Tax Planning

Corporate Tax Planning

Topic : Tax PlanningPaper : Corporate TaxationProgram : MBA

OBJECTIVES OF TAX PLANNING

• Reduction of tax liability• Minimisation of litigation • Productive investment• Healthy growth of economy • Economic stability

Basic principles• There are many perfectly legal and socially acceptable

ways to increase your wealth in a tax efficient manner. Some of these methods are very powerful. Legitimate methods of increasing your tax efficiency are called “tax planning”.

• Methods that are unlawful are categorised under two different labels:– “Tax avoidance” is where you set up contrived accounting

structures and strategies that abuse a loophole so you can claim large tax deductions or take advantage of some benefit that was never intended to be used in such a way.

– “Tax evasion” is where you deliberately try to hide income from the Tax Office, by various methods including secret bank accounts, not recording cash transactions, “cooking the books” etc.

TAX PLANNING, TAX AVOIDANCE AND TAX EVASION

• In the judgement of the Supreme Court in McDowell’s case 1985 (154 ITR 148) SC, tax avoidance has been considered as heinous as tax evasion and a crime against society. The Supreme Court held that it is true that planning may be legitimate provided it is within the framework of the law.

• The line of demarcation between tax planning and tax avoidance is very thin and blurred. There could be elements of malafide motive involved in tax avoidance also.

• Any planning which, though done strictly according to legal requirements defeats the basic intention of the Legislature behind the statute could be termed as instance of tax avoidance.

Review Question

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Review Questions• Deposit of Rs. 60,000 in public provident fund account to reduce total tax

liability.Tax Planning : It is tax planning because depositing money of Rs. 60,000 in PPF and taking deduction under section 80C is as per the provisions of law.

• A company installed an air conditioner at the residence of its director and treated it as business asset for depreciation.Tax Evasion : Treatment of installed Air conditioner at residence of director as business asset for depreciation would amount to tax evasion if such installation is not as per the term of employment. OrTax Management : If the installation of AC at the residence of director as per the terms of employment then treatment of it as business asset for depreciation is tax management.

• X Ltd. issued a credit note for Rs. 40,000 as commission payable to Y who is son of X, managing director of the company. The sole purpose was to transfer the income of the company as income of Y.Tax evasion : The issue of credit note for Rs. 40,000 as commission to reduce the tax liability of company is tax evasion.

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Review Questions• Y, a non-resident Indian citizen visits India every year only for 181 days

to remain non-resident.Tax planning : It is tax planning, by residing in India for less than 182 days will reduce his tax liability and it is in accordance with the provisions of tax laws.

• Z Ltd. deduct tax at source but fails to deposit the same in government treasury.Tax Evasion : Fails to deposit the collected TDS shows that undue benefit is taken by not complying tax provisions it is tax evasion.

• B transferred 1,000 debentures of a company to his son C before the due date of interest to reduce his tax liability.Tax avoidance : In accordance with section 60 of the Act, transfer of debenture to C and income thereon for reducing the tax liability shall not to be clubbed in the hands of B as the asset is also transferred along with the income. Hence, it is the case of tax avoidance as advantage is taken by finding out loophole in the law.

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Illustrative instances of tax-planning measures

• Varying the residential status (of a limited application).• Diversion of income by over-riding title• Choosing the suitable form of assessable entity (individual, HUF, Firm, Co-

operative society, Association of persons, Company, Trust, etc. to obtain the maximum tax concessions e.g. hotel industry in the form of a company to obtain tax holiday benefit.)

• Choosing suitable forms of investment (share capital, loan capital, lease, mortgages, tax exempt investments, priority sector, etc.)

• Programmed replacement of assets to take free advantage of the provisions governing depreciation and provisions governing investment allowance, investment deposit account scheme.

• Diversification of the business activities (hotel industry, agro-based industry, export oriented industries, etc.)

• The use of the concept of commercial expediency to claim deduction in respect of expenditure, in computing business income.

