UNIT III

Tax Management with reference to –

‘Capital Structure'
Tax Management With Reference To Capital Structure

CAPITAL STRUCTURE DECISIONS

What is the Optimum Capital Structure : The optimum capital structure is a mix of
equity capital and debt funds. Their composition depends upon many factors namely
:

1. Cost of Capital and also expenditure incurred in raising of such capital.

2. Expectation of shareholders by way of dividend, growth etc.
3. Expansion need of the business i.e. the rate by which profits of the business
shall be again ploughed back in the business.
4. Taxation policy ; and
5. Rate of return on investment ( Equity + Debt funds ).

TAX CONSIDERATIONS
1. 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.
2. 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 @
12.5% + surcharges + education cess.
3. 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.
4. The Cost of raising dent fund is treaded as revenue expenditure. It can be
claimed as deduction in computing the total income.
5. Where the assesses is entitled to incentives u/s 10A etc. maximum equity
fund should be utilized.
6. Where interest on debt fund is payable outside India, tax should be deducted
at source otherwise deduction is not allowed.

TAX PLANNING
1. 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.
2. if rate of return on investment < rate of interest, minimum debt funds should
 be used.
3. 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 reduces the profits ( profits less interest)
before tax and to the extent exemption is reduce.

The balance of capital structure shall depend upon maximizing the return on capital
employed which is computed by using following formula :

Distributable Profit

_________________________ X 100

Equity Capital

Tax Management with reference to -Issue of

Bonus Share, Purchase of Own Shares &
Distribution of Own Devidents !

2.7. 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.

2.8. TAX PLANNING THROUGH PURCHASE OF OWN SHARES OR DISTRIBUTION OF

DIVIDEND

Purchase of Own Shares :

0. Where the company purchase its own shares, the payment

refund by shareholders is not treated as dividend.

1. 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.

2. The Capital Gain shall be computed u/s 48. Indexation of cost of

acquisition

Value of the year of purchase shares

. . X Cost of
acquisition
Index value of the year of acquisition of share

0. 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.

Tax Management with reference to –Lease

or Buy Decisions
LEASE OR BUY DECISIONS

Assets may purchased or taken on lease. Apart from tax angle other factors also are
important in taking lease or buy decisions like rate of change in technology.

Advantages when Assets are taken on Lease : Lease Rental can be claimed as
deduction as revenue expenditure. However Depreciation cannot be claimed since
assets are not owned by the assessee.

Advantage when Assets are Purchased : Depreciation on specified assets can

be claimed as deduction u/s 32. the Assets may be purchased outrightly or may be
taken on loan. Where the asset is taken on loan interest amount can either be
claimed as revenue expenditure or can be capitalized. But where interest is paid
after the asset is first put us use, the deduction on account of interest shall be
claimed as revenue expenditure, i.e. such interest cannot be capitalized.

Note :
>> Since the lease rentals and loan are repayable in instilments, then the cash
outflow for each separate year should be converted into present value of today’s
cost, i.e. Cash Inflow.

HOW TO SOLVE QUESTIONS

Where the Asset is Purchased on Loan :

1. Compute Repayment of Loan spread over a number of years.

 2. Compute Interest on Loan spread over a number of years.

3. Compute each Outflow ( Interest + repayment of Loan) spread over a number

of years.

4. Compute Depreciation on Assets spread over a number of years.

5. Compute Tax saved on deduction claimed ( Interest + depreciation) spread

over a number of years.

6. Compute adjusted cash outflow which is ( 3 – 5 )

7. Compute present value of adjusted cash outflow.

Where the Asset is Leased :

1. Compute the time processing fees in zero year.

2. Computer Lease Rental spread over a number of years.

3. Compute Cash Outflow (processing fees + lease rental) spread over a number
of years.

4. Compute Tax saved on deduction claimed ( processing fees + lease rental)

spread over a number of years.

5. Compute adjusted cash Outflow which is ( 3 – 4 )

6. Compute present value of adjusted cash outflow.

What is the Present Value (PV Value) :

It is the discontinue value, its opposite is future value of cash investment which you
make today. In simple terms what is the value of cash in ‘Zero year’ when there is
cash outflow in 5th year or for that matter nth year. To discount the cash outflow
occurring in 5th year, there is table given which is known as annuity table. This is
shown below by way of illustration.

