Class: M.Com. 1st Semester Lesson N0.

1: Tax Planning

Subject: Corporate Tax Planning & Mgt. Unit: I

OBJECTIVES:

The objective of this course is to provide basic knowledge of the corporate tax planning and management. After
going through this lesson, the students should be able to understand corporate tax planning and management.

Tax Planning: A Brief Analysis

Scope of Tax Planning.
Methods of Tax Planning.

STRUCTURE:

1.1 Introduction
1.2 Meaning & Scope of Tax Planning & Management.
1.3 Meaning of Effects of Taxation
1.4 Effects of Taxation on Production of Growth.
1.5 Effects of Taxation on Distribution
1.6 Effects of Taxation on Stabilization
1.7 Summary
1.8 In Text Activity
1.9 Self Assessment Questions
1.10 Reference

1.1 INTRODUCTION

Tax planning is an arrangement of ones financial affairs in such away without violating in any way the legal
provisions full advantage is taken of all tax exemptions, deductions, concessions, reporter, allowances and other
allowances and other reliefs or benefits permitted under the act.

1.2 MEANING AND SCOPE OF TAX PLANNING

Tax planning has become an important feature of all business enterprises, new or old, small or big, public or
private. Tax planning is an arrangement of ones financial affairs in such a way that, without violating in any way the legal
provisions full advantage is taken of all tax exemptions, deductions, concessions, rebates, allowances and other reliefs or
benefits permitted under the Act so that the incidence of tax is reduced to minimum thereby ensuring that the money
remaining after payment of tax is kept at as high a level as possible

In simple words, corporate tax planning means estimates and programmes that a company carries attract minimal
tax liability apart from fulfilling legitimate expectations and aspiration of the people. The most successful tax planning
system is that which would lead to the least litigation. It is in this context it is necessary that one must be aware of the
legislative intention, economic and social winds, political climate and various other circumstances before one can think of
proceeding ahead with tax planning.

Study of corporate tax planning demands a thorough examination of all laws of taxation as failure to recognized
the tax implications of business decisions can have serious consequences for the survival and growth of the business, while
a step in the right direction could mean a considerable saving of sources, a wrong step will bring disaster to this enterprise.
Thus to avoid uncertainties in future in regard to the tax liability and to avoid harassment at the hands of tax authorities in
the matter of assessment, the company should resort to tax planning in its own interest.

1.3 MEANING OF EFFECTS OF TAXATION

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 Taxation is only a small element in the structure of rules and conventions which constitute the framework of the
modern economic system. Effects of taxation can be clearly apprehended only as phases of the broad budgetary
implications for modifying this framework in such a manner as to make the system more efficient and more secure.

Taxes have micro and macro-economic effects in a modern economy. The economic effects of taxation may be
good as well as bad. Due to heavy imposition of tax, the ability of the tax-payer to work may be affected adversely or he
may be reluctant to work more since his additional income is taxed. This is turn, may affect production adversely.

There are also direct and indirect effects on the distribution of income. Taxation also affects the allocation of
resources and may change the composition and direction of production and income of the community. Such changes
caused by different taxes have far-reaching effects on the economic welfare of the society. Therefore, the government
should not keep only the revenue consideration in mind but the economic effects of taxation should also be considered. To
put it in the words of Dalton, the best system of taxation from the economic point of view is that which has the best, or the
least bad economic effects.

Effects of taxation may he analyzed under the following heads:

(1) Effects of Taxation on Production

(2) Effects of Taxation on Distribution

(3) Effects of Taxation on Stabilization.

1.4 MEANING OF EFFECTS OF TAXATION ON PRODUCTION

The effects of taxation on production may be viewed through:

(I) Effects on the ability to work, save and invest;

(2) Effects on the will to work, save and invest,

(3) Effects on the composition and pattern of production.

(A) Effects on Ability to Work

Ability to work depends on the health and efficiency possessed by the people. Health is related to the IeveI of
consumption which is determined by the money income of the assesse. Imposition of higher tax reduces the purchasing
power of the tax payer and his ability to obtain the necessaries, comforts and luxuries of life. This effect is most strongly
felt by the poorer people. When the tax burden falls upon the poor, it curbs the consumption of necessaries and comforts
which lowers the standard of living and thus efficiency and ability to work of poor people is adversely affected by taxation.
For the rich, however, the ability to work is not so much affected by taxation because taxation on rich may only curb his
luxurious consumption and this may not affect his efficiency and ability to work. Therefore, heavy taxation on the poorer
section of the community has been strongly objected by most of the economists. Therefore, to maintain the health
efficiency and ability to work of the people, system of progressive taxation should be duly implemented by the
government. In other words, taxes on low incomes and on those articles which are largely consumed by less well to do
sections of the community should be avoided in the interest of production. This will keep the health and efficiency intact
without additional work load on them.

(2) Ability to Save

Capacity of the people to save depends on the tax policy followed by the government. Ability to save is affected by
taxation as taxes fall on income and savings depend on income. When income is reduced by taxation, savings automatically
decline. Ability to save is affected adversely in the case of those who have a higher marginal propensity to save. It is the
rich who possesses a high marginal propensity to save since their incomes exceed their expenditure. Taxes falling on the
poor have no effect on their ability to save as they have no margin to save out of their low income. Since the rich are
accustomed to a very high level of living, they maintain their expenditure and pay taxes out of their savings. Hence their
ability to save is greatly reduced. This affects investment and capital formation in the economy. Therefore, to maintain the
capacity of the people to save the government should provide tax incentives to the rich and spend the tax income on the
poor to enhance their ability to save.
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(3) Ability to Invest

Ability to invest depends on the resources available for investment i.e. savings. It is clear from the above
discussion that savings are reduced by taxation. When ability to save is adversely affected by high taxes, ability to invest of
those who take investment decisions is automatically reduced. These are the people having a high entrepreneurial ability.
Such people are generally the people in the higher income group.

The government has to play a major role in exploiting the capacity to invest of the tax-payer by adopting an
appropriate tax policy. The government should exempt earnings from investment to encourage savings and capital
formation.

(B) Effects of Taxation on the Will to Work, Save and Invest

(1) Effects on the Will to Work

Will of the people to work depends on the nature of taxes. Each individual tax has its specific effects. However,
some taxes by their very nature have the least or no bad effect on the willingness to work e.g., estate duty excess profit tax
etc. Likewise, reasonable rates of income-tax, sales tax etc., have no bad effects on the desire of the people to work hard.
Conversely, unduly high rates of income-tax, wealth tax and commodity taxes adversely affect the desire of the people to
work hard.

(2) Will to Save

Will of the people to save depends on the volume of income, volume of tax and the tax policy pursued by the
government. If a tax payee has limited income and is hardly sufficient to meet his day to day requirements it will be
difficult for him to save anything. Some people save for their old age and many times they save to improve their social
prestige. So in order to enhance the will of the people to save, the government should provide tax incentives to the people.

(3) Will to Invest

Will of the people to invest depends on savings. If savings are taxed, nothing will be left with the people for
investment purposes.

To enhance the will of the people to invest, the government should devise such a tax policy which provides tax
incentives to those who divert their savings towards investment. Investment also depends on the treatment of income from
investmentunder tax laws. If earnings are exempted from tax net, people will divert most of their savings towards
investment.

People will also save and invest if they have full knowledge about the avenues available for investment and the tax
incentives associated with each of these channels of investment.

(C) Effects on the Composition and Pattern of Production

The effects of taxation on the composition and pattern of production depend upon allocation of resources. When
higher taxes are imposed on some industries, resources will shift from the high taxed industries to low taxed industries.
Likewise, when a tax rebate is offered, it will encourage allocation of resources in favour of developing industries.

Similarly, there will be reallocation of resources from high taxed regions to the low taxed regions.

High rate of tax on goods of harmful consumption has a beneficial impact as the production of these goods will be
diverted to low-taxed essential goods.

Taxes may thus change the pattern of production in an economy. A high tax on the production of luxuries may
improve the production of necessaries. Some taxes, however, have no effect on diversion of resources, e.g., taxes on
windfall gains, high land values, monopoly profits and non- differential taxes such as income-tax, etc. have no effect on the
composition or pattern of production.

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1.5 EFFECTS OF TAXATION ON DISTRIBUTION

There are two aspects of an economy:

(1) Income Generation

(2) Income Distribution.

Income generated in society if not distributed properly will create inequality in the distribution of income and
wealth. It will give rise to the creation of two classes i.e. the class of the rich and the class of the poor. The gap between
rich and poor will lead to class conflict which may prove disastrous to the society. Every government in the world tries to
bridge this gap by imposing higher taxes on the richer section of society and the proceeds realized from such taxes are
distributed among the poorer section of society by way of providing social amenities to them.

In other words equitable distribution is the main goal of the modern economy. Taxes serve as a means of reducing
inequalities by taking away the excessive capacity to pay of the richer section of society. According to Dalton, Other
things being equal, one tax-system is preferable to another if it has a stronger tendency to check inequality.

The effects of taxation on the distribution of income and wealth among different sections of the society, however,
depend upon the following two factors:

(1) Nature of Taxes and Tax Rates; and

(2) Kinds of Taxes.

By nature, taxation may be proportional, progressive or regressive. The nature of taxation also implies as how the
burden of taxation is distributed among different sections of the community.

A tax is called as proportional, if all the tax-payers pay the same proportion of their income as tax.

A tax is said to be progressive, if larger is the lax-payers income, the greater is the proportion that he pays as tax.
A tax is regressive, if larger is the tax payees income, the smaller is the proportion, which he pays as tax.

(i) Effects of Regressive Taxation on Distribution

If regressive taxation is followed, the inequalities may increase in the distribution of income and wealth, as the
burden of taxation will fall more heavily on the poor than on the rich. A toll-tax is regressive as the amount of the tax is the
same for the rich and the poor, while the utility of money, which is paid in tax, is greater for the poor than for the rich. A
regressive tax, thus, tends to widen the gap of inequality.

(ii) Effects or Proportional Taxation on Distribution

Under proportional taxation, inequalities would continue as before, if the income remains the same. But, however,
if the income changes in unequal proportions, the inequalities in income will increase. For instance if As income is Rs.
500 and Bs income is Rs. 1,000 and both are taxed at the rate of 10%, the net income of A and B, after tax payment,
would be Rs. 450 and Rs. 900 respectively. The burden of taxation fall heavily on A than on B. Hence, the burden of
taxation is higher on the poor than on the rich.

(iii) Effects of Progressive Taxation on Distribution

Under the progressive system of taxation, inequalities would be reduced, because a higher proportion of the
income and the wealth of the rich would be taken away by taxes than that of poor. Hence, a sharply progressive tax system
tends to reduce inequalities in the distribution of income and wealth. Sharper the progression, greater is the tendency to
reduce inequalities. Obviously, progressive system is desirable in order to bring about a more equitable distribution of
wealth.

However, the tax system should be based on the principle of ability to pay. The higher the income of a person, the
greater would be his ability to pay taxes and vice-versa. People who get unearned income should be taxed at higher rate
than poor because of their greater capacity to pay taxes. The progressive tax system may be designed in such a way that it

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may not have adverse effects on production. In other words, tax system should be progressive to the highest income group,
the middle income groups should be subjected to lower tax rates and the low income groups should be exempted from
taxation.

(1) Tax Rates

While fixing the rates of taxes, progression should be kept in mind. Higher taxes should be imposed on the richer
section of society and revenue realized from the rich should be utilized for the benefit of the poorer section of society by
way of providing social amenities to them. In other words taxes should be progressive because sharper the progression
greater is the tendency to reduce inequalities.

2. Kinds of Taxes

Whether the effect of taxation is progressive, proportional or regressive in nature depends upon the kinds of taxes.
There are two kinds of taxes:

(a) Direct Taxes

(b) Indirect Taxes

(a) Indirect Taxes and Distribution

The burden of indirect taxes, like taxes on commodities is regressive in nature. The commodities on which indirect
taxes are imposed are widely consumed by the poor and they have to spend larger proportion of their income on such
goods than rich. That is, propensity to consume is higher for the poor than that of rich. Hence, the burden of indirect taxes,
like the tax on foodstuff, raw tobacco, cheap alcohol etc., falls more heavily upon the poor than upon the rich. However,
the indirect taxes may be made progressive if the necessities are exempted from taxation and luxuries are subjected to
higher rates of taxation so that the tax rates would be higher for the high priced goods. But it should be noted that purchase
of luxury goods is optional, hence the rich can avoid the payment of these taxes by not purchasing such goods or by
contracting their demand to some extent. Therefore, indirect or commodity taxes in general are and regressive in nature.
Hence inequalities of income and wealth cannot be reduced by these taxes.

(b) Direct Taxes and Distribution

To bring about equitable distribution of income and wealth, all taxes which fall heavily or exclusively upon the
richer section of society can have favourable distributional effects. All direct taxes which are based on the principle of
progression and ability to pay may have desirable distributional effects.

The most important taxes, which can be made progressive are income tax, property-tax and inheritance tax.

(i) Income-Tax Distribution

An income-tax may be made progressive by subjecting larger incomes to high rates of taxation than smaller
incomes. This will not only achieve equity in taxation but will also reduce the inequalities of income. Additional taxes like
super tax alongwith general progressive tax should also be imposed on very high income. Secondly, the exemption should
be granted to the incomes below a certain level, i.e., the income below a certain level should not be taxed at all. And
finally, unearned income may be taxed at higher rate than the income earned by means of hard work.

(ii) Property-Tax and Distribution

A property-tax or a net annual wealth-tax if progressive in nature, will tend to reduce the amount of property in the
hands of property owners. The greater the amount of property or net wealth, the higher would be the burden of tax. Hence,
a progressive property-tax may have favourable distributional effects. Secondly, income from property should be taxed at
higher rate than income earned by means of hard work. Hence, it may be concluded that progressive property- taxation
generally helps in bringing about equitable distribution of wealth and income in the society.

(iii) Inheritance-Tax and Distribution

A progressive inheritance-tax and death-duty may bring about equitable distribution of wealth and income. It may
be made progressive by imposing tax on the amounts inherited by different individuals on the occasion of death. Mills
proposal was to fix up a sum, beyond which no individual could be allowed to inherit. It would be desirable, from the point
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of view of distribution, to graduate an inheritance tax, not also according to the amounts received by inheritance, but also
according to the amount of wealth possessed by them.