Diversion of income by overriding title and application of income

• Diversion of income is at source by an overriding title before it reaches an assessee.

• It can take place either under a legal compulsion or under a contractual obligation or otherwise.

• An obligation to apply the income in a particular way before it has accrued or arisen to the assessee results in the diversion of the income.

• An obligation to apply income which has accrued or arisen or has been received amounts merely to the apportionment or application of the income and not to its diversion.

• Sometimes the dividing line between diversion by overriding title and the application of income after it has accrued is somewhat thin.

• By diversion, the assessee can avoid payment of taxes but tax has to be paid before application of income.

IMPORTANCE OF TAX PLANNING • Rebates and deductions not available at the time of appeal• Severe penalties in case of tax avoidance and tax evasion

under various laws• Activities and programmes, which are of public interest and

good for a civilised society are encouraged by the Government and incentives provided in the tax laws.

• With increase in profits, the quantum of corporate tax also increases and it necessitates tax planning.

• Essential to bear the burden of inflation• Needed for capital formation• Very important in credit squeeze and dear money

conditions

ESSENTIALS OF TAX PLANNING

• upto date knowledge of tax laws, judgments , circulars, notifications, clarifications and administrative instructions

• disclosure of all material information• sham transactions or make-believe

transactions or colourable devices, entered into just with a view to circumvent the legal provisions, must be avoided.

AZADI BACHAO ANDOLAN(MAURITIUS)

Hutch-Vodafone deal• Hutchison International, a non-resident seller and parent company based in Hong

Kong sold its stake in the Cayman Islands (which, in turn, held shares of Hutchison-Essar - Indian operating company, through another Mauritius entity) to Vodafone, a Dutch non-resident buyer. The deal consummated for total value of $11.2 billion, which comprised a majority stake in Hutchison Essar India. In light of this, the revenue issued show-cause to Vodafone asking for an explanation as to why Vodafone Essar (which was formerly Hutchison Essar) should not be treated as an agent (representative assessee) of Hutchison International and asked Vodafone Essar to pay $1.7 billion as capital gains tax.

• The controversy in the case of Vodafone is about the taxability of transfer of share capital of the Indian entity. Generally, the transfer of shares of a non-resident company (the holding company of Hutchison Essar India) by a non-resident (Hutchison International) to another non resident (Vodafone) is not subject to tax in India. But the revenue department is of the view that this transfer represents transfer of “beneficial interest” in the Indian company and hence, it will be subject to tax. On the contrary Vodafone’s argument is that there is no sale of shares of Indian company and what it had acquired is a company incorporated in the Cayman Islands, which in turn holds the Indian entity. Hence, the transaction is not subject to tax in India.

Supreme Court decision• Applying the ‘look at test’ in order to ascertain the true

nature and character of the transaction, the offshore transaction between two non-resident companies is nothing but a bonafide structural foreign direct investment into India which falls outside territorial jurisdiction of India and is hence not taxable.

• Thus, where the offshore transaction evidences participating investment and not a sham or tax avoidant pre-ordained transaction and the offshore transaction is between two non-resident companies and the subject-matter of the transaction is the transfer of the shares in a foreign company, the Indian tax authority has no territorial tax jurisdiction to tax the offshore transaction.

AREAS OF TAX PLANNING IN THE CONTEXT OF INCOME TAX ACT, 1961

• At the time of setting up of new business entity:– Form of organisation/ownership pattern;– Locational aspects;– Nature of business.

• For the business entities already in existence:– Tax planning in respect of financial management decisions; – Tax planning in respect of specific managerial decisions;– Tax planning in respect of corporate restructuring;– Tax planning in respect of employees remunerations;– Tax planning in respect of Foreign Collaborations and Joint

Venture Agreements;– Tax planning in the light of various Double Taxation Avoidance

Agreements.