E.g. Computer Present Value of cash outflow from the following information :
Cash Outflow

1st Year 2nd Year 3rd. Year

Rs.80,000 Rs. 40,000 Rs. 50,000
PV factor at 10% of internal return
0.909 0.826 0.751
Solutions :
Discounted Value in Zero Year

Rs. 72,720 Rs. 33,040 Rs. 37,550

The Value of Rs. 72,720 Rs. 33,040 Rs. 37,550 represents discounted value of Zero
Year.

Tax Management with reference to –Repair,

Replace, Renewal Or Renovation
(A) REPAIR, REPLACE, RENEWAL OR RENOVATION
The main tax consideration which one has to keep in mind is whether expenditure on
repair, replacement or renewal is deductible as revenue expenditure u/s 30,31, or
37(1). It the expenditure is deductible as revenue expenditure under these sections,
then cost of financing such expenditure is reduced to the extent of tax save.

On the other hand if such expenditure is not allowed as deduction u/s 30,31 or 37(1)
then it may be capitalized and on the amount so capitalized depreciation is available
if certain conditions are satisfied.
(B) Difference Between Revenue and Capital
Expenditure

Revenue Expenditure
Capital Expenditure
Cost of acquisition and installment
Purchase price of a current asset for resale or
charges of a fixed asset is a capital
manufacture is a revenue expenditure.
expenditure.
Expenditure incurred to free oneself
Expenditure incurred to free oneself from a
from a capital liability is a capital
revenue liability is a revenue expenditure.
expenditure.
Expenditure incurred towards
Expenditure incurred towards an income is a
acquisition of a source of income is a
revenue expenditure.
capital expenditure.
Expenditure incurred to increase the
Expenditure incurred to maintain the fixed
operating capacity of fixed assets is
assets is a revenue expenditure
capital expenditure.
Expenditure incurred for obtaining Expenditure incurred towards raising loans or
capital by issue of shares is a capital
issue of debentures is a revenue expenditure.
expenditure

“Repair” implies the existence of a thing has malfunctioned and can be set right by
effecting repairs which may involve replacement of some parts, thereby making the
thing as efficient as it was before or close to it as possible. After repair the thing to
which the repair was carried out continues to be available for use. Replacement is
different from repair.

“Replacement” implies the removal or discarding of the things that was in use, by a
different or new thing capable of performing the same function with the same or
greater efficiency. The replacement of a section in a series of machines which are
interconnected , in a segment of the production process which together form an
integrated whole may in some circumstances , be regarded as amounting to repair
when without such replacement that unit in that segment will not function. That
logic cannot be extended to the entire manufacturing facility from the stage of Raw
Material to the delivery of the final finished product.

“Current Repair” implies the expenditure must have been incurred to ‘preserve and
maintain’ an already existing asset and the object of the expenditure must not be to
bring a new asset into existence of for obtaining a new advantage.
Shifting of Administrative Office :
Expenditure incurred for shifting the administrative office from one city to another
city as a result of amalgamation of three companies having a number of activities in
various centers is allowable as Revenue Expenditure.

Shifting of Head Office from one place to another is Capital Expenditure :

Where the assessee-company shifted its head office from one place to another place
after it Board of Directors resolved that it would be commercially prudent to
centralized the Registered Office of the company in one place, in connection with
the shifting , it incurred huge expenses including a certain payment made to the
lawyers, the expenses incurred on this account could not be on revenue account.

Expenditure of shifting of employees is Revenue Expenditure :

Expenditure incurred by assessee on shifting of employees to another place
consequent on shifting of factory to another site due to labour unrest was allowable
as Revenue Expenditure.

Decoration of reception / dining halls in Hotels is revenue expenditure :

Expenses incurred in putting up decorative mirrors in the wall, plaster molded roof,
plywood panels, etc. in reception-cum dinning halls of a Hotel, in order to deep the
place fir and attract customers, is deductible as revenue expenditure.
Expenditure on renovation an modernization of Hotel Premises is Revenue
Expenditure :
Expenditure incurred solely for repairs and modernizing the Hotel and replacing the
existing components of the building, furniture, and fittings, with a view to create a
conductive and beautiful atmosphere for the purpose of running of a business of a
Hotel , will fall under the category of Revenue Expenditure only, and is hence
deductible.

