Corporate tax management:

‘corporate tax management’ means dealing with the tax matters of a corporation or company with a view to maximizing the after-tax rate of return on investments after ensuring voluntary tax compliance. For this purpose, each corporate entity has to –

1. ensure that it keeps proper records;

2. deduct tax at source where it is necessary;

3. pay advance tax in time, if applicable;

4. file returns in time;

5. comply with notices received from the tax authorities; and

6. be aware of legal remedies where it does not have its rights under the law recognized.

Corporate Tax Functions

Tax function activities are those activities which are concerned with fiscal issues.

These functions are of two types:

Tax Compliance Activities:Tax compliance activities are those activities which include the functions or obligations according to the provisions of various fiscal statutes.

Tax Planning Activities:Tax planning means dealing with the tax matters of a taxpayer with a view to maximizing the after-tax rate of return on investments after ensuring voluntary tax compliance.

Tax Evasion, Avoidance & Planning

@ Tax Evasion:

“Evasion is illegal. It can involve acts of commission or omission” (Webley et al. 1991).

“Noncompliance is a more neutral term than evasion since it does not assume that an inaccurate tax return is necessarily the result of an intention to defraud the authorities and it recognizes that inaccuracy may actually result in overpayment of taxes” (Webley et al. 1991).

“‘Tax cheating’ describes deliberate acts of noncompliance and does not entail the difficulty of legal proof of tax evasion” (Webley et al. 1991).

“In evading tax one is knowingly breaking the law. This has social and psychological consequences such as stigma and guilt and involves confronting different costs since there is a risk of being caught and fined or sent to prison” (Webley et al. 1991).

“The expression ‘Tax evasion’ means illegally hiding income or concealing the particulars of income or concealing the particular source or sources of income or in manipulating the accounts so as to inflate the expenditure and other outgoings with a view to illegally reduce the burden of taxation. Hence, tax evasion is illegal and unethical” (Lakhotia and Lakhotia 1998).

@ Tax Avoidance:

According to Justice Jagadisan J., “Avoidance of tax is not tax evasion and it carries no ignominy* with it, for, it is sound law and, certainly, not bad morality, for anybody to so arrange his affairs as to reduce the brunt** of taxation to a minimum” – mentioned in the verdict of Aruna Group of Estate v. State of Madras (1965) case (Palkhivala and Palkhivala 1976).

Avoidance involves ‘every attempt by legal means to prevent or reduce tax liability which would otherwise be incurred, by taking advantage of some provision or lack of provision in the law … it presupposes the existence of alternatives, one of which would result in less tax than the other’ (Report of the Royal Commission of Taxation 1966, 538; vide Webley et al. 1991).

Tax avoidance “is the art of dodging taxes without breaking the law. ……tax avoidance means of traveling within the framework of the law or acting as per the language of the law only in form, but murdering the very spirit of the law and thus acting against the intention of the law and defeating the purpose of the particular legal enactment” (Lakhotia and Lakhotia 1998).

Tax Planning:

‘Tax planning’ takes maximum advantage of the exemptions, deductions, rebates, reliefs and other tax concessions allowed by taxation statutes, leading to the reduction of the tax liability of the tax payer” (Lakhotia and Lakhotia 1998).

According to Shuklendra and Gurha (1992), the prime objectives of tax planning are to achieve the following results:

(i) Reduction of tax liability,

(ii) Minimization of litigation,

(iii) Productive investment,

(iv) Healthy growth of economy, and

(v) Economic stability.

According to Scholes and Wolfson (1992), “Traditional approaches to tax planning fail to recognize that effective tax planning and tax minimization are very different things. The reason is that in a world of costly contracting, implementation of tax-minimizing strategies may introduce significant costs

along nontax dimensions. Therefore, the tax-minimization strategy may be undesirable. After all, a particular easy way to avoid paying taxes is to avoid investing in profitable ventures.” Thus, effective tax planning means not to minimize tax, but to maximize after-tax rates of return on assets.

According to Lakhotia and Lakhotia (1998), the various objectives of corporate tax planning can be grouped under four different heads:

(a) Having maximum taxpayer units;

(b) Taking maximum advantage of the exemptions, deductions, rebates, reliefs, and other tax concessions;

(c) Legally avoiding unwarranted additions to the income; and

(d) Avoidance of tax worries and tensions through voluntary tax compliance and tax management.

