UNIT 2 - IMPLICATIONS OF TAX CONCESSIONS AND INCENTIVES FOR CORPORATE DECISIONS
Setting up a new business: Location of business
1. Full exemption under Section 10A for ten years in the case of a newly established
industrial undertaking in free trade zones, etc. [Not allowed w.e.f. A.Y. 2012-13].
2. Full exemption under Section 10AA for initial five years, 50% for subsequent five
years and further deduction up to 50% on amount credited to a specified reserve
account, for a further period of five years, in the case of a newly established units in
special economic zones on or after 1.4.2006.
3. Full exemption under Section 10B for 10 years in the case of a newly established
100% export-oriented undertaking. [Not allowed w.e.f. 2012-13].
4. Deduction under Section 80-IAB in respect of profits and gains by an undertaking or
an enterprise engaged in the development of Special Economic Zone.
5. Deduction under Section 80-IB in the case of profits and gains from certain industrial
undertaking other than infrastructure development undertaking (production and
refinery of mineral oil & integrated business of handling, storage and transportation of
foodgrains).
6. Deduction under Section 80-IC in case of certain undertaking or enterprises in certain
special category States (Himachal Pradesh and Uttarakhand).
7. Deduction under Section 80-ID in respect of profits and gains from business of hotels
and convention centres in specified area.
8. Deduction under Section 80-IE in respect of certain undertakings in North-Eastern
States.
9. Deduction under section 80LA in respect of certain incomes of Offshore Banking
Units or International Financial Services Centre.
Setting up a new business: Nature of business
1. Income from Tea, Coffee and Rubber is partly taken as agriculture income which is
fully exempt, u/s 10(1). Deductions are also allowed on deposits in Tea, Coffee and
Rubber Development Account u/s 33AB.
2. Capital Expenditure in respect of business of building and operating a new hospital
are eligible for deduction u/s 35AD.
3. Deduction are available u/s 32 for the business of Generation or Generation and
Distribution of Power.
4. Profit and gains of industrial undertakings or enterprises engaged in infrastructure
development, operation and/or maintenance u/s 80-IA.
5. Deductions are available u/s 33ABA in respect of prospecting for, or extraction or
production of Natural Gas.
6. Special provisions for computing profits and gains of business on presumptive basis
u/s 44AD, however deductions u/s 30 to 38 are not allowed.
7. Special provisions in the case of business of plying, hiring or leasing goods carriages
u/s 44AE.
8. Income from qualifying ships may compute income on deemed income basis and tax
benefits are available u/s 115VA to 115VZC.
9. Special provision for deduction in the case of business for prospecting for mineral oil
u/s 42.
10. Special provision for computing profits and gains of shipping business in the case of
non-residents u/s 44B.
11. Special provisions in the case of business of operation of aircraft (u/s 44BBA),
turnkey power projects (u/s 44BBB), royalty income of foreign companies (u/s 44D),
and royalty income of non-residents (u/s 44DA).
12. Deduction u/s 80JJA in respect of profit and gains from business of collecting and
processing of bio-degradable waste.
Capital structure decisions
Capital structure refers to the mix of sources from which funds required for the business are
raised.
1. From tax point of view expenses incurred on raising loans/debentures and interest
payable on loans are deductible in computing taxable income of the assessee. Thus,
borrowings contribute to tax saving resulting in a higher rate of return on owner's
equity. However, if the rate of return on total capital is less than the rate of interest, it
would reduce shareholder’s rate of return. In such cases, minimum loan capital must
be used. And on the contrary, higher borrowed funds may be used subject to other
legalities. However, any amount of interest paid, in respect of a loan for acquisition of
an asset shall not be allowed as a deduction.
2. The expenses incurred on raising capital/share capital and interest on capital/dividend
on share capital are not deductible.
3. Deductions allowed:
● Firm: Interest payable to partners on their capital and loan capital up to 12% p.a.
● Indian company: Expenses incurred on public issue of shares/debentures @ 20%
p.a. for 5 successive P.Y. beginning with the P.Y. in which the business commences.