It should, however, be noted that direct taxes may be helpful in reducing inequalities of income and wealth, only
when they are progressive in nature. Thus, it can be concluded, that direct taxes are helpful in making the distribution of
income and wealth equitable, if they are steeply graduated.

1.6 EFFECTS OF TAXATION ON STABILISATION

Economic stability may be judged by the behaviour of prices. This does not mean that prices should remain static.
Conversely there should be a normal rise in price because a normal rise in price is a sign of healthy economy. Problem,
however, arises whenever there are price fluctuations. These price fluctuations may be known as abnormal economic
situations prevailing in the country. Economic stability also implies stability in the economic activity, output and
employment. It also refers to the avoidance of inflationary and deflationary conditions.

Every government tries to overcome these problems through fiscal measures which is the safest and the durable
course adopted by any government to control such situations.

There may be three abnormal economic situations:

(1) Inflation

(2) Deflation

(3) Stagflation.

(1) Taxation and Inflation

As regards inflation and deflation, taxes can play an important role as they can reduce or stimulate consumption.

Inflation may be defined as a situation in which prices continue to rise. Inflation may be either

(i) Demand Pull, or

(ii) Cost Push.

Demand pull inflation is caused by rising demand owing to higher capacity to pay of the people. In comparison
to the capacity to pay of the people, supply of goods and ervices fails to keep pace with it. In other words, prices rise
because the money supply far exceeds the availability of goods and services in the market. Since people have more money
to offer for goods which are in short supply, prices continue to rise.

Taxation, if applied properly, may take away the excessive capacity to pay of the people. The aim of taxation in
times of inflation should be to reduce the purchasing power in the hands of the people. Thus a rise in the rates of existing
taxes and the imposition of new, taxes would check consumption decrease the level of effective demand and therefore, help
in bringing up stability in prices. To increases the rate of saving and investment and thus, to increase production, certain
tax exemptions and tax concessions should be given and savings utilized for the payment of insurance premium may be
exempted from the taxation.

(ii) Cost-Push inflation is caused on account of rising cost of production which erodes the value of money. In this situation
capacity of the people to buy continues to go down, with the result that the demand also continues to fall.

Cost-Push inflation may be checked by keeping the cost of production in control. To keep the cost of production in
control, certain tax exemptions and concessions should be granted to the producers. Savings may also be exempted from
taxation to encourage production.

(2) Taxation and Deflation

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 Deflation is a situation of falling prices. In such a situation peoples capacity to pay continues to fall with the result
that demand for goods also comes down. With the continuous fall in demand, most of the manufacturing enterprises are
unable to stand as the prices prevailing in the market may even be lower than the cost of production. Most of the
enterprises, under this state decide to close down their business. To check this situation, the government should devise a tax
policy which will reduce the tax liability of the people so that they have the needed capacity to buy goods and services in
the market. Reduction in taxation during depression may have favourable effects on the level of economic activity and
employment. The demands for goods will be created which will lead to greater production of goods and services.
Moreover, the revenues collected through taxation should be incurred on the construction of services of public utilities such
as roads, so that effective demand for goods and services may increase. Again a reduction in those taxes, which falls more
heavily on the poorer section of society, such as sales-tax and excise duties on commodities, which are generally used by
poor people may have desirable effects on the level of economic activity and employment. Hence, total spending will
increase considerably, if tax concessions are made. In fact, the objective of taxation in depression should be to increase the
purchasing power of the people by reducing the burden of taxation and by transferring the purchasing power from the
hands of the richer section of the community to poor people.

(3) Taxation and Stagflation

The third situation consists of the two elements:

(i) Stagflation

(ii) Inflation.

Hence inflation with stagflation may also be called recession.

Recession is that abnormal economic situation in which the price continues to rise in spite of continuously falling
demand. Normally, when demand continues to fall, the manufacturers and sellers control the situation by reducing the
prices of products. In this abnormal situation of stagflation, the producers/sellers are not able to effect any reduction in the
price owing to the rising cost of production. The result of the existence of inflationary conditions prevailing in the market,
material and wage cost also continues to rise in such a situation, manufacturers are left with only two choices:

(i) to close the business, or

(ii) to continue charging high prices owing to higher cost of production to remain in the market.

This situation may be averted by following a proper tax policy. On individuals, effective progressive taxation
ought to be implemented so that excessive capacity to pay is withdrawn from the richer section of the society. To check
this situation, the government should provide tax incentives in the form of tax holiday to the producers of goods and
services and should also reduce the rates of commodity taxes such as sales-tax, excise duties etc., so that manufacturers
producers could sustain themselves in the face of higher cost of production.

1.7 SUMMARY

The simple words, corporate tax planning means estimates and programmes that a company carriers attract
minimal tax liability apart from fulfilling legitimate expectations and aspiration of the people.

The most successful tax planning system is that which would lead to the least litigation. It is in this context it is
necessary that our just be aware of the legislative intentions, economic and social winds, political climate.

1.8 IN TEXT ACTIVITY

Q1. Explain Tax Planning.

Q2. Explain Scope of Tax Planning of Management.

Q3. What do you understand by Taxation on Production of Growth?

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1.9 SELF ASSESSMENT QUESTIONS

Long Answer

Q1. What is the Tax Planning?

Q2. What is the Significant of Tax Planning?

Short Answer

Q1. Scope of Tax Planning.

Q2. What do you understand by effects of Taxation on Stabilization?

Q3. Explain effects of Taxation on Distribution.

1.10 FURTHER REFERENCES

1) Direct Taxes : Singhania, Gaur and Narang

2) Direct Taxes : V.K. Sareen and Ajay Sharma

3) Direct Taxes : K. B. Sibbal

4) Tax Planning : R.K. Sharma

5) Income Tax & : Taxmannia

Practice

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Class: M.Com. 1st Semester Lesson N0. 2: Tax Evasion and Tax Avoidance

Subject: Corporate Tax Planning & Mgt. Unit: I

OBJECTIVES:

The objective of this course is to provide basic knowledge of the Tax Evasion and Tax Avoidances.

Tax Evasion and Tax Avoidance Differences

Areas of Tax Planning
Significance of Tax Planning

STRUCTURE:

2.1 Introduction
2.2 Write the difference between Tax Evasion and Tax Avoidances
2.3 What are the Problems in Tax Planning?
2.4 Discuss the methods of Tax Planning.
(a) Legal Diversion of Income.
(b) Ensuring Maximum claims for Deductions.
(c) Taking advantages of Available Relief.
(d) Rebates and Tax free Source of Income.
2.5 Significance of Tax Planning.
2.6 Areas of Tax Planning.

2.1 INTRODUCTION OF TAX EVASION AND TAX AVOIDANCE

Tax evasion is a method of evading tax liability by dishonest means like suppression or falsification of facts with
regard to sales, inflation of expenses. And the tax avoidance is taken to refer to arrangement by which a personality within
the letter of law, reduce his true tax liability infringing in the process both the spirit and the intention of law.

2.2 TAX PLANNING: DIFFERENTIATED FROM TAX EVASION AND TAX AVOIDANCE

Three methods of saving taxes have been developed most countries of the world in the past few decades: tax
evasion, tax avoidance and tax planning. A great deal of confusion prevails in the corporate sector about the correct
connotation of these terms. Hence we shall attempt to explain these terms to show that tax planning is absolutely legal.

(1) Tax Evasion

Tax evasion is a method of evading tax liability by dishonest means like suppression or falsification of facts with
regard to sales, inflation of expenses, etc. It is a dubious way of attempting to solve tax problems. Hence tax evasion is
illegal and unethical. It is uneconomical as well. It deserves to be condemned not only by the Government but by the
companies as well.

(2) Tax Avoidance

Tax avoidance is taken to refer to arrangements by which a person acting within the letter of law, reduces his true
tax liability, infringing in the process both the spirit and the intention of law. In other words tax avoidance is the art of
dodging taxes authorities without breaking the law. It means acting within the framework of law or acting as per the
language of law only in form, but murdering the very spirit of law and thus acting against the intention of law defeating the
purpose of the particular legal enactment. In short, we may state that tax avoidance is taking advantage of loopholes in tax
laws. But taking advantage of loopholes in law only provides a short run benefit because, as and when the loopholes in the
law are made public, legislature steps in to plug the loopholes.

(3) Tax Planning

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 Tax planning is a method of planning corporate affairs by availing of the incentives and benefits provided by the
legislature. In other words, tax planning takes maximum advantage of the exemptions, deductions, rebates, reliefs and
other tax concessions allowed by taxation statutes, leading to the reduction of the tax liability of the tax payer.

Tax planning has been compared with the tax avoidance and has the legal sanction of the Supreme Court as well.
On the other hand, tax avoidance is viewed with displeasure by Supreme Court as it is an art of escaping the burden of tax
without breaking the law. But taking advantage of the loopholes in law only provides a short run benefit because, as and
when the loopholes in the law are made public, legislature steps in to plug the loopholes. On the contrary tax planning by a
company cannot be called a crime or illegal activity or an immoral action. What constitutes a crime is tax evasion or what
is undesirable is tax avoidance, but tax planning benefits the company as well as community. It enables a company to save
a good deal of tax and also avoid unwarranted harassment, worry and tension.

2.3 AREAS OF TAX PLANNING

The prosperity of the corporate sector depends on systematic planning be in finance or production. Some of the
important areas where planning can be attempted in an organized manner, have been briefly indicated below:

(1) Expansion

Expansion may be internal or external. Internal expansion involves expanding existing operations by either starting
a new branch or new unit or a new company in such a case, if the new business is financed by ploughing back profits, more
tax holiday benefit may be available to the company. If the old company borrows funds, interest on borrowings may be
claimed by it as a deduction. Also, such borrowings do not affect the quantum of capital employed in the new business.

External expansion, on the other hand, generally involves amalgamation of two or more companies to form either
an altogether different company or one of the existing companies taking over the other. Expansion of business through
amalgamation leads to the reduction in tax liability like the provision of tax holiday and depreciation allowance because a
new company gets all the benefits under tax laws.

(2) Diversification

Diversification also reduces the tax liability of an assessee. Many successful companies have diversified their
operations to new lines of business mainly to solve the financial problems attached to their capital structure decisions,
working capital management etc. In respect of diversifications it would be better to invest retained profits for starting a new
unit because 5 year tax holiday benefit is granted on the establishment of a new unit.

(3) Location or Business

Location of business is yet another area which attracts reduction in tax liability. From the point of view of income-
tax, certain concessions are available for opening new industrial under seating in backward areas or rural areas or free trade
zones (sections 80 HH, 80 HHA, 10-A).

(4) Capital Structure Decisions

Capital structure decisions of a company play an important role in influencing the incidence of income-tax payable
by a company. For example, if a company borrows money from banks, friends, directors, it can get 100% deduction in
respect of interest payable on loans. In contrast if a company raises its funds by issue of capital or from its partners, it will
be required to distribute 900% of the dividend/profit among its shareholders/partners. If profit is not distributed as per the
statutory requirement, the company may be subjected to additional income-tax and dividend payable by a company may
not be eligible for any deductions in the computation of taxable income of a company and thus the burden of tax on a
company may increase. Therefore, a company should resort to borrowings in order to reduce its tax liability.

(5) Reorganization

Tax factors are to be considered even in reorganizing an existing business. For example, a conversion of a
partnership into a company, splitting up or amalgamation of companies, capital reduction etc. In this case tax benefits like
investment allowance, depreciation allowance, and tax holiday benefit have to be considered.

(6) Research and Development

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 Tax incentives are said to induce companies to enter into research activities. Research, design and development
expenditure incurred by companies is of varied in nature and normally very substantial. Research development expense is
either incurred by a company even before its incorporation or after, for introducing a new product line or new design for
the already existing line of activity.

(7) Form of Organization

Planning for the affairs should begin even before starting the organization. The various forms of organizations
available for an entrepreneur are: (i) proprietary concern (ii) Partnership firm and (iii) Joint stock company. A suitable
form may be chosen after taking account the deductions and other benefits associated with each and every form of
organization.

(8) Amalgamation of Sick Units

Amalgamations of two or more companies attract reduction in tax liability and a number of tax concessions.
Therefore, many successful businesses take over sick businesses firstly, to reduce their tax liability and secondly. to take
advantage of tax benefits like depreciation allowance, investment allowance etc.

(9) Source of Finance

One of the important elements of tax planning while setting up a new business is the tax planning to be adopted in
the matter of deciding the source of finance of the new business set up by a company. Therefore, from tax planning
purposes, that source of finance should be adopted by a company that attracts maximum concessions.

In the end, we may say that tax planning is inevitable in the sense that tax subjects must attempt to minimise their
tax burden in a planned way without cashing the loopholes in the law and by attempting to follow legislative opinion in
each case.

2.4 SIGNIFICANCE OF TAX PLANNING

Tax planning is the legitimate right of every tax payer. It is important to both the corporate as well as non-
corporate assessee. Through tax planning the assessee may reduce his tax liability. The amount so saved by him from the
tax net may be gainfully utilized for some other purposes. In other words, as tax payment results in decrease in the
disposable income in the hands of the tax payer, reduction in his tax liability would mean that he would have so much more
money to invest or spend at his discretion.

It saves the assessee from resorting to tax evasion through illegal means. Dilating on this point further, it may be
stated that the heavy dose of taxation may induce the assessee to take recourse to tax evasion. Despite perceptible efforts
on the part of the Government to reduce tax incidence in general, persons in the higher income brackets are subject to a
relatively high tax burden. Also, there are several disallowances and ceilings as regards many genuine expenses incurred in
connection with earning taxable income, which only add to the existing tax burden. Only effective tax planning can help in
minimising high tax incidence. Tax planning when resorted to will reduce the incidence of tax evasion and will add to the
revenue of the government which may be used for the welfare of the people.

Tax planning improves the overall climate to make payment of tax honestly. This climate not only induces the
assesses to make correct payment of tax but also reduces the incidence of corruption which may take an ugly turn when
people have long outstanding liability. Tax planning thus, enables the tax payer to bear inequality in the distribution of tax
burden.

Tax planning further leads to optimisation of return on investment.

Tax planning leads to saving in tax payment without violation of any law or norms of social behaviour. The tax
payer neither fears any penal action for breach of tax law nor is afflicted with guilty conscience for flouting the social code.
The assessee after paying the tax liability always feel relieved of the tension which may be posing before him to disturb
peace and harmony and better business relations. It increases the fund position of the assessee. He may put such funds to
such uses which may bring adequate return besides improving his resource position.

