Presentation 1
Presentation 1
Presentation 1
attract the minimum liability to tax with the help of various concessions, allowances and
reliefs provided for in the tax laws. As such, the basic purpose of tax planning is to reduce or
postpone the overall tax burden in the present and foreseeable future. Tax planning is a
discipline and an attitude towards solving the corporate problems in a methodical way from a
long–run point of view.
The correct approach in regard to tax planning has been formulated by Rangnath Mishra,a
Supreme Court Justice of India, in the case of McDowell (Supra) in the following words: "Tax
Planning may be legitimate provided it is within the framework of law. Colourable devices
cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is
honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation
of every citizen to pay tax honestly without resorting to subterfuges".
There are three common methods of saving taxes viz, tax evasion, tax avoidance and
tax planning. Tax evasion involves hiding income illegally or concealing the particulars
of income or a particular source or sources of income or manipulating the accounts to
overstate expenditures and other outgoings and understate incomes with a view to
reducing profit and thus the taxable income. tax evasion is, therefore, illegal, and
uneconomic as well.
a. Non-reporting of income
b. Under reporting of income
c. Maintaining multiple sets of accounts.
d. Operating business transactions under different
names
e. Over- reporting of expenses
f. Opening bank account in dummy name.
Tax evasion is unethical illegal and uneconomic activity. The activity of not
paying tax is against moral ethics, whereas, it is the loss of government
revenue. and it promotes black money and tax evasion is way of reducing tax
liability in which the prevailing rules does not permit to evade the tax.
As regards tax avoidance, G.S.A. wheat crafts say' it is the art of dodging tax
without actually breaking the law'. It is a method of reducing tax liability by
taking advantages of certain loopholes in the tax laws. Wheat craft analyses
tax avoidance as a transaction which would not be adopted if the tax saving
elements were absent. Therefore, tax avoidance involves (i) a transaction
entered into avoid tax and with full legal backing and (ii) a transaction which
the legislature would not intent to encourage.
Tax avoidance involves the arrangement of a tax payer's affairs in such a way
that, when all the facts are known, the tax payer can still legally contend,
whether successfully or unsuccessfully, for the reduced tax liability that the
arrangements are intended to achieve.
Under any tax system, creative tax payers will make every effort to discover unintended
loopholes and there will be a constant race by tax payers to take advantage of those
loopholes before the government can close them. It is as yet impossible to predict what
those loopholes might be in the tax system but based on experience, they are sure to
exist. When the tax regulations have been revised innumerable times to stop tax
avoidance transactions, this cycle will be starting a new with an entirely new system.
Tax avoidance is saving taxes without actually breaking the law. It is an exercise where a
tax payer tries to take advantages of the loopholes of the existing rules and regulation. It
is legally permissible but unethical; in other words, tax avoidance is the reduction of tax
liability through the manipulation of existing tax law.
In a country where business houses are relatively small size, people are relatively poor
and tax morale is relatively low tax payer's use avoiding practices in developing countries.
Income tax Act 2058 has defined tax avoidance as any means or arrangement; one of the
main purposes of which is the avoidance or reduction of tax liability. Sec 35 of the Act
has given certain rights to Inland Revenue Department to minimize tax avoidance. The
provisions in this Act relating to tax avoidance are:
1. Use of arm’s length price to avoid transfer pricing (u\s33)
2. Provision against splitting of income (u/s 34)
3. Provision of not allowing to reduce dividend income (u/s58)
4. Right of tax authorities to have access to the information of the tax payers (u/s 82)
5. Provision of not allowing double expenses under lease sale (u/s32)
Tax planning is not only planning the basic structure of the business and industry but also
the planning of its various projects from time to time and its day-to-day activities so as to
acquire the maximum benefits under the provisions of the existing laws of the state. Tax
planning should not be mistaken for tax avoidance and tax evasion because the latter are
clearly against the law or the spirit of the law.
Tax Planning is one of legal method of reducing tax liability by the tax payer. Tax means
compulsory contribution by a person to the government without having any direct benefit
for the payment and planning means taking decision about the future by choosing the
best from different alternatives. Income tax Act provides tax concessions, tax rebates and
tax allowances to tax payers in order to encourage to set up new industries. Tax planning
is defined as a scheme whereby tax payer makes use of all the tax concessions available
under tax law and pays the minimum possible tax. It is a legal ethical ,economic way of
reducing tax liability by taking full advantages of all the tax related exemptions, relates,
deductions and allowances.
Objectives
1. Reduction of tax liability
2. Minimization of litigation
3. Productive investment
4. Healthy growth of the economy
5. Economic stability
Features of tax planning
a. It is future oriented activities
b. It is a legal, ethical and economic device
c. It is the genuine use of the facilities provided by government.
d. It reduces tax liability
e. It establishes a good relationship between the government, and business
community by enhancing and healthy business environment in the
country.
Tax planning requires intelligent and well thought out strategy to reduce or postpone
tax liability in the present and foreseeable future with stress on being honest,
responsible and trustworthy citizen.
A company should aim at not only maximizing profits but also maximizing after tax
profits. Tax planning is to be done in advance with a view to minimizing the payment of
tax within the framework of tax laws. Tax Planning presupposes a thorough knowledge
of tax laws so that the best alternative choice may be thought of in order to attract
least tax liability. Tax planning is the method through which taxpayer makes use of all
the concessions including exemptions ,deductions and allowances under tax laws and
pays the minimum possible tax.
Tax planning for capital structure decisions
• Companies need capital in order to run their business, do necessary
investments and grow larger. These actions are combined with high costs
where both internal and external financing might be appropriate. Capital
structure refers to the mix of debt and equity used by a company in financing
its assets. The capital structure decision is one of the most important
decisions made by financial management. The capital structure decision is at
the centre of many other decisions in the area of corporate finance. Capital
structure is one of the effective tools of management to manage the cost of
capital. An optimal capital structure is reached at a point where the cost of
capital is minimum.
