MODULE 3

TAX PLANNING RELATING TO CAPITAL STRUCTURE DECISION

Capital structure 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 of an undertaking would he between
capital and borrowings and the planning of the optimum
debt-equity ratio.
From tax point of view expenses incurred on raising loans/ debentures
and interest payable on loans are deductible in computing taxable
income of the assessee. However, any amount of' interest paid, in
respect of loan for acquisition of an asset for extension of existing
business(whether capitalised in the hooks of account or not) for any
period beginning from the date on which loan was taken for acquis ition
of the asset till the date on which such asset was first put to use, shall
not be allowed as a deduction. It will be added to the cost of the asset.
On the other hand, the expenses incurred on raising capital/share
capital and interest on capital/dividend on share capital are not
deductible in computing the taxable income of the assessee.
However, the following expenses in relation to capital are deductible :

1. If the assessee is a firm, the interest payable to partners on their

capital and loan capital, subject to a maximum of 12% p.a.

2. If the assessee is an Indian company and in connection with the

issue, for public subscription, of• shares in or debentures of the
company, incurs expenses (being under-writing commission,
brokerage and charges for drafting, typing, printing and advertise-
ment of the prospectus) twenty percent of such expenses are
allowed for each of the five successive previous years beginning
with the previous year in which the business commences.

From this one may conclude that the borrowings contribute to tax
saving resulting a higher rate of return on owner’s equity. But this does
not hold good in every case. If the rate of return on total capital is more
than the rate of interest, definitely the borrowing would increase the
rate of return on owner’s equity. Otherwise it would reduce this rate of
return.

 Impact of Capital Structure on Exemption or Deduction

The exemption/deduction under Section 10AA or deduction

under Section 801A or 80IAB or 801B or 801C or 801E etc. of the
Income Tax Act increases the profits after tax or in other words
increases the rate of return on equity capital. But the borrowed
capital reduces the profits (profits less interest) before tax and to
that extent the exemption is reduced or proportionately deduction
is reduced. Therefore, minimum possible loans may be taken at
the time of commencement of an industrial undertaking.

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  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.
However, the legal requirements for raising capital through
any means of finance cannot be ignored.

3. The capital may be utilised for acquisition of non-depreciable

assets like land, goodwill, etc. and borrowed funds may be
utilised to acquire depreciable assets. The interest on loans for
the period after setting up of business but before the asset was
put to use will be capitalised and a higher amount of depreciation
will be allowed.

4. If the gestation period in an industry is more it is better to use

capital rather than loans. On the loans interest will be paid out of
capital. This interest payment will be carried forward as business
loss which the assessee may not be able set-off within the
prescribed period of eight years. On the other hand, the money-
lenders have to pay tax on their interest income.

5.If interest is payable outside India tax must be deducted at

source. If tax has not been deducted at source, the amount
paid as interest will not be allowed as a deduction in
computing business income.

6.The term 'Interest' has been defined in Section 2 (28A) of the

Income Tax Act, liberally. 'Interest.' means interest Payable in any
manner in respect of any money borrowed or debt, incurred and
includes any service fee or other charge in respect of the moneys
borrowed or debt incurred or in respect of any credit facility which
has not been utilised.

Hence, not only interest but also service fee or other charge on loans,
whether utilised or not, should be claimed as revenue expense in
computing the business income.

DIVIDEND POLICY

Meaning of Dividend in common use. In ordinary language dividend

means the SLIM received by a shareholder of a company on the
distribution of its profits, whether out of taxable income or tax-free
income. It is immaterial whether it is received in cash or in kind.

S.G.T Collage Ballari Page 2

 AMALGAMATION AND DEMERGER

AMALGAMATION
♦ Definition
According to Accounting terminology the term `amalgamation'
means taking over of business of two or more companies by a newly
formed company for this purpose. The companies, whose business is
taken over, are wound up. Further, the term `absorption' means
taking over of the business of one or more companies by an existing
company. Thus, in case of amalgamation, a new company is formed
to take over the business of one or more existing companies while in
case of absorption no new company is formed.

