chapt 2 tax planning

12 Taxation Planning PDP

Chapter 2

13Taxation PlanningPDP

Tax Planning

There is nothing which hurts more than payment of taxes. One question that goes through every taxpayer’s mind is “how can I reduce my tax liability?” Reducing tax liability is not always a bad or illegal

exercise. There are legitimate ways to reduce taxes through proper tax planning and such methods arealways encouraged. But unfortunately, there is also a tendency to reduce tax through illegal or colourablemethods. They are not accepted practice and can invite problems.

There are three methods which are commonly used by the taxpayers to reduce their tax liabilities

n Tax evasion,

n Tax Avoidance and

n Tax Planning

2:1 Tax evasion

Dishonest taxpayers try to reduce their taxes by concealing income, inflation of expenses, falsification ofaccounts and willful violation of the provisions of the Income-tax Act. Such unethical practices oftencreate problems for the tax evaders. Tax department not only imposes huge penalties but also initiateprosecution in such cases.

2:2 Tax Avoidance

Tax avoidance is minimizing the incidence of tax by adjusting the affairs in such a manner that althoughit is within the four corners of the laws, it is done with a purpose to defraud the revenue. It is the act ofdodging without directly breaking the law. For example if A gives gift to his wife, the income from the assetgifted will be clubbed in the hand of A. But to avoid this clubbing provision “A” decides to give gift to B’swife and B reciprocates it by giving gift to A’s wife. This is not tax planning but tax avoidance.

Such practices are not acceptable. In the words of Justice Rangnath Misra of Supreme Court in the caseof McDowell & Co Limited v CTO [1985] 154 TR 148,

“tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot bepart of tax planning and it is wrong to encourage or entertain the belief that it is honorable to avoidpayment of tax by resorting to dubious methods.”

2:3 Tax Planning

Tax planning is arrangement of financial activities in such a way that maximum tax benefits, as provided inthe income-tax act are availed of. It envisages use of certain exemption, deductions, rebates and reliefsprovided in the act.


Some examples of tax planning are given below:

n Residential status: Sometime by better tax planning a taxpayer can avoid becoming resident in aparticular year. The advantage of this is that if he is non-resident in a particular year, he is not liable tobe taxed for his overseas income in India. In case he becomes resident in India for tax purpose, he istaxed for his worldwide income. However, this may not have any effect if the tax paid abroad onoverseas income is equal to more than the tax payable on such income in India, as the taxpayer isentitled to get credit of taxes paid abroad in case that income gets taxed in India.

n Individual’s investment: Taxpayer can plan investment in a manner so that overall return is optimum.This may involve analyzing different investment options taken into consideration, availability of taxdeduction u/s 80C, exemption of interest/dividend income on a particular investment, capital gain,possibility of exemption from capital gain, rate of return, risk factor, liquidity etc.

n Employee’s remuneration: There is no effect on the tax liability in the hand of the employer onaccount of designing of salary package of employees. Still, every employer wants to design thesalary package in a way so that the incidence of tax on the employee is kept to minimum. Bydoing this, the take home pay of the employee is increased. To design such a package it isnecessary to understand how perquisites and benefits are taxed and which are those perquisitesor benefits which are not taxed or taxed at concessional rate. It is also necessary to understand,how Fringe Benefit tax is payable, as it may be advisable for the employer to pay FBT instead ofletting that benefit be taxed in the hand of the employee through allowances.

n New Business, What should be the form of ownership? : While starting his business, taxpayercan plan his taxes by evaluating tax implication in different choices available like individualproprietorship, partnership firm or company.

Proprietorship is easy to establish with less cost and with no restriction on enjoyment of profit.The tax rate is also less because of slab system of taxation. However, it is suitable for smallbusiness only.

Partnership firm: If there is more than one person having common interest in the business then itmakes sense to incorporate it as partnership firm. The tax liability may be a little more thanproprietorship but firm can reduce this tax liability by taking advantage of initial exemption availablein the hand of various individual partners by providing for their salary and interest within the givenlimit. This will work if the partners have no other source of income.