• Under the classical tax system, the tax deductibility of interest makes debt
financing valuable, the cost of capital decreases as the proportion of debt in
the capital structure increases. The optimal structure then would be to have
virtually no equity at all.
In general, since dividend payments are not tax deductible but
interest payment are one would think that, theoretically, higher
corporate tax rates would call for an increase in usage of debt to
finance capital, relative to usage of equity finance.
There are different kinds of debts that can be used, and they
may have different deductibility and tax implications. This will
affect the types of debt used in financing, even of corporate
taxes do not change the total amount of debt used.
The capital structure has to be planned initially when the company is formed and
also subsequently when it raises additional funds. This has to be done very carefully so
that capital structure is the most advantageous to the company. The choice between equity
and debt is decided by their relative merits and demerits. So far as the choice is
concerned, companies prefer to go in for debt financing as the interest paid on debt is a
tax deductible expense, whereas dividend on equity capital is not deductible at the time of
computing taxable income. The following are the views expressed by some economists,
taxation experts concerning the rational of interest deduction and the possible bias is
favor of debt financing. Chad Leecher 1 , who conducted detailed survey of the tax
systems in Colombia, Republic of Korea, Mexico and Thailand expresses deep concern
about the possible adverse impact on corporate financial structure arising out of
discriminatory treatment of equity vis–a–vis debt. His observations were as follows: (a)
Debt capital produces tax deduction in the form of interest payments, a privilege equity
capital is not entitled to (b) Because of the interest deductibility, corporations can lower
their tax liabilities by raising the debt–equity ratio (c) Equity financing, therefore,
represents an inferior method of fund raising. Some countries have introduced different
measures to counter the bias in favour of debt financing. However, Mexico allows
dividend deduction in the determination of corporate profits; other countries provide
dividend relief at the personal income level.
Richard Goode 2 the author of a celebrated book on "Corporate Taxation", has considered
two methods of the corporation income tax with the objective of eliminating the difference
in taxation of interest and dividends paid. The first is to allow a deduction for dividends paid
as well as interest paid. The second is to eliminate the deduction of interest paid. But he
rightly points out that the elimination of interest deduction with respect to outstanding debt
would be a harsh measure. For some corporations, the increase in tax liabilities would mean
insolvency. The additional tax would fall entirely on the equity stockholders who would
suffer windfall losses. These telling objectives to outright elimination of the interest
deduction, the author suggest the possibility of removing it only with respect to future
issues. He further adds that "the additional tax would still fall entirely on dividends and
undistributed profits, but it could be taken into account in making decisions to borrow. The
arguments in favour of disallowing the interest deduction apply mainly to interest on long-
term debt. But the possibility that a provision refusing the deduction only for interest on
long-term debt would lead to avoidance by repeated renewals of short-term debt. It, thus,
suggests that distinction based on maturity would not be satisfactory."
As mentioned earlier, the author recognizes the problem of bias in favour of debt financing
but fails to offer any concrete solution. Deduction of dividends along with interest would
mean a windfall gain to corporations and revenue loss to government. He also pointed out that
if interest is not allowed for deductions, the increase in tax liabilities would mean in
insolvency for some corporations arising from such elimination of deductibility of interest.
Royal commission 3 observed that tax consideration had affected capital formation of
Canadian Corporations. Double taxation of dividend was found once at the corporate level
and again at the individual level, thereby greatly discouraging equity financing. And as such
bias was in favour of debt financing because of the interest deductibility on debt for tax
purposes. Thus, the Royal Commission had recommended full integration of corporate tax
with individual income tax by way of 100 percent credit which was a system of tax credit in
proportion to earlier paid on dividend. If full integration system is in operation, the choice
between debt and equity financing would be less affected by tax consideration.
Vaish and Surekha 4 observed that "the corporate tax system makes a distinction between
profits and interest. In the computation of taxable profit, interest is treated as cost and
allowed as deduction. This has tended to upset the balance between owned capital and
borrowed capital. Companies have gradually tended to increase the degree of financial
leverage. However, excessive gearing is not in the long-term interest of corporations and
ways have been devised to put owned capital and borrowed capital on the same plane for
tax purposes."
In this regard, the authors had put questions on the rationality about discriminatory tax
treatment of equity capital and then recommended that the "whole of profits distributed,
subject to the maximum of 12 percent of equity capital, or 10 percent of capital employed,
whichever is higher, should be allowed as deductible expenditure while computing tax
liability. This will help expand the flow of equity capital and revive the capital market
which is stagnant for the last several.
Our above discussion shows that tax is an important factor in determining capital structure
of a company. Capital structure adjustment can be used to reduce the total tax burden on
company investment, since the taxation of the return on equity and debt capital differs in
most countries. At the corporate level, interest payment reduces taxable profits while such a
deduction is not feasible in the case of equity financing. At the shareholder's level, effective
tax rates on dividend and interest income differ as well. Therefore, the relative tax benefits
of different source of finance are supposed to have an impact on financing decisions. Theory
suggests that corporate profit tax should be considered in order to analyse the tax impact on
capital structure choice. Besides tax, other important determinants of capital structure are
risk, income, control, and cost of capital and asset structure. We shall now briefly discuss
them and then examined how much importance is given by the management to the tax
factors among the various factors determining capital structure. The importance of tax factor
will be judged by ranking method.
Assets structure of the company:
• The assets structure of a company is related to the nature and size of the
company. Companies whose assets are suitable for security against loans
tend to use debt heavily; general purpose assets which can be used by
many businesses make good collateral, whereas special purpose assets do
not. Furthermore, capital intensive and also large companies have
generally heavily investment in fixed assets which serves as a security for
issue of debentures. But the trading companies and consumer goods
industries which have generally a thin base of fixed assets, besides
suffering from income oscillations, rely more on equity capital.