According to Section 2(1B) of the Income Tax Act, 1961, the term
`amalgamation' means When one or more companies merge with another
existing company or two or more companies merge to form a new
company, it is known as amalgamation. The company which so merges
is known as the amalgamating company and the company with which
the merger takes place or the company which is formed as a result of the
merger is known as the amalgamated company.

It means there is no difference between amalgamation and absorption

for income tax purposes. However, in order to constitute a valid
amalgamation for Income tax purposes, it must be in such a manner
that :

(i) all the property of the amalgamating companies immediately before

the amalgamation becomes the property of the amalgamated
company;

(ii) all the liabilities of amalgamating companies immediately

before the amalgamation becomes the liabilities of the
amalgamated company;

(iii) shareholders (equity and preference) holding not less than 75% in
the value of the share in the amalgamating companies become
shareholders of the amalgamated company. However, the value of the
shares already held before the amalgamation by the amalgamated
company or by its nominee or by its subsidiary company shall be
excluded in computing aforesaid 75% value of shares. For example, `A'
company holds 30% shares of `B' company which wants to merge with
`A' company. Shareholders of `B' company holding at least 75% of the
remaining shares i.e., 52.5% (75 x 70 = 100) should become the
shareholders of `A' company.

In the following cases there is no ‘amalgamation’ for Income tax

purposes:
(i) Where the property of one company is acquired by the other
company pursuant to the purchase of such property.
(ii) Where under liquidation the company receives the property of
the other company from the liquidator

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  Tax incentives for Amalgamation

Some tax incentives have been provided for amalgamation of a

company to :
1. the amalgamating company;
2. the shareholders Of the amalgamating company; and
3. the amalgamated company.

 Tax incentives to Amalgamating Company

1 . Exemption from Capital gains tax. There shall be no liability for

a capital gains tax on the transfer of capital assets by the
amalgamating company if the amalgamated company is an Indian
company. [Sec.47(vi)]

2. Tax Concession to foreign company. 'There shall be no liability

for capital gains tax on the transfer of shares of an Indian company
by a foreign company to another foreign company in pursuance of a
scheme of amalgamation between the two foreign companies, if :

(a) at least 25% of the shareholders of the amalgamating foreign

company continue to remain shareholders of the amalgamated
foreign company;
(b) such transfer does not attract tax on capital gains in the
country in which the amalgamating company is incorporated.
[Sec.47(vi)]

3.Exemption from tax liability on transfer of licence to operate

telecommunication services etc. There shall be no tax liability on
transfer of right to use spectrum for telecommunication services (u/s
35ABA) or transfer of a licence to operate telecommunication services
(u/s 35ABB) or on transfer of a business of prospecting for or
extraction or production of petroleum and natural gas(u/s42) by the
amalgamating company if the amalgamated company is an Indian
company.

4. If the plant or machinery is transferred. Under a scheme of

amalgamation on which investment allowance (u/s 32AD) is
claimed, the benefit of deduction shall not be withdrawn.

 Tax incentives to Shareholders of Amalgamating Company

1. Period of holding of shares of the amalgamated company.

Where shares (a capital asset) in an Indian Company, which become
the property of the assessee in consideration of shares transferred i n
case of amalgamation, there shall be included the period for which
the shares in the amalgamating company were held by the assessee.
[Sec 2(42A)(C)]

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 2. Exemption from tax on exchange of shares. The shareholders
of the amalgamating company are not liable to capital gains tax,
when they are allotted shares by the Indian amalgamated company
in lieu of shares held by them in the amalgamating company.
. [Sec.47(vii)]

 Tax incentives to Amalgamated Company

'1. Capital expenditure on scientific research. Where a company is

amalgamated before claiming full deduction in respect of capital
expenditure on scientific research, the amalgamated company (being an
Indian company) is entitled to claim deduction of such unabsorbed
amount. [Sec. 35(5)]