Tax planning for business deductions• a clear and thorough understanding of the various statutory

provisions governing the deductions.• Some general considerations

– Allowability– Year of allowbility– Extent of allowability– Carry forward to future years

• Specific deductions are subject to certain conditions and limitations• Restrictive conditions apply to expenditure which is prima facie

suspect, such as transactions with the relatives or associates within the same group coming within the scope of section 40A(2). Such transactions are considered as specified domestic transactions under section 92BA and the transfer pricing provisions shall be applicable.

All Important deductions relevant to A.Y 2015-16

• http://taxguru.in/income-tax/section-wise-details-deduction-income-tax-act1961.html

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Capital or Revenue Expenditure

Tests

• The test of enduring benefit• Creation of fixed capital• Whether or not a new business/asset comes

into existence• Whether deduction of 100% of the capital

expenditure is available under section 35AD• Whether the expenditure is illegal

expenditure

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Review question


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Expenditure incurred on purchase of computer software. The assessee has capitalised such

expenditure in accounts.

• As decided in CIT v. M/s Asahi India Safety Glass Ltd., the expenditure incurred on purchase of software or application of software is allowable as revenue expenditure.

• The High Court held that the test of enduring benefit is not certain or conclusive in determining the expenditure as capital or revenue. The real intent of the expenditure and whether the expenditure results in creation of fixed capital for the taxpayer are to be examined. In this case, payment for application software though is an enduring benefit, does not result in acquisition of any capital asset. Since, it merely enhances the productivity or efficiency. Further, the accounting entries in the books of accounts cannot determine whether expenditure is revenue in nature or capital in nature.


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Expenditure incurred on feasibility study conducted for examining proposals

for technological advancement relating to the existing business, where theproject was abandoned without creating a new asset.

• In the case of Dy. CIT v. Assam Asbestos Ltd, the assessee-company was engaged in the business of manufacture of asbestos sheets and has incurred the expenditure in connection with survey and feasibility report and various technical services for setting up the cement plant, however, the project was abandoned for the want of permission from the Government. The assessee claimed the expenditure to be revenue in nature. The High Court observed that, in such cases, whether or not a new business/asset comes into existence would become a relevant factor. If there is no creation of a new asset, then the expenditure incurred would be of revenue nature.

• In this case, since the feasibility studies were conducted by the assessee for the existing business with a common administration and common fund and the studies were abandoned without creating a new asset, the expenses were of revenue nature.


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Amount spent on replacement of an old machine with a new one. Assesseeclaims that the machine installed in the textile plant is a part of the entirecomposite machinery of spinning mill, hence it is a repair of the old and

existing machine.

• Alternative 1• As decided in CIT v. Sri Mangayarkarasi Mills Pvt. Ltd., when expenditure

amounts to an enduring advantage for the business, it is to be considered as of capital nature. Repair is different from bringing a new asset for the business, bringing into existence a new asset or an enduring benefit for the assessee amounts to capital expenditure. Moreover, replacement of asset is not deductible under section 37 of Income Tax Act and hence not revenue in nature.

• Alternative 2• An alternative submission was also made that when a machine which is

put to continuous use for decades is to be replaced or where old parts are not available in the market then even the expenditure incurred on the replacement of the said machine is to be treated as expenditure on account of current repairs in view of the judgment of the Supreme Court as seen in the case of CIT v. Mahalakshmi Textile Mills Ltd.


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Expenditure incurred on total reconditioning and overhauling of machinery,which broke down several years ago, to make the same functional and increase

its useful life by replacing many vital parts, overhauling and repairing of itspower transmission unit, replacing electronic panel, geometrical aligning and

painting of machine.

• In Bharat Gears Limited v. CIT, the assessee has claimed certain expenditure as revenue expenditure on the ground that it was incurred for repairs and reconditioning of Fent Gear Machine and was in the nature of “current repairs”. Income Tax Appellate Tribunal observed that machine which was lying idle in a broken down position and was unfit for production resulted in a benefit of enduring nature by subsequent reconditioning and imparting useful life to hitherto old and unfit machinery.