Income:
• Capital structure should be such that it maximizes the return to
shareholders. The greater return on investment of a company increases its
capacity to utilize more debt capital. The capacity of a company to take
debt depends on the cost of debt. In case, the rate of interest on the debt
capital is less, more debt capital can be utilized and vice versa. If cost of
capital is lower than the rate of return, it would be advisable to have more
debt in the capital structure and vice versa. Therefore, from return point
of view EBIT–EPS relationship should be analysed for different debt-equity
mixes and then it should be decided which alternative should be accepted.
Control:
• Control is concerned with the privilege of exercising voting rights.
According to this factor, at the time of preparing capital structure, it
should be ensured that the control of the existing shareholders (owners)
over the affairs of the company is not adversely affected. If funds are
raised by issuing equity shares, then the number of company's
shareholders will increase and it directly affects the control of existing
shareholders. In other words, now the number of owners (shareholders)
controlling the company increases.
• This situation will not be acceptable to the existing shareholders. On the
contrary, when funds are raised through debt capital, there is no effect on
the control of the company because the debenture holders have no
control over the affairs
Risk factors:
• While planning the capital structure, the risk factor consideration inevitably
comes into picture. If the company raises the capital by way of equity capital, the
risk on the part of the company is minimum. Firstly, as dividend is the
appropriation of profits. If there are no profits, the company may not be paying
the dividends for years together. Secondly, the company is not expected to repay
the equity. On the other hand, if the company raises the capital by way of
borrowed capital, it accepts the risk in two ways. Firstly, the company has to
maintain the commitment of payment of the interest as well as the instalment of
borrowed capital, at a predicided rates and at a predicided times, irrespective of
the fact whether there are profits or losses. Secondly, the borrowed capital is
usually the secured capital. If the company fails to meet its contractual
obligations, the lenders of the borrowed capital may enforce the sale of assets
offered to them as security. Besides, it also results in a higher variability in
earnings available to equity holders/EPS. Therefore, from risk point of view,
equity is preferred as against debt.
Tax effect in financing:
• "Financing decisions in particular must take taxes into consideration. The
choice of use of debt or equity capital in financing is influenced by tax
factor. While taking the decisions about the timing of purchases of
inventory and fixed assets, most of the companies were relying heavily on
debt capital for meeting their capital requirement.5 In this regard, the
companies go for debt financing as the interest paid on debt is a tax
deductible expense. The same advantage is not found in the case of equity
capital.
• Every new interest payment provides a new deduction in calculating a
company's income tax. For example, at a 30 percent tax rate, 13 percent
interest charge is assumed to be partially off-set by a tax saving equal to
3.9 percent on the capital amount involved, giving a net annual cost of
borrowing of 9.1 percent. But a new dividend on preferred or equity stock
has no influence on a company's tax status. Therefore, financing with debt
instrument is cheaper than equity instrument.
• Nepalese companies consider tax factor as an important factor in deciding
their capital structure. For 16 companies surveyed, all companies
considered it as one of the determinants while planning their capital
structure. This is obvious as it has its favourable impact on the cost of debt
capital and thus on the overall cost of capital. We have tried to find out
the relative importance of the tax factor among the various determinants
of capital structure, such as, risk, income, control, asset structure,
corporate tax and cost of capital. In order to determine the relative
importance of the above factors, we have calculated mean weight and
ranked them according to the mean weight of each factor.
Table–1: Relative importance of some internal factors determining capital structure of
16 private sector companies
1. Control 20 1.25 VI
2. Cost of capital 49 3.06 V
3. Asset structure 62 3.88 III
4. Risk 65 4.06 II
5. Income 60 3.75 IV
6. Tax effects in 80 5.00 I
financing
Our above analysis clearly shows that tax factor stands at the top among the various
determinants of capital structure. This had happened in the cases of both private sector
companies as well as public sector companies.
Cost of Capital:
• Cost of capital refers to the cost of obtaining funds from the different
sources. The process of raising the funds involves some cost. While
planning the capital structure, it should be ensured that the use of capital
should be capable of earning the revenue enough to meet cost of capital.
It should be noted here that the borrowed funds are cheaper than the
equity funds so far as the cost of capital is concerned. This is because of
two reasons: (a) interest rates (i.e. the form of return on the borrowed
capital are usually less than the dividend rates) (b) the interest paid on
borrowed capital is an allowable expenditure for income tax purposes,
while dividends are appropriate out of profits. In the light of above
discussion, we shall now see whether debt capital is cheaper than equity
capital or not to make a plan for capital structure decision. For instance,
four alternative plans are offered by the company varies according to the
need and benefit of different source. The following example will explain
the situation including tax consideration under the choice of four different
capital.
Example–1:An industrial company required additional capital of Rs.14 lakh for its
expansion programme. The four alternative plans offered by its finance department are as
follows:
Experience shows that equity capital could be collected within 60 days and debentures in
30 days. Bank loan could be collected within 10 days and private loan in 5 days. The rate
of interest of debenture, bank loan and private loan are 11%, 13% and 21% respectively.
The supplier of machine agreed to grant 20 days credit subject to payment within the
credit period. Fund cost of issuing share and debenture is 3% and 2% respectively.
Similarly commission on bank loan is 1%. Extension work will be completed within 15
days and would generate Rs.6000 profit per day before charging tax, depreciation, interest
and insurance cost after completion of extension work. At present, the company is
suffering Rs.1000 loss per day – out of the total capital, 25% is required for working
capital and rest on machinery.
• Now, pertinent question is as to how we recommend the best
alternative factors from above example in deciding capital
structure choices. It should be ensured that the use of capital
is capable of earning enough revenue to justify the cost of
capital associated with it. Let us elaborate to above four plans
of capital structure decision which is associated the process of
raising the various sources of funds.
Table–2: Calculation of Earnings after Tax
Particulars Plan–I Plan–II Plan–III Plan–IV
Profit 18,30,000 18,30,000 2010000 2070000
before depreciation, interest and (305×6000 (305×6000) (335×6000 (345×6000)
taxes ) )
Decision: Plan III is the best alternative as it has maximum earning after tax.
