M. COM.

PART-II MC-404
CORPORATE TAX PLANNING
LESSON NO. 2.5 AUTHOR : DR. SHALINDER SAINI

TAX PLANNING AND FINANCIAL MANAGEMENT DECISIONS

2.5.0 Objective
2.5.1 Financial Management Decisions
2.5.2 Capital Structure
2.5.2.1 Capital Structure decision in case of a new project
2.5.2.2 Impact of capital structure on exemptions or deductions
2.5.2.3 Tax planning
2.5.2.4 Illustration-I
2.5.3 Inter-corporate dividend
2.5.3.1 Exemption U/S 50(34)
2.5.3.2 Tax Planning
2.5.4 Dividend Policy and bonus shares
2.5.4.1 Dividend Policy
2.5.4.2 Tax Planning
2.5.4.3 Bonus Shares
2.5.4.4 Tax Planning
2.5.4.5 Issue of Bonus Debentures instead of Bonus shares
2.5.4.6 Illustration-II
2.5.5 Answers to Self Check Questions
2.5.6 Exercise
2.5.7 Suggested Readings
2.5.0 OBJECTIVE OF THE LESSON
The main objective of this lesson is to discuss with the students main
possibilities of tax planning with reference to financial management
decisions. To cmplete this objective this lesson convers the topics about
capital structure decisions, dividend policy, issue of bonus shares or bonus
denebtures in the light of reducing tax liability of the company.
2.5.1 FINANCIAL MANAGEMENT DECISIONS
The students have already studied capital structure and dividend policy,
from the financial management point of view in their 'Financial Management'
paper. So, here the discussion has been restricted from the point of view of income
tax and tax planning to be adopted in the matter of deciding the financial structure

62
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of the company.
5.2.1 CAPITAL STRUCTURE
It refers to the mix of sources from which funds required for the business
are raised. The choice relating to raising of funds and planning the capital
structure would be between capital and borrowings and the planning of the
optimum debt-equity ratio. From tax point of a view expenses incurred on raising
loans/debentures and interest payable on loans is deductible under section 36
(i) (iii). But expenses incurred on raising capital and dividend on share capital is
not deductible. However the following expenses are deductible in relation to
capital.
1. If the assessee is a firm, the interest payable to partners on their capital
and loan, subject to a maximum 12%.
2. If the assessee is an Indian Company, and in connection with the issue,
for public subscription of shares or debentures of the company, incurs
expenses (being undertaking commission, brokerage and charges for
drafting, typing, printing and advertisement of the prospectus) 10% of such
expenses are allowed for each of the 10 successive previous years
beginning with the previous year in which the business commences.
If such expenses are incurred after 31.3.2018, !/5 of such expenses for
each of the 5 successive previous years shall be allowed under section 35 D.
2.5.2.1 Capital Structure decision in case of a new project
An optimum capital structure is one which maximises shareholders return.
The advantanges of having an optimum capital structure are two-fold. It maximises
the value of the assets of the company and wealth of its owner and minimises the
cost of capital which, in turn, raises its ability to find inbuilt additional investment
opportunities. One of the main reason for raising finance through borrowing (as
against issue of equity shares) is to increase earnings on equity share capital.
But excessive use of debt capital increases the financial risk of the company.
From the above picture one may include that the borrowings contribute to
tax saving resulting a higher rate of return on owner's equity, but this doesn't
hold good in every case.
2.5.2.2 Impact of Capital Structure on Exemption or Deduction
The exemption U/S 10A or 10B or deduction U/S 80IA or 801B or 80IC of
the Income Tax Act increases the profits after tax or increases the rate of return
on equity capital. But the borrowed capital reduces the profits (profits-interest)
before tax and to that extent the exemption is reduced or proportionately
deduction is reduced.
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Therefore, minimum possible loans may be taken at the time of
commencement of an new industrial undertaking.
2.5.2.3 Tax Planning
1. Where rate of return on investment is less than the rate of interest, the
minimum loan capital must be used.
2. Where rate of return on investment is more than the rate of interest, it will
increase the rate of return of equity capital.
3. The capital may be utilised for acquisition of non-depreciable assets like
land, goodwill; and borrowed capital may be used to acquire depreciable
asset because 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.
4. If the gestation period in an industry is more it is better to use capital
rather than loans. On the loan, interest will be paid out of capital. This
interest payment will be c/f as business loss which may not be set-off within
the prescribed period of 8 yrs.
Second, the money-lender have to pay tax on their interest income.
5. If interest is payable outside India then tax must be deducted at source
otherwise the amount paid as interest will not deductible in computing
business income.
6. Not only interest but also service fee or other charge. On loans, whether
utilised or not, should be claimed as revenue expenses in computing
business income because in Income Tax Act. 'Interest' term has been
defined liberally, it includes any service fee or other charge in respect of
money borrowed or debt incurred or in respect of any credit facility.
2.5.2.4 Illustration-I
X Ltd. is a widely-held company. It is currently considering a major
expansion of its production facilities and the following alternatives are available.