4. The capital may be utilised for acquisition of non-depreciable assets like land,
goodwill, etc. and borrowed funds may be utilised to acquire depreciable assets. The
interest on loans for the period after setting up of business but before the asset was put
to use will be capitalised and a higher amount of depreciation will be allowed.
5. It is better to use capital rather than loans in industries having longer gestation period.
6. The term 'interest' has been defined u/s 2(28A) liberally. It includes interest as well as
service fee or other charge on loans, whether utilised or not. TDS must be deducted
on interest payments being made outside of India to be eligible for claiming
deductions thereon.
Conclusion: (1) When rate of return on capital is 25% (which is more than rate of interest
10%) the capital structure of company 3 is the best. The company can declare dividend at a
higher rate.
(2) When rate of return on capital is equal to rate of interest, the rate of return on capital is
the same, whether the company takes the loan or issues share capital.
(3) When the rate of return is less than the rate of interest, if the company takes a loan, it
will reduce the rate of return on capital. In the given situation the capital structure of
company 1 is the best.
Dividend Policy
Dividend, in general, means the sum received by a shareholder of a company on the
distribution of its profits, whether in cash or in kind.
Dividend u/s 2(22) includes the following distributions or payments by a company to its
shareholders to the extent of accumulated profits of the company :
(a) Any distribution which entails the release of all or any of the assets of the company;
(b) Any distribution of debentures or deposit certificates or bonus shares to preference
shareholders;
(c) Any distribution on its liquidation;
(d) Any distribution on the reduction of its capital;
(e) Any payment by a closely-held company by way of advance or loan to a shareholder
(being a person who is the beneficial owner of shares) having at least 10% of the voting
power or to any concern in which such shareholder is a member or a partner and in which he
has a substantial interest.
Accumulated Profits
Explanation 1: Includes all profits of the company up to the date of distribution except
capital gains arising before 1st April, 1946 or after 31st March, 1948 and before 1st April,
1956.
Explanation 2: All profits of the company up to distribution or up to the date of liquidation.
However, where the liquidation is due to compulsory acquisition of undertaking by the
Government or a Government company, accumulated profits do not include any profits of the
company prior to three successive years immediately preceding the P.Y. of liquidation.
● Capital gains whenever chargeable to tax are accumulated profits excluding, if any,
additions made by the Assessing Officer.
● However, the amount of loan etc. which has been treated as deemed dividend u/s
2(22)(e) must be deducted from accumulated profits.
Tax Planning relating to Dividends
(1) Normal Dividend: Any dividend declared by a company at its AGM shall be deemed to
be the income of the previous year in which it is so declared.
(2) Deemed Dividend: It is deemed to be the income of the previous year in which it is so
distributed or paid.
(3) Interim Dividend: An interim dividend is one which is declared by a company at any
time prior to its AGM for the year. It is deemed to be the income of the previous year in
which the amount of such dividend is unconditionally made available.
(4) Place of accrual: Dividend paid by an Indian company outside India shall be deemed to
accrue in India.
(6) Dividend received by an Indian shareholder from a foreign company which has
deducted tax at source; but has not paid the same to the GoI, the amount deducted shall not be
included in the dividend income. However, where assessee is entitled to double taxation
relief, the gross dividend shall be included in income.
(7) If dividend for several years is declared in some later year and paid in lump-sum, it shall
be deemed to be the income of the previous year in which they are declared.
(8) Tax rate on Buy-Back: 20% Income tax, 12% Surcharge and 4% H&E Cess. Such
payment is not liable where a listed company made such announcement before 05.07.2019.
Such payment has to be made within 14 days of the payment to the shareholders, failing
which a 1% interest will be chargeable per month. If the assessee doesn't make the payment,
they are deemed to be assessee in default. Income to shareholders due to buy-back is exempt.
(9) Dividends received by the Indian companies from specified foreign companies will be
chargeable at normal rates instead @15% as earlier allowed u/s 115BBD from A.Y. 2023-24.
(10) A domestic company may issue bonus shares in lieu of dividend in cash. Thus avoiding
the tax. However, it will increase tax liability of its shareholders.