Tax planning is a discipline and an attitude towards solving the corporate problem in a systematic manner from a
long run point of view. Corporate sector in India is taxed so heavily that even the most prosperous companies find it very
difficult to retain adequate profits. Therefore, when they want to expand or modernize their machinery, they have to

11
borrow heavily from financial institutions. The interest rates are so high at present that the interest paid by many companies
exceed the net profits which remain after paying the interest and providing for depreciation. If appropriate strategies for tax
planning are adopted, a company would be able to retain the maximum profits in the business. Tax planning enables
companies to make proper expense planning, capital budget planning, sales promotion planning etc.

Thus, by evolving tax planning, we derive greatest satisfaction of making contribution towards realizing social
objectives of growth and development.

2.5 METHODS OF TAX PLANNING

Following are the methods of tax planning:

(1) Legal Diversion of Income.

(2) Ensuring Maximum Claim for Deductions.

(3) Taking Advantage of Available Relief.

(4) Rebates and Tax free Sources of Income.

(1) Legal Diversion of Income

Legal diversion of income towards such expenditure or investment that reduces the tax liability, may be discussed
under the following heads:

(i) Expenses in Respect of Business Prernises-Section-30

Following deductions shall be allowed in respect of rent, rates, repairs of the premises, the amount paid for the
purpose of business or profession:

(a) Where the premises are occupied by the assessee: as a tenant, the rent paid for such premises, and further if he has
undertaken to bear the cost of repairs of the premises;

(b) any sums paid on account of land revenue, local rates or municipal taxes;

(c) the amount of any premium paid in respect of insurance against risk of damage or destruction of the premises.

Companies also divert their incomes towards installation of new plant and machinery so as to get benefits in the
form of depreciation allowance and other allowances.

(ii) Expenditure on Scientific Research

When a company incurs expenditure on scientific research or on the extension of knowledge in the fields of natural
or applied science including agriculture, animal husbandry or fisheries, shall qualify for deduction.

(iii) Expenditure on the Conservation of Natural Resources

Where a company incurs any expenditure by way of payment of any sum to an association or institution for
undertaking any programme of conservation of natural resources shall be allowed a deduction equal to amount of
expenditure incurred during previous year.

(iv) Expenditure by way of payment to Associations and Institutions for Carrying out Rural Development Programmes

When a company incurs expenditure on associations and institutions for carrying out rural development
programmes and for imparting training to persons to equip them for implementing rural development programmes,
qualifies for deduction.

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(v) Deduction for Expenditure on Prospecting etc. for Certain Minerals (U/S 35 E).

Under Section 35 E, if any Indian Company or other resident non-corporate tax payer, is engaged in any operations
relating to prospecting for, or extraction or production of any mineral or if the expenditure is incurred on the development
of a mine, would be entitled to amortize. Deduction of an amount equal to one-tenth of expenditure incurred would be
allowed under law for 10 years beginning with the year of commercial production.

(vi) Expenditure on know-how

Any lump sum paid by the assessee for acquiring any know-how for use for the purpose of his business, will be
allowed as a deduction.

(2) Ensuring Maximum Claim for Deductions

The deductions under this head are as follows:

(1) Deduction in Respect of Donation to Certain Funds, Charitable Institutions, etc. Section 80 G

In computing the total income of an assessee, there shall be allowed a deduction of 100% of the qualifying amount
of donations specified below. In other words, an assessee shall be allowed 100% deduction in respect of:

(A) Any sum paid by the assessee in the previous year as donations to:

(i) the National Defence Fund set up by the Central Government; or

(ii) the Prime Ministers Drought Relief Fund; or

(iii) the Rajiv Gandhi Foundation; or

(iv) the Indira Gandhi Memorial Trust; or

(v) the Jawaharlal Nehru Memorial Fund; or

(vi) the National Childrens Fund; or

(vii) the National Blood Transfusion Council or a State Blood Transfusion Council; or

(viii) any fund set up a State Government to provide medical relief to the poor; or

(ix) the Army Central Welfare Fund or the Indian Navy Benevolent Fund or the Air Force Central Welfare Fund
established by the armed forces of the Union.

(B) Any sums paid by the assessee as donations in the previous year for the renovation or repair of any such temple,
mosque, gurudwara church or an other place of historic archaeological artistic or religious importance.

(ii) Deduction in respect of profits and gains from newly established industrial undertaking or hotel business in
backward (Sec. 80 HH)

All assesses are entitled to a deduction of 20% of the profits from newly established industrial undertakings and
approved hotels set-up in backward area.

(ii) Deductions in respect of profits and gains from newly established small-scale industrial undertaking in Rural
Area (Sec. 80 HHA)

A tax-payer deriving profits and gains from a new small- scale industrial undertaking set-up in rural area will be
entitled to a deduction of an amount equal to 20% of such profits and gains.

(iv) Deduction in respect of Profits and Gains from Projects outside India (See. 80 HHB)

An Indian Company or a non-corporate assessee resident in India will be entitled to a deduction, in the
computation of the taxable income of 50%, of the profits and gains derived from the business of the execution of a foreign
project undertaken by the assessee in pursuance of a contract undertaken by him with the foreign country or a foreign
enterprise.
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(3) Taking Advantage of Available Relief

A Company is entitled to the following set of relief under this head to reduce its tax liability:

(i) Deduction in respect of profit and gains from Industrial Undertakings, Ship or Hotel, etc. (Sec. 80 1)

Under Section 80 1 a deduction will be allowed in respect of profits and gains from industrial undertakings, ship or
business of repairs of ocean-going vessels or of other powered craft, established after a certain date. The deduction will be
of an amount equal to 30% of such profit and gains of industrial undertakings or a ship or hotel. if it is a company and 25%
in the case of other categories of assesses Where the assessee is engaged in the business of repairs to oceangoing vessels or
other powered craft, the deduction will be of an amount equal to 20% of such profits.

(ii) Deduction in respect of profits and gains from Industrial Undertakings. Ship or Hotel (Sec. 80 - IA)

If an industrial undertaking is (a) located in a backward state or union territory or (b) set-up in any part of India for
the generation or distribution of power, or (c) begins to operate cold storage plant, the deduction will be of an amount equal
to 30% of the profits and gains in the case of corporate assessee and 25% in the case of non-corporate assessee. Secondly,
if the ship is brought into use by an Indian Company, 30% deduction is allowed. Thirdly, if a hotel (owned by an Indian
Company) starts functioning in a hilly area, rural area or a place of pilgrimage, 50% deduction is allowed or if a hotel is
located at other places notified by the Central Government, 30% deduction is allowed to an assessee.

AMENDMENT OF SECTION 80- IA

A Company which is engaged in scientific and Industrial research and development activities would be entitled to
5 year tax holiday. Likewise, a company which undertakes irrigation project, water-supply, and sanitation and sewerage
projects would also be allowed 5 year tax holiday as per 1996- 97 Budget.

(iii) Deduction in respect of profits and gains from business of poultry farming (Sec. If)

Where the gross total income of an assessee includes any profits and gains derived from business of poultry
farming, a deduction of an amount equal to one-third of such income shall be allowed.

(iv) Deduction in respect of royalties etc., received from certain foreign enterprises (Sec. 80 0)

Where an Indian Company or a non-corporate assessee who is resident in India earns any income by way of
royalty, commission, fees, etc., from a foreign government or a foreign enterprise in lieu of providing technical know-how
or technical or professional services to the foreign Government or foreign enterprise outside India, there shall be allowed a
deduction of an amount equal to 50% of income received or brought into India.

(v) Deduction in respect of profits and gains from publication of books business (Sec. 80 Q)

A deduction will be allowed in respect of profits and gains from the business of printing and publication of books
in India @ 20% of such profits. The deduction will be allowed for five assessment years.

(4) Tax Free Sources of Income

Another method of tax planning is taking advantage of tax free sources of income. Such incomes are classified as
under:

(1) Deduction in respect of profits retained for export business (Sec. 80 HHC)

Where an assessee being an Indian Company or a person other than a Company who being resident in India
exports out of India during the previous year any goods or merchandise, will be allowed 100% deduction.

(ii) Deduction in respect of profits and gains from export of Computer Software, etc. (Sec. 80 HHE)

If an Indian Company or a person other than a Company, resident in India, is engaged in the business of:

14
(i) export out of India of Computer Software by any means; or

(ii) providing technical services outside India in connection with the development or production of Computer
Software; the assessee shall be allowed a deduction in computing his total income.

Quantum of deduction: 100% of the profits derived by the assessee from the aforesaid business.

(3) Deduction in respect of profits and gains of newly established industrial undertaking in a Free Trade Zone:-
(Sec. 10-A)

If an assessee establishes export-oriented undertaking in any of the six free trade zones, 5 year tax holiday shall be
allowed. This tax con is available to all tax payers, including foreign companies and non-resident non-corporate
tax payers. This tax-holiday is in lieu of all other tax concessions e.g. investment allowance, the partial tax holiday etc.

At present there are six Free Trade zones viz. Kandla, Saepz Bombay, Falta (Calcutta), NOIDA, Madras and
Cochin.

15
Class: M.Com. 1st Semester Lesson N0. 3: problems of Tax planning, Tax Evasion and Tax Avoidance

Subject: Corporate Tax Planning & Mgt. Unit: I

OBJECTIVES: after studying this lesson a student will understand the problems of tax planning. And to have in depth
knowledge about tax evasion and tax avoidance

STRUCTURE:

3.1 General Problems

3.1.1 Changeability in tax laws

3.1.2 Complexity in tax laws

3.1.3 Dichotomy in tax laws

3.2 Specific Problems

3.2.1 Form of organisation

3.2.2 Choice of Business decision

3.3 Tax Evasion

3.3.1 causes of Tax Evasion

3.3.2 Methods of Tax Evasion

3.4 Tax Avoidance

3.4.1 Causes of Tax Evasion

3.4.2 Remedial Measures

3.1 General Problems

Benefits of tax planning are diluted by a set of problems which influence entire net work of tax planning. Some of
these problems are of such basic nature that they call for changes in corporate policy, company law, corporate financial
strategy and other managerial decisions which may not easily be effected. All fundamental problems may be discussed
under the following heads:

3.1.1 Changeability in Tax Laws

Tax laws have been changing at a very fast rate. Even knowledgeable persons and experts having proficiency in
tax laws fail to keep pace with the changes in the provisions of tax laws. Frequent amendments in tax laws causes
uncertainty to assesses apart from disturbing the corporate planning and corporate tax planning processes. Hence, many
companies and individuals are not able to derive requisite benefit by was of reducing their tax liability.

3.1.2 Complexity in tax-Laws

Tax-laws in our country are highly complex in nature. Different classifications of companies involving different
types of tax-liability, long term and short term capital gains, provision of additional income-tax, provision of sales tax and
other taxes, are instances of complexity in tax-laws. Hence, the assessees are forced to engage the services of legal experts

16
to get a proper perspective of tax laws. Legal experts, many times, force assesses to take recourse to the court of law which
is a time consuming process. Therefore, these complexities make the task of tax planning difficult.

3.1.3 Dichotomy in Tax Laws

There exists dichotomy in tax laws in our country which makes the task of tax planning difficult. This dichotomy
in legal provisions create confusion to the tax payee. For instance, the term company has different connotations in Indian
Income Tax Act 1961 and Indian Companies Act 1956. Whereas, no association of person can acquire the status of a
company under the Indian Companies Act 1956 without being registered with the registrar of companiesbut the status of
company to association of persons/company can be assigned easily by the Income-Tax authorities under the Income-Tax
Act 1961. Such difference in the concept of tax laws creates a sense of uncertainty to such businesses -that arc not
registered formally as companies.

3.2 Specific Problems

Specific problems with regard to tax planning can be discussed under the following beads

3.2.1 Form of Organization

Changeability and complexities of tax-laws prevents assessees from taking appropriate decisions with regard to the
form of organization to be adopted.

Planning for tax affairs should begin even before starting an organization. Various forms of organizations be
adopted are proprietary concern, partnership firm and joint stock company. Which form of organization should be adopted
depends on the level of profits and extent of dependence on outside sources of finance for capital requirement.

Incidence of tax is the lowest on the company form of organization as compared to sole-proprietorship or
partnership firm or Hindu Undivided Family or Association of Persons. The selection of a company form of organization
will further throw the problem of which type of a company closely held company or widely held company, foreign
company or domestic company would get more benefits. Thus, we may say that which form of organization to be adopted,
poses yet another problem to the assessee.

3.2.2 Choice of Business Decision

Choosing the right product mix or decision is yet another problem in the area of tax-planning. Whether a company
should buy raw-material from outside or produce it in a factory is a decision which an assessee fails to take owing to
complex nature of tax-laws. For instance, an assessee, instead of buying raw-material from outside produces inside the
factory, would get tax benefits/incentives by way of exemption, is yet another problem. Thus, complexity of tax laws
prevents assessees from taking an appropriate decision.

3.3 TAX EVASION AND TAX AVOIDANCE

Tax evasion and tax avoidance were neither new nor peculiar to India. They constitute a problem which is
prevalent in almost all countries of the world. As early as 1920, the Royal Commission on incometax in the United
Kingdom drew attention to the existence of tax evasion in that country and expressed views on as, that evasion of income
tax exists at the present is beyond question. The citizen who is deficient in public spirit has always aimed at paying less
than his fare share of the nations expenses and it is safe to assume that he will always continue to do so. This may be said
to every tax, but it is especially true of the income tax.

The position in the United States of America also appears to be the same. In 1936, it was found that efforts at
evasion were wide spread. A Joint Committee on evasion and avoidance was, therefore, appointed to investigate the
methods of evasion and avoidance of income, estate and gift taxes and to recommend remedies for the evils.

The Evasion, therefore, denotes down right defrauding of revenue through illegal acts and deliberate suppression
or falsification of the facts relating to ones true tax liability.

In tax evasion, however, a person deliberately pretends that he is not liable to tax by showing himself not in
possession of goods or services or income subject to tax. Tax evasion, therefore, is illegal as the evader cheats the
Government by concealing facts and the latter loses its due revenue. It also increases the burden of tax on honest taxpayers
who do not resort to such practices. Tax evasion also leads to the creation of black money. As the burden falls heavily on

17
honest tax-payers, inequality and the concentration of wealth in the hands of few, increases. This shatters the faith of the
common man in the dignity of honest and virtuous living.