Alternative Alternative Alternative

I II III
Rs. Rs. Rs.
Share Capital 5,00,00,000 2,00,00,000 1,00,00,000
Debentures (14%) — 2,00,00,000 1,50,00,000
Loan from Financial
institution/bank @ 18% - 10,00,00,000 2,50,00,000
M. Com. Part-II 65 MC-404
Expected rate of return (before tax) is 25%. The rate of dividend of the
company since 1990 is not less than 20% and the date of dividend declaration is
june 30 every year. Discuss which alternative is the best choise before company?
Solution :
Capital Structure Decision Alternative Alternative Alternative
I (Rs.) II (Rs.) III (Rs.)
Return on Rs. 5 crore 1,25,00,000 1,25,00,000 1,25,00,000
Less :
(i) Interest on debenture - 28,00,000 21,00,000
(ii) Interest on loan - 18,00,000 45,00,000
Taxable Profit 1,25,00,000 79,00,000 59,00,000
Tax @ 30% (plus 7% of tax as
surcharge plus 4% of tax and
surcharge, HEC) 41,73,000 24,64,800 18,40,800
*Return on equity share capital
before dividend tax 83,27,000 54,35,200 40,59,200
Rate of return on equity share
capital 16.65% 27.18% 40.59%

The Company should, therefore, opt for the third alternative.

* Note : Dividend tax is not applicable on companies now. Thus, tax on 'dividend
income received' is payable by the person who has dividend income.
2.5.3 INTER-CORPORATE DIVIDEND
When a company receives dividend from another company it is known as
inter-corporate dividend.
2.5.3.1 Exemption U/S 10 (34)
When a domestic company receives dividend (including deemed dividend) from another
domestic company (except loan from a closely-held company) it is exempt U/S 10 (34).
However, the domestic company who is declaring, distributing or paying dividend
is liable to pay tax on such amount U/S 115-0 in addition to normal tax on its total income.
2.5.3.2 Tax Planning
When a company issues bonus shares to its equity shareholders it is not a
deemed dividend and not liable to pay tax on such deemed dividend.
Hence, a domestic company may issue bonus shares to its equity
shareholders instead of dividend in cash to reduce its tax liability.
2.5.4 DIVIDEND POLICY AND BONUS SHARES
2.5.4.1 Dividend Policy : From tax point of view, the company has to follow the
following dividend policy :
M. Com. Part-II 66 MC-404
1. Dividend must not be paid out of capital.
2. Dividend must be paid only out of after tax profits.
3. The dividend is subject to double taxation as the company pays tax
on dividend distributed u/s 115-0.
When the recipient of dividends (domestic company) distributes dividends
to its shareholders out of the dividends received from another company, it has to
pay tax again on the amount of dividend distributed u/s 115-0. Further, the
interest on amount borrowed to purchase shares is not deductible in computing
income, since the dividends received are exempt. Hence, the share should be
purchased out of own funds and for other assets the company may borrow funds.
2.5.4.2 Tax planning :- For tax planning in relation to dividend income, the
undermentioned suggestions are given :
1. Issue Bonus Share :- A domestic company may issue bonus shares
to its equity shareholders in lieu of dividend in cash. By this it can
avoid the tax u/s 115-0 on dividend distributed but it will increase
tax liability of its shareholders.
2. Reduce voting power less than 10% :- Payment made by a closely
held company to a shareholder who is the beneficial owner not less
than 10% of the equity shares or on his behalf or for his benefit, is
deemed to be dividends to the extent of accumulated profit. (This
deemed dividend was not exempt u/s 10(34). But in the present
time with the abolishment of dividend distribution tax such
payments will not be taxed as dividend distribution. So, such a
shareholder can take loan from the company or ask the company to
make payment on his behalf or for his benefit.
Earlier, experts suggest that a concern, in which shareholder
has substantial interest (entitled to not less than 20% of the income
or 20% voting right in the company) should not borrow from the
closely-held company. Otherwise, it will be taxed as deemed
dividend in the hands of the concern.
3. Where a loan in the hands of a shareholder or concern, mentioned in
point 2 which was taxable as DDT and has been taxed as deemed
dividend, such loan should not be repaid to the closely-held company.
It should be adjusted against the dividends declared by the company
in future. The dividend declared in future and adjusted against the
loan is not treated as dividend declared. Thus, the double taxation
liability can be avoided.
4. The tax liability of the company can be reduced by purchase of own
shares by the company from shareholders, instead of distribution of
M. Com. Part-II 67 MC-404
dividend because it is not deemed to be dividend distribution. Where
a company purchase its own shares from a shareholder, the capital
gains shall be chargeable to tax in the hands of transferor. The
shareholders are liable to pay tax on LTCG@ 10% + surcharge +
education cess (without indexing the cost of aquisition of shares)
or @ 20% + surcharge + education cess + secondary and higher
education cess (after indexing the cost of acquisition of shares).
2.5.4.3 Bonus Shares
When a company issues shares to the existing shareholders in lieu of
dividends such shares are termed as 'bonus shares'.
Expenditure incurred on issue on bonus shares is capital expenditure,
hence not deductable in computing the income of the company.
[Brooke Bond India Ltd. vs CIT (1997) 225 ITR798 (SC)]
1. Bonus shares to equity shareholders :- When bonus shares are issued to
the equity shareholders, the value of the shares is not taxed as dividend
distributed.
But, when they sell the bonus shares, the cost of bonus of share is taken as
nil, Hence, the whole net consideration (i.e. selling price - selling expenses) is
treated as long-term or short-term capital gains.
The table given below highlights the tax consequences, if bonus shares are issued
to equity shareholders.
Situation Tax treatment in the Tax treatment in the
hands of Company hands of Shareholders
1. At the time of No tax liability No tax liability
issue of bonus shares
2. At the time of No tax liability See Note-I
sale of bonus share
by shareholder
3. At the time of redemption Under section 2(22)(a) Out of the amount
of bonus share or at the or (c), it will be treated received at the time
time of liquidation of the as dividend distribution of redemption or
company to the extent of accumlated liquidation, amount
profit and, consequently, treated as 'dividend'
the payer company will under section 2 (22)
pay dividend tax. (a)(c) will be exempt
in the hands of
shareholders,
balance will be sale
consideration to
compute capital gain.
M. Com. Part-II 68 MC-404