(11) Payment made by a closely-held company to a shareholder who is the beneficial owner
(10% ownership) is deemed to be dividends to the extent of accumulated profits. Such a
shareholder should not take loan from the company or ask the company to make payment on
his behalf or for his benefit. Similarly, a concern, in which a shareholder has substantial
interest (20% ownership), should not borrow from the closely-held company. Otherwise, it
will be taxed as deemed dividend in the hands of the lending company. Any advance in
nature of commercial transaction will not be treated as deemed dividend.
(12) Where a loan in the hands of a shareholder mentioned in 11, has been taxed as deemed
dividend, such loan should not be repaid rather it should be adjusted against the future
dividends declared. Thus, the double taxation liability can be avoided.
Bonus Shares
Bonus Shares issued by a company are not deemed as a dividend and are thus not taxable in
hands of the company. Any expenditure incurred by the company on issue of bonus shares is
also deductible.
1. Where bonus shares are issued to the equity shareholders, the value of the shares is not
taxed as dividend distributed. However, where bonus shares are issued to the preference
shareholders, it is deemed to be dividend and liable to tax.
Also, when redeemable preference shares are issued as bonus shares, on their redemption, the
amount shall be taxed as dividend distributed.
2. When a shareholder sells the bonus shares, the cost of bonus shares is taken as nil. Hence,
the whole net consideration (consideration less selling expenses, if any) is treated as
long-term or short-term capital gains, as the case may be.
3. An equity shareholder may transfer his bonus shares after one year from allotment to a
firm or an association of persons as capital contribution. The amount recorded in the books of
firm/AOP for such shares will be the cost of acquisition for the firm/AOP and long-term
capital gains to the transferor. Now, when the firm/AOP will sell these shares as long-term
capital asset it will be entitled to deduct the indexed cost of acquisition instead of nil cost as
applicable to equity shareholder. Conversely, where bonus shares are received by a firm it
may transfer such shares to partners by sale and, the buyer will get the benefit of indexation.
4. A preference shareholder may first convert preference shares into equity shares and
thereafter receive bonus shares.
5. A company may capitalise its profits by converting partly paid shares into fully paid shares
instead of issue of bonus shares. This conversion will not be a deemed dividend. Further, the
benefit of indexation for the price paid by the shareholder will be available from the date of
allotment of shares.
6. If a domestic company distributes dividends to its shareholders, the company is not liable
to pay taxes on such distribution.
7. Instead of Bonus Shares a company can issue bond debentures as the interest paid will be
tax deductible whereas the dividends on shares are not.
Owning or leasing of an asset
Leasing is an arrangement that provides a person with the use and control over an asset, for a
price payable periodically, without having a title of ownership. In case of lease agreement the
owner of the asset is called the lessor and the user is called the lessee.
While deciding whether the asset should be purchased or taken on lease one should keep in
mind the following factors:
1. Cash position: When a person has sufficient cash, or he can borrow funds at a reasonable
rate of interest, he may decide to buy it. The interest on borrowed funds or under hire
purchase/installment system is deductible in computing the income. If he neither has
sufficient cash nor he can borrow, he has to take the asset on lease. The lease rent is
deductible in computing the income.
2. Depreciation: When the asset is purchased or acquired under hire purchase/installment
system, the depreciation is allowed in computing income. When the asset is taken on lease
the depreciation is not allowed to the lessee.
3. Obsolescence risk: When a plant or machinery becomes obsolete, it has to be replaced.
The replacement cost can be met partly out of depreciation fund and partly by arranging
further cash. In case of lease the asset will be replaced by the lessor. However, the lessor will
also keep in mind the risk of obsolescence and increase the lease rent to offset such a loss.
4. Residual Value: When a person purchases an asset, he has full rights to the value of
the asset at the end of any given period. In the case of asset with large residual value it is
better to purchase it rather than taken on lease.
