Business Tax Planning

Business Tax planning

Tax planning is the art and science of planning the company's operations in such a way as to 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.

Tax Evasion is defined as criminal activity or any offence of dishonesty punishable by civil penalties, which is intended to reduce the incidence of taxation. This might involve theft, fraud or forgery in relation to tax or specific statutory offences of tax evasion, depending on the jurisdiction concerned. Evasion involves the misrepresentation of the facts to the tax authorities by deliberate or reckless misstatement, concealment or omission.

Tax evasion may involve the followings

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:

a. Use of arm’s length price to avoid transfer pricing (u\s33)

b. Provision against splitting of income (u/s 34)

c. Provision of not allowing to reduce dividend income (u/s58)

d. Right of tax authorities to have access to the information of the tax payers (u/s 82)

e. 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

- Reduction of tax liability

- Minimization of litigation

- Productive investment

- Healthy growth of the economy

- Economic stability

Features of tax planning

- It is future oriented activities

- It is a legal, ethical and economic device

- It is the genuine use of the facilities provided by government.

- It reduces tax liability

- 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 favour 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 of the company. Thus, for those who support this principle, debt capital is the best.

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

Determinant factors	Weighted value	Mean weight	Overall Rank
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 financing	80	5.00	I

Source: Opinion survey

Table 1 shows that private sector companies give due importance to the tax factor in planning their capital structure. For, it ranked first with mean weight of 5.00. Risk was considered another most important factor as it ranked second with mean weight of 4.06. The other factors like asset structure, income, cost of capital and control ranked third, fourth, fifth and sixth with mean weights of 3.88. 3.75, 3.06 and 1.25 respectively. The revealing fact is that Nepalese companies in the private sector also give least importance to control factor which is unexpected.

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:

Plan I : 100% through equity capital

Plan II : 40% through equity and 60% from debentures

Plan III : 50% through debenture and 50% from bank loan

Plan V : 100% through private loan

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 before depreciation, interest and taxes	18,30,000 (305×6000)	18,30,000 (305×6000)	2010000 (335×6000)	2070000 (345×6000)
Less other expenses
Depreciation	157500	157500	157500	1,57,500
Interest	Nil	77000	152639	289917
Floatation/Brokerage	42000	33600	21000	–
Current loss	55000	55000	25000	15000
Total Expenses	254500	323100	356139	462417
Earning before tax	1575500	1506900	1653861	1607583
Less Tax @20%	315100	301380	330772	321517
Earning after tax	1260400	1205520	1323089	1286066

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:

Non operating days must be equal or more than extension period

Non-operating days = fund rising period + Extension period – credit period

Operating days = total days – non-operating days.

Profit = operating days × profit per day

Loss = non-operating days × loss per day

To calculate interest fund rising period or credit period (whichever is higher) should be taken as interest free period.

Example–1

XYZ manufacturing company is planning to purchase a plant to extend its activities for which it needs Rs.1200000 additional capital. The finance manager of the company has developed the following financial plan.

Sources of capital	Plan–I	Plan–II	Plan–III
Equity capital	100%	50%	–
14% Debenture	–	50%	50%
24% Term loan	–	–	50%

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

Collection period

Flotation

60 days

30 days

10 days

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

Particulars	Plan–I	Plan–II	Plan–III
Profit before charging interest Floatation cost, losses and taxes (a)	(315×7000)= Rs.2205000	(315×7000)= Rs.2205000	(345×7000)= Rs.2415000
Less finance expenses interest on loan	Nil	70000	209000
Floatation cost	24000	24000	30000
Current loss	54000	54000	18000
Total expenses (b)	78000	148000	257000
Earning before Tax (a–b)	2127000	2057000	2158000
Less Tax @ 20%	425400	411400	431600
Earning after Tax	1701600	1645600	1726400

Working notes:

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

An Industrial company required additional capital of Rs.1400000 for its expansion programme. The four alternative plans offered by its finance department are as follows:

Alt 1 : 100% through equity capital

Alt 2 : 50% through equity and rest from debenture

Alt 3 : 50% through debenture and rest from bank loan

Alt 4 : 100% through private loan

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.

Required: As a tax planner recommend the best alternative.

Solution: Calculation of Earnings after Tax (EAT)

Particulars	ALT–1	ALT–2	ALT–3	ALT–4
Profit before charging depreciation, interest and taxes	(305×8000)= 2440000	(305×8000)= 2440000	(335×8000)= 2680000	(345×8000)= 2760000
Less other expenses Depreciation	210000	210000	210000	210000
Interest	Nil	58333	153611	276111
Floatation/Brokerage	42000	35000	28000	–
Current loss	110000	110000	50000	30000
Total expenses	362000	413333	441611	516111
Earning before tax	2078000	2026667	2238389	2243889
Less tax @ 20%	415600	405333	447678	448778
Earning after Tax	1662400	1621334	1790711	1795111

Alternative 3 is preferable to other alternatives because of the highest after–tax income.