2. Bonus shares of preference shareholders :- When preference shareholders

get the bonus shares, on their issue it is deemed to be dividend and liable
to tax. And when redeemable preference shares are issued as bonus shares,
on their redemption, the amount shall be taxed as dividend distributed.

Note - I : Capital gain on transfer of bonus shares shall be calculated as given

below :
1. Cost of acquistion of bonus shares FMV on April Ist, 1981 is taken
allotted before Ist April, 1981 as cost of acquisition.
2. Cost of acquisition of bonus shares Cost of acquisition is taken as
allotted on or after April 1, 1981. zero.
3. Period of holding bonus shares The period of holding shall be
determined from the date of
allotment of bonus shares (and
not from the date of aquisition
of original shares).
These rules are applicable even in the case of shares, securities,
debentures, bonds, units allotted without any payment on the basis of holding of
any other financial assets.
If Securities Transaction Tax is applicable at the time of transfer, LTCG is not
chargeable to tax and STCG @ 10% plus surcharge + Health and education cess is
applicable.
Note-2 : Tax treatment w.r.t. dividend distribution tax on issue of bonus shares as
discussed in para 2.5.4.3 is not applicable now because from 01-04-2020-21 F.Y.
DDT was abolished.
2.5.4.4 Tax Planning
Tax Planning in relation to bonus shares is possible as below :
1. An equity shareholder may transfer his bonus shares after one year from
allotment to a firm or AOP as capital contribution. The amount recorded
in the books of firms/AOP for such shares will be the cost of acquisition for
that firm or AOP and LTCG to the transferor.
Now, when a 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.
Alternatively, such shares may be sold to a relative after one year of
their allotment. The selling price will be the long-term capital gains of the
allottee for the year of sale. Whenever, the relative will sell these shares he
will get the benefit of indexation of the cost of acquisition.
M. Com. Part-II 69 MC-404

2. A preference shareholder may convert first preference shares into equity

shares and thereafter receive bonus shares. This will reduce the tax liability
at least at the time of issue of bonus shares.
3. 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 shareholders
will be available from the date of allotment of shares.
4. Where bonus shares are received by a firm it may transfer such shares to
partners by sale. When such shares are transfered by sale, the buyer will
get the benefit of indexation of cost.
2.5.4.5 Issue of Bonus debentures instead of Bonus shares
A company can reduce its tax liability if it issues bonus debentures to its
equity shareholders instead of bonus shares.
When a company issues bonus debentures, the interest on debentures is
deductible in computing its income while dividend on bonus shares is not
deductible in computing its income. Further, when a company wants to distribute
deferred dividend it should issue bonus debentures instead of bonus shares.
2.5.4.6 Illustration II
A domestic company possesses huge reserves. It wants to distribute deferred
dividends of Rs. 100 crore to its equity shareholders. For this purpose it may issue
3 year 10% redeemable preference shares or 3 year 10% redeemable debentures.
Keeping in view the following information suggest to the company whether
it should issue bonus shares or bonus debentures so that the tax liability of the
company and its shareholders is reduced :
1. Company is liable to pay tax @ 30% on its income and 17% as
dividend distribution tax.
2. Shareholders are liable to pay tax on distribution/interest income @ 30%.
Solution : 1. Tax liability when company issues bonus shares
(a) Company Rs.
1. On issue of Bonus shares Nil
2. On dividend distribution on Rs. 30
crore for 3 yrs @ 17% (Dividend distribution tax) 5,10,00,000
3. On redemption of bonus shares on
Rs. 100 crore @ 15% 15,00,00,000
Total tax liability 20,10,00,000
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(b) Shareholders Rs.

