UNIT - III

DERIVATIVES OF COMPENSATION (MID-II Syllabus)

Tax Planning- Comparative International Compensation, Downsizing, Voluntary Retirement

Scheme and Mergers & Acquisition.

Introduction to Tax Planning:

Tax Planning: Tax planning is the analysis of a financial situation or plan to ensure that all
elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how
much you pay in taxes is referred to as tax efficient. Tax planning should be an essential part of
an individual investor's financial plan. Reduction of tax liability and maximizing the ability to
contribute to retirement plans are crucial for success.

Objectives of Tax Planning:

 Minimal Litigation: There is always friction between the collector and the payer of tax. In
such a situation, it is important that the compliance regarding tax payment is followed and
used properly so that friction is minimum.
 Productivity: Among the most important objectives of tax planning is channelization of
taxable income to various investment plans.
 Reduction of Tax Liability: As a tax payer, you can save the maximum amount from
payable tax amount by using a proper arrangement of your enterprise working as per the
required laws.
 Healthy Growth of Economy: The growth in an economy depends largely upon the growth
of its citizens. Tax planning estimates generation of white money that is in free flow.
 Economic Stability: Stability is supplemented when the tax planning behind a business is
proper.

Types of Tax Planning:

 Short-range tax planning: Under this method, tax planning is thought of and executed at the
end of the fiscal year. Investors resort to this planning in an attempt to search for ways to
limit their tax liability legally when the financial year comes to an end. This method does not
partake long-term commitments. However, it can still promote substantial tax savings.
 Long-term tax planning: This plan is chalked out at the beginning of the fiscal and the
taxpayer follows this plan throughout the year. Unlike short-range tax planning, you might
not be offered with immediate tax benefits but it can prove useful in the long run.
 Permissive tax planning: This method involves planning under various provisions of the
Indian taxation laws. Tax planning in India offers several provisions such as deductions,
exemptions, contributions, and incentives. For instance, Section 80C of the Income Tax Act,
1961, offers several types of deductions on various tax-saving instruments.
 Purposive tax planning: Purposive tax planning involves using tax-saver instruments with
a specific purpose in mind. This ensures that you obtain optimal benefits from your
investments. This includes accurately selecting the appropriate investments, creating an apt
agenda to replace assets (if required), and diversification of business and income assets based
on your residential status.

Advantages of tax planning:

 To minimize litigation: To litigate is to resolve tax disputes with local, federal, state, or
foreign tax authorities. There is often friction between tax collectors and taxpayers as the
former attempts to extract the maximum amount possible while the latter desires to keep their
tax liability to a minimum.
 To reduce tax liabilities: Every taxpayer wishes to reduce their tax burden and save money
for their future. You can reduce your payable tax by arranging your investments within the
various benefits offered under the Income Tax Act, 1961. The Act offers many tax planning
investment schemes that can significantly reduce your tax liability.
 To ensure economic stability: Taxpayers’ money is devoted to the betterment of the
country. Effective tax planning and management provide a healthy inflow of white money
that result in the sound progress of the economy. This benefits both the citizens and the
economy.
 To leverage productivity: One of the core tax planning objectives is channelizing funds
from taxable sources to different income-generating plans. This ensures optimal utilization of
funds for productive causes.
Comparative international compensation:

The traditional approach to compensation worked well with stable organizations and
clearly defined job descriptions for various positions in the hierarchy. However the rapid and
fundamental changes in the business environment in which today is organizations operate are
making the traditional approach inappropriate in aligning compensation with the aspiration of
people and needs of the organizations. The traditional concept of job is diapering as
organizations try to adapt themselves to the instability of the environment. Organizations are no
longer satisfied with their employees doing what is prescribed for them in their job descriptions.

Emerging trends:
Alternative systems of compensation are gradually emerging in response to new demands
of a radically different business environment. New approaches are based on the premise that the
compensation system should be aligned to other human resources management processes. A
well-designed and implemented system should reward the right kind of results and the right kind
of behaviors. Employers are rethinking their position based on three fundamental questions:

 Should the pay for performance be delivered as base salary or a periodic incentive?
 Should pay for performance be based on individual or team results or a combination of both?
 Should the pay for performance be focused on the job or the person performing the job?

