) Subject to the provisions of this section, in computing the total income of an assessee, being an entrepreneur as referred to in clause (j) of section 2 of the Special Economic Zones Act, 2005, from his Unit, who begins to manufacture or produce articles or things or provide any services during the previous year relevant to any assessment year commencing on or after the 1st day of April, 2006, but before the first day of April, 2021, the following deduction shall be allowed— (i) hundred per cent of profits and gains derived from the export, of such articles or things or from services for a period of five consecutive assessment years beginning with the assessment year relevant to the previous year in which the Unit begins to manufacture or produce such articles or things or provide services, as the case may be, and fifty per cent of such profits and gains for further five assessment years and thereafter; (ii) for the next five consecutive assessment years, so much of the amount not exceeding fifty per cent of the profit as is debited to the profit and loss account of the previous year in respect of which the deduction is to be allowed and credited to a reserve account (to be called the \"Special Economic Zone Re-Investment Reserve Account\") to be created and utilized for the purposes of the business of the assessee in the manner laid down in sub-section (2). Explanation. — For the removal of doubts, it is hereby declared that the amount of deduction under this section shall be allowed from the total income of the assessee computed in accordance with the provisions of this Act, before giving effect to the provisions of this section and the deduction under this section shall not exceed such total income of the assessee.] (2) The deduction under clause (ii) of sub-section (1) shall be allowed only if the following conditions are fulfilled, namely: — (a) the amount credited to the Special Economic Zone Re-Investment Reserve Account is to be utilised— (i) for the purposes of acquiring machinery or plant which is first put to use before the expiry of a period of three years following the previous year in which the reserve was created; and (ii) until the acquisition of the machinery or plant as aforesaid, for the purposes of the business of the undertaking other than for distribution by way of dividends or profits or for remittance outside India as profits or for the creation of any asset outside India; (b) the particulars, as may be specified by the Central Board of Direct Taxes in this behalf, under clause (b) of sub-section (1B) of section 10A have been furnished by the assessee in respect of machinery or plant along with the return of income for the assessment year relevant to the previous year in which such plant or machinery was first put to use. 181 CU IDOL SELF LEARNING MATERIAL (SLM)
(3) Where any amount credited to the Special Economic Zone Re-Investment Reserve Account under clause (ii) of sub-section (1), — (a) has been utilised for any purpose other than those referred to in sub-section (2), the amount so utilised; or (b) has not been utilised before the expiry of the period specified in sub-clause (i) of clause (a) of sub-section (2), the amount not so utilised, shall be deemed to be the profits, — (i) in a case referred to in clause (a), in the year in which the amount was so utilised; or (ii) in a case referred to in clause (b), in the year immediately following the period of three years specified in sub-clause (i) of clause (a) of sub-section (2), and shall be charged to tax accordingly: Provided that where in computing the total income of the Unit for any assessment year, its profits and gains had not been included by application of the provisions of sub-section (7B) of section 10A, the undertaking, being the Unit shall be entitled to deduction referred to in this sub-section only for the unexpired period of ten consecutive assessment years and thereafter it shall be eligible for deduction from income as provided in clause (ii) of sub- section (1). Explanation. —For the removal of doubts, it is hereby declared that an undertaking, being the Unit, which had already availed, before the commencement of the Special Economic Zones Act, 2005, the deductions referred to in section 10A for ten consecutive assessment years, such Unit shall not be eligible for deduction from income under this section: Provided further that where a Unit initially located in any free trade zone or export processing zone is subsequently located in a Special Economic Zone by reason of conversion of such free trade zone or export processing zone into a Special Economic Zone, the period of ten consecutive assessment years referred to above shall be reckoned from the assessment year relevant to the previous year in which the Unit began to manufacture, or produce or process such articles or things or services in such free trade zone or export processing zone : Provided also that where a Unit initially located in any free trade zone or export processing zone is subsequently located in a Special Economic Zone by reason of conversion of such free trade zone or export processing zone into a Special Economic Zone and has completed the period of ten consecutive assessment years referred to above, it shall not be eligible for deduction from income as provided in clause (ii) of sub-section (1) with effect from the 1st day of April, 2006. (4) This section applies to any undertaking, being the Unit, which fulfils all the following conditions, namely: — 182 CU IDOL SELF LEARNING MATERIAL (SLM)
