This document discusses capital structure planning and tax considerations related to capital structure. It notes that an optimal capital structure balances various factors to maximize shareholder return. Key tax considerations for capital structure include interest payments on debt being tax deductible while dividend payments are not, and how the proportion of debt and equity affects taxable income and returns. The document provides several recommendations for tax planning with different capital structures depending on factors like return on investment compared to interest rates.

1. Asist. Prof. Maneesha valecha,BBC 1
MODULE-3
Tax Planning With Reference To Capital Structure
Need for Capital Structure Planning
For the real growth of the company the Financial
Manager of the company should plan an optimum capital for the
company. The optimum capital structure is one that maximizes
the market value of the firm. In practice the determination of the
optimum capital structure is a formidable task and the manager
has to perform this task properly, so that the ultimate objective
of the firm can be achieved. There are significant variations
among industries and companies within an industry in terms of
capital structure. Since a number of factors influence the capital
structure decision of a company, the judgment of the person
making the capital structure decisions play a crucial part. A total,
theoretical model can’t adequately handle all those factors,
which affects the capital structure decision in practice. These
factors are highly psychological, complex and qualitative and do
not always follow accepted theory, since capital markets are not
perfect and decision has to be taken under imperfect knowledge
and risk.
An appropriate
capital structure or target capital structure can be developed only
when all those factors, which are relevant to the company’s
capital structure decision, are properly analyzed and balanced.
The capital structure should be planed generally keeping in view
the interest of the equity shareholders and financial requirements
of the company. The equity shareholders being the owner of the
company and the providers of risk capital (equity), would be
concerned about the ways of financing a company’s operations.
However, the interest of other groups, such as employee,
customers, creditors, society and government, should be given
reasonable consideration when the company lays down its
objective in terms of the shareholders wealth maximization, it is
generally compatible with the interest of other groups. Thus,
while developing an appropriate capital structure for a company
the finance manager should inter alia aim at maximizing the
long-term market price per share. Theoretically, there may be
precise point or range within which the market value per shares
is maximum. In practice, for most companies within an industry
there may be a range within which there would not be great
differences in the market value per share. One way to get an idea
of this range is to observe the capital structure patterns of
company’s vis-à-vis their market prices of share. The
management of companies may fix its capital structure near the
top of this range in order to make maximum use of favorable
leverage, subject to other requirements such as flexibility,
solvency, control and norms set by the financial institutions –
The Security Exchange Board of India (SEBI) and Stock
Exchanges.
Capital Structure Decision:
It refers to the various sources through which a project can be
financed. Financing can be done through either own funds or

2. Asist. Prof. Maneesha valecha,BBC 2
through loan funds or though combination of both. It comprises
either of debt or equity or combination of the two.
When the decision to be taken
a) At the time of commencement of business.
b) At the time of major expansion of business.
c) During the course of business to meet the working capital
requirement.
Factors considered selecting capital structure
decision.
1. Risk - In case of debt, repayment of principal and interest have
to be made as per the loan agreement irrespective of profits or
losses. Failure to make contractual payments may lead to
bankruptcy and closure of the business. And such contractual
payments are required to be made if the projects is financed
through equity. Thus, debt carries more risks as compared to
equity.
2. Control - Equity may lead to a decrease in the promoters control
over the company as the other shareholders would also
participate in the decision making process. On the other hand
financing would not dilute promoters control over the company
as the banks or financial institutions are not entitled to participate
in the decision making.
3. Gestation Period - When investment is done in a project, the
time between your investment and before the production occurs
is said to be gestation period. Financing through debt would be
difficult in a long gestation and financing through equity may be
preferred in such case.
4. Shareholders satisfaction - In order to keep the shareholders
satisfied the company should ensure that the capital structure
does not adversely affect the earnings per share, dividend
payout, market price of the share.
5. Debt equity ratio- Generally debt equity ratio of 2 is to 1 is
registered as an ideal ratio. Case the existing debt equity ratio is
1:1 debt may be preferred. On the other hand where debt equity
ratio 3:1 equity route may be preferred.
6. Marketability of shares – Marketable securities are liquid
financial instruments that can be quickly converted into cash at a
reasonable price. Fund can be raised through equity route only if
the shares are marketable. Otherwise, finance can be arranged
through debt.
7. Future rate of return - List of the proposed capital structure on
the future rate of return on equity should also be kept in mind
while making the capital structure decisions. Capital structure
decision is basically subject to financial management. In the
context of tax planning, the discussion has to be limited only to
implication of tax factor in capital structure decisions.
C