Apart from tax dodging, smuggling is also a sort of tax evasion as custom duties arc evaded on smuggled goods.
Tax evasion, therefore, an offence and is punishable. There is, however, legitimate evasion of commodity taxes or even
income-tax, when a person does not buy the taxed commodities or does not earn the income beyond the exempted limit and
thus escape taxes.

3.3.1 CAUSES OF TAX EVASION

There are many causes of tax evasion. Causes of tax evasion are as follows:

1. High Rates of Taxation

Prevalence of high tax rates is the first and foremost reason for tax evasion. This makes the tax evasion profitable
and attractive in spite of the attendant risks.

The high rates of taxation create a psychological barrier to greater effort and undermine the capacity and will to
save and invest. The Direct Taxes Administration Enquiry Committee also agreed to it and said, while it cannot be denied
that higher the rate of tax, the greater will be the temptation for evasion and avoidance. But high rate of taxation is not the
only cause of evasion in the country. However, even if the rates are reduced, evasion will still continue, because it exists at
all levels of income.

2. Complexity of Tax Laws

The complicated provisions of the Direct Taxes Acts, were also stated to he responsible to some extent, for tax
evasion and tax avoidance. The tax procedure prevailing in our country is very complicated. It involves lot of time and
cost. The average tax payer has inevitably to seek the assistance of tax experts and their advice is not always disinterested
but to help the tax-payer for evasion and avoidance.

3. Inadequacy of Powers

The inadequacy of powers vested in the personnel of the department is yet another cause for tax evasion. The facts
relating to income, wealth, expenditure etc., are known to the tax-payer and if does not disclose the facts to the assessing
officer, he may not be able to determine correctly the tax liability of the tax-payer. However, whatever powers are vested in
the assessing officers, are not used freely by an honest officer for fear of causing harassment to the tax-payer.

4. Shortage of Experienced Personnel

Shortage of experienced personnel is yet another cause of tax evasion. Income-tax department should have
sufficient number of trained and experienced personnel to cope with assessment and investigation work. To make the
department efficient, procedures and organization of the Department should be improved.

5. Absence of Deterrent Punishment

Another reason for tax evasion is that no deterrent punishment like imprisonment is being meted out to tax evaders
when they are caught. It is therefore, recommended by the Direct Taxes Enquiry Committee that, unless it is brought
home to the potential tax evader that attempts as concealment will not pay but actually send him to jail, there could be no
effective check against tax evasion. Therefore, the absence of prosecution and deterrent or strict punishment have
undoubtedly encouraged the growth of evasion.

6. Lack of Publicity

Lack of publicity of information of a persons return or assessment, is vet another reasons for tax evasion At
present, the Department is statutorily prohibited from disclosing any information relating to a persons return or
assessment, except to specified authorities like Central and State Government authorities, courts of law and Reserve Bank.
Even if a tax evader is caught and penalised for concealment, he can keep it as secret from everyone. Relaxation of secret
provision of Direct Taxes Act to a limited extent will go a long way towards checking tax evasion.

18
7. Moral and Psychological Factors

Certain moral and psychological factors have also been pointed out as responsible for tax evasion in the country.
Every person should realise his responsibility towards the Government. Unfortunately, all citizens do not realise their
duties to the State and the necessity of paying the correct amount of taxes and paying them in time. Only a reformed moral
outlook and the development of better civic conscience can improve matters in this respect.

8. Attitude of Income-Tax Departments

Biased attitude of the Income-Tax department is also one of the important causes of tax evasion. It has been said
that even if when the assesses returns are correct in respect of income, wealth etc., and produce evidence in support, the
assessing officers do not always accept them. Because of this attitude of the department, assesses, sometimes, understate
their income and wealth, etc. in returns. This mutual distrust between the assessing officers and the tax-payers also,
encourage, to some extent tax evasion. For this purpose the administration has to take the initiative and trust the assesses,
and conduct itself with a high sense of justice and fair play.

9. Officers of the Department should be ten of Integrity

Lack of integrity in some of the officers of the department is also responsible for tax evasion. The Direct Taxes
Administration Enquiry Committee under the Chairmanship of Shri Mahavir Tyagi also laid stress on the point and said
that, Not only should the departmental officials be honest but they must also be above suspicion and they should so
conduct themselves in their private as well as official life that no wrong motives could be attributed to any of their actions.

10. Donation to Political Parties

Our political system is such that there is not control on the activities of political parties particularly regarding
financial matters. All political parties raise funds from big business houses. Businessmen and companies give donation to
political parties especially at the time of election to secure and maintain their interests. Political parties who receive
donation, help and protect them from the clutches of the Government.

11. Corrupt Business Practices

In spite of number of legislations for the protection of consumers, we still find the prevalence of black marketing
and hoarding in our country. Businessmen indulge in hoarding and sell his goods in the market at inflated rates. All such
corrupt and unfair business practices lead to the generation of black money.

3.3.2 METHODS/SOURCES OF TAX EVASION

There are many means and methods to evade the payment of tax. Some of the methods/sources of tax evasion are
as follows:

1. Omission to Report Taxable Income

One of the methods of tax evasion is the omission of the tax-payer to report taxable income to taxation authorities.
Under law, every individual, Hindu Undivided Family, Partnership Firms and Joint Stock Companies have to furnish their
income-tax returns in time in case his or her total income from all sources exceed the maximum exemption limit. But many
people in India do not supply any such information to the Government They cheat their Government by concealing facts
with regard to their income and wealth returns.

2. Maintenance of Multiple Set of Books of Accounts

Many big business houses have been showing some baseless transactions of expenditure to lower down their tax
burden. The reports of various committee and commissions appointed by the Government of India have also identified the
practice of maintaining double set of books of accounts by tax evaders. One set of book of account is for personal use and
another for tax purposes. Book of accounts which is for personal use, contains lull and accurate particulars of business
transactions and the other book which is for tax purposes gives a different picture of the conduct of business.

3. Opening Accounts under Dummy Names

19
 Tax evaders have been opening number of bank accounts under dummy names, since the bank manager cannot
find out the real identity of all depositors particularly those who come only at the time of the maturity of their fixed deposit
receipts. The bank manager simply compares the signature of the person withdrawing or depositing the money with his
earlier signatures. Regular tax dodgers are always alert and they remember when and in what form they had earlier signed
their receipts.

4. Securing Contracts under Dummy Names

Many persons secure contracts under fictitious names. When a persons income exceeds maximum exemption
limit, he establishes or secures a contract under the name of his wife or child, which is allowed under law. But regular tax
dodgers carry on their business under the names of such persons who do not exist altogether.

5. Deduction of Personal Expenses as Business Expenses

Some employees of big business hoses regularly deduct their personal expenses from office. For examples an
officer using official conveyance for personal purposes. By treating personal expenses as business expenses people
increase business expenses thus lowering the profit of the enterprise.

6. Omission to Report Several Incomes from Irregular Sources

Many individuals are in receipt of different types of income from different irregular sources. For example, people
receive interest on deposits in the banks or dividend on shares etc. But they rarely report such income to the taxation
authorities.

7. Understatement of Receipts

Receipts received from credit sale add to the total income of the business man. This addition to the income due to
credit sale, increases his tax liability. Hence, he takes such steps as to underestimate his receipts so that he could reduce his
tax liability.

8. Over-Estimation of Business Expenses

A person, who evades the payment of tax, over-estimated his business expenses by showing more salaries to
employees as compared to actual amount paid. This deflates his taxable income and he succeeds in reducing his tax
liability.

3.3.3 MEASURES TO CHECK TAX EVASI0N/ RECOMMENDATIONS OF WANCHOO COMMITTEE TO

FIGHT TAX EVASION

The Direct Taxation Enquiry Committee, which is popularly known as Wanchoo Committee, recommended that
following measures should be taken into consideration to fight the problem of tax evasion:

1. Reduction in Tax Rates

Wanchoo Committee pointed out that high rates of taxation are one of the main causes of evasion, this makes the
tax evasion profitable and attractive in spite of the risks attached to it.

The high rate of taxation affects the capacity and will to save and invest of the people. This shatters the faith of the
common man in the dignity of honest labour and virtuous living. To check tax evasion, the Committee recommended that
tax rates should be reduced by the government so that it is able to improve its financial position.

2. Allowance of Certain Business Expenses

The Committee recommended that, entertainment expenditure which is incurred primarily for the expansion of the
tax-payers business and is directly related to its active conduct should be allowed to be deducted up to a certain ceiling.

3. Regulation of Donation to Political Parties

One of the causes of tax evasion is that the businessmen enterprises give donations to political parties to secure
their interests. Therefore, the Committee recommended regulation of donations to political parties. The tax-payers should

20
be allowed to deduct up to a certain limit. The committee also suggested that reasonable grant-in-aid should be given to
political parties and their accounts should be audited and published annually.

4. Uniform Tax on Agricultural Income

The share of agriculture in the countrys national income is about 40% but the tax revenue received from
agriculture is negligible. Hence, the Committee suggested that there should be a uniform tax on agricultural income. This
tax should be at par with the tax on other incomes.

5. Changes in Penal Provisions

To check tax evasion, changes in penal provisions should be brought about by the Government. In other words, a
person who evades tax, should be punished by the Government. Hence, the Committee recommended changes in penal
provisions. It recommended that the minimum penalty imposable for the concealment of income should be the amount of
tax sought to be evaded and the maximum penalty imposable should be fixed at twice the said amount.

6. Permanent Account Number

One of the causes of tax evasion is that tax dodgers open accounts under fictitious names to evade the payment of
tax. Therefore, to check tax evasion, the Committee recommended that a permanent account number should be allotted to
each tax payer for use in transactions.

7. Public Opinion

To fight tax evasion, the Committee recommended that public opinion should be aroused against tax evasion and
tax invaders should be excommunicated from the society so that others could not indulge in such malpractices. But it is
possible only when the public is convinced that tax evasion is anti-social

8. Vigorous Prosecution

In a country like India, people do not realise their duties and responsibilities towards the State. To make people
aware of their duties and to instil in them a respect for tax laws, the Committee recommended that the Department should
adopt a vigorous prosecution policy. If a tax-payer is found lacking in his duties i.e. if a tax-payer conceals the facts with
regard to their income and wealth and evades the payment of tax, he should be prosecuted.

9. Education to People

To make people pay tax correctly and regularly, they should be educated with regard to the payment of tax through
press, radio and films.

10. No Awards or Recognition

No official patronage or recognition or awards should be given to persons who have been penalised for
concealment or in whose case prosecution proceedings have been taken.

3.4 TAX AVOIDANCE

The term tax avoidance is taken to refer to arrangements by which a person acting within the letter of law, reduces his true
tax liability, infringing in the process, both the spirit and intention of law. In other words, tax avoidance is method of
reducing ones tax liability by making use of loopholes in tax laws. Therefore, tax avoidance is not illegal. For example,
conversion of sole proprietorship or partnership firm into a joint stock company is not illegal.

But whatever be the method an assessee adopts whether it is avoidance or evasion, the consequence of his action
is the same, i.e., loss of revenue to the State and increase in the burden of the tax on other tax-payers who do not resort to
such practices.

Thus, tax avoidance is the art of dodging taxes without breaking, the law. In other words, tax avoidance means
travelling within the framework of law or acting as per the language of the law in form, but murdering the very spirit of law
and thus acting against the intention of law and defeating the purpose of the particular legal enactment.

21
3.4.1 METHODS/SOURCES OF TAX AVOIDANCE

(1) One of the methods of tax avoidance is that the definition of expenses as permissible deductions is elastic. There is
over-generous provision for the relief of losses. Consequently, businessmen claim all types of deductions and
sometimes they manufacture losses for tax purposes.

(2) Another method of tax avoidance is the conversion of property into trust. To avoid the payment of tax, people
convert their property into trust because incomes from trusts are either completely exempted or taxed lightly.
Accordingly, a rich tax-payer wishing to avoid income-tax may convert his property into a trust, make himself a
trustee and enjoy the usual benefits without paying taxes or by paying them at considerable low rates.

(3) Another method of tax avoidance is the formation of Hindu Undivided Family. To avoid the payment of taxation,
people from small Hindu Undivided Families and show joint income of all the earning members of the Family,
thereby avoiding the payment of tax.

(4) Securing contracts in the names of the wife and child is another method of tax avoidance. To carry on their
business and to earn black money, people obtain contracts in the name of wife and child which is legal.

3.4.2 REMEDIAL MEASURES TO CHECK TAX AVOIDANCE

(1) Avoidance could be checked only by plugging the loopholes in the law and by careful drafting of new legislations.

(2) In India, it is seen that people take undue advantage by forming small Hindu Undivided Families. It has been
suggested that if the income of the member of Hindu Undivided Family is above the maximum exemption limit, it
should be taxed at progressive rates and all the members should be taxed separately.

22
Class: M.Com. 1st Semester Lesson N0. 4: BLACK MONEY

Subject: Corporate Tax Planning & Mgt. Unit: I

OBJECTIVE: The objective of this lesson is to have information and deep understanding of black money and various
measures thereof.

STRUCTURE

4.1 Meaning of Black Money

4.2 Causes of Black Money
4.3 Remedial Measures
4.3.1 Voluntary Disclosure Schemes
4.3.2 Raids
4.3.3 Taxation Reforms
4.3.4 Miscellaneous Measures
4.4 summary (Lesson 2,3 and 4)

4.1 MEANING OF BLACK MONEY:

The problem of black money is one of the major serious burning problems of the Indian economy. It is a multidimensional
problem with dire consequences. The Government of India is keenly aware of this disgusting problem endangering the
social and economic stability of the country. Black money is a complex phenomenon. There are many approaches in
viewing the black money in an economic society. It has carious connotations such as unaccounted incomes, tax evaded
incomes, undisclosed wealth, unrecorded gain etc.

The Wanchoo Committee defined black money as, The term black money is generally used to denote
unaccounted money or concealed income and for wealth as well as money involved in transactions wholly or partly
suppressed. This definition makes no distinction between the black money and black wealth.

The NIPFP Report, on the other hand, begins with a categorical distinction between the Black Income and the
Black Wealth. Conceptually, the black income is a flow, the black wealth is a fund or stock. The black wealth is an
accumulated unaccounted income at any given point of time. The black income is generated over a period of time. The
black money held by public in the form of currency as well as liquid bank deposits. A large portion of black wealth is held
in the forms of real estate, gold, jewelleries, stocks in business etc.

Black income, in a macro sense, is thus defined as the aggregate of taxable incomes not reported to tax authority.
In essence, income evading taxation is referred to as black income.