1. At the time of receiving bonus shares Nil
(As issue of bonus shares to equity shareholders
is not treated as deemed dividend)
2. Tax on dividend for 3 yrs. Nil
3. On redemption of bonus shares Nil
Total tax liability Nil
Total tax liability of company and shareholders =(a+b) Rs. 20,10,00,000
2. Tax Liability When Company Issues Bonus Debentures
(a) Company Rs.
1. On issue of debentures on Rs. 100 crore @ 15% 15,00,00,000
2. On Payment of interest on debentures Nil
3. On redemption of debentures Nil
4. Tax saved by company on interest payment on
debentures Rs. 100 crore @ 10% on Rs. 10 crore
@ 30% = Rs. 3 crore
Tax saved for 3 years (Rs. 3 crore x 3) 9,00,00,000
Net Tax liability (a) 6,00,00,000
(b) Shareholders Rs.
1. At the time of receiving bonus debentures Nil
2. On interest Rs. 10 crore @ 30% = 3 crore
On interest for 3 years = 3x3 = 9 crore
3. On redemption of bonus debentures Nil
Total liability (b) 9,00,00,000
Total tax liability of company and shareholders
(a+b) = 15,00,00,000 crore.
1. As per present rules of income tax laws DDT is abolished, therefore
now total tax liability of a company will be reduced with the amount of DDT i.e.
5,10,00,000.
2. Against to this shareholders tax liability will be increased as now
tax on dividend income is not exempted in their hands.
Thus, it is suggested that company should issue bonus debentutes to its
equity shareholders instead of bonus shares.
2.5.5 ANSWERS TO SELF CHECK QUESTIONS
Ans.1 Hints (i) Tax Planning
(ii) Tax Evasion
(iii) Tax Management
(iv) Tax Evasion
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Ans.2(a) Tax Planning includes, all such arrangements by which the tax laws
are fully complied and which meet all legal obligations and transactions,
but not taking form of 'Colourable devices' and having no intention to
deceit the legal spirit behind the tax law.
(b) Tax Management is the first step towards tax planning.
2.5.6 EXERCISE
(A) Short Questions :
Q.1 Enlist the tax considerations in issue of bonus shares.
Q.2 What do you mean by accumulated profits?
Q.3 Write a short note on the capital structure decision in case of a new project.
(B) Long Questions :
Q.1. Explain the tax consideration to be kept in mind while deciding dividend
policy of company.
Q.2. What is a ‘bonus share’ ? How can a shareholder reduce his tax liability
regarding bonus shares?
2.5.7 S U G G E S T E D R E A D I N G S
1. Income Tax (Law & Practice)
(Including wealth & Tax planning)
By Dr. H.C. Mehrotra
Dr. S.P. Goyal.
(A.Y. 2021-22)
2. Direct Taxes Planning and Management Taxmann's Publication.
By Dr. Vinod K. Singhania
Dr. Kapil Singhania
Dr. Monika Singhania
(A.Y. = 2021-22)
3. Direct Tax Laws and Corporate Tax Planning
By : Dr. Shailinder Sekhon (A.Y. 2021-22)
M. COM. PART-II MC-404
CORPORATE TAX PLANNING
LESSON NO. 2.6 AUTHOR : DR. SHALINDER SAINI