(i) it has begun or begins to manufacture or produce articles or things or provide services during the previous year relevant to the assessment year commencing on or after the 1st day of April, 2006 in any Special Economic Zone; (ii) it is not formed by the splitting up, or the reconstruction, of a business already in existence: Provided that this condition shall not apply in respect of any undertaking, being the Unit, which is formed as a result of the re-establishment, reconstruction or revival by the assessee of the business of any such undertaking as is referred to in section 33B, in the circumstances and within the period specified in that section; (iii) it is not formed by the transfer to a new business, of machinery or plant previously used for any purpose. Explanation. —The provisions of Explanations 1 and 2 to sub-section (3) of section 80- IA shall apply for the purposes of clause (iii) of this sub-section as they apply for the purposes of clause (ii) of that sub-section. (5) Where any undertaking being the Unit which is entitled to the deduction under this section is transferred, before the expiry of the period specified in this section, to another undertaking, being the Unit in a scheme of amalgamation or demerger, — (a) no deduction shall be admissible under this section to the amalgamating or the demerged Unit, being the company for the previous year in which the amalgamation or the demerger takes place; and (b) the provisions of this section shall, as they would have applied to the amalgamating or the demerged Unit being the company as if the amalgamation or demerger had not taken place. (6) Loss referred to in sub-section (1) of section 72 or sub-section (1) or sub-section (3) of section 74, in so far as such loss relates to the business of the undertaking, being the Unit shall be allowed to be carried forward or set off. (7) For the purposes of sub-section (1), the profits derived from the export of articles or things or services (including computer software) shall be the amount which bears to the profits of the business of the undertaking, being the Unit, the same proportion as the export turnover in respect of such articles or things or services bears to the total turnover of the business carried on by the undertaking: Provided that the provisions of this sub-section [as amended by section 6 of the Finance (No. 2) Act, 2009 (33 of 2009)] shall have effect for the assessment year beginning on the 1st day of April, 2006 and subsequent assessment years. 183 CU IDOL SELF LEARNING MATERIAL (SLM)
(8) The provisions of sub-sections (5) and (6) of section 10A shall apply to the articles or things or services referred to in sub-section (1) as if— (a) for the figures, letters and word \"1st April, 2001\", the figures, letters and word \"1st April, 2006\" had been substituted; (b) for the word \"undertaking\", the words \"undertaking, being the Unit\" had been substituted. (9) The provisions of sub-section (8) and sub-section (10) of section 80-IA shall, so far as may be, apply in relation to the undertaking referred to in this section as they apply for the purposes of the undertaking referred to in section 80-IA. (10) Where a deduction under this section is claimed and allowed in respect of profits of any of the specified business, referred to in clause (c) of sub-section (8) of section 35AD, for any assessment year, no deduction shall be allowed under the provisions of section 35AD in relation to such specified business for the same or any other assessment year. Explanation 1. —For the purposes of this section, — (i) \"export turnover\" means the consideration in respect of export by the undertaking, being the Unit of articles or things or services received in, or brought into, India by the assessee but does not include freight, telecommunication charges or insurance attributable to the delivery of the articles or things outside India or expenses, if any, incurred in foreign exchange in rendering of services (including computer software) outside India; (ii) \"export in relation to the Special Economic Zones\" means taking goods or providing services out of India from a Special Economic Zone by land, sea, air, or by any other mode, whether physical or otherwise; (iii) \"manufacture\" shall have the same meaning as assigned to it in clause (r) of section 2 of the Special Economic Zones Act, 2005; (iv) \"relevant assessment year\" means any assessment year falling within a period of fifteen consecutive assessment years referred to in this section; (v) \"Special Economic Zone\" and \"Unit\" shall have the same meanings as assigned to them under clauses (za) and (zc) of section 2 of the Special Economic Zones Act, 2005. Explanation 2. —For the removal of doubts, it is hereby declared that the profits and gains derived from on site development of computer software (including services for development of software) outside India shall be deemed to be the profits and gains derived from the export of computer software outside India. 11.3 SPECIAL PROVISIONS IN RESPECT OF NEWLY ESTABLISHED HUNDRED PER CENT EXPORT-ORIENTED UNDERTAKINGS. (SEC 10B). 184 CU IDOL SELF LEARNING MATERIAL (SLM)