Expenditure on Wall to Wall Carpet for office is capital expenditure :

Expenditure on purchase of wall-to-wall carpet, for being used in the office, has
nothing to do with the augmenting, preserving or protecting the turnover or profits
of the business and hence it is in the nature of capital expenditure.

Repairs to building can be capital or revenue, depending on nature of change

brought about :
So long as the repair does not bring into existence an additional advantages or
benefit of an enduring nature or change the nature, character or the identity of the
building itself, the expenditure must be regarded as a revenue expenditure. On the
other hand, if it does, it will be in the nature of a Capital Expenditure.

Replacement of Assets as a whole is not ‘Repair’ :

Where substantial repairs are carried out in order to put to use an existing asset, the
same could be termed as Revenue Expenditure. But where there is replacement ‘As
a Whole’ , it amounts to reconstruction and not repairs. It is pertinent that the asset
in its old form must continue to exist to say that the expenditure involved in
improving the assets is Revenue Expenditure. Where effacement takes place and a
new asset comes into being, then expenditure involved would become a Capital
Expenditure.

Repairs for converting Godown into Administrative Office :

Where the assessee incurred expenditure on repairs to a godown used for business
purpose so as to convert it into an Administrative Office, the expenditure was
allowable as revenue expenditure, since the business asset has retained its character
and only its use had changed, and the use at both points of time, i.e. before and after
the expenditure was incurred, related to the business of the assessee without there
being any addition to or expansion of the profit-making apparatus of the assessee.

Remodeling of furniture in retail outlet is revenue expenditure :

The expenditure incurred by the assessee company towards the remodeling of
furniture in its various retails depots which was necessitated by changes in design,
was deductible as revenue expenditure.

Repair and replacement of false ceiling in cinema building is revenue expenditure :

Expenditure on repair and replacement of false ceiling in cinema building owned by
the assessee was allowable as revenue expenditure, since it was incurred for keeping
the business running.

Replacement of electric wiring in cinema building is revenue expenditure, since it

was incurred for keeping the business running.

Expenditure in repairs to car damaged during riots are deductible :

Expenditure to repair damage to car in which director of assessee-company was
traveling to the business premises, was allowable as business expenditure.

Tax Management with reference to – ‘Make

Or Buy’ Decisions
‘MAKE OR BUY’ DECISIONS

This applies to industries where assembly of products takes place to make a finished
product. Like a manufacturing of car, where thousands of different parts or
components are assembled to make a car.

It is quite natural every components or part of a car cannot be manufactured by one

company. Since part manufacture involves cost, time, energy, and different kinds of
technology and expertise. Therefore, in such cases company purchases parts from
outside agencies. But where the cost involved in purchasing from outside market is
high, then the company might go in for in house production.

Apart from costing consideration following factors also go in decision-making

process :

0. Utilizations of Capacity

1. Inadequacy Fund

2. Latest Technology

3. Dependence of supplier

4. Labor problem in the factory

What are the cost involved in making of a Pat.

1. Fixed Cost : Purchased of Plant etc.

2. Variable Cost : Raw Materials, Labour, Electricity etc.

What are the cost involved in buying of a part from outside agency :

1. Buying Cost

2. Inventory Cost

Comparison of the above tow cost shall determine which decisions the company
shall follow. But, however it should be kept in mind that while comparing Cost,
common cost should not be taken into account.

It should also be noted that the cost incurred in making a product and buying a
product, both involves incurring of revenue expenditure. Therefore, tax saved in
both the cases are same. It comes into picture only when there is a need for
extension or establishment of new unit to manufacture that new components.

Tax Consideration :

1. Establishing a new Unit : If the decision to manufacture a part or

component involves a setting up a separate industrial unit than tax incentives
available u/s 10A, 10B, 32, 80IA and 80IB should be considered.