In the case of company the tax rate is highest and the dividend is further subjected to tax.However, the limited liability and ability to raise finance are also important factors other thantaxes. Also there is no limitation on the salary payable to Director.

Taxation of individual, firms and companies is discussed in chapter 16 and 17 of this book.

n New Business, Location of Business: the correct selection of location of business also playsan important role in Management decision making. There are a few locational tax advantages inthe Income Tax Act which must be considered while arriving at the decision. In other words, whenone is trying to start a new business or start a new unit in the existing business, it can considerlocating business in a place so that it get some tax exemption which will reduce the tax liability.Important sections of income-tax act which will help in this tax planning are:

1. Section 10A: Newly established undertaking in Free Trade Zone, Electronic HardwareTechnology Park or Software Technology Park.


2. Section 10AA: Newly established undertaking in Special Economy Zone.

3. Section 10B: Newly established 100% Export Oriented Undertaking.

4. Section 10BA: Newly established manufacturing unit producing hand made article orthings or artistic value with wood (not being imported) as the main raw material. Atleast 90% must be exported.

5. Section 80IB: Industrial undertaking located in industrial backward state or district.

6. Section 80IC: Undertakings or enterprises located in notified area in North Eastern State,State of Sikkim, Himachal Pradesh, Uttranchal. For units commencing production orundergoing substantial expansion on or after 1.4.2007 and located in North Eastern Statesor Sikkim, the provisions of section 80IE shall be applicable instead of this section.

7. Section 80ID: Undertaking doing business of hotel or convention centre in NationalCapital Territory of Delhi and the districts of Faridabad, Gurgaon, Gautam Budh Nagarand Ghaziabad, where the new hotel or the conventional centre is constructed on orafter 1st of April 2007 and before 31st March 2010.

8. Section 80IE:Underaking located in North Eastern states or state of Sikkim whobegun to commence production or complete substantial expansion on or after 31stmarch 2007 but before 31st March 2017 are covered under this section instead ofsection 80ID.

These are discussed in detail in chapter 5 of this book.

n New Business: Nature of business: Before starting a business it is important to know varioustax incentives available under the Income Tax Act for some specific types of business. Most ofsuch exemptions have now become non-existent. However, in the following cases, fresh businessmay still get tax exemption.

1. Export Business : Under Section 10A, 10AA, 10B, 10BA,

2. Developer of SEZ: 80IAB

3. Infrastructure Development: 80IA

4. Business of Scientific Research & development, production/refining of mineral oil, development and building of housing project approved by a local authority, operation &maintenance of hospital in rural area, processing, preservation & packaging of fruits orvegetables: Section 80IB

5. Hotel or conventional centre in National Capital Territory of Delhi and the districts of Faridabad,Gurgaon, Gautam Budh Nagar and Ghaziabad, where the new hotel or the conventionalcentre is constructed on or after 1st of April 2007 and before 31st March 2010.

n Management Decision - Capital Structuring: In Financial Management Course, students aretaught to understand the basis of arriving at the decision about capital structure, i .e. debt, equityor preference shares. The factors like risk, cost and control are relevant. In addition one mustunderstand the tax implication and should also consider this while deciding the best mix to optimizeshareholder’s return. Dividend on share is not allowable deduction in the hand of the company;however, interest on debt paid is allowable deduction. The cost of raising equity is a capitalexpenditure which can only be capitalized and amortized in certain conditions (may not beamortized in all cases). However, the cost of raising debt is allowed as deduction. This has directimplication in calculating corporate tax liability. On dividend from Indian company, the companyis liable to pay DWT and then such dividend is exempt in the hand of the shareholders.


n Management Decision: Make or buy: In Financial management course, students are taught tounderstand the basis of arriving at the make or buy decision considering capacity utilization,inadequacy of fund, cost of fund, latest technology, variable cost of manufacturing etc. Whilearriving at this decision due consideration must also be given to tax implication as this willcertainly influence the decision. One must consider that if one decides to make, there is lessoutflow due to tax benefit on depreciation/interest and tax advantage available due to location ofmanufacturing in a particular area. These tax advantages have already been listed earlier. If thecompany is able to take advantage of any of these tax incentives, the decision to make maycome out better in comparison to decision to buy.