• This benefit of enduring nature was very much in capital field and the expense, having regard to the facts and circumstances of the case, has its bearing on the fixed capital of the assessee, which, inter alia, generates profits. Thus, expenditure is of capital nature.


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Corporate membership fee paid by a company to the golf club for running the business to earn profit, if the membership is for

a limited period of six years.

• The High Court made following observations in the case of CIT v. M/s Groz Beckert Asia Ltd. :

• The membership of club was obtained for business purposes in as much as it facilitated interaction with business associates etc.

• Although the membership of the club provides an enduring benefit as it is for a period beyond the year of payment, the benefit remains in the revenue field and not in the capital field.

• Resultantly, the expenditure incurred on acquiring an enduring benefit in the revenue field is liable to be treated as revenue expenditure.

• Hence, the corporate membership fee paid for six years to a golf club for running the business to earn profit is revenue expenditure.


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SOME OTHER EXAMPLES….


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• Convertible Debenture expenses: Karnataka High Court decided that expenditure incurred on issue of convertible debentures is to be allowed as revenue expenditure. Refer CIT v ITC Hotels Limited 190 Taxman 430 (2010). Further, expenses incurred on issue of right shares were held as capital expenditure.

• Fees paid to ROC : It has been decided by the Rajasthan High Court that fees paid to the registrar of Companies for bringing about change in the memorandum and Articles should not be allowed. Refer CIT v Aditya Mills 181 ITR 195 (1990). Further, fees paid for increasing authorized capital is a capital expenditure. Refer CIT v Tungabhadra Industries Limited 207 ITR 553 (1994), CIT v Hindustan Insecticides Limited 250 ITR 228 (2001) & PSIDC v CIT 225 ITR 792 (1997).Such expenditure also not eligible for deduction under section 35D of the act.

• Bank Guarantee : Gujarat High Court decided that any payment of bank charges related towards bank guarantee required for purchase of machinery should not be allowed as revenue expenditure. Refer CIT v Bharat Suryodaya Mills Co Limited 202 ITR 942 (1993).

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• Lease on permanent basis: Amount paid in installments for obtaining a lease on permanent basis is a capital expenditure. Refer CIT v Project Automobiles 167 ITR 781

• Compensation to Tenant: Amount paid by the assessee, who purchased the plot of land, to the tenant occupying the structure erected by the tenant on such land for getting vacant possession is a capital expenditure. Refer CIT v Lucky Bharat Garage 174 ITR 526 (1998) & Chloride India Limited v CIT 130 ITR 61 (1981). However, assessee entered into an agreement for purchase of property for infrastructural facilities for business, assessee terminated the agreement and paid compensation, payment to be treated as capital in nature and not allowable as revenue expenditure. Refer Sap Labs India Pvt. Ltd. vs. ACIT 6 ITR 81.

• New Project Report : Expenditure incurred on project report for setting up a new unit is a capital expenditure. Refer CIT v J.K. Chemicals Limited 207 ITR 985 (1994)., However, Consultation charges paid by the assessee in connection with the expansion of assessee’s existing project were held to be allowable as revenue expenditure. Refer, Jyoti Ltd. 24 DTR 177. Similarly, Travelling and incidental expenditure in finalization of project for existing business allowable as revenue expenditure. Refer, Jt. CIT vs. Rallies India Ltd. 3 ITR 1 (Mum.) (Trib.) When no new asset created , then revenue expenditure Refer, CIT v DLF Commercial Developers Limited 323 ITR 321.