Tax Formula & Traditional Tax Planning

Tax Planning Formula

Traditional Tax Planning Techniques based on Tax Formula

Traditional tax planning is based on maximizing the tax-favored status and minimizing the tax-disfavored status.Since the ultimate objective of traditional tax planning is the minimization of the bottom line (i.e., the minimization of the net tax payable), the rules of simple arithmetic suggest that tax planning must necessarily involve:

• Maximization of tax credits/rebates/reliefs,

• Minimization of the applicable tax rate(s), and

• Maximization of deductions and/or exclusions.

1. Maximization of Exclusions:

• Exclusions are the incomes which are not included in the tax-base of the income tax [‘total income’ as defined u/s 2(65), the scope of which is outlined u/s 17 and computed u/s 43 according to the heads of income u/s 20, but to be reported under the heads mentioned in the ‘Form of Return of Income’ (Form IT-GA for non-company assessees and Form IT-GHA for companies) u/r 24].

• Under section 44(1), any income or class of income or the income of any person or class of persons specified in Part A, Sixth Schedule shall be exempt from the tax, and shall be excluded from the computation of total income.

• Along with this list under Part A, Sixth Schedule, Government has issued a number of S.R.O. u/s 44(4) of the ITO to extend this exclusion list.

• 6 (six) SROs issued u/s 60(1) of the Income-tax Act 1922 are still in force for similar exclusion purpose.

• The business entities which have been allowed tax holiday u/s 46A or under any SRO are able to exclude their income enjoying tax holiday.

2. Maximization of Deductions:

Except ‘Salaries’ head u/s 21, all other statutory heads of income have provisions of deductions:

• Sec. 23 for deductions from “Interest on securities”,

• Sec. 25 for deductions from “Income from house property”,

• Sec. 27 for deductions from “Agricultural income”,

• Sec. 29 for deductions from “Income from business or profession” [along with section 30 for inadmissible expenses from “Income from business or profession”],

• Sec. 32(1) for deductions from “Capital gains” [along with section 32(12) for restricted deductions from “Capital gains”], and

• Sec. 34 for deductions from “Income from other sources”.

• All these deductions are subject to limits, and conditions and subject to evidential proofs.

• So a business entity must be careful about these conditions, limits and authenticity of the transactions and thereby, disallowances may be avoided and deductions can be maximized.

Maximization of Deductions: Loss as a Deduction:

• Under section 37, in the year of loss, losses under any head other than two losses – loss in speculation business and capital loss –can be set-off against other head(s) except against speculation business income and capital gain.

• But one speculation business loss can be set off against other speculation business income only and one capital loss can be set off against other capital gain only.

• From AY 2007-08, “loss from business or profession” is restricted to set off against “income from house property.”

• Under other provisions of sections 38-42, set-off of losses can be done in future six successive income years only against the concerned head of income and applicable only for following incomes:

• Speculation business income (u/s 39),

• Other business income (u/s 38),

• Capital gains (u/s 40), and

• Agricultural income (u/s 41)

• But in case of capital loss, carry-forward can be done after deduction of Taka 5,000 [u/s 40(3)].

• Loss will be calculated for carry-forward after deducting any cash subsidy from the Government [second proviso to section 37].

• Loss due to depreciation can be carried forward for unlimited period [u/s 42].

• In case of loss, how to maximize the setting-off of the loss in the year concerned should be given special attention and in case of unset-off losses, special tax planning regarding accounting method can help to set off those losses before the expiry of the time limits.

3. Minimization of Tax Rate(s):

• Marginal tax rate (MTR) is the relevant tax rate for any business decision.

• As stated by Sommerfeld et al. (1980), “the marginal tax rate is to business affairs what the law of gravity is to physics. Just as water seeks its lowest level (due to the laws of gravity), so also taxable income seeks its lowest marginal tax rate. The tax planning objective is achieved, of course, when the marginal tax rate is minimized.”

4. Maximization of Credits/Rebates/Relief :

• Final emphasis for tax planning is to be given to maximize tax credits, tax rebates and tax reliefs.

• Again these are subject to conditions, limits and special applicability.

Alternative View of Tax Planning Opportunities

An alternative way of viewing tax-planning opportunities is to observe that income tax is constrained by:

Time, Entity, and Accounting method.

• Since income tax rates “start over” with each new tax year and because very few taxpayers have a constant level of taxable income in each year, there tend to be high-tax years and low-tax years.

