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TAX MANAGEMENT WITH REFERENCE TO CAPITAL STRUCTURE

CAPITAL 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 @ 12.5% + 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