(1) Subject to the provisions of this section, a deduction of such profits and gains as are derived by a hundred per cent export-oriented undertaking from the export of articles or things or computer software for a period of ten consecutive assessment years beginning with the assessment year relevant to the previous year in which the undertaking begins to manufacture or produce articles or things or computer software, as the case may be, shall be allowed from the total income of the assessee: Provided that where in computing the total income of the undertaking for any assessment year, its profits and gains had not been included by application of the provisions of this section as it stood immediately before its substitution by the Finance Act, 2000, the undertaking shall be entitled to the deduction referred to in this sub-section only for the unexpired period of aforesaid ten consecutive assessment years: Provided further that for the assessment year beginning on the 1st day of April, 2003, the deduction under this sub-section shall be ninety per cent of the profits and gains derived by an undertaking from the export of such articles or things or computer software: Provided also that no deduction under this section shall be allowed to any undertaking for the assessment year beginning on the 1st day of April, 2012 and subsequent years: Provided also that no deduction under this section shall be allowed to an assessee who does not furnish a return of his income on or before the due date specified under sub-section (1) of section 139. (2) This section applies to any undertaking which fulfils all the following conditions, namely: — (i) it manufactures or produces any articles or things or computer software; (ii) it is not formed by the splitting up, or the reconstruction, of a business already in existence: Provided that this condition shall not apply in respect of any undertaking which is formed as a result of the re-establishment, reconstruction or revival by the assessee of the business of any such undertaking as is referred to in section 33B, in the circumstances and within the period specified in that section ; (iii) it is not formed by the transfer to a new business of machinery or plant previously used for any purpose. Explanation. —The provisions of Explanation 1 and Explanation 2 to sub-section (2) of section 80-I shall apply for the purposes of clause (iii) of this sub-section as they apply for the purposes of clause (ii) of that sub-section. 185 CU IDOL SELF LEARNING MATERIAL (SLM)
(3) This section applies to the undertaking, if the sale proceeds of articles or things or computer software exported out of India are received in, or brought into, India by the assessee in convertible foreign exchange, within a period of six months from the end of the previous year or, within such further period as the competent authority may allow in this behalf. Explanation 1. —For the purposes of this sub-section, the expression \"competent authority\" means the Reserve Bank of India or such other authority as is authorised under any law for the time being in force for regulating payments and dealings in foreign exchange. Explanation 2. —The sale proceeds referred to in this sub-section shall be deemed to have been received in India where such sale proceeds are credited to a separate account maintained for the purpose by the assessee with any bank outside India with the approval of the Reserve Bank of India. (4) For the purposes of sub-section (1), the profits derived from export of articles or things or computer software shall be the amount which bears to the profits of the business of the undertaking, the same proportion as the export turnover in respect of such articles or things or computer software bears to the total turnover of the business carried on by the undertaking. (5) The deduction under sub-section (1) shall not be admissible for any assessment year beginning on or after the 1st day of April, 2001, unless the assessee furnishes in the prescribed form, along with the return of income, the report of an accountant, as defined in the Explanation below sub-section (2) of section 288, certifying that the deduction has been correctly claimed in accordance with the provisions of this section. (6) Notwithstanding anything contained in any other provision of this Act, in computing the total income of the assessee of the previous year relevant to the assessment year immediately succeeding the last of the relevant assessment years, or of any previous year, relevant to any subsequent assessment year, — (i) section 32, section 32A, section 33, section 35 and clause (ix) of sub-section (1) of section 36 shall apply as if every allowance or deduction referred to therein and relating to or allowable for any of the relevant assessment years 59[ending before the 1st day of April, 2001], in relation to any building, machinery, plant or furniture used for the purposes of the business of the undertaking in the previous year relevant to such assessment year or any expenditure incurred for the purposes of such business in such previous year had been given full effect to for that assessment year itself and accordingly sub-section (2) of section 32, clause (ii) of sub-section 186 CU IDOL SELF LEARNING MATERIAL (SLM)