Designing compensation packages:

 Job Content Related Compensation: The most traditional and still the most prevalent
approach is to link the annual increment ' to the performance. The basic pay is a job specific
range, which is wide enough to accommodate all levels of performance.
 Performance Related Compensation: An advance on the traditional approach has emerged
in the form of combination of job specific basic pay, performance based annual increment
and periodic incentive linked to individual or group performance. This approach, the variable
component of compensation based on individual or group performance is becoming more
significant. The attempt here is to keep a significant part of the compensation package as a
variable cost linked to performance and limit the fixed component represented by basic pay.
 Competency Related Compensation: The most recent development in the field of
compensation has been to link basic pay to the job holder competencies and not to the worth
of the job or the performance of the employee against some quantitative targets. The
 approach is based on the premise that the possession of competencies that is critical to the
strategic needs of the employer are a significant predictor of superior performance.

Paradox of performance related compensation:

Performance related compensation has been extensively tried in the United Kingdom.
The experience has been mixed. There has been overwhelming skepticism about its effects
on performance, yet it is being adopted by an increasing number of both public and private
organizations. It is estimated that at least two-third organizations in UK have individual-
based performance-related compensation. The experience appears to suggest that the
expected benefits were not realized in practice.
 Firstly, the performance- related compensation did not motivate even those with high
performance ratings.
 Secondly, there was little evidence to suggest that it helped to retain high performers and
no evidence that poor performers left the organizations.
 Thirdly, employees were negative or broadly neutral about its impact on changing the
culture. Finally, employees were unclear as to whether performance related compensation
schemes rewarded on a fair basis.
These criticisms appear to support the view that the financial rewards fail to motivate
employees unless there are clear linkages between the effort and performance on the other
hand it is performance and reward.

Concept of Career Stages:

Career stages or competency levels define the broad complex of knowledge, skills and
personal attributes that an employee is expected to acquire and demonstrates he grows in his
career. There are normally four stages or levels:

Stage #1: Stage of Dependency

 Willingly accepts supervision
 Shows directed creativity and initiative
Stage#2: Stage of Independence
 Assumes responsibility for definable projects
 Increases his technical competence and ability
 Stage #3: Stage of contribution through other
 Stimulates others through ideas and knowledge
 Represents the organization effectively to clients and external bodies
Stage # 4: Stage of leadership through vision
 Provides global technical direction to the organization
 Influences decisions and participates in securing resources.

Creating Linkages between Achievement and Reward:

Method of establishing linkages between the four building blocks of competency based
compensation system is a two-step process described in the following sections.

Evaluating Contribution:
In competency-related model of compensation, the contribution of the employee is
evaluated in terms of the level of competencies demonstrated during the assessment period. This.
Evaluation is done by explicitly expressing the achievement or the level of attainment on each
competency and then aggregating across the entire set of competencies critical to the attainment
of key or strategic business objective. If the competencies in the concerned set differ widely in
importance, specified weightage is applied to each competency and then weighted aggregate is
calculated.
Level-1 Under some supervision and or guidance effectively uses written and verbal
communications. Reports findings and recommends immediate to short term action for
self and direct contacts.-
Level-2 Independently maintains excellent communication with all appropriate parties. Has
strong technical credibility within the group.
Uses well written reports and persuasive verbal skills to convince others to adopt
recommendations.
Level-3 Communicates effectively across functional boundaries to add value to the business
and gain support for recommendations. Uses strong verbal and written skills to bring
about technical decisions that affect both his function and multifunctional efforts
Level-4 Uses communication skills and personal credibility to shape long term technical
direction and other significant business decisions. Credibility within SBU and /or
company has been established by a history of recommendations that resulted in
significant contribution to business.
Traditional VS Competency-based Model: The total reward strategy required for the
competency-based workplace to function effectively is quite different from what is appropriate
for traditional workplace. The differences are illustrated in the following table.

Reward Traditional System Competency-based System

component
Basic pay Based on internal job evaluation and Based on competency levels
external market survey comparisons demonstrated by the employee
Variable Privilege of membership of the group. Share of the employee as a partner in
Pay the success of the business.
Benefits Company decides as a matter of Employee is share for undertaking risk
policy. and accountability as a business
collaborates.
Career Job for life for loyalty. Employee and the employer are
Opportunity mutually responsible for career.
Employer offers opportunity as
business demands and employee has
to keep his competencies in line with
demand.