• In above four plans, plan III will be the most beneficial. The company may
use only equity capital in plan I, In this plan, the investors who invest in
own capital (i.e dividend) of the company. This is the case of 100% equity
capital investing companies, where companies with very high rates of
return on investment use relatively little debt. According to Brigham, there
is no theoretical justification for this fact, one practical explanation is that
very profitable companies such as Intel, Microsoft and Coca–cola simply
do not need to do much debt financing. Their high rate of return enables
them to do most of their financing with retained earnings. The cost
associated with the process of raising the equity capital which is referred
to as cost of capital. The return paid on own capital (i.e. dividend) is not an
income tax deductible expenditure for the company. Payment of dividend
does not affect the tax liability of the company as the same is paid out of
profit after taxes.
• In the case of plan II, 40% equity capital and 60% debt capital are combined as a capital
structure of a company whereas capital structure decisions refers to the cost associated with
the process of raising the debt portion of capital. It should be noted that the borrowed capital is
a cheaper form of capital for company, as such, when the company pays the interest on
borrowed capital, its tax liability gets reduced, whereas payment of dividend does not affect the
tax liability of the company as the same is paid out of profit after taxes. As against this, in plan
IV, with 100% debt capital is a possibility of bankruptcy, because the greater the company debt
capital leads to higher the possibility of default in interest and capital repayment. From the
above analysis, plan I, plan II and IV has no scope for beneficial scheme to the company. In the
case of plan III, the portion of equity and debt capital investing in a company is equally
preferred. The above analysis shows that plan third is the most beneficial as it enables the
company. This is due to the fact that the return which the company pays on borrowed fund is an
income tax deductible expenditure for the company. The above analysis shows that capital
structure should be at that level of debt/equity proportion where the market value per share is
maximum and cost of capital is minimum. This may result the better capacity of the company
for fund raising. The reason behind it that higher earning after tax is the deduction of interest
on debt capital from the profits considering it a part of expenses and saving in taxes.
Valuable Key points:
The company expects Rs.7000 profit per day before charging interest tax and
other financing scheme expenses. The current loss suffered by the company in
Rs.1200 per day. The following details are given:
Equity share Debenture Term loan
The supplier of the machine has agreed to extend 30 days credit subject to payment
within the credit period. The extension work would be completed within 15 days.
Required: As a Tax planner suggest which plan is preferable from the view of tax planning.
Solution: Computation of earnings after tax at different alternative financial plan
a) Calculation of profit
Plan I : Non-operating days = Extension period + excess of collection period over
credit period
= 15 days + 30 days = 45 days
Operating days/profit earning days = 360 – 45 = 315 days
Plan II: Same as plan 1, as it considered equity capital
Plan III: Non-operating days = extension period only = 15 days
Operating days = 360 – 15 = 345 days
b) Calculation of interest
Plan II: Collection period of equity capital is more than the credit period, so
interest is not required for 60 days.
Interest required days = 360 – 60 = 300 days
Interest = (600000 × ) = Rs.70000
Plan III: Collection period of debenture and credit period is same, so interest is
not required for 30 days.
Interest required days = 360 – 30 = 330 days
Interest = (600000 × = Rs. 209000
c) Flotation cost:
Plan I = 2% of 1200000 = Rs.24000
Plan II = 2% of 1200000 = Rs.24000
Plan III = 2% of 600000 + 3% of 600000 = Rs.30000
Current loss = Non-operating days × loss per day
Plan I = 45 × 1200 = Rs.54000
Plan II = 45 × 1200 = Rs.54000
Plan III = 15 × 1200 = Rs.18000
Decision: From the above analysis, it is found that the plan III is best
alternative among different alternatives, where maximum earning
after tax is Rs.17,26,400
Example–II
Evidence shows that equity capital could be collected within 60 days and
debenture in 30 days. Bank loan could be collected within 10 days and private
loan in 5 days. The rate of interest of debenture, bank loan and private loan are
10%, 14% and 20% respectively. The supplier of machine agreed to grant 20
days credit subject to payment within the credit period. Fund cost of issuing
share and debenture is 3% and 2% respectively.
Similarly, commission on bank loan is 2%, Extension work will be completed
within 15 days and would generate Rs.8000 profit per day before charging tax,
depreciation, interest and issurance cost after completion of extension work. At
present, the company is suffering Rs.2000 loss per day. Out of the total capital
25% is required for working capital and rest on machinery.
Less: Expenses
Nil 73333 231917
Interest expenses
Decision: The 3rd Alternative is the best option as it has maximum after Tax profit
among 3 different alternatives.
Particulars ALT–1 ALT–2 ALT–3
From the above analysis, the 4th alternative is the best alternative among different alternatives
available from the tax planning view point.
8.2. Salary tax planning
The tax structure of a developing economy should be so designed that it is not only
instrument in mobilizing savings but also in affecting the cause to invest. Many countries
like the UK and the USA provide a slightly lower rate of tax on earned income than
investment income on equity base. But under the present tax system in Nepal, an individual
with investment income (such as income from business or profession) pays tax at the same
rate as is applicable to individual with earned income (such as income from salary). Income
from salary is taxed on the basis of progressive tax rate structure. The social justice can be
achieved through progressive tax rate. If the income tax rate is very high, the taxpayer
cannot bear the burden of tax. Some economists argue that a progressive income tax system
incorporates the concept of ability to pay very well by forcing large income earners to pay
heavy taxes. The use of progressive income tax may accomplish the goal of reducing high
incomes, but high incomes do not represent a serious threat to economic and social stability.
The concept of ability to pay is impossible to measure satisfactorily and there is no
consensus on, how sharply progressive tax rate should be to reflect perceived differences in
ability to pay. Some argue that the poor have no ability that the personal exemption and the
standard deductions are not adequate and if it is desired that income levels reflect ability to
pay, the poor should, in fact, receive a payment– a 'negative' income tax. On the other hand,
if income tax rate is low, the objective of the income tax cannot be achieved. This is why;
the income tax rate has been changed frequently.