3. Asist. Prof. Maneesha valecha,BBC 3
CAPTIAL STRUCTURE DECISIONS
What is the Optimum Capital Structure : The optimum capital
structure is a mix of equity capital and debt funds. Their
composition depends upon many factors namely :
1. Cost of Capital and also expenditure incurred in raising of such
capital.
2. Expectation of shareholders by way of dividend, growth etc.
3. Expansion need of the business i.e. the rate by which profits of
the business shall be again ploughed back in the business.
4. Taxation policy ; and
5. Rate of return on investment ( Equity + Debt funds ).
TAX CONSIDERATIONS
1. Interest on debt fund is allowed as deduction as it is a business
expenditure. Therefore, it may increase the rate of return on
owner’s equity.
2. Dividend on equity fund is not allowed as deduction as it is the
appropriate of profit. Dividend is exempt in the hands of
shareholders u/s 10(34) . However, the company declaring the
dividend shall pay dividend distribution tax @ 17.304% +
surcharges + education cess.
3. The Cost raising owner’s fund is treated as capital expenditure
therefore not allowed as deduction. However if conditions of
Sec. 35D is satisfied then specified expenditures can be
amortized.
4. The Cost of raising dent fund is treaded as revenue expenditure.
It can be claimed as deduction in computing the total income.
5. Where the assesses is entitled to incentives u/s 10A etc.
maximum equity fund should be utilized.
6. Where interest on debt fund is payable outside India, tax should
be deducted at source otherwise deduction is not allowed.
TAX PLANNING
1. If the return on investment > rate of interest , maximum debt
funds may be used, since is shall increase the rate of return on
equity . However, cost of raising debt fund should be kept in
mind.
2. if rate of return on investment < rate of interest, minimum debt
funds should be used.
3. Where assessee enjoys tax holidays under various provisions of
Income-Tax in such case minimum debt fund should be used,
since the profit arising from business is fully exempt from tax
which increase the rate of return of equity capital. But the
borrowed funds reduces the profits ( profits less interest) before
tax and to the extent exemption is reduce.
The balance of capital structure shall depend upon maximizing
the return on capital employed which is computed by using
following formula :
Distributable Profit
_________________________ X 100
Equity Capital

4. Asist. Prof. Maneesha valecha,BBC 4
DIVIDEND POLICY
Meaning of Dividend in common use. In ordinary language
dividend means the sum received by a shareholder of a company
on the distribution of its profits, whether out of taxable income
or tax-free income. It is immaterial whether it is received in cash
or in kind.
Definition of Dividend
The following distributions or payments by a company to its
shareholders are deemed as dividends to the extent of
accumulated profits of the company
(a) Any distribution which entails the release of all or any of the
assets of the company;
(b) Any distribution of debentures or deposit certificates or
bonus shares to preference shareholders;
(c) Any distribution on its liquidation;
(d) Any distribution on the reduction of its capital;
(e) Any payment by a closely-held company by way of advance
or loan to a shareholder (being a person who is the beneficial
owner of shares) having at least 10% of the voting power or to
any concern in which such shareholder is a member or a partner
and in which he has a substantial interest.
Advances/loans received by HUF from a closely-held company
is taxable as deemed dividend u/s 2(22)(e) if Karta, who is
shareholder in lending company has substantial interest in the
HUF even if HUF is not a registered shareholder.
TAX PLANNING IN RELATION TO DIVIDEND
INCOME
1. A domestic company may issue bonus shares to its equity
shareholders in lieu of dividend in cash. By this method it can
avoid the tax u/s 115-0 on dividend distributed. However, it will
increase tax liability of its shareholders.
2. Payment made by a closely-held company to a shareholder
who is the beneficial owner of not less than 10% of the equity
shares of the company or on his behalf or for his benefit, is
deemed to be dividends to the extent of accumulated profits. On
this deemed dividend the company is liable to pay tax at a higher
rate (34.944%) u/s 115-0. Such a shareholder should not take
loan from the company or ask the company to make payment on
his behalf or for his benefit. However, if it is not possible, before
taking a loan etc. he should reduce his shareholding (voting
power) to less than 10% of equity share capital.