Downsizing: Downsizing means reducing the strength of employees through planned

elimination of positions and jobs (or) Downsizing are the permanent reduction of a company's
labor force through the elimination of unproductive workers or divisions. Downsizing is a
common organizational practice, usually associated with economic downturns and failing
businesses. Cutting jobs is the fastest way to cut costs, and downsizing an entire store, branch or
division also frees assets for sale during corporate reorganizations.
Reasons:
 To Solve the Problem of Initial Over-Staffing
 To Deal with the Adverse Consequences of Economic Recession
 To Take Advantage of Technological Advancements
 To Concentrate on Core Activities and to Outsource Non-Core Activities

Role of HR Manager:

 Proper Communication with Employees

 Convincing Employees’ Unions and Winning their Support
 Providing Outplacement Services
 Working out Alternatives to Termination.
Methods for Implementing Downsizing:
 Outplacement: Outplacement is an effort made by a downsizing organization to help its
redundant employees to find jobs outside the organization. For this purpose, an outplacement
agency which may also be a recruitment agency, is engaged. This agency contacts the
employees to be outplaced and arranges jobs for them. In most of the cases, the employees
are not aware that this process has been undertaken on behalf of the organization.

 Secondment: The term secondment is used broadly to cover a temporary movement or loan
of an employee to another part of the same organization or to a completely different
organization. Though the objectives of secondment extend beyond effecting downsizing
strategy like employee development, filling key positions by secondees’ organization, etc., it
can also be used as a method of implementing downsizing strategy. The organization opting
for secondment can loan its surplus employees to an organization which can absorb these
employees for the time being. With this kind of arrangement, all the three parties stand to
benefits- the organization intending to reduce surplus staff gets an easy alternative; the
secondees’ organization is able to get skilled employees without going through long-drawn
process of recruitment, development, etc.; and the surplus employees get alternative
employment with their existing terms and conditions.

Voluntary Retirement Scheme (VRS):

VRS stands for voluntary retirement scheme, whereby an employee is offered to voluntarily
retire from services before the retirement date. The scheme allows companies to reduce the
strength of employees. It can be implemented by both the public and private sectors. VRS is
also known as 'Golden Handshake'.
Voluntary retirement scheme in India: Indian labor laws do not allow direct retrenchment
of employees under a union. According to the Industrial Disputes Act, 1947, employers
cannot reduce excess staff by retrenchment. In fact, any plans of retrenchment and reduction
of staff and workforce are subjected to strong opposition by trade unions. So, VRS was
introduced as an alternative legal solution to solve this problem. The voluntary retirement
scheme was not vehemently opposed by the Unions, because it is 'voluntary' in nature and
not compulsory.
 Voluntary retirement rules:
 VRS is voluntary. Meaning, there has to be a mutual agreement between the employer
and the employee stating that the latter would voluntarily terminate their services on
receiving compensation from the former.
 Since the primary objective of Voluntary Retirement Scheme is to reduce the strength of
employees in an organization, the vacancy created thereby is not to be fulfilled. In other
words, employees retrenched by way of VRS shouldn’t be employed in any other
company belonging to the same management
 VRS is applicable to employees aged over 40 yrs or those who have served the company
for 10 yrs. The scheme applies to all employees including workers and executives but
not the directors of a company/co-operative society
 Public sector companies are required to take prior approval of the government before
they offer Voluntary Retirement Scheme to their employees
 Companies can have different rules of VRS but they should conform to the guidelines
mentioned under section 2BA of the Income Tax Rules
Firm opt for voluntary retirement scheme:
Private and public sector firms can opt for VRS under the following circumstances:
 Recession in business
 Intense competition
 Joint-ventures with foreign collaborations
 Takeovers and mergers
 Obsolescence of product/technology

Benefits of VRS:

 Employing just the right number of laborers has a significant bearing on a company’s profit
and success. It results in cost and resource optimization and achieves operational
effectiveness and efficiency.
 VRS also helps companies to fight competitors. Thanks to globalization, companies are
fighting intense competition in critical fields including innovation, technical know-how, and
 skills. Ergo, companies look to recruit labour and management that can adapt to the latest
developments and let go of the old workforce.
 VRS is the most humane way to reduce staff. The employee opting for VRS is entitled to
receive monetary compensation. Some companies may also offer non-monetary
compensation to employees.
 Although a company has to bear a heavy VRS payout initially, they save significant wage
bills over time

Mergers and Acquisitions: Mergers and acquisitions (M&A) is a general term used to describe
the consolidation of companies or assets through various types of financial transactions,
including mergers, acquisitions, consolidations, tender offers, purchase of assets, and
management acquisitions.

 Mergers: A merger is an agreement that unites two existing companies into one new
company. There are several types of mergers and also several reasons why companies
complete mergers. Mergers and acquisitions are commonly done to expand a company’s
reach, expand into new segments, or gain market share. All of these are done to
increase shareholder value. Often, during a merger, companies have a no-shop clause to
prevent purchases or mergers by additional companies.
 Acquisitions: An acquisition is when one company purchases most or all of another
company's shares to gain control of that company. Purchasing more than 50% of a target
firm's stock and other assets allows the acquirer to make decisions about the newly acquired
assets without the approval of the company’s other shareholders. Acquisitions, which are
very common in business, may occur with the target company's approval, or in spite of its
disapproval. With approval, there is often a no-shop clause during the process.

Mergers and acquisitions: he Indian scenario:

M&A activity had a slow take-off in India. Traditionally, Indian promoters have been
very reluctant to sell out their businesses since it was synonymous with failure and was never
viewed as a sensible move. This scenario changed dramatically in the 90s with the Tatas selling
TOMCO and Lakme. Suddenly selling out had become a sensible option. The second major
reason for the slow take-off of M&A activity was due to the fact that even while the companies
continued to decline, the banks and financial institutions, normally the biggest stakeholders in
most Indian companies were reluctant to change the managements. Fortunately this situation has
changed for the better. Worried about the spectre burgeoning NPAs, these institutions are now
willing to force the promoters to sell out. The FIs and banks are flushed with funds and they are
willing to assist big companies in acquiring new companies.

Mergers and acquisitions in India, just as in other parts of the world, are primarily aimed
at expanding a company’s business and profits. Acquisitions bring in more customers and
business, which in turn brings in more money for the companies thus helping in its overall
expansion and growth. More and more companies are, therefore, moving towards acquisitions
for a fast-paced growth. Consolidation has become a compelling necessity to counter the effects
of increasing globalization of businesses, declining tariff barriers, price decontrols and to please
the ever demanding and discerning customers. And these pressures are expected to intensify and
relentlessly batter every business in the future. The M&A activity is helping the companies
restructure, gain market share or access to markets, rationalize costs and acquire brands to
counter these threats. The shareholders of many companies are also supporting these moves and
sharp increase in share prices is an indication of this support.

Different forms of Mergers Growth Strategies

 Horizontal Merger: Merger of two companies that are in direct competition in the same
product categories and markets.
 Vertical Merger: Merger of two companies which are in different stages of the supply chain.
This is also referred to as vertical integration. A company taking over its supplier’s firm or a
company taking control of its distribution by acquiring the business of its distributors or
channel partners is examples of this type of merger.
 Market-extension Merger: Merger of two companies that sell the same products in different
markets.
 Product-extension Merger: Merger of two companies selling different but related products
in the same market.
 Conglomeration: Merger of two companies that have no common business areas.
From the finance standpoint, there are three types of mergers:

 Pooling of Interest: A pooling of interests is generally accomplished by a common stock

swap at a specified ratio. This is sometimes called a tax-free merger. Such mergers are only
allowed if they meet certain legal requirements. A pooling of interests is generally
accomplished by a common stock swap at a specified ratio.
 Purchase Mergers: As the name suggests, this kind of merger occurs when one company
purchases another one. The purchase is made by cash or through the issue of some kind of
debt investment, and the sale is taxable. Acquiring companies often prefer this type of merger
because it can provide them with a tax benefit. Acquired assets can be “written up” to the
actual purchase price, and the difference between book value and purchase price of the assets
can depreciate annually, reducing taxes payable by the acquiring company.
 Consolidation Mergers: In a consolidation, the existing companies are dissolved, a new
company is formed to combine the assets of the combining companies and the stock of the
consolidated company is issued to the shareholders of both companies.