A strong case can be made for using a salary tax in which benefits are strongly tied
to contributions. In this case, the tax payers' views the tax as a contribution to a
retirement or insurance plan, in which we realize a return comparable to our
contribution. With the personal income tax, not all income is taxed; certain types of
incomes are exempted, such as personal exemption limit in terms of family or
individual allowance and employee fringe benefits. In addition, each individual is
granted allowances such as personal exemption, for family members and deductions
of certain types of expenditures such as donation paid to exempt organization,
contribution to recognized provident fund and citizen investment trust above a
certain level. The amount of income after subtraction of the allowances is called the
taxable income. Moreover, exemption limit for non-resident was withdrawn from
1974–75.
Nowadays, Tax rates for single individuals and couples have a progressive three tier
structure. First, a basic exemption threshold is taxed at the rate of 1%, representing
the taxpayers' basic living amounts. Second, after the exemption threshold a middle
part of the taxable income is taxed at the rate of 15%. Third, the part of income
exceeding a certain upper limit or ceiling of income is taxed at the highest rate of
25%. The amounts of the basic exemption threshold, the middle part of the income
and the upper limit vary depending on whether the taxpayer is taxed as a single
individual or a couple.
Changes in tax rate structure
The analysis here is started assuming that there has been no inflation during the period of
2062-63 to 2067-68 (Shrawan-Ashad). Barring the inflation effects the analysis that how the
changes in the rate of tax structure started up during the period has influenced individual tax
payers is done here. Tables 1, 2 and 3 demonstrate this analysis. A thoughtful study of
income tax rate structure pertinent to 2062-63 income year shows that the component of
progression in tax rate structure was more as compared to income tax structure presently
applicable. The tax rate relevant to the lowest income slab was 15% in 2062-63 and this was
the same tax rate for 2067-68. It would be interesting to note that the marginal rate of income
tax relevant to the lowest slab was only 6.43 in the fiscal year 2062-63 while in 2067-68, the
marginal tax rate pertinent to the lowest slab was 5.77 times increase. In the name of
simplification, the government of Nepal has so far neglected the basic principles of
progression in income tax structure. The concept of capacity to pay tax has not been
considered. This is clearly against the dual objectives of economic growth and social justice.
The system encouraged tax payers from low income group to work less and thereby misuse
the interest of society by subscribing to the growth of dualistic economy. Neglecting the
effects of inflation and comparing the consequences of the modifications in the tax rate
structure during the period of study. It is found that high income groups have also been
granted a relief of 53.85 percent or more than this in tax liability. Hence, the government
granted relief in income tax liabilities to individual assesses is really on homogeneous base.
Table–1 : Structure of income tax rate for income year 2062/63
Source : Self calculation from data taken from Government of Nepal, Finance Act 2062-63
Table–2 : Salary tax Rate structure for income year 2067/68
Source: Self Calculation from data taken from Government of Nepal, Finance Act 2067-68
Table–3 : Impact of changes on the Tax Rate Structure under steady value of Money supposition
Money Tax amount Deflated tax Deflated income Tax on Differe- Extra pay
income on Money calculated calculated from deflated nce on off tax in
(Rs.) income as per from col.2 col.1 based on income col.3–5 col.6/col.3
2067/68 prices based on CPI= CPI=Rs.152.5 as per
Rs.152.5 2062/63
According to the capacity to pay principle, those who have low capacity to pay tax should be
given more relief from the tax burden. It is because; the money has more value for those who
accumulate less money. This fundamental reality has again been neglected.
Inflation impact
The fundamental exemption limit was Rs.One lakh in the income year 2062-63. It
was lifted to Rs.160000 in the fiscal year 2067-68 and continued to be the same,
taking the overall consumer price with base year 2062-63 as started earlier being
152.5 in Ashad 2067-68. It simply means that the basic exemption limit should be
Rs.152500 (i.e. Rs.100000×1.525) without charging 1% security Tax. Table 4 was
prepared by deflating money of income year 2067/68 with consumer price of Ashad
end 2067-68, that is, 152.5. First of all, tax on money income was completed in the
context of tax rate applicable for 2067-68 fiscal years. Then, calculation of income
tax on real income was done on the support of tax rates of 2062-63 financial years.
Table 4 reveals that had there been no inflation during the study period and no
modification in tax rate structure, how much income tax would have been paid by
the tax payers. Besides, it is deflated the income tax based on the rates of 2067-68
income year computed on money income. In the last column, the difference between
computed values of income tax in terms of deflated value based on the present tax
rate structure and that based on 2062-63 tax rate structure are shown. The last
column exhibits interesting facts. It discloses that the present tax rate structure
renders wholly unreasonable due to inflation. Tax payers obsessing a total taxable
income up to Rs.160000 are paying extra income tax of 29.68 percent.
This is a need of urgent review of present tax rate structure for the purpose of close
examination of inflation impact on the tax payers especially from low income group.
The proposed tax rate structure based on certain assumptions is as follows:
a) Basic income tax exemption limit should be connected to price level changes.
b) Ratio between the lowest tax-rate and the highest tax rate should be fixed at around
1:1.5
c) Different slabs of income should be based on current money income.
d) Individual income tax payers should be permitted to have adequate motivation to earn
more and slowly more from lower slabs to higher slabs.
e) Maximum rate of income tax should not exceed a limit of 25 percent.
If the above facts are believable, it is our desire that the proposed tax structure will
satisfy criterion of economic growth with social justice.
Proposed Tax-Rate Structure
On the basis in the preceding section, the following tax-rate structure for the attention of the government
is recommended.