5. Asist. Prof. Maneesha valecha,BBC 5
3. Similarly, a concern, in which the aforesaid shareholder has
substantial interest (entitled to not less than 20% of the income
of the concern or 20% voting right in the company), should not
borrow from the closely-held company. Otherwise, it will be
taxed as deemed dividend in the hands of the lending company.
4. Where a loan in the hands of a shareholder mentioned in 2 and
3, has been taxed as deemed dividend, such loan should not be
repaid to the closely-held company. It should be adjusted against
the dividends declared by the company in future. The dividend
declared in future and adjusted against the loan is not treated as
dividend declared. Thus, the double taxation liability can be
avoided.
AMALGAMATION IN THE NATURE OF
MERGER
Under Income Tax Act, 1961 Section 2(1B) of Income Tax Act
defines ‘amalgamation’ as merger of one or more companies
with another company or merger of two or more companies to
from one company in such a manner that:-
• All the property of the amalgamating company or companies
immediately before the amalgamation becomes the property of
the amalgamated company by virtue of the amalgamation.
• All the liabilities of the amalgamating company or companies
immediately before the amalgamation becomes the liabilities of
the amalgamated company by virtue of the amalgamation
• Shareholders holding at least three-fourths in value of the shares
in the amalgamating company or companies (other than shares
already held therein immediately before the amalgamated
company or its nominee) becomes the shareholders of the
amalgamated company by virtue of the amalgamation.
Tax Relief’s and Benefits in case of Amalgamation
If an amalgamation takes place within the meaning of section
2(1B) of the Income Tax Act, 1961, the following tax reliefs and
benefits shall available:-
1. Tax Relief to the Amalgamating Company:
a. Exemption from Capital Gains Tax [Sec. 47(vi)]: Under section
47(vi) of the Income-tax Act, capital gain arising from the
transfer of assets by the amalgamating companies to the Indian
Amalgamated Company is exempt from tax as such transfer
will not be regarded as a transfer for the purpose of Capital Gain.
b. Exemption from Capital Gains Tax in case of International
Restructuring [Sec. 47(via)]: Under Section 47(via), in case of
amalgamation of foreign companies, transfer of shares held in
Indian company by amalgamating foreign company to
amalgamated foreign company is exempt from tax, if the
following two conditions are satisfied:

6. Asist. Prof. Maneesha valecha,BBC 6
• At least twenty-five per cent of the shareholders of the
amalgamating foreign company continue to remain shareholders
of the amalgamated foreign company, and
• Such transfer does not attract tax on capital gains in the country,
in which the amalgamating company is incorporated
2. Tax Relief to the shareholders of an Amalgamating
Company:
a. Exemption from Capital Gains Tax [Sec 47(vii)]: Under section
47(vii) of the Income-tax Act, capital gains arising from the
transfer of shares by a shareholder of the amalgamating
companies are exempt from tax as such transactions will not be
regarded as a transfer for capital gain purpose, if:
o The transfer is made in consideration of the allotment to him of
shares in the amalgamated company; and
o Amalgamated company is an Indian company.
3. Tax incentives to Amalgamated Company
a. Capital expenditure on scientific research:- Where a company is
amalgamated before claiming full deduction in respect of capital
expenditure on scientific research, the amalgamated company
(being an Indian company) is entitled to claim deduction of such
unabsorbed amount.
b. Expenditure incurred to obtain licence to operate
telecommunication services etc:- Where a company is
amalgamated before claiming full deduction in respect of
expenditure to obtain right to use spectrum for
telecommunication services or license to operate
telecommunication services, the amalgamated company (being
an Indian company) is entitled to claim deduction in respect of
remaining instalments of such expenditure.
c. Preliminary expenses:- Where an Indian company is
amalgamated before claiming full deduction in respect of certain
preliminary expenses, the amalgamated company (being an
Indian company) is entitled to claim deduction in respect of
remaining instalments of such expenses.
d. Expenses for amalgamation:- Where an Indian company incurs
expenditure wholly and exclusively for the purposes of
amalgamation, it shall be allowed a deduction@ 20% of such
expenditure for each of five successive previous years beginning
with the previous year in which amalgamation takes place.
e. Expenses incurred under voluntary retirement scheme:- Where
an Indian company is amalgamated before claiming full
deduction in respect of expenses incurred under voluntary
retirement, the amalgamated company (being an Indian
company) is entitled to claim deduction in respect of remainin
instalments of such expenses.
f. Expenses on prospecting etc. of certain minerals:- Where an
Indian company is amalgamated before claiming full deduction
in respect of expenditure incurred on prospecting for or
extraction or production of certain minerals, the amalgamated
company (being an Indian company) is entitled to claim
deduction in respect of remaining instalments and unabsorbed
Amount of such instalments.
g. Capital expenses on family planning:- Where a company is
amalgamated before claiming all deduction in respect of capital
expenditure incurred for the purpose of promoting family
planning amongst its employees, the amalgamated company
(being an Indian company) is entitled to claim deduction in