5. Profit margin: Where profit margin is low, it is better to purchase the asset.
6. Consider profit after tax: The assessee should follow such a method for obtaining an
asset which reduces his tax liability and the profits after tax are greater. For this purpose some
people suggest that own funds should not be used in purchase of an asset because interest on
own funds is not deductible in computing the income, whereas interest on borrowed funds is
deductible. But one should keep in mind that if own funds are invested outside the business,
the interest earned will offset the interest payment.
Conclusion: As far as possible the asset should be purchased and not taken on lease because
the cost of use of the asset purchased is less than the cost of lease asset. However, where the
assessee is suffering from a liquidity crunch and cannot invest in an asset nor can he avail
substantial credit from the suppliers or money-lenders, he should take an asset on lease.
Manufacturing or buying
When a business concern requires a product or any part or component of the product for its
existing unit, it has to decide whether it should make it or buy it from other manufacturers.
There are many costing and non-costing considerations guiding the decision towards make or
buy it. Some of the important factors affecting such decision are:
1. Availability of infrastructural facilities.
2. Utilisation of undertaking’s capacity: If not, it can be by making the required product.
3. Availability of adequate funds if an additional unit is required for manufacturing the
required product. Whole production of the unit will be consumed by the concern or there is
market for the sale of extra production.
4. Whether the product is available in the market easily and at reasonable terms.
5. Cost of manufacture of a product/component against cost of purchase.
6. Import trade control regulations and forex control regulations, in case of import.
7. If there is change in technology in production of that product, the concern will be in a
position to acquire the new technology without much difficulty.
8. Nature of product: Product of national security or of strategic importance to a
country/company should always be manufactured regardless of cost.
Tax Considerations
1. If a concern has surplus capacity and even decide to buy a product it may require to sell a
part of its plant and machinery. In such a case it may be liable to capital gains tax.
2. If a new industrial undertaking (unit) is established to make the product, which fulfils the
conditions laid down in section 80-IB/80-IC of the Act, a deduction will be allowed in
computing the income of the undertaking (unit) for tax purposes.
3. Cost of product, being a capital asset, is not deductible whether it’s purchased or
maufactured. However, depriciation is allowed in both cases. If the product is a consumable
one, its cost will be treated as revenue expense and will be deductible.
Repairing, replacing, renewing or renovating of an asset
From the accounting point of view a person can debit the expenses incurred on repair or
replacement of an asset in profit and loss account. But to show a better profitability or to
increase the gross block of assets so that higher amount of loans could be taken from banks or
financial institutions, the expenses on replacement of an asset are capitalised. When expenses
incurred on replacement of an asset are capitalised, this increases the tax liability. From tax
point of view the person is not at liberty to capitalise or not to capitalise the expenses
incurred on replacement of a part of asset or the asset itself.
Deduction of Expenses Incurred on Repairs
1. Use a building: Entitled to a deduction of the amount paid on account of 'current repairs' to
the premises. If he has undertaken to bear the cost of repairs to the premises in rent
agreement, he is entitled to a deduction of the amount paid on account of such 'repairs'.
2. Uses any machinery, plant or furniture: Entitled to a deduction equivalent to the amount
paid on account of current 'repairs'.
● ‘Repairs’ means any expenditure incurred to preserve and maintain an existing asset.
The object of the expenditure is neither to bring a new asset into existence nor to
obtain any fresh advantage.
● ‘Current repairs’ neither refers to petty repairs nor the repairs carried out year to
year but it refers to the repairs carried out presently, whatever its cost may be.
3. Replacement or Renewal: If the replacement is of parts only, the expenditure for such
replacement is deductible in computing the income. On the other hand if the replacement is
the whole machinery, the expenditure will not be deductible being capital in nature.
Tax Planning in relation to repair and replacement of an asset
1. There are stringent conditions to carry-forward and set-off of business losses. Hence, if in
the relevant year less income is expected, it will be better to slow down the pace of repair and
renewal. Conversely, if the income is high, the pace can be increased.
2. As far as possible a part of the asset should be replaced and not the entire asset.
Sale of assets used for scientific research
If an assessee purchases an asset for scientific research related to its business, the expenditure
incurred is deductible during the P.Y. in which it is incurred. If such asset ceases to be of any
research use, the assessee can sell it or use it in the business for some other purpose.