Tax Rate Structure
Income Slab Cumulative income Tax Rate Tax Amount Effective Tax
(Rs.) (Rs.) Rate
152500 152500 – – –
The depreciation allowance was first introduced as far back as 1880 in the UK
immediately after the great depression. Its scope then was restricted to a particular type
of assets.
Depreciable assets are those assets that have a useful economic life of more than one
year. Their value decreases over the years due to the wear and tear etc. This loss in
value of assets is deductible in computing taxable income over the useful life of assets.
By doing so, the cost of an asset is spread over a period of time when it is used. There
are different methods of depreciation such as declining balance method and straight line
method. There is also a practice to use accelerated depreciation.
Use of accelerated depreciation
Using accelerated depreciation on the income tax return will mean greater
depreciation expense and smaller taxable income in the earlier years of an asset's
life. However, it will be followed by smaller depreciation expense and greater
taxable income in the later years of the asset's life.
For a company with consistent taxable income, the use of accelerated
depreciation on the income tax return instead of the straight line method, will
defer same income tax until the later years of an asset's life. Over the entire life of
the asset the total depreciation expenses is the same. Accelerated depreciation
means taking more depreciation in the first few years and less depreciation in the
later years of the asset's life. This saves income tax payment in the first few years
of the asset's life but will result in more taxes in the later years. Companies that
are profitable will find the accelerated depreciation to be attractive.
Pooled of Assets
The depreciation base of the block A, B, C and D refers to the total of the depreciation
base of a pool at the end of preceding income year after deducting depreciation calculated
for that year and amounts added to the depreciation basis of the pool during the income year
in respect of outgoings (additions) for assets of the pool minus the amount derived from the
disposal of any assets during the year. The Income Tax Act 2058 has made the pool based
diminishing balance method for building, office equipment, vehicle and plant and
machinery. Similarly, it has prescribed straight line of system of depreciation for intangible
assets i.e. Block 'E' for intangible assets, the formula is as follows:
Depreciation amount of the class of intangible assets carried from the previous year +
absorbed portion of any addition during the year to the same class of the intangible assets =
depreciable bases
Absorbed portion of addition during the year means the portion of the cost of assets
purchased or constructed during the year on which depreciation is allowed.
Absorbed and unabsorbed Assets
After introducing Income Tax Act 2002, depreciation provision is becoming more liberal
than the previous one especially for industrial sector.
The Income tax Act 2002 has provided one-third additional depreciation of the
normal rate to the following entities–
Entity engaged in building, public infrastructure to transfer to the Government of Nepal
and any other entity engaged in power generation, transmission or distribution of electricity.
Entity wholly engaged in operating special industry under section 11.
Entity wholly engaged in operating road, bridge, tunnel, ropeway or Sky Bridge
constructed by the entity.
Entity wholly engaged in operating trolley bus or trams.
Co-operative registered under co-operative Act 2048 except involved in tax exempt
transactions.
Table–4
Additional Depreciation Rates for special Industries
The amount of depreciation which is permitted to write off as expenditure by tax law is tax
depreciation. It is tax depreciation because it reduces the amount of tax to be paid by the
company. A tax system based on income generally does not allow a deduction for the cost
of an asset in the year in which it is purchased. Instead, it spreads out the deduction over a
period roughly consistent with the asset's useful life. The amount allowed as an annual
deduction reflects the reduction in the value of the capital asset as it ages, and is called
depreciation.
Revenue impact
There was an increasing impact on tax revenues as the deductions from previous years were added
to those being earned and used in the current year. The deductions earned in one sector reduced the
taxable income of another sources of income. The build up of unused deductions and losses also
reduced the predictability of the government revenue.
The value of money goes to be decreased each year due to inflation. Because of this decrease
in real value of money each year, the depreciation covers only a certain percentage of the original
cost. Since depreciation is a deductible expense before deriving the taxable income, it saves the tax
of the tax payer. The amount of tax saving depends on the rate of depreciation and tax rate. The
higher are the rate of depreciation and rate of tax, the higher is the amount of tax saved.
Depreciation is used primarily for tax purposes. Income tax Act allows companies to deduct
a certain percentage of the expenses on machinery, furniture and office equipment that is
used over a period of time to generate revenue of the company. Unlike a regular write off,
which is taken in one year, depreciable assets are written off or deducted from operating
income over the asset's life, which varies depending on the type of asset being depreciated.
Some extra tax benefits are given to industrial companies under the Industrial Enterprises
Act 1992 in the form of additional depreciation which acts as an incentive for making
investment in industry. For instance, one of the additional tax benefits to industrial
companies relates to the adding of additional one-third to the normal rate of depreciation
allowed under the existing income Tax Rules. This benefit is not available to non-industrial
companies. Therefore, section 15(h) of the Industrial Enterprises Act provides higher rates
of depreciation than in the Income Tax Rules for all type of assets of the industrial
companies vis –a–vis non-industrial companies. Further, as per section 15(k) of the
Industrial Enterprises Act, permission is granted for a deduction upto 50% of adjusted
taxable business income for the investment by a company on process or equipment which
has the objective of controlling pollution and research and development. The excess amount
over allowable limit of pollution control cost and research and development cost is
capitalized and depreciated under Block 'D' from next income year. Consequently, tax
liability of a company will be reduced resulting in a lower effective tax rate.
The amount of annual depreciation may depend on facts reasonably known to exist at the end
of each year.
Neither a company nor the tax officer can revise the depreciation amount charged in earlier
years on the basis of the facts discovered in later years. The asset's useful life must still be
based on the facts as they appeared in the earlier years. Furthermore, tax payers are not
permitted to deduct, in the current year, the depreciation allowance which the company had
failed to take in the past year(s). Tax payer must deduct depreciation each year even though
the deduction does not benefit tax payer because of loss. Similarly, a company cannot now
adjust its depreciation if it charged excess depreciation in earlier years. It does not make any
difference either that the excess deduction gave no tax benefit when it was charged. They can
not now alter their computation to make up for former errors. This is an international standard
2
which is applicable in Nepal also.