TAX PLANNING OF SPECIFIC MANAGEMENT DECISIONS

2.6.1 Objective
2.6.2 Introduction
2.6.3 Make or Buy Decisions
2.6.4 Lease or Buy Decisions
2.6.5 Illustration-1
2.6.6 Purchase by investment or Hire
2.6.7 Repair, replace, renewal or renovation
2.6.8 Illustration-2
2.6.9 Tax planning in relation to repair and replacement
2.6.10 Shut down or continue decisions
Self Check Exercise
2.6.11 Tax treatment in respect of sale of assets used for scientific research
2.6.12 Illustration-3
2.6.13 Tax planning
2.6.14 Exercise
2.6.15 Answer to self check questions
2.6.16 Suggested Readings
2.6.1 OBJECTIVE
The objective of this lesson (i.e. tax planning of specific management
decisions) is to introduce the students with the possible and latest provisions of
the tax laws in area of specific managerial decisions (e.g. make or buy decisions,
own or lease decisions, shut-down or continue decisions, repair, replace, renewal
or renovation decisions).
2.6.2 INTRODUCTION
The perceptions of the tax payer and the tax collector are different. The tax
payer spares no efforts in maximising his profits and attracting the least tax
incidence. On the other hand, tax collector, tries to maximise revenue within
the tax framework of law.
The primary objective of the tax planning as per this lesson is to save the
hard labours of the taxpayers in enjoying the fruits of his income and wealth,
while doing business and taking managerial decisions.
2.6.3 MAKE OR BUY DECISIONS
Many costing or non-costing considerations guide the decision relating
72
M. Com. Part-II 73 MC-404
to make or buy, some considerations are
(a) Utilisation of capacity
(b) Inadequacy of funds
(c) Latest technology
(d) Various cost of manufacturing or purchase price
(e) Dependence upon supplier
(f) Labour problem in the factory, etc.
From taxation point of view some other important factors also affecting
such decisions. These factors are :
(1) Establishing a new unit : If the decision to manufacture a part or
component involves setting up a separate industrial unit, tax
incentives available u/s 10A, 10B, 32, 80-IA and 80IB one has to
keep in mind.
(2) Export : If make or buy decision is taken for exporting goods, tax
incentives available u/s 10B in case the assessce is a newly
established 100% export oriented undertaking.
(3) Sale of Plant and Machinery : 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.
(4) Depreciation : If the product, either manufactured or purchased, is
a capital asset, its cost will not be allowed as a deduction in
computing the income. However, if the asset is such on which
depreciation is allowed, it will be allowed in both the cases i.e.
manufactured or purchased.
(5) Raw Material : If the product is consumable one, raw material
required to replace a worn out part at the time of repair, its cost will
be treated as revenue expense and deductible in computing the
income.
2.6.4 LEASE OR BUY DECISIONS
In recent years, leasing has become a popular source of financing in India.
From the lessors point of view, leasing has the attraction of eliminating immediate
cash outflow, and the lease rentals can be claimed or admissible expenditure
against the business income. On the other hand, buying has the advantages of
depreciation allowance and interest on borrored capital being tax deductible.
Thus, an evaluation of the two altrernatives is to be made in order to take a
decision.
While taking the decision, whether the asset should be purchased or taken
M. Com. Part-II 74 MC-404
on lease, one should keep in his mind the following factors :
(1) Cash Position : When a person has reasonable cash or he can borrow
funds at reasonable rate of interest or can acquire the asset under
hire purchase/instalment system, he may decide to buy it. The cost
of own asset is not deductible but the interest or borrowed funds or
under higher purchase/instalment system in deductible.
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/instalment system, the depreciation is allowed u/s 32. If
the asset is taken on lease then depreciation is not allowed to the
lessee, it will be allowed to the owner of the asset (i.e. lessor). This
will increase assessee's tax liability.
(3) Obsolescence risk : When a plant or machinery is purchased and it
becomes absolete earlier than its expected working life it has to be
replaced. The replacement cost can be met partly from depreciation
and partly by arranging further cash. In case of lease the lessor will
keep in his mind the risk of obsolescene.
(4) Residual value : When a person purchases an asset, he has full
right to the value of the asset at the time 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. If it is purchased with borrowed capital the cash outflow
would be equal to loan instalment, interest payment and slightly
higher tax.
On the other hand, in case of leasing the lease rent would be
equal to part of the cost of asset to lessor, interest on investment
and profit to the lessor. The cash outflow will be equal to lease rent
less nominal tax saving. In case of lease, the profit of the lessor will
be the loss to the lessee.
(6) 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, some people suggest that own funds
should not be used in purchased of an asset because interest on
own funds is not deductible, whereas interest on borrowed funds is
deductible. But one should be keep in mind that if own funds are
invested outside the business, the interest earned will off-set the
M. Com. Part-II 75 MC-404
interest payment.
Conditions for the benefit u/s 80IB, 80IC, 10A and 10B are same :
The deductions/exemptions are available to an industrial undertaking if
the plant or machinery (whether owned or leased) used by it, has not been
previously used for any purpose.
(1) If an industrial undertaking is established in free trade zone or in
software technology park or in Electronic Hardware Technology park its income
is deductible upon certain limit for 10 A.Ys u/s 10A.
(2) Income of 100% export industrial undertaking is deductible upto a
certain limit for 10 AYs u/s 10B.
(3) In case of newly established industrial undertaking in Integrated
Infrastructure development centre or Industrial growth centre located in the
North-Eastern Region etc. its income is deductible upto certain limit for 10 AYs
u/s 80 IC.
However, when deduction/exemption is claimed u/s 10A or 10B the
deduction u/s 80IB or 80IC will not be allowed to the aforesaid undertaking.
If an undertaking is not claiming exemptions u/s 10A or 10B, it is entitled
to deduction for 16 AYs. at the prescribed rate from the GTI.
(4) If an undertaking claiming deductions/exemptions u/s 10A or 10B,
from tax point of view it will be beneficial to acquire assets on lease basis during
the period of tax holiday. Because if the assets are acquired on purchase basis,
there will be no use of claiming depreciation and other tax benefits during the
tax holiday period as the income is deductible/exempt.
Conclusion
As far as possible the asset should be purchased and not taken on lease
because the cost of used of the asset purchased is less than the cost of lease
asset.
2.6.5 ILLUSTRATION-I
XYZ Ltd., manufactures electric pumping sets. The company has the option
to either make or buy from the market component Y used in manufacture of the sets.
1. The component will be manufactured on new machine costing Rs.
1,00,000 with a life of 10 years. Material required cost Rs. 2 per Kg.
and wages Rs. 0.30 per hour. The salary of the foreman employed is
Rs. 1500 p.m,. and other variables overheads include Rs. 20,000 for
manufacturing 25,000 components per year. Material required is
25,000 Kgs. and requires 50,000 labour hours. The component is
available in the market at Rs. 4.30 per piece. Will it be profitable to
make or to buy the component? Does it make any difference if the
component can be manufactured on an existing machine.
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Solution :
The cost estimate of manufacture will be Rs.
Material @ Rs. 2 Kg. (25,000x2) 50,000
Labour @ Rs.0.30 hour (50,000x0.30) 15,000
Foreman's Salary (Rs. 1500x12) 18,000
Variable Overhead 20,000
Total Variable Cost 1,03,000
Cost per Unit (i.e. Rs. 1,03,000÷25,000) (a) = 4.12
Fixed Cost : Cost of new machine (net of taxes) (see note-I) Rs. 81,157

(b) Net fixed cost per unit = 81,157

2,50,000 (units to be manufactured in 10 years)

= 0.325
Total [(a)+(b)] = 4.12+0.325 = 4.445
Conclusion :
(1) If new machine is required, cost of manufacturing Rs. 4.45 and
cost of buying Rs. 4.30, hence, Buying is better.
(2) If exisiting machine can be used then cost of manufacturing Rs.
4.12 and cost of buying is Rs. 4.30, then making is better.
Note: I Prevent value of outflow of cash when plant is purchased out of own funds :
Investment in plant machinery Rs. 1,00,000
Tax saving on account of depreciation Rs. 18,843
Net outflow of cash 1,00,000-18,843=81,157
2.6.6 PURCHASE BY INVESTMENT OR HIRE
If an asset is purchased by instalments, then the taxpayers can claim
depreciation u/s 32. Besides it, interest payable on unpaid purchase price can
also be claimed as deduction. In it the case of obtaining an asset on hire,
deduction can be claimed in respect of hire charges. Thus, by calculating the
present value of cash outflows a correct decision can be taken.
2.6.7 REPAIR, REPLACE, RENEWAL OR RENOVATION
From accounting point of view a person can debt, 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 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
M. Com. Part-II 77 MC-404