(3) of section 32A, clause (ii) of sub-section (2) of section 33, sub-section (4) of section 35 or the second proviso to clause (ix) of sub-section (1) of section 36, as the case may be, shall not apply in relation to any such allowance or deduction; (ii) no loss referred to in sub-section (1) of section 72 or sub-section (1) or sub-section (3) of section 74, in so far as such loss relates to the business of the undertaking, shall be carried forward or set-off where such loss relates to any of the relevant assessment years ending before the 1st day of April, 2001; (iii) no deduction shall be allowed under section 80HH or section 80HHA or section 80- I or section 80-IA or section 80-IB in relation to the profits and gains of the undertaking; and (iv) in computing the depreciation allowance under section 32, the written down value of any asset used for the purposes of the business of the undertaking shall be computed as if the assessee had claimed and been actually allowed the deduction in respect of depreciation for each of the relevant assessment year. (7) The provisions of sub-section (8) and sub-section (10) of section 80-IA shall, so far as may be, apply in relation to the undertaking referred to in this section as they apply for the purposes of the undertaking referred to in section 80-IA. (7A) Where any undertaking of an Indian company which is entitled to the deduction under this section is transferred, before the expiry of the period specified in this section, to another Indian company in a scheme of amalgamation or demerger— (a) no deduction shall be admissible under this section to the amalgamating or the demerged company for the previous year in which the amalgamation or the demerger takes place; and (b) the provisions of this section shall, as far as may be, apply to the amalgamated or resulting company as they would have applied to the amalgamating or the demerged company if the amalgamation or the demerger had not taken place. (8) Notwithstanding anything contained in the foregoing provisions of this section, where the assessee, before the due date for furnishing the return of income under sub-section (1) of section 139, furnishes to the Assessing Officer a declaration in writing that the provisions of this section may not be made applicable to him, the provisions of this section shall not apply to him for any of the relevant assessment year. Explanation 2. —For the purposes of this section, — 187 (i) \"Computer software\" means— CU IDOL SELF LEARNING MATERIAL (SLM)
(a) Any computer programme recorded on any disc, tape, perforated media or other information storage device; or (b) Any customized electronic data or any product or service of similar nature as may be notified by the Board, which is transmitted or exported from India to any place outside India by any means; (ii) \"convertible foreign exchange\" means foreign exchange which is for the time being treated by the Reserve Bank of India as convertible foreign exchange for the purposes of 65a[the Foreign Exchange Management Act, 1999 (42 of 1999)], and any rules made thereunder or any other corresponding law for the time being in force; (iii) \"export turnover\" means the consideration in respect of export 66[by the undertaking] of articles or things or computer software received in, or brought into, India by the assessee in convertible foreign exchange in accordance with sub-section (3), but does not include freight, telecommunication charges or insurance attributable to the delivery of the articles or things or computer software outside India or expenses, if any, incurred in foreign exchange in providing the technical services outside India; (iv) \"hundred per cent export-oriented undertaking\" means an undertaking which has been approved as a hundred per cent export-oriented undertaking by the Board appointed in this behalf by the Central Government in exercise of the powers conferred by section 1467 of the Industries (Development and Regulation) Act, 1951 (65 of 1951), and the rules made under that Act; (v) \"Relevant assessment years\" means any assessment years falling within a period of ten consecutive assessment years, referred to in this section.] Explanation 3. —For the removal of doubts, it is hereby declared that the profits and gains derived from on site development of computer software (including services for development of software) outside India shall be deemed to be the profits and gains derived from the export of computer software outside India. Explanation 4. —For the purposes of this section, \"manufacture or produce\" shall include the cutting and polishing of precious and semi-precious stones. 11.4 PROVISIONS RELATING TO CARRY FORWARD AND SET OFF OF ACCUMULATED LOSS AND UNABSORBED DEPRECIATION ALLOWANCE IN AMALGAMATION OR DEMERGER, ETC. (SEC 72A). 188 CU IDOL SELF LEARNING MATERIAL (SLM)
(1) Where there has been an amalgamation of— (a) a company owning an industrial undertaking or a ship or a hotel with another company; or (b) a banking company referred to in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949)27 with a specified bank; or (c) one or more public sector company or companies engaged in the business of operation of aircraft with one or more public sector company or companies engaged in similar business, then, notwithstanding anything contained in any other provision of this Act, the accumulated loss and the unabsorbed depreciation of the amalgamating company shall be deemed to be the loss or, as the case may be, allowance for unabsorbed depreciation of the amalgamated company for the previous year in which the amalgamation was effected, and other provisions of this Act relating to set off and carry forward of loss and allowance for depreciation shall apply accordingly. (2) Notwithstanding anything contained in sub-section (1), the accumulated loss shall not be set off or carried forward and the unabsorbed depreciation shall not be allowed in the assessment of the amalgamated company unless— (a) The amalgamating company— (i) Has been engaged in the business, in which the accumulated loss occurred, or depreciation remains unabsorbed, for three or more years; (ii) Has held continuously as on the date of the amalgamation at least three-fourths