As was mentioned earlier, higher rates as per the provisions of the Industrial Enterprises Act
1992 were intended to promotic growth and facilitate speedy replacement of fixed assets.
Further, as the method of depreciation prescribed by Income Tax Act is the Written down
Value Method. It provides opportunity to charge the depreciation at higher rates during the
early stage of the life of asset's resulting in a lower taxable profit and thus a lower tax
liability in the initial years.
In India, the Tax Reform Committee (TRC) had shown that at a 25% rate of
depreciation, the total cost of the assets could be recovered in 6 years if the declining
balance method is used and if the net interest earned on the investment of depreciation fund
is also taken into account 3. However, it is not necessary that one should follow the same
basis for the recovery of capital costs as was suggested by the Tax Reform Committee.
Some of the capital assets employed in production are plant and machinery, office
equipment and building.
Table 5.1
Funds in hand on account of depreciation and interest (16%) with tax rate of 30%
Year End Book value Depreciation Cumulative Interest Cumulative Total funds in
(cost less during the Depreciation accrued interest hands
depreciation) year (Total) (Depreciation+Inte
rest)
Initial 1000 – – – – –
position
In the light of above discussion, we shall now see whether the present rate of depreciation
in the income tax Rules of Nepal is adequate or not to recover the capital cost. For
instance, normal rate of depreciation for fixed assets varies according to the nature and life
of assets. Industrial Enterprises Act provides for additional one-third to the normal rate
and therefore, these rates would become 33.33%, 26.67% and 20%
Table 5.1 shows the flow of funds to a company through depreciation on fixed assets
provided at 3 different rates viz, 33.3%, 26.7% and 20% with the help of subsidiary tables
5.1 A, 5.1 B and 5.1 C which ultimately show total funds in hand (depreciation+interest) at
the end of each year at depreciation rates of 33.3%, 26.7% and 20% respectively. In each
case, interest (net of tax @ 30%) earned on depreciation reserve is also included.
In each case, interest net of tax (at 30%) earned on the depreciation reserve is also included.
With 33.3% rate of depreciation, the total funds accumulated including interest reach 100%
of cost at the end of 4 years (table 5.1). It may also be observed from the table that the
cumulative depreciation without taking into account the interest accrued amounts only to
98.2 at the end of 10 years, while the total funds accumulated after taking into account the
interest accrued would reach 177 percent of the cost by the end of that year. With a rate of
depreciation of 26.7%, the accumulated depreciation reaches without taking into account the
interest earned 100 percent of cost at the 5 th year–a year later than in the previous case.
Similarly, accumulated depreciation without taking into account interest accrued reaches
100 percent of cost in the 6th year with a depreciation rate of 20%. At the end of 10 years,
the total depreciation funds accumulated after taking into account the accrued interest reach
167% and 151% with the depreciation rates of 26.7% and 20% respectively. In short, our
analysis shows that the higher the rate of depreciation, the shorter the period of recovery of
capital costs. It is, therefore concluded that 33.33% rate of depreciation is more preferable
than that of other two rates of depreciation.
8.4. TAX planning for investment
It may be mentioned that many of the companies enjoyed tax–holiday facility under section
9 (a) of Industrial Enterprises Act 1961. These included among others, Agricultural Tools
factory Ltd (established in 1968), Birgunj Sugar Factory Ltd. (set–up in 1962) and Janakpur
Cigarette Factory Ltd. (established in 1964) were benefitted by tax holiday of 10 years.
Similarly, Hetauda Cement Udhyog Ltd (1976), Hetauda Textile Udyog Ltd (1975) and
Himal Cement Company Ltd. (1976) enjoyed tax holiday benefits for the period of 13 years,
10 years and 11 years respectively as per section 9 (b)(i) and (ii) of the Industrial Enterprises
Act 1973.
The benefits of tax holiday period of 7 years under section 10 (a) of the Industrial
Enterprises Act 1982, (akin to the provision of existing tax law) had been granted to
Lumbini Sugar Factory Ltd. (1983), tax holiday of 5 years to Nepal Rosin and Turpentine
Ltd. (1986), 7 years to Udayapur Cement Udyog Ltd. (1986), 6 years to Bottlers Nepal
Limited, Balaju (1984) and 5 years to Bottlers Nepal(Terai) Ltd. (1985), Gorakhkali Rubber
Udyog Ltd (1984), Jyoti spinning Mills Ltd (1989) and Nepal Battery Company Ltd (1984).
Appeal to the Supreme Court
Income Tax Act provides that if Tax holiday is not claimed for the full
period or a part thereof the same cannot be claimed in future and, therefore,
this benefit will be lost for all times to come. No claim for tax holiday
happens mainly due to lack of proper tax planning by the industry. The
following are the examples of companies who have lost benefits of Tax
holiday though they had claimed through writ petitions to avail of tax
holiday benefits to the Supreme court:
a) Nepal Synthetic Pvt. Ltd vs. Tax office, Hetauda
Writ petition No. 1072 of 2047 B.S.
Claim for 5 years tax holiday as per section 42 (b) of Income Tax Act 1974.
b) Narayan Brick factory vs. Tax office, Sunsari
Writ petition No. 3398 of 2050 B.S.
Claim for 5 years tax holiday as per section 10 of Industrial Enterprises Act 1982 and
section 9 (i)(a) of the Industrial Enterprises Act, 1973.
c) Himalayan Bruwary Limited vs. HMG, Ministry of Finance, HMG, Department of
Taxation, HMG Department of industries vs. Tax office, Lalitpur.
Writ petition No. 2045 of 2048 B.S.
Claim for 5 years tax holiday as per section 10 (a) – 2 of Industrial Enterprises Act 1982.
d) Mahashakti Soap and Chemical Industries Pvt. Ltd. vs. HMG, Ministry of Finance, HMG,
Department of Taxation, HMG, Department of Industries vs. Tax–office, Hetauda.