capitalise the expenses increased on replacement of a part of asset or the asset

itself. Let as see the provisions of the Income Tax act regarding deduction of
expenses incurred on repairs and renewal/replacement of an asset.
Deduction of expenses incurred on repairs
Building : Where the assessee uses a building for the purpose of business
or profession, he is entitled to a deduction of the amount paid on account of
'current repairs' to the premises. If he has taken that building on rent and
undertaken to bear the cost of repairs to the premises, he is also entitled to a
deduction of the amount paid on account of such repair u/s 30.
Plant and Machinery : Similarly if the assessee uses any machinery, plant
or furniture for the purpose of its business or profession he is entitled to a
deduction, in computing his income, the amount paid on account of current
repairs.
As per decided cases, the expression '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.
Replacement, renewal or renovation
Where an expenditure is incurred to bring new asset into existence or to
obtain a new or fresh advantage it is considered as a replacement or renewal.
The replacement may be of defective parts or of the entire machinery or a
substantial part of the entire machinery. If the replacement is deductible in
computing the income. On the other hand, if the replacement is the whole
machinery with a view of obtaining a new asset into existence, the expenditure
will be deductible being capital in nature. However, on such asset the depreciation
may be allowed u/s 32.
Following are some expenses w.r.t. renewals which are deductible in
computing the income :
(1) Cost of replacement of sleepers by a railway company.
(2) Cost of replacement of parts of boilers or boilers of old locomotives.
(3) Cost of relaying the railway lines so as to restore it to its original
conditions. But the cost of relaying the railway line so as to improve it
(conversion from meter gauge to board gauge) is a capital expenditure.
(4) Replacement of the old engine by a new engine in a motor van.
(5) Renewal of bodies of lorries owned by a transport operator.
(6) Replacement of existing wooden staircase with reinforced concrete
stiarcase.
Note : The amount paid on account of repairs or current repairs shall not
include any expenditure in the nature of capital expenditure.
M. Com. Part-II 78 MC-404
If in a given case cost of repair/renewal is not deductible u/s 30 or 31 it
may be deductible u/s 37(1) on fulfilment of conditions of that section.
2.6.8 ILLUSTRATION (2)
AB Ltd. is carrying on the business of manufacturing automobiles. It has
also estabished its 'Research and Development' section. The company, installed
a machine for scientific research on 1-6-16 by spending Rs. 15,00,000. The entire
cost has been debited to P&L Account. Now this machine is sold for Rs. 17,00,000
on July 1,2020 without using it for any other purpose of the business. The business
income of the company before giving any effect to above facts is Rs. 70,00,000.
Discuss the tax treatment on sale of above machine.
Solution : Since the machine was purchased for scienfitic research related to
the business of the company, hence the entire sum of Rs. 15,00,000 has been
claimed by the assessee as expense in the year of purchase of asset i.e. P.Y.
2016-17. It is given that asset has been sold without having been used for any
other purpose of the business.
Tax treatment on sale of above assets
Previous year of sale 2020-21 and A.Y. 2021-2022
(1) Deemed Business Profit u/s 41(3)
Sale price to the extent of deduction claimed
u/s 35 i.e. Rs. 17,00,000 (Sale Proceeds)
or
Rs. 15,00,000 (Deduction Claimed)
(2) Capital Gain/Loss
Sale Proceeds 17,00,000
Less : Cost of Acquisition 15,00,000
Short Term Capital Gain 2,00,000

Calculation of Total Income of P.Y. 2020-2021

(1) Business Income (Given) 70,00,000
Add : Deemed Business Profits 15,00,000
u/s 41(3)
85,00,000
(2) Short Term Capital Gain 2,00,000
GTI 87,00,000