of the book value of fixed assets held by it two years prior to the date of amalgamation. (b) The amalgamated company— (i) holds continuously for a minimum period of five years from the date of amalgamation at least three-fourths of the book value of fixed assets of the amalgamating company acquired in a scheme of amalgamation. (ii) Continues the business of the amalgamating company for a minimum period of five years from the date of amalgamation. (iii) Fulfils such other conditions as may be prescribed to ensure the revival of the business of the amalgamating company or to ensure that the amalgamation is for genuine business purpose. (3) In a case where any of the conditions laid down in sub-section (2) are not complied with, the set off of loss or allowance of depreciation made in any previous year in the hands of the amalgamated company shall be deemed to be the income of the amalgamated company chargeable to tax for the year in which such conditions are not complied with. 189 CU IDOL SELF LEARNING MATERIAL (SLM)
(4) Notwithstanding anything contained in any other provisions of this Act, in the case of a demerger, the accumulated loss and the allowance for unabsorbed depreciation of the demerged company shall— (a) where such loss or unabsorbed depreciation is directly relatable to the undertakings transferred to the resulting company, be allowed to be carried forward and set off in the hands of the resulting company. (b) where such loss or unabsorbed depreciation is not directly relatable to the undertakings transferred to the resulting company, be apportioned between the demerged company and the resulting company in the same proportion in which the assets of the undertakings have been retained by the demerged company and transferred to the resulting company and be allowed to be carried forward and set off in the hands of the demerged company or the resulting company, as the case may be. (5) The Central Government may, for the purposes of this Act, by notification in the Official Gazette, specify such conditions as it considers necessary to ensure that the demerger is for genuine business purposes. (6) Where there has been reorganisation of business, whereby, a firm is succeeded by a company fulfilling the conditions laid down in clause (xiii) of section 47 or a proprietary concern is succeeded by a company fulfilling the conditions laid down in clause (xiv) of section 47, then, notwithstanding anything contained in any other provision of this Act, the accumulated loss and the unabsorbed depreciation of the predecessor firm or the proprietary concern, as the case may be, shall be deemed to be the loss or allowance for depreciation of the successor company for the purpose of previous year in which business reorganisation was effected and other provisions of this Act relating to set off and carry forward of loss and allowance for depreciation shall apply accordingly: Provided that if any of the conditions laid down in the proviso to clause (xiii) or the proviso to clause (xiv) to section 47 are not 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 such conditions are not complied with. (6A) Where there has been reorganisation of business whereby a private company or unlisted public company is succeeded by a limited liability partnership fulfilling the conditions laid down in the proviso to clause (xiiib) of section 47, then, notwithstanding anything contained in any other provision of this Act, the accumulated loss and the unabsorbed depreciation of the predecessor company, shall be deemed to be the loss or allowance for depreciation of the successor limited liability partnership for the purpose of the previous year in which business 190 CU IDOL SELF LEARNING MATERIAL (SLM)
reorganisation was effected and other provisions of this Act relating to set off and carry forward of loss and allowance for depreciation shall apply accordingly : Provided that if any of the conditions laid down in the proviso to clause (xiiib) of section 47 are not complied with, the set off of loss or allowance of depreciation made in any previous year in the hands of the successor limited liability partnership, shall be deemed to be the income of the limited liability partnership chargeable to tax in the year in which such conditions are not complied with.] (7) For the purposes of this section, — (a) “accumulated loss” means so much of the loss of the predecessor firm or the proprietary concern or the private company or unlisted public company before conversion into limited liability partnership or the amalgamating company or the demerged company, as the case may be, under the head “Profits and gains of business or profession” (not being a loss sustained in a speculation business) which such predecessor firm or the proprietary concern or the company or amalgamating company or demerged company, would have been entitled to carry forward and set off under the provisions of section 72 if the reorganisation of business or conversion or amalgamation or demerger had not taken place;] (aa) “industrial undertaking” means any undertaking which is engaged in— (i) the manufacture or processing of goods; or (ii) the manufacture of computer software; or (iii) the business of generation or distribution of electricity or any other form of power; or (iiia) the business of providing telecommunication services, whether basic or cellular, including radio paging, domestic satellite service, network of trunking, broadband network and internet services; or] (iv) mining; or (v) the construction of ships, aircrafts or rail systems;] (b) “unabsorbed depreciation” means so much of the allowance for depreciation of the predecessor firm or the proprietary concern or the private company or unlisted public company before conversion into limited liability partnership or the amalgamating company or the demerged company, as the case may be, which remains to be allowed and which would have been allowed to the predecessor firm or the proprietary concern or the company or amalgamating company or demerged company, as the case may be, under the provisions of this Act, if the reorganisation of business or conversion or amalgamation or demerger had not taken place; 191 CU IDOL SELF LEARNING MATERIAL (SLM)