2. Expenditure incurred to obtain licence to operate telecommunication

services etc. Where a company is amalgamated before claiming full
deduction in respect of expenditure to obtain right to use spectrum for
telecommunication services or licence to operate telecommunication
services, the amalgamated company (being an Indian company) is
entitled to claim deduction in respect of remaining instalments of such
expenditure. [Sec. 35ABA and See. 35ABB]

3. Preliminary expenses. Where an Indian company is amalgamated

before claiming full deduction in respect of certain preliminary expenses,
the amalgamated company (being in Indian company) is entitled to claim
deduction in respect of remaining instalments of such expenses.
. [Sec. 351-)(5)]

4. Expenses for amalgamation. Where an Indian company incurs

expenditure wholly and exclusively for the purposes of amalgamation, it
shall be allowed a deduction C 20% of such expenditure for each of five
successive previous years beginning with the previous year in which
amalgamation takes place. (Sec,35DD)

5. Expenses incurred under voluntary retirement scheme. Where an

Indian company is amalgamated before claiming full deduction in
respect of expenses incurred under voluntary retirement, the
amalgamated company (being an Indian company) is entitled to claim
deduction in respect of remaining instalments of such expenses.
[Sec.35l)DA(2)]

6. Expenses on prospecting etc. of certain minerals. Where an Indian

company is amalgamated before claiming full deduction in respect of
expenditure incurred on prospecting for, or extraction or production of
certain minerals, the amalgamated company (being an Indian company
is entitled to claim deduction in respect of remaining instalments and
unabsorbed amount of such instalments . (Sec. 34E(7)]

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 7. . Capital expenses on family planning. Where a company is
amalgamated before claiming full deduction in respect of capital
expenditure incurred for the purpose of promoting family planning
amongst its employees, the amalgamated company (being an Indian
company) is entitled to claim deduction in respect of remaining
instalments and unabsorbed amount of such instalments.
[(Se.36(1)(ix)]

DEMERGER

The business and economic environment of the country has thrown up

the need for rationalisation of laws relating to business re-organisation
of production system and better utilisation of resources which have
become necessary with a view to enable the Indian industry to rearrange
itself to become globally competitive. With this view :

(a) Demerger has been made tax neutral and it does not attract any
additional tax liability.

(b) In demerger, tax benefits and concessions available to any

undertaking, shall be, available on its transfer to the resulting company.

 Definition-Demerger[ Sec. 2(19AA)]

Demerger in relation to a company means the transfer, pursuant to
a scheme of arrangement under sections 230 to 232 of the Companies
Act, 2013, by a demerged company of its one or more undertakings to
any resulting company in such a manner that :

(i)All the property of the undertaking(transferred by the demerged

company) immediately before demerger, becomes the property of the
resulting company by virtue of demerger.

(ii) All the liabilities relatable to the undertaking (transferred by the

demerged company) immediately before demerger, become the liabilities
of the resulting company by virtue of demerger.

(iii) The property and the liabilities aforesaid are transferred at values
appearing in the books of account immediately before demerger.

(iv) The resulting company issues, in consideratio n of demerger, its

shares to the shareholders of the demerged company on proportionate
basis except where the resulting company itself is a shareholder of the
demerged company.

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 (v) The shareholders holding not less than 75% in value of the shares in
the demerged company (other than shares already held therein
immediately before demerger by the resulting company or by a nominee
or its subsidiary) become shareholders of the resulting company or
companies by virtue of demerger.

(vi) The transfer of the undertaking is on a going concern basis.

(vii) The demerger is in accordance with the conditions, if any, notified

by the Central Government u/s 72A(5).

,Explanation :
(1) `Undertaking' shall include any part of an undertaking or a unit or
division of an undertaking or a business activity taken as a whole, but
does not include individual assets or liabilities or any combination
thereof not constituting a business activity.)

(2) `Liabilities' shall include :

(a) The liabilities which arise out of thb activities or operations of the
undertaking.
(b) The specific loans or borrowings (including debentures) raised,
incurred and utilised solely for the activities or operations of the
undertaking.
(c) Other than above, the amounts of general or multipurpose
borrowings, proportionate to the value of assets transferred in demerger.
(3) For determining the value of property transferred, any change in the
value of assets on account of their revaluation shall be ignored.