Dr. Raja Chelliah, however, broadly defines the black money income as the sum total of transactions deliberately
kept out of the books of accounts by households and business in the economy.

4.2 CAUSES OF BLACK MONEY

There are several causes operating together in the creation of black money in the country. The major contributory
factors in this regard may be stated as under:

1. High Rates of Taxation

High effective rates of taxation are basically responsible for the generation of black money in the country. High tax
rates makes the tax evasion and in turn black money profitable and attractive and leave the Government little scope for
23
raising additional resources-in time of emergency. Therefore, high rates of taxation are responsible for inducing tax evasion
and consequently black money generation in the country.

2. Bureaucratic Corruption

Control breeds corruption. Corruption and black incomes are interlinked. Dishonest public administration becomes
an easy prey of corruption. Corruption was prevalent in the days of British and even Mughals. Today, corruption is
rampant in every sector as well as section of the Indian society including the Government. It has become a commonly
accepted phenomenon for all. Corruption makes it easy to earn and enjoy black money. Today speed money, secret,
commission, paper weight, Mithai, hush money, etc., have become an open secret for getting any work done, illegal or
legal, at official levels.

3. Black Marketing and Hoarding

In an economy under the environment of scarcities, controls and inflation, hoarding and black marketing is always
profitable which apparently produces black incomes.

In spite of number of legislations for the protection of consumers, we find that hoarding and black marketing is still
prevalent in our country. Businessmen hoard commodities and sell their goods in the market at the time of inflation.
Therefore, all such corrupt and unfair practices lead to the generation of black money.

4. Donation to Political Parties

Our political system is such that there is no control on the activities of political parties. All political parties raise
funds from big business houses. Businessmen and companies give donations to political parties especially at the time of
election to secure and maintain their interests. Political parties who receive donation, help and protect such
businessmen/companies from the clutches of the Government.

5. Prohibition

Certain activities are usually forbidden by law, such as gambling, production of illicit liquor, smuggling etc. All
these activities, since done illegally, generate lot of money which does not fall under the tax net. Since all these activities
are carried with the connivance of bureaucrats and law enforcement agencies it is difficult to lay hands on such black
money.

6. Deteriorated Public Morality

Standards of moral values and social attitudes of people in India have declined during recent years. In todays
society black-marketers, smugglers, corrupt politicians and public officials, tax-evaders, etc., are not condemned, but rather
admired and envied for possessing black money power. Dishonesty has become the best policy for the majority of us.
In short, deteriorated public morality has facilitated the growth of black economy in our country.

7. Demonstration Effect

The conspicuous consumption and luxurious life style of black moneyed people have created a sort of
demonstration effect on many others to inspire for such consumption patterns and they are tempted to earn black income by
legal or illegal means, as and when opportunities are available.

8. Inflation

The origin of black money can also be found in the persistent inflation in the country which has enhanced
incentives and opportunities to earn such incomes. Inflation leads to growth of parallel markets and strengthens inclination
to hide incomes and to evade taxes. Inflation also tempts people to maintain dual accounts for tax evasion. As a matter of
fact, inflation is both the cause as well as consequences of the growth of black money in Indian economy.

9. Weak Deterrence

It has been observed that despite adequate legal provision to curb the growth of black economy in India, it has
persisted because of weak deterrence against tax evasion

24
in practice. The system of permanent account numbers has not been completely adopted and returns are not carefully
checked. Not much has been done in exploiting the potential for detecting evasion through systematic surveys. No serious
action has been taken against detected cases of tax-evaders. Till recently, too few penalties were imposed, too few
prosecutions have been launched and even fewer have been convicted. In short, the search and seizure provisions have not
been very effectively implemented in practice by the corrupt tax administration.

4.3 REMEDIAL MEASURES

The menace of ever rising black money in Indian economy is very high. Package of policy measures are required
to scale down the generation of black income. Certain measures have already been tried by the Government in the past with
little success. Some additional measures have been occasionally suggested by the learned Indian economists and recently
some policy issues have been recommended by the Authors of the Black Money Report. We shall make a review of some
important measures below, suggested to curb black money in the economy.

I. Voluntary Disclosure Schemes

The Government has also tried with the policy that those who voluntarily disclose their black income of the past to
the taxation authorities will not be punished and penalties may be waived or minimized. But there has not been much
response to the schemes launched by the Government.

2. Raids

To check the menace of black money, Income tax department powers have been considerably enlarged and it is
empowered to conduct raids on the premises and properties of the tax payers or any individual and can seize the
unaccounted income and wealth and take necessary legal actions against the taxevaders. Similarly, there are customs
raids to curb smuggling activities. But so far due to weak implementation of the law and corruption, raids have not proved
to be really effective in this matter.

3. Taxation Reforms

India needs a rationalized tax structure. A number of tax reforms have been suggested from time to time by various
committees. Prof. Kaldor, Wanchoo Committee and many others have pleaded and advocated for a substantial reduction in
corporate taxation, personal income tax, wealth tax, stamp duties, customs duties and excise duties. A healthy trend in this
direction has already begun by the Government.

4. Miscellaneous Measures

To check the menace of black money, the government as launched number of voluntary disclosure schemes. The
first V.DS. was launched by the Government in 1951. This scheme aimed at pursuing the tax evaders to come forth and
disclose their unaccounted incomes. Another scheme to be launched by the Government to weed out corruption was S0-40
scheme. According to this scheme, tax dodgers were required to pay 60% of their disclosed income by way of tax and 40%
they could keep with them. Similar other schemes like Block Scheme, Voluntary Disclosure of Income and Wealth, Special
Bearer Bond Scheme etc. were also launched by the Government.

4.5 SUMMARY ( LESSON 2. 3 AND 4)

Tax evasion is a method of evading tax liability by dishonest means like suppression or falsification of facts with
regard to sales inflation of expenses.

And another side tax avoidance refer to arrangement by which a person acting within the letter of law, reduce his
true tax liability in fringing in the process both the spirit and the intention of law.

4.5 IN TEXT ACTIVITY

Q1. Areas of Tax Planning

Significance of Tax Planning.

Q2. Tax Evasion and Tax Avoidance

25
 Measure to check Tax Evasion.

Q3. Problems in Tax Planning

Legal Diversion of Income

4.6 SELF ASSESSMENT QUESTIONS

Short Answer

Q1. What is Tax?

Q2. Discuss in short about Tax Evasion.

Q3. Difference between Evasion and Avoidance.

Long Answer

Q1. What are the problems in Tax Planning?

Q2. Difference between Tax Avoidance and Tax Evasion.

Q3. Discuss any three methods of Tax Planning?

26
Class: M.Com. 1st Semester Lesson No. 5 INCIDENCE AND SHIFTING OF TAX

Subject: Corporate Tax Planning & Mgt. Unit: I

OBJECTIVES:

After going through this lesson, the students should be able to understand incidence and shifting of Tax.

STRUCTURE:

5.1 Introduction & Meaning of Incidence

5.2 Distinction between Impact and Incidence
5.3 Meaning of Shifting
5.4 Types of Tax Shifting
5.5 Factors of Tax Shifting
5.6 Theories of Shifting
5.7 Criticism

5.1 INTRODUCTION

When a tax is imposed on some person, it is quite impossible that it may be transferred by him to a second person,
and this tax may be ultimately borne by this second person or transferred to others by whom it is finally borne. Thus, a
person who originally pays the tax may not be actually bearing its money burden as such. The problem is therefore, to
determine who bears the tax ultimately. This is known as incidence of taxation. In other words, incidence of tax is upon
that person who cannot shift it further. Incidence of a tax relates to money burden of a tax finally settles or comes to rest on
the ultimate tax payer, we may call it the incidence of tax.

The concept of incidence of taxation has been variously described by different economists. Dalton, for instance,
considers incidence as the direct money burden of tax on the person who ultimately pays it. Incidence, thus, rests on the
person who cannot shift the money burden of the tax to ay other person. For example, when a sales-tax is imposed on Bata
Shoes, the Companys shop recovers it from the buyers, so the incidence of this tax lies on the buyers since they ultimately
bear its money burden. Thus, according to Dalton, the incidence of tax refers to the direct money burden of tax, i.e., the
actual initial payment of tax which may either fall upon a person on whom it is initially imposed.

According to Philip Talyor, Incidence is the locus of direct burden of a tax.

According to Seligman, the incidence is upon him who bears the ultimate direct money burden of tax.

5.2 DISTINCTION BETWEEN IMPACT AND INCIDENCE.

The impact refers to the initial burden of tax while incidence refers to the ultimate burden of the tax.

Impact is felt by the tax-payer at the point of imposition of the tax, while the incidence is felt by the tax-payer at
the point of settlement or rest of the tax. For example, if an excise duty of Rs. 2,000/ per T.V., set is imposed on the
manufacturer of colour TV sets, then the impact of the tax falls on him. This is the immediate money burden of the tax on
the manufacturer who must arrange to pay it to the Government even before the goods are actually sold.

However, the incidence of the tax levied on the manufacturer may fall on the buyers of the colour T.V., sets.

Thus, impact of the tax is always on the person who is responsible by law to pay the tax amount to the Government
treasury, in the first instance. Incidence may fall on somebody from whom the manufacturer ultimately recovers the
amount, provided he shifts the tax.

27
5.3 SHIFTINGMEANING

Shifting of a tax refers to the process by which the money burden of a tax is transferred from one person to
another. Whenever, there is shifting of taxation, the tax may he shifted forward. Thus, a producer upon whom a tax has
been imposed may shift it to the consumer, or a seller may shift it to the purchaser. The tax is shifted forward or backward
to the consumer or the purchaser, respectively. On the other hand, the tax may he imposed in first instance on the consumer
or purchaser, he may shift it to the producer or the seller respectively. In this case, tax is shifted backward. When the tax is
shifted from the seller to an immediate purchaser, who then sells it to another person, and so on until the tax finally settles
on the ultimate purchaser or consumer, it may be called forward shifting.

In other words, the person upon whom the tax is imposed not necessarily bear the burden of tax. In this case, the
assessee is given the right to pass on the tax burden to the buyer of goods. Thus, the process of passing on the tax burden to
the buyer of goods by the seller of goods is known as shifting of tax.

Shifting can occur only in connection with the price transaction. Price is the only vehicle through which a tax can
be shifted. As Seligman points out, shifting of a tax is primarily a function of price. Thus, shifting is common is
commodity taxation.

If a tax is shifted, the price of the taxed commodity increases. For example, if a tax is imposed on the
manufacturers of T.V., the manufacturers, if they are successful, collect the tax by adding it to the price, charged to dealers,
who in turn, if they are fortunate, add the tax to the retail price.

5.4 TYPES OF TAX SHIFTING

Tax shifting may be of two types:

(1) Forward Shifting

(2) Backward Shifting.

(1) Forward Shifting

A tax is said to have shifted forward if price of the commodity which constitutes the medium for shifting the money burden
of taxis increased. Under complete shifting; the price will be higher by the full amount of tax. In forward shifting of
commodity taxation, the money burden of a tax is transferred from the producer or seller to the consumer for buyer when
the tax is initially imposed on the producer. Thus, forward shifting is possible with regard to all indirect taxes which are
generally passed partly or shortly to the buyer of goods.

(2) Backward Shifting

Backward shifting refers to the process by which the money burden of a commodity tax is shifted from the
consumer or buyer to the producer or seller, if the tax is initially imposed on the consumer. In other words, it is a typical
situation in which the tax burden is shifted backward, i.e. from the buyer of good to the seller of goods under the following
conditions:

(1) Backward shifting is applicable in the case oi property-tax only.

(2) Backward shifting is effected when the buyer o property shifts the entire tax burden to the seller of property.

(3) The shifting is done by buyer of property by way of capitalizing the value of tax by the life of the property and
deducting it out of the total value of the property.

Whether tax is shifted forward or backward, depends on the relative strength of resistance to transfer the burden
Commodities having inelastic demand will have less resistance to forward shifting, while commodities having relatively
elastic demand would have greater resistance to forward than backward shifting.

5.5 FACTORS OF TAX SHIFTING

28
 The current condition of the market is an important determinant of the direction and extent of shifting. There are
two set of factors which influence tax shifting:

(I) Internal Factors

(2) External Factors.
(1) Internal Factors

Internal factors imply the market conditions which are reflected in the form of (i) elasticity of demand, and (ii) elasticity of
supply.

(i) Elasticity of demand means changes in the level of demand due to price variation. If with the slight rise in price a
considerable fall in demand is obtained, we call it highly elastic demand or elasticity is greater than one, i.e., e>1. When
with the moderate rise in price, there is moderate fall in demand we call it moderately elastic demand or
elasticity equal to one e=1. In the case of the rise in price, if there is no shortfall in demand, we call it inelastic demand or
elasticity is less than one, i.e., e>1.

(ii) Elasticity of Supply

Another component of market condition is elasticity of supply. When supply changes with the change in the price,
the supply is said to be highly elastic. The more elastic the supply of the commodity, the more will be the incidence of the
tax upon the buyer. And, the less elastic the supply of a commodity, the greater will be the incidence of the tax upon the
seller. If the supply of a commodity is perfectly elastic, the entire tax burden is shifted to the buyers.- With the imposition
of a tax, the cost of production will rise, hence, the price will rise, which may affect the demand of the commodity and
bring loss to the seller. Therefore, the seller would curtail the supply of the commodity, increase the price of the
commodity by the amount of tax and will shift the entire burden of the tax upon the buyers. If it is perfectly inelastic, the
entire tax burden will be on the seller. If the supply of a commodity is more elastic, a greater part of the tax burden will be
upon the buyer and vice-versa.

EXTERNAL FACTORS

Following factors also effect shift ability:

(i) Public Policy

Public Policy of the Government resists shift ability. Such policies may pertain to the price of the product.

If the Government wants that the business enterprise should not raise the price of the product in the event of
shifting the tax burden forward, or in other words, if the government wants that the seller should charge the pre-tax price
even after the imposition of tax, then in that situation, the seller/producer/business enterprise should bear the burden
himself or itself. Therefore, we may say that the government policy to ask the sellers to charge pre-tax price offers
maximum resistance to shift ability.

(2) Advertised Prices

Advertised prices can have real effect upon the shift ability of a tax. As per the policy of the Government, prices of
the products should be displayed at the counter so that the customers become used to the advertised price. In other words,
advertised price would psychologically prepare the customers in the event of shiftability.