(c) “specified bank” means the State Bank of India constituted under the State Bank of India Act, 1955 (23 of 1955) or a subsidiary bank as defined in the State Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959) or a corresponding new bank constituted under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970) or under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980). 11.5 SUMMARY • Special economic zones (SEZs) in India are areas that offer incentives to resident businesses. • SEZs typically offer competitive infrastructure, duty free exports, tax incentives, and other measures designed to make it easier to conduct business. • Export-oriented units are units undertaking to export their entire production of goods. • EOUs can engage in manufacturing, services, development of software, repair, remaking, reconditioning, re-engineering including making of gold/silver/platinum Jewelry and articles. • A loss carryforward refers to an accounting technique that applies the current year's net operating loss (NOL) to future years' net income to reduce tax liability. • Special provisions for amalgamation or demerger: • In the case of amalgamation, such deduction would continue to be admissible to the amalgamated company as if the amalgamation had not taken place. Likewise, in case of demerger where such deduction can be availed of by the resulting company as if the demerger had not taken place. Further, no deduction will be admissible to the amalgamating/ demerged company in the year of amalgamation/ demergers 11.6 KEYWORDS • Amalgamation- In an amalgamation, two or more companies are combined into one by merger or by one taking over the other. Therefore, the term ‘amalgamation’ contemplates two kinds of activities: (i) two or more companies join to form a new company or (ii) absorption and blending of one by the other • Demerger- A de-merger (or \"demerger\") allows a large company, such as a conglomerate, to split off its various brands or business units 11.7 LEARNING ACTIVITY 1. Learn about Slump sale and its tax implications ___________________________________________________________________________ __________________________________________________________________________ 192 CU IDOL SELF LEARNING MATERIAL (SLM)
2. Learn the difference between SEZ and EPZ ___________________________________________________________________________ ___________________________________________________________________________ 11.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Write a short note about allowability of deductions in case of Amalgamation 2. Explain briefly about carry forward of losses in case of Amalgamation 3. Explain tax implications of 100% export-oriented units 4. Explain the consequences of Amalgamation and demerger with respect to Tax deductions 5. Discuss the deduction part of 100% EOUs. Long Questions 1. Discuss the tax implications of Amalgamated Company and its share holders 2. Discuss about the capital gains tax implication on disposal of shares of Amalgamated company 3. Sai Ltd. has a block of assets carrying 15% rate of depreciation, whose written down value on 01.04.2020 was Rs.40 lacs. It purchased another asset (second-hand plant and machinery) of the same block on 01.11.2020 for Rs.14.40 lacs and put to use on the same day. Sai Ltd. was amalgamated with Shirdi Ltd. with effect from 01.01.2021.You are required to compute the depreciation allowable to Sai Ltd. & Shirdi Ltd. for the previous year ended on 31.03.2021 assuming that the assets were transferred to Shirdi Ltd. At Rs.60 lacs. Also assume that the plant and machinery were purchased by way of account payee cheque. 4. What are the key tax benefits of SEZ units? 5. Special Provision in respect of Newly Established Undertakings in 100% Export oriented Units B. Multiple choice Questions 1. In case of an 100% EOU the profits derived from such a unit will be allowed as deduction for a period of a. 5 years b. 10 years c. 3 years d. None of these 193 CU IDOL SELF LEARNING MATERIAL (SLM)
2. In the case of a demerger, the accumulated loss and the allowance for unabsorbed depreciation of the demerged company shall be, where such loss or unabsorbed depreciation is not directly relatable to the undertakings transferred to the resulting company a. Be allowed to be carried forward and set off in the hands of the resulting company. b. Be apportioned between the demerged company and the resulting company c. Both a and b d. None of these 3. The direct tax exemption in case of an entity in SEZ is a. 100% exemption of Income Tax b. 50% exemption of Income Tax c. 25% exemption of Income Tax d. None of these 4. \"Computer software\" means— a. any computer programme recorded on any disc, tape, perforated media or other information storage device b. any customized electronic data or any product or service of similar nature as may be notified by the Board c. Both (a) and (b) d. None of these. 