2.6.9 TAX PLANNING IN RELATION TO REPAIR AND REPLACEMENT

The following points should be kept in mind to reduce tax liability while
taking a decision to repair or replace an asset :
M. Com. Part-II 79 MC-404
(1) There are stringent conditions to carry- forward and set-off 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 of a part of
asset in such a manner that it is spread over number of years.
Conversely, if the income is high, the pace can be fastered.
(2) As far as possible a part of the asset should be replaced and not the
entire asset. In this way, the cost of replacement is allowed as a deduction
in computing the income for tax purposes. On the other hand the cost of
replacement of the asset itself is treated as capital expense.
2.6.10 SHUT DOWN OR CONTINUE DECISIONS
A business may suffer loss due to one or more of the following reasons :
(1) Fall in demand : The demand of the product may fall due to
availability of new products in the market, change in fashion or
increase in number of producers/competitors.
(2) Financial problems : A firm may not have sufficient finance of its
own nor further credit is available from banks or financial
institutions due to government restrictions.
(3) Change in technology : Where the growth of technology is rapid
and if it is not possible to keep pace with it the net result may be a
loss of profit.
(4) High rates of taxes : Higher rates of taxes-import duty, excise duty,
sales tax, octroi etc. increase the price of the product.
(5) Mismanagement : Efficient management is an important factors for
success of business.
When a business suffers loss continuously, the management has to decide
whether the business should be shut-down or continue. Following provisions
should not be overlooked, while taking shut down or continue decisions :
(A) Business loss : If the business or profession has been discontinued
in P.Y. loss can be C/F and set-off against profits and gains of business or
profession upto eight assessment years.
(B) Unabsorbed depreciation : From A.Y. 2002-03, the unabsorbed
depreciation shall be added to depreciation allowance for the following P.Ys. It
means : (1) it can be set-off against income from business or profession or income
under any head; (2) it can be c/f and set-off for indefinite period, whether business
is carried on or discontinued.
In the following cases, business cann't be considered as discontinued business :
(1) Where the business has been shifted from one premises to another
or from one market to another market or from one city to another city.
(2) Where one or the other department of the business had been closed
down.
M. Com. Part-II 80 MC-404
(3) Where the business of an industrial undertaking carried on in India
is discontinued in any P.Y. by reason of extensive damage to or
destruction of any building, plant, machinery or furniture owned
by the assessee.
Who can set-off the loss
The loss can be set off by the same person who has suffered the loss. In this
connection the following points are worth noting :
(1) Where succession takes place by inheritance, the loss incurred by
the father in his business can be c/f and set-off by his son, if he
succeeds to the business father on account of his death.
(2) Where the assessee transfers his business to his spouse and or minor
child and the income from such business is to be included in his
total income u/s 64(I), the essence is entitled to the set-off of his
loss c/f from the P.Y.
(3) Where two or more companies amalgamate and form a new company,
the assessee (i.e. amalgamating companies and amalgated
companies) and the business are not the same and the loss sustained
by amalgamating companies be c/f and set-off by the amalgamated
company.
However section 72 A provides an exception to this general rule.
Section 72 A states that where a company
(i) owning an industrial undertaking or ship or hotel amalgamate with
another company or
(ii) a banking company amalgamates with a specified bank, the accumulating
company shall be deemed to the loss or unabsorbed depreciation of
amalgamated company. Thus, amalgamated company will be entitled
to c/f and set-off the loss and unabsorbed depreciation of the
amalgamating company.
(4) Where there has been a demerges of an undertaking, the
accumulated loss and the unabsorbed depreciation transferred by
the damaged company to the resulting company shall be allowed to
be c/f and set-off in the hands of resulting company.
(5) Where a firm is succeeded by a company/a proprietory concern is
succeeded by a company, which fulfils the conditions u/s 47(xiii)/
47(xiv), the accumulated loss and unabsorbed depreciation of
predecessor firm/proprietory concern shall be deemed to the loss of
the successor company for the P.Y. in which business reorganisation
was effected.
(6) Where business is carried on by a H.U.F. is transferred to the
M. Com. Part-II 81 MC-404
members of the family or position there is a change in persons
carrying on the business, the loss suffered by the family in its
business cann't be set-up by the members after position of the family.
(7) Where a partner leaves a firm (retirement or death) his share of loss
cann't be carried forward and set-off by the reconstituted firm.
(8) A closely-held company shall not be allowed to c/f and set-off its
losses against the income of the P.Y. unless on the last day of the
P.Y. the shares of the company carrying not less than 51% of voting
power were beneficially held by persons who beneficially held shares
of the company carrying not <51% of the voting ower on the last day
of the year in which the loss was incurred.
(9) Speculative loss can be set-off against speculative income either in
the same year or in subsequent 4 years.
(B) Withdrawal of certain deductions : The benefits of deduction u/s
33AB (i.e. tea development account, coffee development, rubber
development account) has been withdrawn and liable to pay tax for
the year in which business in discontinued.
(C) 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 P.Y. in which such assets are sold.
(D) Sale of depreciation assets : The asset on which the assessee has
claimed depreciation, are sold in the event of discontinuance of
business, the difference between (Net consideration-W.D.V.) shall be
treated as short-term capital gain/loss. This gain will be liable to tax.
In case of loss it can be set-off only against the capital gains, if any.
Self Check Exercise :
1. A Ltd. runs two business, jute and tea. The tea business is profitable but
the jute business has made substantial losses in the past wiping out the
profits in the tea business completely. The position of the jute business at
the beginning of the P.Y. 2020-21 is :
Rs.
Trading loss B/f from 2018-19 4,00,000
Unabsorbed depreciation 2,80,000
The jute business is not likely to make any profits in the
future, but the tea business will earn Rs. 25,000 annually. The jute business is
estimated to make an annual loss of Rs. 50,000 including estimated provision
for depreciation if run at a minimum level. A Ltd. hence proposes to close down
its jute business. Advise whether the business should be shut down or continued
giving your reasons.
M. Com. Part-II 82 MC-404
Hint : Jute business should discontinued in previous year 2020-21.
2.6.11 TAX TREATMENT IN RESPECT OF SALE OF ASSETS USED FOR SCIENTIFIC
RESEARCH
Where the assessee incurs any expenditure of a capital nature on scientific
research related to his business, the whole of such expenditure in any previous
year is allowable as deduction for the P.Y.
The following three ingredients are necessary to be satisfied for allowance
under section 35 :
(I) the expenditure has been incurred during the year;
(II) it is of capital nature;
(III) it should be on scientific research.
The following are some examples of capital expenses deductible u/s 35 :
(1) The expenditure on purchase of plants and equipments for
laboratory and on purchase or construction of a building for
conducting research.
(2) Expenditure on purchase of air-conditioners for laboratory.
(3) Expenses on purchase of cars and buses which are used to transport
employees engaged in scientific research — (IT V. Smith Kline, &
French (India) Ltd. (1994).
(4) Expenditure incurred by the assessee on construction of approach
road to its research and development laboratories — (IT V. Sandoz
(India Ltd. (1994).
Tax treatment when asset is sold : If the asset is sold without having been
used for other purposes, sale proceeds or deduction allowed, whichever is less, is
chargeable to tax as business income of the previous year in which the sale took
place [section 41(3)]. The excess of sale proceeds over deduction allowed is,
however, chargeable to tax as capital gains according to the provisions of section 45.
Depreciation not admissible : Deduction by way of depreciation is not admissible
in respect of an asset used in scientific research either in the year in which expenditure
is incurred or in a subsequent year. There is no provision in the Act, which provides
that if the assessee has acquired some assets for the business and after using some
assets for business for some time, transfer them by mere book entry from business
side to the residence side, he can get the benefit of deduction under section 35.
2.6.12 ILLUSTRATION-3
X Ltd. a domestic company, has two businesses A and B. For the last 2 years
business A has been running at a loss wiping out the entire profits of business B.
At the end of the financial year 2019-20 there are brought forward losses of Rs.
8,00,000 and unabsorbed depreciation Rs. 5,00,000.
In the financial year 2020-21 onwards it is expected that B will earn a profit
of Rs. 5,00,000 annually and if business A is continued at a minimum level
there will be an annual loss of Rs. 1,00,000 and rate of tax will be 30.9%.
M. Com. Part-II 83 MC-404
Please suggest (1) whether business A should be continued or shut-down.
(2) If continued for how many years.
Solution : If business A is discontinued in P.Y. 2019-20 the company will
not loose the right to carry-forward and set-off the part losses and unabsorbed
depreciation. Let us calculate after tax cash in hand in both the situations :
(I) Business A continued
(II) Business A discontinued, and then draw the conclusion.
(I) Business A continued
F.Y. 2020-21 Onward Years
I year II year III year IV year
Rs. Rs. Rs. Rs.
Profit of business B 5,00,000 5,00,000 5,00,000 5,00,000
Less : c/f loss of business A 1,00,000 1,00,000 1,00,000 1,00,000
4,00,000 4,00,000 4,00,000 4,00,000
Less : B/F loss of business A 4,00,000 4,00,000 — —
Less : unabsorbed depreciation — — 4,00,000 1,00,000
———— ———— ———— –————
— — — 3,00,000
Tax @ 30.90% 92,700
———— ———— ———— –————
Cash in hand (Profit Tax) after
meeting Current year loss and tax 4,00,000 4,00,000 4,00,000 2,07,300