• The ‘tax value’ of a deduction is directly dependent on the marginal tax bracket of the party reporting it.

• Obviously, therefore, taxpayers tend to recognize losses and other deductions in high-tax years and to defer the recognition of taxable income to low-tax years.

• To the extent that a taxpayer can control tax timing, s/he should do so only after giving full considerations to the time value of money.

• Sometimes the financial cost of deferral is greater than the tax benefit.

Method of Accounting in ITO: All income classifiable under the head:

• “Agricultural income” [u/s 26 & 27],

• “Income from business or profession” [u/s 28-30, 30A] or

• “Income from other sources” [u/s 33, 34, 36 & 43]

• shall be computed in accordance with the method of accounting regularly employed by the business entity [sec. 35(1)].

• However, every public or private company as defined in the Companies Act, 1913 or 1994 shall, with the return of income required

to be filed under the ITO for any income year, furnish a copy of the trading account, P&L account and the balance sheet in respect of that income year certified by a CA [sec. 35(3)].

• Where no method of accounting has been regularly employed, or if the method employed is such that, in the opinion of the DCT, the income of the assessee cannot be properly deduced therefrom; or where a company fails to furnish financial statements certified by a CA with its return, the income of the entity shall be computed on such basis & in such manner as the DCT may think fit [sec. 35(4)].

Method of Accounting in ITO: The method of accounting may be:

• ‘Mercantile system’ (or accrual basis) or

• ‘Cash system’ (or cash basis) or

• Hybrid system (i.e., mixture of these two for separate heads of income).

However, in the income tax laws, few incomes must be computed under a specific accounting method. For instance,

• Dividend is taxable under cash system [u/s 19(7)],

• Income from house property is taxable under cash system [S.R.O. No. 454-L/80 dt. 31.12.80], and

• Advance salary income are taxable under cash system [u/s 21(1)(b)] subject to a relief u/s 172.

Owner/Operator (O/O) of a Company: Shareholder Director of a Private Company :

• The time constraint may also be important in case of working with a closely held private company as a shareholder director, i.e., the owner/operator (O/O).

• The salaries with arrangement of TDS of the director are an allowable deduction with some other limits u/s 30 in case of determining the total income of the company.

• The salaries are taxable in the hand of the director subject to the exclusions under rules 33 and 33A-33J and Part A, Sixth Schedule.

• The method of accounting followed by the company may be ‘mercantile system’, but the accounting method followed by the director may be ‘cash system’.

• Depending on this entity level advantage (as O/O of the company), a year-end bonus to the director may be shown as a deduction under accrual basis but the O/O is not required to show it as an income until the time of receipt.

• Even income year might be different from the entity to its O/O.

• Such accounting legerdemain* is a common practice for tax planning purpose.

TAX PLANNING under the SCHOLES-WOLFSON PARADIGM

Scholes-Wolfson Paradigm jointly developed in 1992 by:

• Myron S. Scholes, the 1997 Nobel Winner in Economics as the co-originator of the Black-Scholes option pricing model and a partner of Oak Hill Capital Management and

• Mark A. Wolfson, a managing partner of Oak Hill Capital Management,

Distinguish between Effective Tax Planning vs. Tax Avoidance

Effective Tax Planning Tax Avoidance

Objective Maximizing after tax return

Legal tax avoidance to minimize tax

Desir-ability Always desirable May be undesirable in some cases

Non-tax cost Considered Not considered and hence those costs may be introduced significantly

Consideration of tax implication of all parties involved

Yes considered Usually not considered

Possible avoidance of investment in profitable ventures

Not done May be done by adopting easy way to avoid paying tax

Tax cost May be high along with higher after tax return

Minimum

Scholes-Wolfson have adopted a contractual perspective for their paradigm & suggested 3 key aspects of tax planning globally:

1. Multilateral Approach: All contracting parties must be taken into account in tax planning, which allows a global or multilateral, rather than a unilateral, approach.

2. Importance of Hidden Taxes: All taxes (both implicit tax and explicit tax) must be taken into account considering the global measures of taxes. Implicit tax is the decrease in return due to availing tax favored investment and explicit tax is the tax deposited in the treasury.

3. Importance of Nontax Costs: All costs of business must be considered, not just taxes.

Thus, the paradigm is based on consideration of : all parties, all taxes, all costs.