5. Under section 10A, the deduction allowed for the first five consecutive years are a. 100% of profits and gains derived from the export b. 50% of profits and gains derived from the export c. 150% of profits and gains derived from the export d. None of these Answers 1-b 2-b 3-a 4-c 5-a 11.9 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. 194 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 12: TAXATION OF NON-RESIDENTS Structure 12.0 Learning Objectives 12.1 Introduction 12.2 Make or buy decision 12.3 Own or lease 12.4 Lease Rent 12.5 Replace or retain 12.6 Summary 12.7 Learning activity 12.8 Keywords 12.9 Unit End Questions 12.10 References 12.0 LEARNING OBJECTIVES After studying this unit students will be able to • State the tax implications on maker or buy decisions • Learn the tax implications on own or lease transactions • Explain the tax implications in replace are retained decisions 12.1 INTRODUCTION Though management/ investment decisions are not based on the tax factor alone, yet it has become imperative to consider tax factors before adopting any course of action because the effect of this factor is not only significant but it may also differ from one alternative to another. Tax Planning with regard to specific management decisions: 12.2 MAKE OR BUY DECISION In making ‘make or buy’ decisions, the variable cost of making the product or part/component of product is compared with its purchase price in the market. The article is brought if the former is greater than the latter. Alternatively, if the decision to make involves establishment of a separate industrial unit for this purpose, a decision may be taken on the basis of total cost rather than variable cost. In such an event, the assessee would also be in a position to get the tax benefits arising from allowances such as depreciation, tax holiday benefit and deduction in respect of profits from new industrial undertakings, wherever they are applicable. 195 CU IDOL SELF LEARNING MATERIAL (SLM)
There are many other costing and non-costing considerations which are kept in mind at the time of taking the decision, like capacity utilisation, supply position of the article to be bought, terms of purchase, etc. The basis of taking make or buy decision should be ‘saving after tax’. The net saving can be ascertained after deducting from gross savings, income-tax payable on the amount of saving. The long-term advantages arising out of a decision to make should also be given due weightage in arriving at a decision. At the time of ascertaining variable cost of the product (for taking make or buy decision) all taxes such as GST, customs duty etc., payable in the process of manufacture should be taken into account and in determining purchase price of the product. All taxes to be borne by the purchaser should be added for the purpose of comparison and cost of purchasing. 12.3 OWN OR LEASE Another important area of decision making is whether to own or lease (or sale and lease back). There are advantages as well as disadvantages in leasing. Leasing avoids ownership and with it, the accompanying risks of obsolescence and terminal value losses. In leasing, immediate payment of capital costs is avoided but fixed rental obligation arises. There are many factors which are required to be considered before making ‘own or lease’ decision such as cost of asset to be owned, rent of the asset to be taken on lease, source of financing the asset, risk involved in the alternatives, impact of tax concessions such as depreciation, tax holiday benefit, etc. Leasing can also provide important tax advantages. If the asset is taken on lease, the firm can deduct for income-tax purposes, the entire rental payment. If the rate of tax is 30%, then, the effective rent obligation is reduced to that extent. Another tax advantage of the lease is that the life of the lease can be shortened compared to the depreciable life otherwise allowed if the assessee purchased the asset. Thus, there is a delay in paying taxes and in effect an interest free loan by the Government to the extent of the delay in taxes. There is one more tax advantage arising out of lease which arises from the opportunity to depreciate otherwise non- depreciable assets. The principal asset of this type is land. The lease rental covers the cost of the land which thus becomes deductible. This arrangement may prove particularly attractive where the land value constitutes a high percentage of the total value of the real estate or where the building is already fully depreciated. Leasing is becoming popular in India. For purpose of decision making in a lease or own situation, for comparison purpose the lease rentals for each separate year should be converted into present value of today’s cost. Wherever possible or appropriate, the concept of sale and lease back can also be made use of as a tool for tax planning with its attendant advantages. 12.4 LEASE RENT PAID 196 CU IDOL SELF LEARNING MATERIAL (SLM)