• Logo Fees : Payment made by the assessee for non exclusive user of logo based on turnover and not lump sum payment is allowable as revenue expenditure. ( Asst year 2006-07). Refer Asst CIT v Shriram Transport Finance Co Ltd 9 ITR ( Trib)


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• Corporate Guarantee : Giving corporate guarantee was not only one of the objects of the assessee company but the same was given for its subsidiary company and it was in the interest of the assessee company and hence, the commercially expedient decision, hence, one time settlement with bank was allowable as business loss. Refer ACIT vs. Industries (India) Ltd. 128 ITD 98.

• Keyman Insurance Policy : Keyman Insurance premium paid by the Company on the lives of Chief cardiac surgeon, chairman, and managing director of company was qualified as deduction under section 37(1). Consultancy fees paid for maintenance of software were to be allowed as revenue expenditure. Refer Escort Heart Institute & Research Center Ltd. vs. ACIT 128 ITD 108


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• Legal expenses : Deductibility of Legal Expenses will depend on Nature & purpose of legal proceeding in relation to business whose profits are under computation and cannot be affected by final outcome of that proceedings. Refer Vivek P Talwar v ACIT 8 Taxmann.com 268.However, Legal charges incurred for defending criminal proceedings which has get nothing to do with Assessee profession is definitely of personal nature and such expenditure cannot be allowed against income from business and Profession. Refer DCIT v Salman Khan 9 Taxmann.com 74. However, in the case of KNP Securities P. Ltd. I ITR 130 Assessee is barred from doing business by SEBI till further orders. Assessee contesting order. Expenses incurred in keeping business alive deductible. Again, Legal expenses incurred on obtaining advice as to feasibility of acquiring a new unit is a revenue expenditure. Refer, CIT vs. United Breweries Ltd. 36 DTR 80 Foreign Exchange Loss : Exchange loss on refund of advance received is business exp. Refer Diamonds R US v DCIT 9 Taxmann.com 67.


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• Public Utility : The contribution made by the assessee due to various business reasons ,to participate in a scheme framed by High court , as a remedy to a perpetual public hazard , i.e. social cause , hence the expenditure incurred allowable as revenue expenditure. Refer CIT v Jayendra Kumar Hiralal 327 ITR 147. Again, Expenditure incurred by the assessee on community assistance programme and the welfare measures undertaken in the vicinity of the manufacturing unit which also benefited its employees is allowable as business expenditure. Refer Madura Coats Ltd. 24 DTR 24.

• Advertisement : Expenditure on advertisement to create brand image, partly debited in profit and loss account and balance deferred over a period of three years, expenditure allowable as revenue expenditure, entry or absence of entry does not determine allowability of expenditure. Refer, Dy CIT v Godrej Tea Ltd. 4 ITR (Trib) 649.


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• See more at: http://taxguru.in/income-tax/understanding-allowability-business-expenditure-section-37-income-tax-act-1961-latest-case-laws.html#sthash.t9mUbz1O.dpuf


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Depreciation

Section 32


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Depreciation (u/s 32)

• Following conditions are to be fulfilled.

• a) Assessee must be owner of the Asset.

• b) Asset must be used for the purpose of business or Profession.– Active use– Passive Use

• c) Such use must be in the relevant previous year.


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Additional Depreciation

• Additional Deprecation @ 20 % of Actual Cost of Machinery acquired after 31.03.2002 for

• a) New Industrial Undertaking • b) Existing Industrial Undertaking

Note : If the Asset is put to use for less than 180 Days in the year, depreciation will be allowed at 50 % of the eligible rate.


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New Section 32 AC• Manufacturing companies investing more than Rs. 100

crore( investment in one previous year Rs. 25 Crores for 2015-16 to 2016-17 u/s Sec) in new plant and machinery during the period from 1.4.2013 to 31.3.2015 entitled to investment allowance@15%

• The investment allowance@15% under this section is in addition to the depreciation and additional depreciation allowable under section 32(1). Further, the investment allowance would not be reduced to arrive at the written down value of plant and machinery.

• Investment allowance can be claimed only after installation of the plant and machinery.