Steps in merger and acquisition deals:

1. Comparative Ratios: The following are two examples of the many comparative measures on
which acquirers may base their offers:
 P/E (price-to-earnings) Ratio: With the use of this ratio, an acquirer makes an offer
as a multiple of the earnings the target company is producing. Looking at the P/E for
all the stocks within the same industry group will give the acquirer good guidance for
what the target’s P/E multiple should be.
 EV/Sales (price-to-sales) Ratio: With this ratio, the acquiring company makes an
offer as a multiple of the revenues, again, while being aware of the P/S ratio of other
companies in the industry.
2. Replacement Cost: In a few cases, acquisitions are based on the cost of replacing the target
company. The value of a company is simply assessed based on the sum of all its equipment
and staffing costs without considering the intangible aspects such as goodwill, management
skills, etc. The acquiring company can literally order the target to sell at that price, or it will
create a competitor for the same cost.
3. Discounted Cash Flow: An important valuation tool in M&A, the discounted cash flow
analysis, determines a company’s current value according to its estimated future cash flows.
Future cash flows are discounted to a present value using the company’s weighted average
cost of capital.
4. Synergy: Quite often, acquiring companies pay a substantial premium on the stock value of
the companies they acquire. The justification for this is the synergy factor: a merger benefits
shareholders when a company’s post-merger share price increases by the value of potential
synergy. For buyers, the premium represents part of the post-merger synergy they expect can
be achieved.
Merger and Acquisition Strategy:
There are number of reasons that mergers and acquisitions take place. These issues
generally relate to business concerns such as competition, efficiency, marketing, product,
resource and tax issues.
 Reduce Competition: One major reason for companies to combine is to eliminate
competition. Acquiring a competitor is an excellent way to improve a firm’s position in
the marketplace. It reduces competition and allows the acquiring firm to use the target
firm’s resources and expertise.
 Cost Efficiency: Due to technology and market conditions, firms may benefit from
economies of scale. The general assumption is that larger firms are more cost effective
than are smaller firms. It is, however, not always cost effective to grow. Inspite of the
stated reason that merging will improve cost efficiency.
 Improve Earnings and Reduce Sales Variability: Improving earnings and sales
stability can reduce corporate risk. If a firm has earnings or sales instability, merging with
another company may reduce or eliminate this provided the latter company is more
stable. If companies are approximately the same size and have approximately the same
revenues, then by merging, they can eliminate the seasonal instability.
 Market and Product Line Issues: Often mergers occur simply because one firm is in a
market that the other company wants to enter. All of the target firm’s experience and
resources are readily available of immediate use. This is a very common reason for
acquisitions.
  Acquire Resources: Firms wish to purchase the resources of other firms or to combine
the resources of the two firms. These may be tangible resources such as plant and
equipment, or they may be intangible resources such as trade secrets, patents, copyrights,
leases, management and technical skills of target company’s employees, etc.
 Tax Savings: Although tax savings is not a primary motive for a combination, it can
certainly “sweeten” the deal. When a purchase of either the assets or common stock of a
company takes place, the tender offer less the stock’s purchase price represents a gain to
the target company’s shareholders. Consequently, the target firm’s shareholders will
usually gain tax benefits. However, the acquiring company may reap tax savings
depending on the market value of the target company’s assets when compared to the
purchase price.


Reasons for failure of merger and acquisition:

The potential pitfalls that a firm is likely to encounter during diversification includes
 Integration Difficulties.
 Faulty Assumptions
 Mergers are also driven by fear psychosis
 Failure to carry out effective due-diligence
 Too much diversification

Five compensation mistakes in mergers and acquisition:

When two companies merge, there is much to consider when it comes to structure vs
restructure and compensation implications.

 You haven’t identified and summarized the ROI of a new compensation plan.
 Fail to involve managers
 Started the process with job consolidation
 Pay structure without knowing where employees currently fit into it to the job or not.
 Fail to communicate the process to employees