2. Export : If ‘Make or Buy’ decision is taken for exporting goods then

tax incentives available u/s 80HHC depends upon whether goods manufactured by
taxpayer himself are exported or goods manufactured by others are exported by the
taxpayers.

3. Sale of Plant & Machinery : If buying is cheaper than manufacturing and the
assessee decides to buy parts or components for along period of time, he may like to
sell the existing plant and machinery. Tax implication as specified by Sec. 50 has to
considered.

Tax Management with reference to – ‘Sale of

Scientific Research Asset'
Sale of Scientific Research Asset
SCIENTIFIC RESEARCH ASSET SOLD AFTER HAVING BEEN USED FOR THE PURPOSE OF
BUSINESS.
As per explanation 1 to section 43(1) where an asset is used in the business after is ceases
to be used for scientific research related to that business the actual cost of the asset to be
included in the relevant block of asset shall be taken as nil as 100% deduction has already
been allowed. If such asset is sold then the value of block shall be reduce by the sale value
of the asset.
SECTION 41(3). SCIENTIFIC RESEARCH ASSET SOLD WITHOUT HAVING BEEN USED FOR THE
PURPOSE OF BUSINESS
(1) Where an asset representing expenditure of a capital nature on scientific research, is
sold, (2) without having been used for other purposes, and (3) the proceeds of the sale
together with the actual amount of the educations made, the amount of the deduction
exceed the amount of the capital expenditure (4) the excess or the amount of the
deductions so made, whichever is the less, (5) shall be chargeable to income-tax as income
of the business or profession of the previous year in which the sale took place.
The Clause is applicable even if the business is not in existence during PY.
ANALYSIS :
0. Profit from Business = Sale price or cost whichever is lower.
1. Capital Gain = Sale consideration minus cost of acquisition . If LTCA
minus indexed cost of acquisition. There can be no loss under the head
Capital G

TAX PLANNING VIEW :

Tax planning question can be whether the scientific research asset should be sold by using
for the purpose of business or without being used for the purpose of business.
 Scientific research asset can either be sold without being used
for the purpose of business as such. Sale of scientific research
asset as such shall give rise to capital gain which can be either
short-tem capital gain or long-term capital gain.
 Sale of Scientific Research Asset after it is put to use for the
purpose of business shall reduce the depreciation for
subsequent years. Capital gain shall arise depending upon the
block of asset. As per section 50 Capital Gain can arise only if on
the last day of the PY.
 Block of Assets do not exist ; or
 WDV is Zero.

Tax Management with reference to -

Deemed Dividend
2.1. INTRODUCTION

10(34) : Exempted
115O : DDT 194 : TDS
of Dividend
2(22)(a) to (d) Applicable Applicable Not Applicable
2(22)(e) Not Applicable Not Applicable Applicable
1. General Meaning of Dividend : It is the sum received by the
Shareholders of a Company on the distribution of its profits. However Sec. 2(22)
define dividend which are notionally or by friction of law is treated as dividend.

2. Dividend Is not impressed with character of Profit : ‘Dividend’ in its ordinary

connotation means the sum paid to or received by a shareholder proportionate to
his shareholding in a company out of the total sum distributed. Dividend distributed
by a Company being a share of its profits declared as distributable among the
shareholders, is not impressed with the character of the profits from which it
reaches the hands of the shareholders.

3. A Dividend u/s 205 of the Companies Act can be paid only out of the profits of
a company whether for that year or out of the profits of the company for any
previous financial years as set out in that section, and in the manner set out in that
section.

4. While reading Sec.2(22) stress on these sentences particularly the italicized

words :

(a) To the extent to which distribution is attributable to the accumulated profits.

(b) To the extent to which the company Possesses accumulated profits.

(c) Distribution which entail the release of company’s assets.

5. As per sec. 2(22) following payments or distribution are not treated as

dividend..

(a) any payment made by a company on purchase of its own shares from a
shareholder in accordance with the provisions of Sec. 77A of the Companies Act,
1956.

(b) any distribution of shares pursuant to a demerger by the resulting company

to the shareholders of the demerged Company ( whether or not there is a reduction
of capital in the demerged Company).