The display of prices at the counter will show separately the actual price of the product and the value of tax. The
entire goodwill of the seller, revolves around the advertised price. If the seller, after the imposition of tax changes the price,
he may lose all the customers. Under this circumstance, the seller instead of shifting the tax burden forward, should bear
the tax burden himself. In other words, advertised price also resists shift ability.

(3) Customary Price

Customary price means one price charged by the seller year after year. The existence of customary prices in the
market militates against forward shifting to the consumer. For example 25 paisa strap charged by the seller every year is
known as the customary price. Any rise in price owing to the shifting of tax, will put an end to the years of valuable

29
goodwill of the seller within no time. This is particularly true in cases where the price has traditionally been a small, round
sum. If the seller increases the price of the product, all his customers will withdraw from him. Under such a circumstance,
the seller should take a decision of not shifting the tax burden forward if the tax is imposed on him.

(4) Geographical Coverage.

Narrow distance between the markets offers maximum resistance to shift ability. The geographical coverage of the
tax law can be an important determinant of shift ability. If a local area is covered by a tax on goods, it is difficult to shift it,
because, if the prices of such goods rise, local people will buy them from neighbouring, areas which are not covered be
such taxes. In other words, if the seller, having a shop in one market, raises the price of a product and if the same product is
available at a lower price in the neighbouring market, the customers, may, in such a circumstance, purchase the commodity
from the neighbouring market at a lower price. Therefore, we may say that geographical coverage offers maximum
resistance to shift ability.

(5) Substitute

It will be difficult to shift the tax burden in the case of a commodity which has an effective substitute. If the price
of the main commodity rises owing to the shift abiity of a tax burden forward, the customers will withdraw from the
consumption of the main commodity to the consumption of the substitute. In such a case, the seller, instead of shifting the
tax burden forward, should bear the tax burden himself. Therefore, the substitute can be an important determinant of shift
ability.

(6) Market Structure

Shifting of a tax also depends upon the market structure. Shifting of a tax is easier in the case of a monopoly
market for a product. In the case of a perfectly competitive market for goods, taxes cannot be shifted. In case of
monopolistic competition, shifting will be determined by the extent of elasticity of demand for the goods. Greater the
elasticity of demand for the goods taxed, the lesser is the shifting of the tax to the consumer and vice-versa.

(7) Size of the Taxed Area

The size of the taxed area will always affect shift ability of a tax on the production or sale of a commodity. When
the goods can be brought in near-by untaxed markets, an attempt at forward shifting will meet vigorous resistance caused
by the availability of untaxed competing goods.

(8) General Business Conditions

Buying and selling prices and costs are affected by general business conditions, along with tax shifting. In periods
of rising prices and prosperity, it is easier for most enterprises to sell at prices equal to or greater than costs than it is during
falling prices and depression. Tax can, therefore, be shifted more easily during prosperity than during depression. New
taxes which are imposed at a time of business crises or depression are especially difficult to shift.

5.6 THEORIES OF SHIFTING

There are quite a few theories and ideas as to who finally pays the tax or on whom the final incidence of a tax rests.
Theories of tax shifting were advocated by Adam Smith, David Richardo and anthers. There are three prominent
approaches which we shall consider one by one.

(i) The Concentration Theory

This theory was developed by Physiocrats in the 18th centuries. Physiocrats and others have advanced the theory
that all taxes ultimately concentrate on a particular object. The French economists believed that the tax levied on anything
is ultimately shifted to landlords. They reasoned that agriculture was the only occupation which created surplus over and
above the cost of production. According to them all other occupations, such as trade and commerce did not yield any
surplus. Wages were at the subsistence level and could not be taxed. Industry was not in a position to generate surplus. This
left land rents as the sole taxable surplus. Physiocrats, therefore, strong1y advocated that the government should
concentrate on a single tax on economic rent earned by landlords from the agricultural occupation. They also argued that
the existing diversity of taxes should be abolished. This would simplify taxation, reduce the excessive cost of tax collection
and lessen the tax charges upon the land owners.

5.7 CRITICISM
30
 The theory advocated by Physiocrats has been condemned by Adam Smith and modern economists too. This
theory is criticized on the ground that agriculture is not the only occupation yielding economic surplus, i.e. rent. Modern
economists are of the view that other occupations are also productive and yield surplus over and above their cost of
production and a single tax on land is not suitable in modern welfare societies. The burden of taxation should be distributed
in equitable manner on the community as a whole and not on a particular section of the community. Hence, it is wrong to
assume that any tax is ultimately shifted to and concentrated in agriculture.

2. The Diffusion Theory

This theory was advanced by French writers like Mansfield and Canard. Diffusion theory is just the opposite of the
concentration theory which may be stated as follows:

The tax burden instead of concentrating on the land owning class having surplus gets diffused over different
sections of society. In other words, the diffusion theory asserted that all taxes are diffused among the members of a
community. According to this theory, the individuals from whom the tax is collected do not ultimately bear the whole
burden but shift it on to the other classes, so that it is diffused all over the society.

However, for some time, a tax may stick at a place where it is imposed, but it is shifted again and again till its
burden spreads over the entire society

According to Canard, the French economist, the buyer of a commodity is also the seller of something else, and as
seller, he passes a part of the tax paid by him to the buyer of his goods. This buyer, being the seller of some other goods,
passes on a part of the tax again to his buyers, and in this way, a tax imposed on labour or business gets diffused over the
whole community through such shifting and re-shifting.

The supporters of the diffusion theory are of the opinion that it is immaterial as to where a tax is imposed. It is
soon partially shifted and re-shifted till its entire burden is spread over the various factors in more or less equitable way.
Since surplus exists in different classes of society, the tax imposed gets diffused among different sections of society. It
keeps on shifting from one person to another till it gets diffused on the entire social system.

CRITICISM

(1) The theory is shallow and misleading as there is no diffusion of tax in the real sense. This theory avoids the
question of justice in taxation. In other words, this theory is not based on the principle of ability to pay. It is not
progressive in nature. More often the tax imposed on one section is passed on to the other section, i.e. the poor
section which does not have either the ability or the mechanism to shift the tax burden.

(2) This theory violates the principles of equity in taxation. Equity in taxation implies that the sacrifice of the
community should be equal. All the tax-payers should feel the same pinch by paying the last rupee as tax. But
since the poorer section of society is supposed to pay higher tax, there is the virtual sacrifice of the equity
principle.

(3) This theory ignores the fact that this dillusion does not take place automatically. Unless, the price vehicle exists,
the tax burden cannot be diffused.

3. Demand and Supply Theory/Modern Theory

This is the most acceptable approach is explaining the incidence of tax. Tax incidence can be shifted only through
sale/purchase transactions and only through, price revision. A price revision is determined by demand and supply
elasticitys. Similarly, tax shifting and sharing of the incidence will be determined by the demand and supply elasticitys.
The more elastic the demand, the more will be the incidence of tax upon the seller, because an increase in the price due to
tax will make the demand of the commodity zero. If the demand for the commodity is perfectly inelastic, the entire tax
burden will be passed on to buyers because an increase in price due to tax will not affect the demand.

Similarly, the more elastic the supply of the commodity the more will be the incidence of the tax upon the buyer.
The less elastic the supply of a commodity the greater will be the incidence of the tax upon the seller. If the supply of a
commodity is perfectly elastic, the entire tax burden is shifted to the buyers. With the imposition of a tax, the cost of
production will rise. Hence, the price will rise, which may affect the demand of the commodity and bring loss to the seller.
Therefore, the seller would curtail the supply of the commodity, increase the price of the commodity by the amount of tax
and will shift the entire burden of tax upon the buyers. If it is perfectly inelastic, the entire tax burden will be on the seller.

31
Class: M.Com. 1st Semester Lesson No. 6 :ANALYSIS OF SHIFTING AND INCIDENCE

Subject: Corporate Tax Planning & Mgt. Unit: I

OBJECTIVE: To understand the shifting and incidence by illustrations and examples, through activities and self-
assessment questions

STRUCTURE

6.1 Analysis of Shifting and Incidence

6.1.1 Taxes imposed on net income
6.1.2 Taxes imposed on property
6.1.3 Taxes imposed on Production or sale of goods
6.2 Imposition of Tax or property under Imperfect Competition
6.3 Summary
6.4 In Text Activity
6.5 Self Assessment Questions
6.6 Further References

6.1 INTRODUCTION

We have seen that taxes can he shifted, either forward or backward, only through a change in price. Some part of
the tax thus becomes either an addition to price (forward shifting) or a deduction from price (backward shifting). It is,
therefore, necessary to analyse the process of price determination if we wish to draw conclusions as to the shift ability of
particular taxes.

We distinguish the following categories of taxes in our present analysis:

(1) Taxes imposed on net income

(2) Taxes imposed on property

(3) Taxes imposed on production or sale of goods.

6.1.1 Taxes Imposed on Net Income

Tax is payable only when there is net income, and the amount of tax is proportionate to or progressive with the size
of net income. Some part of income is retained after the tax is paid. This is in the form of reserves which may he used for a
number of purposes such as maintaining the rate of dividend, ploughing back of profit. It is the endeavour of business or
individual to retain as much income as possible. The amount of such retention depends on the total income before tax.
More the income before tax, more is the income after tax.

Within these premises, we shall discuss if taxes imposed on business could be shifted forward in a state of
Imperfect Competition and Perfect Competition.

Business Under imperfect Competition

Imperfect competition is also known as Monopolistic Competition. It means a situation in which the elements of
both competition as well as monopoly exist in the following manner:

Sellers Buyers A raises the price of the

product
A 100 80
B 100 100+20
200 200

The above illustration shows that A raises the price of the product. The effect of the price rise is that 20 buyers withdraw
from A and go to B. This phenomenon includes two elements:

32
(1) The element of competition which is evident from the withdrawal of the buyers from A. (2) In spite of the rise in price,
80 customers continue to patronise him. This is the element of monopoly of the seller of goods.

The hold of a seller A over the customers is on account of product differentiation. These are one of the important
elements of monopolistic competition.

With this background, the price of the product under Imperfect Competition is determined at a point where the
marginal cost becomes equal to marginal revenue. At a point where marginal cost equals marginal revenue or where
marginal cost curve intersects marginal revenue curve, the total revenue of the firm is the highest. Optimization of revenue
is the basic objective of the firm.

If the tax is imposed on the producer, he cannot shift it forward, as any imposition of the tax which is passed
through price vehicle will disturb the equilibrium of marginal cost i.e. M.C. and marginal revenue i.e. M.R. Accordingly,
any tax shifting forward will raise the price of the product which will adversely affect the objective of optimizing the total
revenues of the firm.

Under these circumstances, the enterprise shall have to bear the incidence of tax itself and therefore, it cannot shift
the tax burden forward. The above description may he illustrated with the

following example:

TableI: Marginal Revenue and Marginal Cost of a Hypothetical Firm

Quantity of Demand Total Marginal Marginal Marginal

output price per revenue revenue per revenue per cost
unit 100 units unit
100 10 1000 1000 10 -
200 9 1800 800 8 1.00
300 8 2400 600 6 1.33
400 7 2800 400 4 1.67
500 6 3000 200 2 2.00
600 5 3000 0 0 2.33
700 4 2800 -200 -2 2.67
800 3 2400 -400 -4 3.00
900 2 1800 -600 -6 3.33
1000 1 1000 -800 -8 3.67

33
 EXPLANATION

The above Table 1 shows that the price is falling and the demand is increasing. Hence, the total demand which stood at 100
units with a price of Rs. 10 each, went up continuously up to 1000 units as the price fell from Rs. 10 to Re. 1. The total
revenue has been worked out by multiplying the total demand by the price per unit of demand. Since the demand has
increased by 100 units at each step, so the revenue for each additional 100 units has been worked out by deducting the total
revenue out of the total revenue of the subsequent 100 units. Hence, the total revenue which stood at 1000 came down to
800, 600 then 0 and up to -800. The marginal revenue per 100 units has been divided by 100 to obtain the marginal revenue
per unit which comes to Rs. 10 and goes down to -8.

We have assumed marginal cost i.e. M.C. as the volume of production increases so does the marginal cost.
Therefore, marginal cost rises continuously with the increase in production. We have accepted if marginal cost, i.e. M.C. is
Re. 1, it can go up systematically from 1 to 1.33, 1.67 and 2.00 and thus up to 3.67. M.C. starts from the second unit, hence
it starts when the demand is 200 units.

In Figure 1, the MC of Rs. 2 per unit becomes equal to MR of Rs. 2 at a point where the total demand is 500 units
and the price charged is Rs. 6 per unit. It is only at this point, the total revenue of the firm is highest. If tax is imposed at
this point, it will disturb the equilibrium of MR and MC, increase the price and reduce the quantity produced. Therefore,
the producer, in such a circumstance, shall have to bear the tax burden himself.

INCIDENCE AND SHIFTING OF TAXES ON NET INCOME UNDER PERFECT COMPETITION

Perfect competition may be defined as a situation which fulfils the following conditions:

(1) Number of sellers or firms and buyers is very large in a perfect competition.

(2) Products are homogenous. There is no product differentiation.

(3) Under perfect competitions a firm is only a price- taker and not a price-maker.

(4) Only one price prevails in the market.

(5) Price is determined by the industry.

(6) Industry is a group of firms producing identical goods.

(7) The equilibrium price is determined at a point where the demand for and supply of the total industry are equal to
each other. In other words, the price for the industry is determined on the basis of interaction of total market
demand and total market supply.

The process of price determination for the industry is shown through the following table:

Table 2: Price Determination Under Perfect Competition for the Industry (Before Tax)

Demand for
Price (in Rs.) Supply of Output
Output

5 20 100

4 40 80

3 60 6

2 80 40

1 100 20

34
 EXPLANATION

In this diagram, quantity demanded and supplied is taken on OX axis. Price of the goods is shown on OY axis. DD
and SS are the demand and supply curves respectively. E is the point where demand and supply interact each other. In
other words, E is the point of equilibrium. By a perpendicular from the point of intersection to OX axis, we get the
equilibrium quantity demanded and supplied i.e. OM. Perpendicular drawn on OY axis from point E shows the equilibrium
price OP.