n Management Decision: Own or Lease: Concept of leasing is gaining immense popularity.One private airline has recently sold and taken back the same aircraft on lease. In the process itgot some fund in its account. One factor which influenced its decision was that the lease rentalpaid to foreign enterprise is not subject to withholding tax if the lease agreement has beenapproved by the Central Government. Other factors which must be considered for tax implicationsare that in case of buying the asset, the assessee will be entitled to deduction on the account ofdepreciation and interest, while in case of lease he will be entitled to deduction on account oflease rental which will be higher in the initial years. Hence, tax consideration will also influencemanagement decision to own or lease.

n Capital Gain: It is important to understand that long term capital gain tax is less than normal taxon business or interest income. Further in case of equities, where security transaction tax ispaid, there is no long-term capital gain and short-term capital gain is only charged at 10%. Evenif the taxpayer has long term capital gain he has the opportunity to reduce it by properly investingit in approved bonds of National Highway Authority or Rural electrification Corporation undersection 54EC or investing in house property under section 54 and 54F. Thus if some one has anoption to earn regularly or through capital gain, the earning through capital gain will attract lesstax. This will influence the investment decision of the taxpayer.

n Amalgamation: There is limitation in the Income-tax Act for carry forward of losses. It is quitepossible that one of the group companies is making profit and another group company is makinglosses. Some of these losses may be getting lapsed due to time limitation. One can not transfer profitof one Group Company to another just like that as it would amount to tax avoidance and can invitetrouble. The tax planning in such cases could be to merge the two companies. However, it must beensured that the conditions of merger as given in the Income-tax Act are satisfied. These are:

1. all property and liability of the amalgamating company or companies immediatelybefore the amalgamation becomes the property of the amalgamated company by virtueof amalgamation.

2. Shareholders holding not less than 75% in value of the shares in the amalgamatingcompany or companies become shareholders of the amalgamated company by virtueof the amalgamation.

3. Conditions as prescribed in section 72A of the Income-tax Act are satisfied by bothamalgamating company and the amalgamated company.


Chapter Review

Methods used for reducing Tax Liability

Form of Ownership

Location

Nature of BusinessTax Planning can be done through

Individual’s Investment

Employee’s RemunerationNew Business

Companies

Capital Gain

Capital Structuring

Make or Buy

Own or LeaseAmalgamation

Residential StatusTax Planning

Tax Avoidance

Tax Evasion

Tax Planning

Utilization of all availablelegal means to reduce/defer taxes

Escaping the incidence of tax legally

Utilizing the allowable

Exemptions

Deduction

RebatesReliefs


Exercise

1. A person manipulates his book of account to exclude some amount of sales and therebyreducing his tax liability. This is termed as ______________.

a. Tax evasionb. Tax avoidancec. Tax Planningd. None of the above.

2. A person invests some money from his income in PPF in order to reduce his tax liability. Thisis termed as:

a. Tax evasionb. Tax avoidancec. Tax Planningd. None of the above

3. Which of the following undertakings are eligible for exemptions under the Income Tax Act, onaccount of their location?

a. Located in Special Economy Zoneb. Located in Free Trade Zonec. Located in notified area in North Eastern Stated. All of the above.

4. All undertakings exporting article or things are eligible for exemption under section 10B. Thestatement is ________.

a. Trueb. False

5. Both developers of SEZ as well as units located in the processing area of SEZ are eligible fortax exemption. The statement is ________.

a. Trueb. False

6. In partnership firm, the share of partners from partnership firm assessed as such, is taxable intheir individual hand. The statement is ________.

a. Trueb. False

7. Fringe Benefit Tax is payable by the employer and like TDS on salary, it is deducted from thesalary of the employees The statement is ________.

a. Trueb. False

8. Resident individual is taxable for his income earned outside India. The statement is ________.

a. Trueb. False


Anwers:

1. a.2. c.3. d.4. a.5. a.6. b.7. b.8. a.

chapt 2 tax planning

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