(1) Selling the asset without using it for business purposes: The selling price up to the cost of
asset is deemed business income. If selling price exceeds the cost, the excess shall be capital
gain.
(2) Selling the asset after using it for business purposes: If an asset used for scientific
research is used in business for some time and then sold, then the selling price of such asset is
not treated as deemed income rather the selling price is deducted from the W.D.V. of the
block of asset. It will reduce tax liability for that year and increase liquidity but future tax
liability will increase (following illustration).
From the tax planning point of view, it is better to sell such asset without using it for business
purposes of the assessee. (See Illustrations 6 and 7).
Shutting down or continuing operations
A business may suffer loss due to one or more of the following reasons:
1. Fall in demand of the product (new products, change in fashion, more competitors)
2. Financial problems (insufficient finance of its own nor further credit is available)
3. Change in technology (rapid change in tech. and unable to keep pace resulting in losses)
4. High rates of taxes (lead to price rise thereby reducing demand)
5. Mismanagement (lax management is disastrous)
When a business suffers loss continuously, the management has to decide whether the
business should be shut-down or continue. Tax provisions in this regards:
(1) Treatment of losses and unabsorbed depreciation:
Business Loss: If the business or profession has been discontinued, loss can be carried
forward and set-off against profits and gains of business or profession.
Unabsorbed Depreciation:
(i) can be set-off against income from business or profession or income under any other head;
(ii) can be carried forward and set-off for indefinite period, whether business is carried on or
discontinued.
Discontinuance of part of a business or business as a whole: Where a part of a business (unit,
department or activity) is discontinued or a business is continued with reduced level of
activity it is not a discontinuation of business. In the following cases it cannot be said that the
business has been discontinued:
(a) Where the business of the assessee has been shifted from one premises to another or from
one market to another or from one city to another city.
(b) Where one or the other department of the business had been closed down.
(c) Where the business of an industrial undertaking carried on in India is discontinued in any
previous year and such business is re-established, reconstructed or revived by the assessee
within three years from the end of previous year in which the business was discontinued, the
losses of such a business shall be carried forward and set-off against the profits and gains of
the business or any other business carried on by him.
● Speculation loss can be set-off against speculation income either in the same year or
in subsequent four years. These losses can also be carried forward to be set-off in the
succeeding year against any other speculation business, in case of discontinuance.
However, the same is not true for losses from an illegal speculation business.
(2) Withdrawal of certain deductions: The benefit of deductions under section 33AB
(Tea/Coffee/Rubber Development Account) and 115VT (Reserve for Shipping Business) may
be withdrawn and liable to tax for the year in which business is discontinued.
(3) Deemed Income: If the business is discontinued and the assets used for scientific research
and family planning are sold, the selling price to the extent of deduction claimed shall be
deemed as profits of the previous year in which such assets are sold.
(4) Sale of depreciable assets: The assets on which the assessee has claimed depreciation,
are sold in the event of discontinuance of business, the difference between the net
consideration and W.D.V. shall be treated as short-term capital gain/loss. Such gain is taxable
while loss can be set-off against the capital gains.
(5) Sale of other assets: When other assets [except mentioned in (3) and (4)] are sold, there
may be long-term or short-term capital gain/loss, as the case may be. Such gain is taxable
while loss can be set-off against the capital gains.
Tax Planning
If a person is running more than one business the loss making business should not be
discontinued but operated at a low key for some time to claim the following losses and
expenses against the income of profit making business:
1. Retrenchment compensation paid to staff is not deductible after the business is closed.
2. Interest on borrowed funds and bad debts in relation to discontinued business.
3. In case of closely-held company it may be taken care that there may not be a change in the
shareholding exceeding 49% of the shareholding. If there is a change in shareholding, and the
transferor/s and transferee/s are relatives, they may transfer some percentage of shares as gift
rather than sale so that the conditions for set-off of losses are complied with.
4. If the assessee is a company, it may amalgamate/demerge with other company.