Writ petition No. 2956 of 2050 B.S.
Claim for additional 3 years tax holiday as per Industrial Enterprises Act 1973 (section ii)
e) Gorkha Travels Pvt. Ltd. vs HMG, Department of taxation, tax office, Lazimpat.
Writ petition No. 1715 of 2048 B.S.
Claim for additional 5 years tax holiday as per Industrial Enterprises Act 1961 (section 9)
f) Sri Ram Refine Oil Products Pvt. ltd. vs. HMG, Department of Taxation, HMG,
Department of industries vs. Tax office, Biratnagar.
Writ petition No. 3472 of 2050 B.S.
Claim for additional 2 years as per section 10, clause 10 (a) of industrial Enterprises Act
1982.
• The above petitions claiming tax holiday were rejected by the
Hon'ble Supreme court of Nepal on the found that these
claims were either not made before the assessing authorities
within the prescribed time limit or the writ petition for the
claims were filed to a wrong lower court/authority or proper
evidences were not produced by the claimaints before the
courts/authorities.
Separation of Tax holiday from Tax Rebate:
The foregoing discussion shows that there are a number of theoretical and practical
problems involved in each nature of tax holiday scheme. The tax holiday is directed to new
industry and is not available to existing operations. With a tax holiday, new industries are
allowed a period of time when they are exempt from the burden of taxation. Sometimes, this
grace period is extended to a subsequent period of taxation at a reduced rate. The tax
treatment of the initial capital expendures made before and during the holiday period must
be determined so that appropriate records will be available for the calculation of
depreciation when the holiday ends. A number of technical issues are important in
determining the impact of tax holidays on the return on investments. Before determining the
tax holiday impact, attention is to be paid to the existing provision of tax holiday scheme
which are given in the following manner.
Various tax incentives are provided in many countries for development of specified
areas, may be high priority areas or backward or rural areas based upon the country's
economic policies and plans for its development Incentives for such specified areas
are provided by countries like Argentina, Belgium, Brazil, Chile, Egypt, Finland,
France, West Germany, Iran, Ireland, Israel, Italy, India, Korea, Lebnon, Mexico,
New Zealand and Pakistan. Nepalese Tax Law also provides incentives for the
development of backward areas based upon the country's economic policy and
approved plans for rural development. For instance, a special industries operating in
remote area, undeveloped area and underdeveloped area (as defined in Industrial
Enterprises Act 2049) is taxed at 50%, 70% and 75% of the applicable tax rate on its
income respectively upto 10 years including the income year of its operation.
Deciding factors for location of industry
Location is yet another important strategic decision of any industry. An ideally located
industry gets the maximum benefits– both physical and financial. The various important
factors which should be considered while deciding the location of a industries are
infrastructural facilities, nearness to the product markets, availability of raw materials and
labour force, tax benefits, etc.
Under the Industrial Enterprises Act 1992, tax rebate ranging from 5% to 10% is given to
different category of districts. As shown in appendix–1 of the total 75 districts 22 (or
29.3%) districts are grouped under remote areas. Manufacturing units set–up in these areas
are entitled to 50% tax rebate. There are 13 (or 17.3%) districts falling under undeveloped
areas with 30% tax rebate. The third group of areas comprising 19 (or 25.3%) districts
falls under the category of underdeveloped areas which get 25% Tax rebate. The
remaining 21 (or 28%) districts are industrially developed districts which are not entitled
to get any tax rebate.
Strategic plan for locational advantages with example
A special industry is planning to invest in capital outlay of Rs.50 lakh. The company expects the
following profit before tax and transportation expenses.
Years 1 2 3 4 5
For this purpose, the Company has selected three various places such as
Bhaktapur, Achham and Baglung. Bhaktapur is the major market of the finished
goods. The 50% of required raw materials are available locally in every location.
The other details of selected locations are as follows:
Locations Bhaktapur Achham Baglung
Transportation cost of finished goods Nil @ Rs. 4/unit @ Rs. 3/unit
Transportation cost of raw materials @ Rs. 5 @ Re. 1 @ Rs. 1.25
for one unit of production
The expected production and sales for the next 5 years are as given:
Years 1 2 3 4 5
As a tax planner, where we would recommend to locate the factory showing the
details calculation?
• As stated earlier, under the provision of industrial Enterprises Act 1992,
different rates of tax rebate have been prescribed for 3 different location
of factory. However, tax rebate is not available in Bhaktapur. If the factory
is established in remote area, 50% tax rebate is available in Achham as tax
benefits for initial ten years. The following example will explain the
situation; we shall see its impact on the decision.
Alternative–1 (if factory is located at Bhaktapur) (Rs. in thousand)
Under these 3 different alternatives, total earnings after tax during next 5 years in
Bhaktapur is Rs.3400000 higher than the EAT of Baglung and Achham, Therefore, the
factory should locate at Bhaktapur.
We have to see whether tax consideration is given to choose the location of factory. The
problem relating to choose the location of factory arises whether the tax rebate or tax
holiday is sufficient enough or not to establish a new factory. By taking a decision of
location, the factors which are considered are both cost and non–cost. Cost of both
transportation expenses incurred on finished goods and raw materials are calculated and are
compared with each other to arrive at the decision. If cost of transportation in developed
area is lowest than that of underdeveloped area and remote area. If for manufacturing, any
industry utilizes locally available raw materials, chemicals and packing materials on which
50% transportation expenses were already saved. Non–cost factors in choosing location of
factory include tax rebates provided to different locations such as 0% tax rebate in
Bhaktapur, 50% tax rebate in Achham and 30% tax rebate in Baglung.
• This tax rebate should be taken into consideration as it will reduce the real
cost of manufacturing. The above analysis shows that Alternative–1 is the
most beneficial as it enables the company to locate factory in Bhaktapur
without any tax incentives. Therefore, tax factor is not most important
factor for deciding the location of newly set up industry.