PRICE DETERMINATION FOR INDUSTRY UNDER PERFECT COMPETITION (AFTER TAX)

EXPLANATION

After the imposition of tax, some of the marginal firms become sub-marginal as their cost of production increases
than the price realized by them in the market. As a result of this fact, supply falls short as compared to the previous
position. Hence, a new supply curve S1 which is higher than the earlier one will be obtained which will interact with the
demand curve at a different place. This new interaction will produce the quantity to be sold from 60 to 45, hence, a new
equilibrium on the basis of new supply curve and the demand curve will be obtained. The new supply curve, in the figure
shown above intersects the demand curve which brings about higher price and a little lower demand in the short run. This
higher price will help the existing firms (whose cost of production is equal to the price realized by them) to get a part of the
tax burden realized in the long run.

PRICE DETERMINATION FOR THE FIRM UNDER PERFECT COMPETITION

In a state of perfect competition, price so determined by the industry shall be the price for all the firms in the
industry because firms are price-takers and not price-makers. Since, only one price prevails in the market in a state of
perfect, pure competition, all firms have to charge the price determined by the industry.
35
 The firm can sell any amount of goods at that price. Hence, the demand curve of the firm is horizontal in nature.
This is also the marginal revenue i.e. MR of the firm.

The firm will take a decision regarding the quantity to be sold on the basis of the interaction of Marginal Cost
curve i.e. MCC with MR. It is only at this point that the total revenue of the firm will be optimised. In other words, given
the price, the firm will fix its output where its profits are maximum.

PRICE DETERMINATION FOR FIRM UNDER PURE COMPETITION

Figure 4. This firm under Pure Competition

EXPLANATION
at this level, if a tax imposed, it will enter the marginal cost i.e. M.C. The M.C will increase by the amount of tax on
income. The MC curve i.e. MC will bring about news interaction which will lead to higher cost with lower demand for
goods.

6.1.2 INCIDENCE AND SHIFTING OF TAXES ON PROPERTY

In discussing the incidence of this broad category of taxes, we are confronted by a multiplicity of tax measures and
taxed objects. For purposes of our analysis, however, it is necessary to distinguish property used in production from
property used for consumption.

Properties which are not utilised for the further production of wealth may be called properties for consumption
purposes. Such properties may be a house, ornaments, automobile etc. Any tax imposed on such properties shall be borne
by the assessee himself as there exists no price vehicle. Hence, the tax imposed on such property i.e. the property meant for
consumption purposes cannot be shifted forward.

In the case of properties meant for production purposes like factory, building, stores, warehouse etc., there exists
the price vehicle through which tax could he shifted forward.

IMPOSITION OF TAX ON PROPERTY UNDER IMPERFECT COMPETITION

Now, we have to examine, if there is a possibility of shifting the tax burden forward under imperfect competition.

In a state of imperfect competition, price is determined at a point where the Marginal Cost i.e. MC intersect
marginal Revenue i.e. MR. If a tax is imposed at this level, it will not enter the MC because it is variable in nature. The
property- tax, on the other hand is fixed and the amount of the tax remains fixed irrespective of the size or volume of
production. Consequently, it will enter the total cost which will affect the total Average Cost. The following figure shows
that there is the Average Cost before tax and Average Cost i.e. AC after tax. This implies that since the property-tax is of
the nature of fixed cost, it will not enter the marginal cost i.e. MC. It will enter Average Cost i.e. AC which means the
entire tax burden shall be borne by the assessee himself.

36
 Table-3

Marginal
Demand Marginal
Quantity Total Revenue Marginal
Price Revenue
of Out put Revenue per 100 Cost
per Unit per Unit
Units

Rs. Rs. Rs. Rs.

100 10 1000 1000 10

200 9 1800 800 8 1.00

300 8 2400 600 6 1.33

400 7 2800 400 4 1.67

500 6 3000 200 2 2.00

600 5 3000 0 0 2.33

700 4 2800 -200 -2 2.67

800 3 2400 -400 -4 3.00

900 2 1800 -600 -6 3.3

1000 I 1000 -800 -8 3.67

The above Figure 5 shows that the imposition of property-tax does not disturb the equilibrium obtained with the
interaction of MC with MR. The tax imposed on property enters the average cost. It seeks to reduce the total revenue and
increase the total cost of production. The above figure shows that the total cost of production of the firm before the
imposition of tax was LMOP. After the imposition of tax, the total cost of production increased to EROP. The difference
between the total cost before tax and total cost after the tax is the tax liability which is shown in shaded form i.e. ERLM. In
other words, since the amount of tax has raised the total cost of production, the burden of tax has to be borne by the
assessee himself. This is indicated by the fact that the total revenue before tax which stood at NQLM has now been reduced
by ERLM. In other words, after the tax, the total revenue of the firm has been reduced by the amount of tax. Hence, the
entire tax liability has to be borne by the assessee himself.

In short, it may be stated that the tax imposed on property can not be shifted forward under imperfect competition.

6.1.3 INCIDENCE AND SHIFTING OF TAX ON PRODUCTION AND SALE OF GOODS

37
 We deal in this section with the incidence of those taxes which are imposed directly upon production or sales. All
such taxes are considered by the producer or seller as a cost of production but the degree of shift ability will vary with the
type of cost upon which the original impact of the tax is felt, and with degrees of pressure for and resistance to shifting,
which vary with local and temporary market conditions. Taxes imposed on production or sales are excise duties, sales tax
etc.

Since the price vehicle is available for shift ability, these taxes may be shifted forward or backward by the
producer or seller of goods to the buyer of goods.

We distinguish three types of cost impact, determined by the nature of the tax measure:

(1) Taxes which are fixed in total amount, and thus become added fixed cost.

(2) Taxes whose total amount varies with the quantity of production or sale, but are constant additions to variable cost
per unit.

(3) Taxes whose total amount varies with the quantity of production or sale, but are varying additions to variable cost
per unit.

In the first category we include fixed amount taxes such as property taxes or taxes of a fixed amount upon the
privilege of doing business. Included in the second category re taxes of a fixed amount per unit of output or sale, such s
specific import duties or specific excise duties such as Re. 1 per unit. The third category embraces those ad valorem duties
of which perhaps the most common example is a 10% retail sales tax.

(1) First Category Taxes

We have analyzed the incidence of taxes of the first type in preceding paragraphs (Incidence and Shifting of Taxes
on Property).

(2) Second Category Taxes

CONSTANT ADDITIONS TO THE VARIABLE COST UNDER IMPERFECT COMPETITION (SPECIFIC

EXCISE

Tax
Demand Total Marginal Marginal Revenue Revenue
(Specific Margi
Quantity of Out Price Revenue Marginal
Excise nal
put Per per 100 per cost
Duty @ Cost
unit Unit Unit
Pi.1
Unit
Per unit
Rs.
100 10 1000 1000 10 -
200 9 1800 800 8 1.00 1.00 2.00
300 8 2400 600 6 1.33 1.00 2.33
400 7 2800 400 4 I.f7 1.00 2.67
500 6 3000 200 2 2.00 1.00 3.00
600 5 3000 0 0 2.33 1.00 3.33
700 4 2800 -200 -2 2.67 1.00 367
800 3 2400 -400 -4 3.00 1.00 4.00
900 2 1800 -600 -6 333 1.00 4.33
1000 1 1000 -800 4 3.67 1.00 4.67

38
Taxes of the second category are generally shift able forward. For marginal cost is increased by a constant amount
throughout the whole schedule creating a new intersection of marginal revenue and marginal cost, and thus a new price and
quantity. Since we are considering those taxes which make a constant addition to variable cost, the marginal cost curve
including the tax will be higher and parallel to the curve before the tax. The incidence of such a tax is indicated in Figure 6.

The Figure 6 shows that since the specific Excise Duty @ Re. 1 per unit has been imposed, it has been added to the
Marginal Cost i.e. MCI. On the basis of addition, a new MC2 has been obtained. As the tax is uniform, i.e. Re. 1 per unit,
hence, the addition to MC1 is also constant. The MC, curve is also parallel to old MC curve i.e. MC1 as shown in the
figure.
The Marginal Cost curve MC2 interacts with the Marginal Revenue curve at a different place which gives a new
equilibrium. This new equilibrium is obtained at a level where the price is Rs. 6.50 and the total quantity demanded
accordingly is reduced to 450 units.

On this basis, we can say that, out of a tax of Re. I per unit, tax shifting has been to the extent of O.50p. In other
words, the incidence of tax has been divided between buyers and sellers. Out of every Re. 1, 50% of the tax has been
shifted forward to the buyer and the remaining has been borne by the seller.

Illustration

Tax @ Re. 1 per unit

Total units sold 450

Total tax @ Re. I per unit = Rs. 450

Price before Tax Rs 6 per unit

Price after Tax Rs. 6.50

450x50/100 = Rs.225

Total Tax = Rs. 450

Total Tax shifted =Rs. 225

Tax borne by Rs. 225 the assessee

In the end, we may say that the incidence is divided between buyers and sellers. The above illustration shows that
out of the total tax i.e. Rs. 450, fifty percent i.e. Rs. 225 has been shifted to the buyer and Rs. 225 has been borne by the
seller.

39
(3) There remains for consideration the incidence of taxes which are varying additions to variable costs. We have
suggested an ad valorem retain sales tax as a typical example of this cost. The amount of tax arise with the price of the
product, and since normally the larger the quantity sold, the lower the price per unit, the larger the quantity sold, the
smaller the tax addition to marginal (variable) cost.

Table 5. Varying Additions to the Variable Cost under imperfect Competition (Ad Valorem Duty 10%)

Quantity Demand Total Marginal Marginal Marginal Ad Marginal

of output price per revenue revenue revenue cost Valorem cost
unit per 100 per unit duty @
unit 10%
100 10 1000 1000 10 - - -
200 9 1800 800 8 1.00 0.90 1.90
300 8 2400 600 6 1.33 0.80 2.13
400 7 2800 400 4 1.67 0.70 2.37
500 6 3000 200 2 2.00 .060 2.60
600 5 3000 0 0 2.33 0.50 2.83
700 4 2800 -200 -2 2.67 0.40 3.07
800 3 2400 -400 -4 3.00 0.30 3.30
900 2 1800 -600 -6 3.33 0.20 3.53
1000 1 1000 -800 -8 3.67 0.10 3.77

Figure 7. Tax as Varying Additions to Variable Cost:

Imperfect Competition

Figure 7 shows decreasing tax additions to Marginal Cost. Figure 7 pictures out typical condition of imperfect
competition. MC2 is calculated on the assumption of a tax as 10% of selling price; the data are shown in Table 5
Determination of the incidence of this type of tax follows exactly the same analysis as was used in the case of a tax which
is a constant addition to variable cost. The quantity sold after tax is less than before and the price is somewhat higher. This
points to the conclusion that the incidence is shared between buyer and seller. Again, the less elastic the demand the greater
the proportion of the tax shifted forward, while the greater the elasticity of demand, the greater the proportion of incidence
remaining with the seller.

Figure 7 shows that in the third category, the tax varies with the volume of sale or production. For example, an ad
valorem duty @ 10% of the value of goods sold has been imposed. In this case, 10% has been calculated on the price of the
goods as has been shown in Figure 7. So the tax per unit varies between 90 paisa to 10 paisa. The amount of tax is added to
the existing Marginal Cost i.e. MC1 to obtain a Marginal Cost curve i.e. MC2. The new Marginal Cost curve, i.e. MC2
keeps on shrinking from the beginning to the end. The new Marginal Cost curve interacts with the Marginal Revenue curve
at a different place to provide a new equilibrium. It interacts at a point where the price is Rs. 6.40 and the demand is 460
40
units. It means that 66% of the tax has been shifted forward to the buyer and the remaining 34% has been borne by the
seller.

Illustration

Tax @ 10% of the value of goods sold

Total units sold 460

Total tax @ 10% = 460

Tax Shifting

Price before Tax Rs. 6

Price after Tax Rs. 6.40

460 x 40/100= Rs. 184

Total Tax = Rs. 460

Total Tax Shifted = Rs. 184

Tax borne by the Assessee Rs. 276

6.3 SUMMARY

When a tax is imposed on some person, it is quite possible that it may be transferred by him to a second person,
and this tax may be ultimately borne by this second person or transferred to others by whom it is finally borne. Thus, a
person who originally pays the tax may not be actually bearing its money burden such. The problem is, therefore to
determine who bears the tax ultimately. This known as incidence of taxation.

6.4 IN TEXT ACTIVITY

Meaning of Incidence
Meaning of Shifting
Distinguish between Impact and Incidence
Factors of Tax Shifting
Types of Tax Shifting
Discuss in details theories of Shifting
Analysis of shifting and incidence
What do you understand by imposition of tax on property under imperfect competition?

6.5 SELF ASSESSMENT QUESTIONS

Short Answer

1) Explain Incidence.
2) Difference between Incidence and Avoidance.
3) Differences between Impact and the in this incidence.

Long Answer

1) Discuss in detail theories of Shifting.

2) Factors of Tax Shifting?
3) Explain types of Tax Shifting.
4) Explain the Shifting.

41
Class: M.Com. 1st Semester Lesson No. 7: specific Managerial Decisions

Subject: Corporate Tax Planning & Mgt. Unit: I

Objective

To understand the concept of specific management decisions.

To know the capital structure.
To understand the Dividend Policy and Cost of Capital.

Structure

7.1 Specific Management Decisions

7.1.1 Capital Structure
7.1.2 Lease or buy decisions
7.1.3 Make or buy decisions.
7.1.4 Repair/Renewal or replacement of an asset.
7.2 Tax planning in case of employees remuneration.
7.3 Summary
7.4 In-Text Activity

7.5 Reference

7.1 Specific Management Decisions

7.1.1 Capital Structure

Importance in selection of capital structure:

Before setting up a new project an important decision about the type of capital structure has to be taken. While selecting a
particular capital structure, the entrepreneur has to keep in view the following consideration

(i) Serving the capital base with consistent dividend policy

(ii) cost of capital to be raised from the market
(iii) Chargeability or otherwise of taxes. i.e., direct and indirect taxes.
(iv) Keeping a margin for ploughing back of profits for future plan towards diversification, expansion,
modernisation and other development aspects.
Means of financing: Generally, the following means of finance are available for a new project:

(i) Equity share capital,

(ii) Debentures/Loans and borrowings/Lease Finance.

Effect of financial leverage: In making capital structure decision, financial leverage plays an important role. The financial
leverage states the percentage increase in earnings before taxes corresponding to percentage increase in earnings before
interest and taxes. This can be explained with the help of following example:

Earnings before interest and taxes (EBIT) 1.000

Less. Interest on securities 500

Earning before taxes (EBT) 500

42
 1000
Financial leverage = 2
500

Here, this financial leverage states that any increase in earnings before interest and taxes will have two fold increase in
earnings before taxes. So if EBIT is Rs. 1,500 then EBT will be

EBIT 1,500

Less Interest 500

EBT 1,000

Hence, it is clear that 50% increase in EBIT has resulted 100% increase in EBT.