• Provisions illustrated in V K Singhania para 110.3


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New Section 32 AC• The new plant and machinery in respect of which investment

allowance has been claimed under section 32AC cannot be sold or otherwise transferred for a period of 5 years from the date of installation. If it is sold or transferred within this period, the deduction allowed earlier would be deemed as income chargeable to tax under the head “Profits and gains of business or profession” of the previous year in which such new plant and machinery is sold or otherwise transferred. This would be in addition to the taxability of gains on transfer of such plant and machinery.

• In case of amalgamation or demerger, this restriction would continue to apply to the amalgamated company or resulting company, as the case may be, as it would have applied to the amalgamating or demerged company.


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Example


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Solution


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Tax planning with reference to financial management decisions

Capital structure decision• Optimum capital structure maximizes shareholders’ return.• Need to properly balance risk, cost, control and tax

consideration.• Dividend on shares is not deductible and distributed profit is

subject to dividend tax.• Interest on borrowed capital is allowed as a deduction u/s

36(1)(iii).• Cost of raising loans is deductible in the year in which it is

incurred (except for pre-commencement period expences)• Cost of issue of shares is allowed as deduction in five years

u/s 35D.

Review Question

Solution

Review Question

Solution

June 15 Question O/S

Tax planning with reference to managerial decisions

•Own the asset or take it on lease•Purchase the asset out of own funds or borrowed funds•Make or buy

Lease vs. Purchase

• Income- Tax Aspects of Leasing• The tax treatment of lease transactions in India is based on whether the lease

qualifies as a lease or will be treated as a hire-purchase transactions.• If the transaction is treated as a lease, the lessor shall be eligible for depreciation

on the asset. The entire lease rentals will be taxed as income of the lessor. The lessee, correspondingly, will not claim any depreciation and will be entitled to expense off the rentals.

• If the transaction is a hire-purchase or conditional sale transaction, the hirer will be allowed to claim depreciation. This is based on an old Circular of the Deptt issued in year 1943. The financing charges inherent in hire instalments will be taxed as the hire-vendor's income and allowed as the hirer's expense.

• Pollution control devices, energy saving devices, renewable energy devices, rollers in flour mills, gas cylinders, etc.are entitled to 100% depreciation.

Purchase of assets out of own or borrowed funds

• Effective tax savings to be determined with – Rate of depreciation– Marginal tax rate– Rate of interest

Decision making

• Estimate the cash flows associated with borrowing and buying the asset

• Estimate the cash flows associated with leasing the asset

• Compare the two financing methods to determine which has the lower present value.

Decision making

Solution

Review Question

• Discuss the facts and decision in the case of ICDS vs. CIT as decided by Supreme Court recently.

Review Question

Solution

Solution contd…

Make or buy

• Tax incentives u/s 10A, 10AA,32, 80IA, 80IB and 80IC to be kept in mind.

• Sale of plant and machinery- section 50 to be kept in mind.

Problem• XYZ needs a component in an assembly operation. It wants to decide whether

make it or buy it.• If the company decides to make the product itself, then it would need to buy a

second hand machine for Rs. 8 lakh which would be used for 5 years. Manufacturing costs in each of the 5 years would be Rs. 12 lakh, Rs. 14 lakh, Rs 16 lakh, Rs. 20 lakh and Rs. 25 lakhs resp.the relevant depreciation rate is 15%. The machine would be sold for Rs. 1 lakh at the beginning of the sixth year.

• If the company decides to buy the component from a supplier the component would cost Rs. 18 lakh, Rs. 20 lakh, Rs. 22 lakh, Rs. 28 lakh and Rs. 34 lakh resp. in each of the five years.

• The relevant discounting rate and tax rate are 14 percent and 33.99 percent resp. Additional depreciation is not available. Should XYZ make or buy the component from outside?

Repair, replace, renew or renovate

• Repair, renewal whether deductible as business expence.

• If not deductible then, capitalise and claim depreciation.

Tax Planning

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