As regards the consideration for the lease, there could be two types of receipts in the hands of the lessor-receipt on capital account termed ‘premium’ or ‘salami’ in respect of the transfer of rights and receipts on revenue account termed ‘rent’ for the right or liberty to use the property for a term of years. The lease rental paid is chargeable to revenue every year. The lease rental may be split into three components—the recovery of principal, cost, the interest chargeable and an element of profit. It is generally believed that the interest rate in-built into the rent would be more than the going market interest rate for term loans for purchase of equipment. Since the entire lease rental is chargeable to revenue the lessee could claim tax benefits on even the principal investment in the equipment. Tax advantage in such cases is reported to be more in a leasing transaction than in a similar loaning transaction. 12.5 RETAIN OR REPLACE DECISION One of the important decisions which involves alternative choice is whether or not to buy new capital equipment. Both have their own merits and demerits. Generally, replacement offers cost saving which results in increase in profit. However, replacement requires investment of large funds resulting in extra cost. The decision is based on the relative profitability and other financial and non-financial considerations. Tax considerations should also be taken into account in this context. Some of the important considerations from the tax angle to which attention will have to be paid relate to the allowance of depreciation, as also the allowance on account of expenditure on scientific research. The applicability of the provisions for allowances should be considered and their impact ascertained before any decision is taken. 12.6 SUMMARY • An important area of decision making is whether to own or lease. • Important decisions which involve alternatives whether to buy new capital equipment. Such decision is called Retain or Replace Decision. • In making ‘make or buy’ decisions, the variable cost of making the product or part/component of product is compared with its purchase price in the market. • If the decision to make involves establishment of a separate industrial unit for this purpose, a decision may be taken based on total cost rather than variable cost. • for the lease, there could be two types of receipts in the hands of the lessor-receipt on capital account termed ‘premium’ or ‘salami’ in respect of the transfer of rights and receipts on revenue account termed ‘rent’ for the right. 12.7 KEYWORDS • Variable cost- Cost which varies with output 197 CU IDOL SELF LEARNING MATERIAL (SLM)
• Sale and lease back- Sale and Leaseback is a simple financial transaction which allows a person to lease an asset to himself after selling it 12.8 LEARNING ACTIVITY 1. Know the difference between operating Lease and Finance lease and its Tax implications ___________________________________________________________________________ ___________________________________________________________________________ 12.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain briefly about Own or lease decision and its Tax implications 2. G Ltd. Planned to buy a machinery to manufacture a component for its assembly operations instead of buying it from the market and to avail tax benefit on account of depreciation on machinery. Is the decision of G Ltd, correct? Explain. 3. Explain the Tax implications of Make or buy decisions. 4. Write a short note on tax implications on dividend policy. 5. What do you understand by capital structure decisions? Long Questions 1. R Ltd., a manufacturing company needs a generator for its activities. The cost is Rs.1, 00,000. On making enquiries, it is learnt that the company has two options. Option 1: Buying the asset by taking a loan of Rs.1,00,000 repayable in five equal instalments of Rs.20,000 each along with interest @ 12% p.a. Option 2: Leasing the asset for which annual lease rental is Rs.30,000 up to 5 years. The lessor charges 1% processing fees in first year. As the Tax Manager advise the company management on which option should be selected. Additional Information: • Tax rate applicable to the company is 30.9%. • The Depreciation Rate is 15% (plus additional depreciation: 20%). • Assuming internal rate of return 10% for present value factor. PVF Table is given below @ 10% for next 5 years. Year 1 Year 2 Year 3 Year 4 Year 5 0.909 0.826 0.751 0.683 0.621 2. An assessee, who carries on a business, acquires a machinery costing Rs.1,00,000. This machinery has a life of 5years. Decide which one is a better alternative – buy or lease – in the following situation: 198 CU IDOL SELF LEARNING MATERIAL (SLM)
The Rate of Depreciation is 15%. Tax Rate: 30.9% Cost of Capital: 14% In case, the machinery is taken on LEASE: Lease Cost: Rs.34000 per annum for 5 years. PVF table is given below @ 14% for next 5 years. Year 1 Year 2 Year 3 Year 4 Year 5 0.877 0.769 0.675 0.592 0.519 3. What are the factors management should keep in mind in taking decision to lease or own? 4. Discuss the tax provision in order to optimise the capital structure of firm. B. Multiple Choice Questions 1. When a Machinery is purchased instead of leasing which of the following gives a tax benefit a. Depreciation b. Interest paid on loan to purchase machinery c. Repairs and renewals d. All of these 2. When is a Machinery leased instead of purchase which of the following gives a tax benefit? a. Depreciation b. Interest paid on loan to lease machinery c. Lease rentals d. All of these 3. When is machinery replaced instead of retaining which of the following is a general benefit available? a. Depreciation b. Interest paid on loan to lease machinery c. Reduced repair cost d. All of these 4. Lease rental may be split into a. 2 Components b. 3 Components c. 4 Components d. None of these. Answers 199 CU IDOL SELF LEARNING MATERIAL (SLM)
1-d 2-c 3-c 4-b 12.10 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. 200 CU IDOL SELF LEARNING MATERIAL (SLM)
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