(2) Business A Discontinued

F.Y. 2020-21 Onward Years
I year II year III year IV year
Rs. Rs. Rs. Rs.
Profit of business B 5,00,000 5,00,000 5,00,000 5,00,000
Less : B/f loss of business A 5,00,000 3,00,000 — —
Less : Unabsorbed depreciation — 2,00,000 3,00,000 —
———————————————————————
Profit of Business B — — 2,00,000 5,00,000
———————————————————————
Tax @ 30.90 % — — 61,800 1,54,500
———————————————————————
Cash in hand (Profit-tax) 5,00,000 5,00,000 1,38,200 3,45,500

Conclusion : If business A is continued there is loss every year. Hence,

business A should be discontinued in previous year 2019-20.
M. Com. Part-II 84 MC-404
2.6.13 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 to staff. If the business is closed and
retrenchment compensation paid, the expenditure would be
disallowed as not incurred for carrying on business.'
[CIY V. Gemini Cashav Sales Corporation (1967)]
(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 share holding exceeding 49% of the
shareholding. If there is a change in shareholding exceeding 49%
and the transferor/s and transfree/s are relatives, they may transfer
some % of shares as gift rather than sale so that the conditions for
set-off of losses are compiled with.
(4) If the assessee is a company, it may amalgamate with other company
after satisfying the conditions laid down in section 72A.
2.6.14 EXERCISE
(a) Short Questions :
Q.1 Distinguish between Repair and Replace of an asset.
Q.2 What factors one should keep in his mind while purchasing or taking of
an asset on lease.
Q.3 If assest is purchased on instalment basis then can the taxpayer claim
deduction for depreciation u/s 32.
(b) Long Questions :
Q.1 What are the factors to be considered while making a lease or buy
decision ? When a leasing be preferred over purchase ?
Q.2 Enumerate the factors that affect the decision to make or buy a product.
Explain the tax considerations also in this regard.
Q.3 Explain 'repair' and 'replace'. Which expenses on repair and replacement
are deductible in computing the income of a business ?
2.6.15 ANSWER TO SELF CHECK QUESTIONS
Ans (1) Hint : Jute business should be discontinued in P.Y. 2020-21.
2.6.16 SUGGESTED READINGS
(1) Taxmann's
Corporate Tax Planning and Business Tax Procedures
By : Dr. Vinod K. Singhania
Dr. Kapil Singhania (A.Y. 2021-22)
(2) Corporate Tax Planning and Management
By : Grish Ahuja
Dr. Ravi Gupta
Bharat Law House Pvt. Ltd. (New Delhi) (A.Y. 2021-22)
3. Direct Tax Laws and Corporate Tax Planning
By : Dr. Shailinder Sekhon (A.Y. 2021-22)