7. Asist. Prof. Maneesha valecha,BBC 7
respect of remaining instalments and unabsorbed amount of such
instalments.
h. Expenses on prospecting etc. of petroleum and natural gas:-
Where a company Amalgamated before claiming full deduction
in respect of expenditure incurred on prospecting for or
extraction or production of petroleum and natural gas, the
amalgamated company being an Indian company) is entitled to
claim deduction in respect of such expenditure.
i. Bad debts:- "Where a part of debts taken over by the
amalgamated company amalgamating company becomes bad
subsequently, such bad debt is allowed as a deduction in
computing the income of the amalgamated company.
j. Actual cost of an asset:- Where, in a scheme of amalgamation,
any capital asset is transferred by the amalgamating company to
amalgamated company and the amalgamated company is an
Indian company the actual cost of the transferred capital asset to
the amalgamated company shall be taken to be the same as it
would have been if the amalgamating company had continued to
hold the capital asset for the purpose of its own business.
k. Actual Cost of depreciable assets:- Where in any previous year,
any block of assets is transferred by an amalgamating company
to the amalgamated company in a scheme of amalgamation, and
the amalgamated company is an Indian Company, then the
actual cost of the block of assets to the amalgamated company
shall be the W.D.V. of the assets to the amalgamating company
for the immediately preceding previous year as reduced by the
amount of depreciation actually allowed in relation to the said
preceding previous year
l. Deduction in respect of profits from undertaking engaged in
infrastructure development and other than infrastructure
development.:-:- Certain deductions are allowed from gross total
income under Sections 801AB or 80IB or 80IC or 80IE on
fulfilment of certain conditions. The amalgamated company
fulfils those conditions it is entitled to these deductions resulting
in reduction of its tax liability.
CORPORATE RESTRUCTURING
It is the process of making changes in the composition of a firm’s
one or more business portfolios in order to have a more
profitable enterprise. The Corporate Restructuring is the process
of making changes in the composition of a firm's one or more
business portfolios in order to have a more profitable enterprise.
Simply, reorganizing the structure of the organization to fetch
more profits from its operations or is best suited to the present
situation.
Types of Corporate Restructuring
1. Financial Restructuring - Financial restructuring is a form of
corporate restructuring strategy which is usually considered
when companies merge or get acquired by another company. It
is the reorganization of the financial assets and liabilities of a
corporation in order to create the most beneficial financial
environment for the company.

8. Asist. Prof. Maneesha valecha,BBC 8
2. Debt Restructuring- Debt restructuring is usually used by a
company to change its strategy to pay off a debt. A company
may restructure its business, divest a particular subsidiary of the
parent company, or raise additional capital to pay off a debts
3. Organizational Restructuring- The Organizational Restructuring
means changing the structure of an organization, such as
reducing the hierarchical levels, downsizing the employees,
redesigning the job positions and changing the reporting
relationships. This is done to cut the cost and pay off the
outstanding debt to continue with the business operations in
some manner. The focus in on management and internal
corporate governance structures. Organizational restructuring
has become a very common practice amongst the firms in order
to match the competition of the market.
4. Operational Restructuring- It is the identification of the causes
of operational underperformance and the development of a
strategy to achieve improvement. That is, Operational
Restructuring focuses on the profitability of operations