1. What Is Shut down Decision?

A shut-down decision is that the firm is temporarily suspending production. It does not
mean that the firm is going out of business. The shut Down decision depends on Shut
Down Point. The shutdown point denotes the exact moment when a company’s
revenue is equal to its variable costs.
 2. What is Shut Down Point ?
A Shutdown point is a position of operation at which a company is receiving no
advantage for continuing operations Thus, decides to shut down temporarily or in some
cases permanently.

The shutdown point denotes the exact moment when a company’s revenue is equal to
its variable costs. Variable costs such as wages, production supplies, etc. It results from
the combination of output and price where the company earns just enough revenue to
cover its total variable costs.

3. Reasons of shut down production

o Fall in demand
o Financial problem
o Change in technology
o High rate of taxes
o Inadequate availability of raw material
o Recession in market
o Mismanagement

4. Shutdown or Continue Decision Rule with

example
Generally, For continuation of business all the firms should have more revenue than
total cost ( REVENUE > TOTAL COST ) But In short-run all firms ignore the fixed cost
hence the requirement for short-run is REVENUE is equal to or higher than VARIABLE
COST
1. Short run rule for shutdown or continue
decision with example
In the short-run shutdown, we only consider the variable cost. Short-run is for a limited
period of time like for quarterly, half-yearly, yearly depend upon company. It means we
check whether the company is able to cover or not the variable cost for the short
period from its sales. If not, the Firm needs to shut down.

For example: If the revenue of a company is Rs. 100 and its variable cost is Rs. 80. then
the contribution will be Rs 20. In this, there is no need to shut down the product. but if
the variable cost is greater than the sales, then the company has to shut down that
product.

2. Long-run rule for Shutdown with example

The Long Run period is basically the future of the company. The long-run can be yearly
or more than yearly depending upon the type of company.
In long run shut down, we consider total cost i.e. fixed cost and variable cost. For
example: If the sale of a company is Rs. 100 and its variable cost is Rs. 80 and fixed cost
is Rs. 40. Then there is a loss of Rs. 20.

It means that the company will not survive in the long run but still can survive in the
short run.

Example Of Shutdown Or Continue Decision|

Numerical
QUESTION

ABC company has fewer sales and less profit so they want to shut down the product.
1. Case: If a company wants to shut down one product?
2. CASE: IF THE COMPANY WANTS TO SHUT DOWN ONE PRODUCT COMBINATION?
3. CASE: COMPANY NEEDS TO SHUT DOWN OR CONTINUE ITS OPERATION?

PARTICULARS Product A Product B

SALE Rs. 1,10,000 Rs. 1,50,000

 UNITS OF PRODUCTION 9000 17000

MATERIAL COST Rs. 3 per unit Rs.3 per unit

LABOUR COST Rs.1 per unit Rs 1.5/Unit

FIXED COST Rs.70,000 Rs. 70,000

Case 1: If company wants to shut down one product

ANSWER

PARTICULARS A B

Sales Rs. 1,10,000 Rs. 1,50,000

– Variable Cost Rs. 36,000 Rs. 76,500

Contribution Rs. 74,000 Rs. 73,500

– Fixed Cost Rs. 70,000 Rs. 70,000

Profit/loss Rs. 4,000 Rs. 3,500

As for the solution, we first need to find the P&L to close down.
A firm should shutdown the C product as it is suffering from high losses other products
i.e A AND B PRODUCT Should continue.

CASE 2: IF COMPANY WANTS TO SHUT DOWN TWO PRODUCTS ( Where firms making
products in combination)

In this firm is making products in combination, if a firm wants to close down the
combination of one product which should be closed and continue?

When a firm wants to close down two products or one combination, we need to
combine to find which two products have the highest loss.

PARTICULARS A-B PRODUCT B-C PRODUCT A-C PRODUCT

Sales 2,60,000 240000 2,00,000

– Variable Cost 1,12,500 96500 56,000

Contribution 1,47,500 143500 1,44,000

– Fixed Cost 1,40,000 140000 1,40,000

Profit/ Loss 7,500 3500 4,000

Conclusion – In this solution, we can see that the B-C combination has suffered from
less profit, and the A-B combination has a higher profit. The firm can close down the B-
C combination and should continue with the A-B product combination.