 Demerged Company [Sec. 2(19AAA)]

It means the company whose undertaking is transferred, pursuant to a
demerger, to a resulting company.

 Resulting Company [Sec 2(41A0]

It means one or more companies (including a wholly owned subsidiary
thereof) (i) to which the undertaking of the demerged company is
transferred in a demerger and (ii) the resulting company in consideration
of such transfer of undertaking, issues shares to the shareholdersof the
demerged company

It also includes any authority or body or local authority or public sector

company or acompany established, constituted or formed as a result of
demerger

S.G.T Collage Ballari Page 7

  Tax incentives to Shareholders of Demerged Company
1. Period of holding of shares of the resulting company. Where
shares (a capital asset) in an Indian company which become the
property of the assessee in consideration of demerger, there shall be
included the period for which the shares in the demerged company were
held by the assessee . [Sec. 2(42Ag)]

2. Exemption from tax on exchange of shares. The shareholders of

the demerged company are not liable to capital gains tax, when they are
allotted shares by the resulting company in consideration of demerger of
the undertaking . [Sec.47 (vid)]

 Tax incentives to Demerged Company

1. Plant or machinery transferred on which investment allowance is
claimed. If such asset is transferred under a scheme of demerger the
benefit of deduction u/s 32AD shall not be withdrawn.

2. Exemption from capital gains tax. There shall be no liability for

capital gains tax on the transfer of capital assets by the demerged
company if the resulting company is an Indian company.

3. Tax concession to foreign company. There shall be no liability for

capital gains tax on transfer of shares of an Indian company by the
demerged foreign company to the resulting foreign company, if :
(a) the shareholders holding not less than three-fourths in value of
the shares of the demerged foreign company continue to remain
shareholders of the resulting foreign company; and

(b) such transfer does not attract tax on capital gains in the country
in which the demerged foreign company is incorporated. [Sec. 47(vic)]

4. Exemption from tax liability on transfer of licence to operate

telecommunication services etc. There shall be no tax liability on
transfer of right to use spectrum for telecommunication services (u/s
35ABA) or a licence to operate telecommunication services (u/s
35ABB) or on transfer of a business of prospecting for or extraction or
production of petroleum and natural gas (u/s 42) by the demerged
company if the resulting company is an Indian company.

 Tax incentives to Resulting Company

1. Capital expenditure for obtaining licence to operate
telecommunication services etc. Where in a scheme of demerger, the
demerged company sells or transfers the right to use spectrum for
telecommunication services or the licence operate telecommunication
services to the resulting company (being an Indian company), the
resulting company is entitled to claim deduction in respect of the
remaining instalments of such capital expenditure.
[Sec. 35ABA(7 )and Sec.35ABB(7)]

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 2. Preliminary expenses. Where the undertaking of an Indian
company, which is entitled to deduct such expenses, is transferred, to
another company in a scheme of demerger, the resulting company is
entitled to claim deduction in respect of remaining instalments of such
expenses. [Sec. 35D(5A)]

3.. Expenses for demerger• Where an Indian company incurs

expenditure wholly and exclusively for the purposes of demerger, it shall
be allowed a deduction @ 20% of such expenditure for each of five
successive previous years beginning with the previous year in which
demerger takes place. (Sec.35DD)

. 4.Expenses incurred under voluntary retirement scheme. Where

the undertaking of an Indian company entitled to deduct such expenses,
is transferred to another company in a scheme of demerger, the
resulting company is entitled to claim deduction in respect of remainin g
instalments of such expenses . [See.35DDA(3)]

5. Expenses on prospecting etc. of certain minerals. Where the

undertaking of an Indian company entitled to deduction in respect of
expenditure incurred on prospecting fir, or extraction or production of
certain minerals, is transferred to another Indian company in a
scheme of demerger, the resulting con any is entitled to claim deduction
in respect of remaining instalments of such expenses. [sec..35E(7A)]

S.G.T Collage Ballari Page 9