Therefore, a high financial leverage would result in a very high return when there is high profitability. But in case of
depression, this may prove to, be dangerous because the residual net income available to shareholders may reduce to great
extent and sometimes may convert in losses. How much financial leverage is safe is considered with reference to the likely
fluctuation in the operating profits and the debt equity mix.

Capital mix: A capital structure is said to be optimum when it has a mix of debt equity that will yield the lowest weighted
average cost of capital. At the same time, A capital mix should not have high debt equity ratio. A high debt/equity ratio has
its own advantages and disadvantages.

Illustration No. 1

Case I: A company wants to raise capital of Rs. 20,00,000 for a project where earning bed; tax shall be 30% of the capital
employed. The company can raise debt fund @12% p.a. Suggest which of the following 3 alternatives should it opt for:

(a) Rs. 20,00,000 to be raised by equity capital (b) Rs. 16,00,000 by equity and Rs. 4,00,000 by loans (c) Rs. 4,00.000 by
equity capital and Rs. 16,00,000 by loans.

Alternative
A B C
Equity share capital 20,00,000 16,00,000 4,00,000
Debt capital - 4,00,000 16,00,000
Total investment 20,00,000 20,00,000 20,00,000
Earning before interest and taxes (EBIT) 6,00,000 6,00,000 6,00,000
Less: Interest on debt @ 12% p.a. - 48,000 1,92,000
Earning before taxes (EBT) 6,00,000 5,52,000 4,08,000
Less: Tas@30%+surcharge Nil + EC@ 2% +
SHEC @ 1% 1,85,400 1,70,568 1,26,072
Earning after tax (EAT) 4,14,600 3,81,432 2,81,928
Tax on dividend to be distributed
16.995 60.226
4.14,600
116.995
55,408
16.995
3.81,432
116.995 40,954
16.995
2,81.928
116.995
Amount of dividend distributed 3,54,374 3,26,024 2,40,974
Return on equity share capital 17.789% 20.376% 60.243%
Solution to Case II
Position when EBIT is 10% of capital i.e., only Rs.2,00,000
EBIT 2,00,000 2,00,000 2,00,000
43
 Less: Interest on debt @ 12% - 48,000 1,92,000
EBT 2,00,000 1,52,000 8,000
Less: Tax @ 30% + surcharge Nil + education cess @2%
+ SHEC @ 1% 61,800 46,968 2,472
EAT 1,38,200 1,05,032 5,528
Less: Tax on dividend to be distribution
16.995
1.38.200 20,075
116.995
16.995 15,257
1.05.032
116.995
16.995 803
5.528
116.995
Amount of dividend distributed 1,18,125 89,775 4,725
Return on equity share capital 5,906% 5.611% 1.181%

The above two situations make it clear that the existence of securities bearing a fixed rate of return in capital structure has a
magnifying effect on earnings after tax. But it is also clear from the second situation that the shareholders suffer to a great
extent.

7.1.2 Lease or buy decisions:

In recent years, leasing has become a popular source of financing in India. From the lessees point of view, leasing has the
attraction of eliminating immediate cash outflow, and the lease rentals can be claimed as admissible expenditure against the
business income. On the other hand, buying has the advantages of depreciation allowance and interest on borrowed capital
being tax-deductible. Thus, an evaluation of the two alternatives is to be made in order to take a decision.

Illustration 2: An asset costing Rs. 1, 00.000 is be acquired. There are two alternatives available to the entrepreneur. First
one is buying the asset by taking a loan of Rs. 1,00,000 repayable in 5 equal instalments of Rs. 20,000 each along with
interest @ 14% p. a. assuming that lease rentals, processing fees, interests as well as the principal amounts are payable at
the year end. The second one is leasing the asset for which annual lease rental is Rs.30,000 up to five years. The lessor
charges 1% as processing fees in the first year. Assumed the internal rate of return to be 10% and the present value factor at
10% is:

Years 1 2 3 4 5

PV Factor .909 .826 .751 .683 .621

Suggest which alternative is better in the above case. Assume the tax rate to be 30.9% and rate of depreciation @ 15%.

Alternative 1

Years

Sl. Particulars 1 2 3 4 5

No. Rs. Rs. Rs. Rs. Rs.

1. Loan repayment 20,000 20,000 20,000 20,000 20,000

2. Interest @14% p.a. 14,000 11,200 8,400 5,600 2,800

3. Cash outflow (1+2) 34,000 31,200 28,400 25,600 22,800

4. depreciation@15% on WDV 15,000 12,750 10,838 9,212 7,830

44
5. Total of (2) & (4) 29,000 23,950 19,238 14,812 10,630

6. Tax saving [@ 30.9% on the amount 8,961 7,401 5,945 4,577 3,285
calculated under (5)]

Adjusted cash outflow (3-6)

7. 25,039 23,799 22,455 21,023 19,515
Present value factor at 10%
8. 0.909 0.826 0.751 0.683 0.621
Present value of adjusted cash outflow
9. (78)
22,760 19.658 16,864 14,359 12,119

Total net present value of cash outflows = Rs.85.760

Alternative 2

Years

Sl. Particulars 1 2 3 4 5

No. Rs. Rs. Rs. Rs. Rs.

1. Lease rentals 30,000 30,000 30,000 30,000 30,000

2. Processing fees 1,000 - - - -

3. Cash outflow (1+2) 31,000 30,000 30,000 30,000 30,000

4. Tax savings [@30.9% of (3)] 9,579 9,270 9,270 9,270 9,270

5. Adjusted cash outflow (3-4) 21,421 20,730 20,730 20,730 20,730

6. Present value factor at 10% 0.909 0.826 0.751 0.683 0.621

7. Present value of adjusted cash 19,472 17,123 15,568 14,159 12,873

outflow(56)

Total net present value of cash outflows = Rs. 79,195

Hence, in the present case, lease finance works out to be cheaper than term loan.

Disadvantages of lease finance: Before opting for a lease decision one has to keep in mind the following
disadvantages:

(i) Leased assets are not owned assets and therefore, the asset cover to equity comes down due to increased
dependence on lease finance.
(ii) Financial ratios are also distorted due to greater dependence on lease finance.
(iii) Lease rent payments are made out of working capital funds which mean that fixed assets are financed out of
short-term funds.
(iv) The asset taken on lease is taken back by the lessor at the expiry of lease period. Thus, he will be bothered
about finding alternative asset at the expiry of lease period.

7.1.3 Make or buy decision:

45
The leasing or buying decision is taken only when it is finalised that a particular asset is to be acquired. In most of the
industries, the conception of establishing a new project itself involves acquisition of fixed assets. In assembling industry
different components are assembled to make a product. Now a decision regarding the manufacturing of these components
is to be taken. It is decided whether the product/part/component of product should be bought from the market' or should be
manufactured by having necessary manufacturing facilities. The main consideration affecting such a decision is cost. In a
make or buy decision, the variable cost of making the product or part/component of product is compared with its purchase
price prevailing in the market.

In this decision making process, it may be possible that the decision to manufacture does not result in increasing
the fixed cost, and the existing manufacturing facilities cannot be otherwise utilised profitably, Thus, where no fixed costs
are incurred for producing the product or component, the main criterion is that it would be more profitable to manufacture
than to purchase, if the variable cost is lower than the purchase price.

For example, if a particular component can be acquired at a cost of Rs. 20 from the market then it will be profitable
for the project to produce that component if the variable cost is below Rs. 20. Here it is assumed that no extra fixed costs
are to be incurred on the manufacturing of these components.

However, where the component manufacturing involves additional fixed expenditure, purchase of any plant and
machinery or establishment of a new separate unit, then total cost will have to be considered. In such special situations the
following tax consideration must be kept in mind:

1. Where the manufacturing of the product requires additional fixed cost also: Since in this case, the assessee will
have to incur the additional fixed cost it will form part of the cost of manufacturing of the product.
2. Where the manufacturing of the product requires establishment of a new unit: In this case, although, there will be
cash outflow for establishing a new unit, but the tax incentives shall be as under:-
(i) Exemption under section 10A: If the product to be manufactured is for exports, there will be full
exemption of income till assessment year 2010-11, if the unit is established in a free trade zone and certain
conditions are satisfied.

(ii) Exemption under section IOAA: The unit of an entrepreneur, which begins to manufacture or produce
any article or thing or provide any service in a special economic zone on or after 1-4-2005, shall be
allowed a deduction of 100% the, profits and gains derived from the export, of such articles or things or
from services for a period of 5 consecutive assessment years beginning with the assessment year relevant
to the +previous year in which the Unit begins to manufacture or produce such articles or things or provide
services, as the case` may be, and 50% of such profits and gains for further 5 assessment years. Besides
this, a further deduction for next 5 consecutive assessment years beyond the period of 10 assessment years
mentioned above shall be allowed if certain conditions are satisfied.

(iii) Exemption under section 10B: If the product to be manufactured is for exports, there will be full
exemption of income till assessment year 2010-11 if the unit is an Export Oriented unit and certain
conditions are satisfied.

(iv) Depreciation under section 32: Since a new unit will be established, it shall acquire building, plant and
machinery, furniture and certain intangible assets,: the assessee, in this case, shall be eligible for
depreciation on such assets.

(v) Deduction of Interest on money borrowed for acquisition of such capital assets: If the money is
borrowed for the acquisition of above capital assets, the assesses will be eligible to claim interest as
deduction.

(vi) Deduction under section 8O-IB: If the unit established is a new unit, it shall be eligible for deduction under
section 80-IB if the assessee cannot claim exemption under section l0A and 10B.

3. If the facilities for production are existing & the assessee wishes to discontinue the manufacturing of such product:
It is possible that buying of such product is cheaper than manufacturing and if it is to be continued for a very long
time. The assessee may have to sell the existing plant and machinery etc. In this case, there will be short term
capital gain/loss if the entire block of assets is sold or there will be short term capital gain if the part of the block is
sold for a price more than the W.D.V. of the block.

46
3.12.4 Repair/Renewal or Replacement of an asset: The old and worn out assets need to be either repaired/renewed or
replaced at regular intervals. Sometimes, even a good machine requires up gradation of replacement so as to compete in the
market. The main tax consideration in these cases shall be whether the assessee, while computing his business income,
shall be allowed deduction on account of such expenditure or not.

7.1.4 Repairs/Renewal:

Deduction for expenditure on repairs/renewal will be allowed as revenue expenditure in computation of business income as
under:

If the building is a rented building, any expenditure on repairs shall be allowed as deduction. On the other hand, if
the building is owned, only current repairs shall be allowed as deduction.

As regards plant & machinery, only current repairs shall be allowed as deduction.
However, the accumulated repairs in the above cases can be claimed under section 37(1).
For detailed discussion of what is current repairs refer to sections 30, 31 and 37(1).
It may be noted that if the repairs expenditure are of capital nature it shall not be allowed as deduction either under
section 30, 31 or 37.

Replacement of assets: If the asset has to be replaced, the expenditure incurred on replacement shall be capital
expenditure and the assessee shall only be entitled to depreciation on such assets and as such, the entire expenditure cannot
be claimed as deduction which was allowed in case of repairs. The capital expenditure incurred on construction of super
structure on rented building is also eligible for depreciation under section 32.

7.2 Tax planning in case of employee's remuneration

This requires consideration from the point of view of

(a) Employer: While calculating the business income of the employer, the remuneration payable to the employee, in
whatever form, should be fully deductible otherwise the employer will have to pay tax on such remuneration also
as the same will not be allowed as deduction while computing his business income. In some cases, the employer
shall have to pay fringe benefit tax on certain benefits given td the employees.

(b) Employee: The salary received by the employee, whether in cash or kind, should attract minimum income-tax
liability. He should be in a position to avail maximum exemption/concession in respect of such salary received by
him. Some of the exemptions/concessions available to employee under Income-tax Act are as under:

1. Section 10(10) exemption in case of death-cum-retirement gratuity.

2. Section 10 (10A) exemption of commuted pension.
3. Section 10(1 OB) exemption of retrenchment compensation.
4. Section 10(IOC) exemption of compensation on voluntary retirement.
5. Section 10(13 A) exemption of House rent allowance.
6. Section 10(14) exemption of specified/notified special allowance.
7. Tax free perquisites, like medical facility, reimbursement of medical expenses, telephone at the residence
of employee, free lunch or dinner/free refreshment, leave travel concession, etc.
8. Contribution by the employer to the provident fund or other welfare fund of the employee.
9. Perquisites taxable at concessional rate, like rent free accommodation, motorcar etc.

Problem: Decide which one is a better alternative lease or buy-in the following situations:
Tax rate: 30.9 %
Cost of capital: 14%
Depreciation rate (Income tax): 15%

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 Lease cost: Rs. 34,000 per annum for 5 years (per Rs.1 lakh)
Present value of Re.1 discounted @ 14% is as follows:
Year 1 = .877: Year 2 = .769: year 3 = .675: Year 4 = .592: Year 5 = .519
Make any other suitable assumption, if necessary. [CS-JUNE, 1997]

Solution

1. Evaluation of decision to Buy

Net cash outflow (Rs.)

Present value of cash outflow on account of lease rent 1,16,688

Less: Present value of Tax savings (36,076)

80,612

As net cash outflow in the case lease is less as compared to the net cash outflow in case of buy, the company should go
for taking the machine on lease.

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Assumptions:

1. The cost of the asset (say machine) is Rs.1, 00,000 with a salvage value of Rs.1, 000 at the end of five year period.
2. There is no income-tax liability on account of capital gains.

7.3 Summary

A capital structure is said to be optimum. When make capital structure decision, financial leverage plays an
important role. The financial leverage states the percentage increase in earnings before taxes corresponding to percentage
increase in earnings before interest and taxes. It is serving the capital base with consistent dividend policy and cost of
capital to be raised from the market.

7.4 In-Text Activity

1. What are the effects of financial leverage?

2. Explain the concept of capital-mix.

3. Explain make or buy decisions.

References

Direct Tax planning and Management, Taxman, Singhania, V.K.

Direct Taxes, Law, Practice, Taxman, Singhania, V.K.
Corporate Tax planning, Tata Mc Graw Hill, Srinivas.
Wealth Tax, Taxman.

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