Working notes:

a) Operating days and profit

Alt 1: Non-operating days = Extension period + Excess of collection period over credit peiod

\ Operating days = 360 – 55 = 305 days

Alt 2: Same as Alt 1, as it consisted equity capital in capital structure

Alt 3: Non-operating days = 15 + (30–20) = 25 days

Operating days = 360 – 25 = 335 days

Alt 4: Non-operating days = Extension period = 15 days

Operating days = 360 – 15 = 345 days

b) Interest required days and interest amount:

Alt 1: Nil

Alt 2: Interest required period = 360 – 60 = 300 days

Interest = (700000 × ) = Rs.58333

Alt 3: 700000 × + 700000 × = 153611

Alt 4: Interest required days = 360 – 30 = 330 days

Interest (1400000 × ) = Rs.276111

c) Allowable depreciation: (1400000 ×

d) Flotation/brokerage:

Alt 1: 1400000 × = Rs.42000

Alt 2: 700000 × + 700000 × = Rs.35000

Alt 3: 1400000 × = Rs.28000

Example–III

X Ltd Company estimated a capital outlay of Rs.2200000 for its expansion programme. Company's advisor has suggested the following three alternatives:

Particulars	Alternatives-2	Alternative-2	Alternative-3
Equity shares	2200000	1100000	–
8% Debenture	–	1100000	1100000
15% Bank loan	–	–	1100000
Total (Rs.)	2200000	2200000	2200000

The company expects on income of Rs.6000 per day before charging interest, depreciation and floatation cost from this expansion programme. It takes only 25 days to complete extension work. The flotation cost is 2% for both new share and debenture.

Normally, it takes two months to avail fund by issuing share and one month by issuing debenture whereas loan from bank can be obtained within 15 days. At present, the company is bearing a loss of Rs.4000 per day. 50% of the collected fund will be used to purchase a plant under pool 'D'. Being an industry, the corporate tax rate is 20%.

Assume 360 days in a year and floatation cost as revenue expenditure.

Required: As a tax planner, suggest which alternative is preferable.

Solution

Calculation of profit after Tax under different alternative structure

Particulars	ALT–1	ALT–2	ALT–3
Profit before tax and other expenses	(275×6000)= 1650000	(275×6000)= 1650000	(305×6000)= 1830000
Less: Expenses Interest expenses	Nil	73333	231917
Floatation cost	44000	44000	22000
Depreciation (Block D)	220000	220000	220000
Present losses	340000	340000	220000
Total Expenses	604000	677333	693917
Taxable income	1046000	972667	1136083
Less Tax @ 20%	209200	194533	227217
Earnings after Tax	836800	778134	908666

Decision: The 3^rd Alternative is the best option as it has maximum after Tax profit among 3 different alternatives.

Working notes:

a) + Extension period Net profit earning days = 85 days

Alt 1: Profit = (360–85) = 275 days (profit 25 earning days)

b) Calculation of interest expenses

Alt 2: Interest = (11,00000 × = Rs.73333

Alt 3: Interest = (1100000 × ) ×

= Rs.231917

c) Calculation of Depreciation

50% of collected fund is used to purchase plant. It is therefore,

50% of 2200000 = Rs.1100000 × 20% = Rs.220000

d) Present losses = Non operating days × Loss per day

Particulars	ALT–1	ALT–2	ALT–3
Non operating days	60+25–Nil= 85	60+25–Nil=85	30+25–Nil=55
Operating days	360–85=275	360–85=275	360–55=305
Profit	275×6000	275×6000	305×6000
Loss	85×4000	85×4000	55×4000
Floatation cost	44000	44000	22000

Exmple–IV

A Company requires Rs.15 lakh capital outlay for its expansion purpose. Company's advisor has suggested the following 4 alternatives.

Particulars	ALT–1	ALT–2	ALT–3	ALT–4
Share Capital	1500000	750000	300000	–
7% Debenture	–	750000	750000	–
18% Term loan	–	–	450000	750000
20% private loan	–	–	–	750000
Total fund	15 lakh	15 lakh	15 lakh	15 lakh

After expansion, the company has expected a profit of Rs.8000 per day before charging interest, floating cost of brokerage charge. It takes only 20 days to complete extension work. The floatation cost is 2% for both new share and debenture. However, the company has to incur. However, The company has to 1% as brokerage charge to obtain loan from bank. Normally, it takes two and half months or avail capital by issuing new shares and one month by issuing debenture, loan from bank can be obtained from bank within 10 days, whereas it takes 4 days to obtain it from private lenders. At present, the company is bearing a loss of Rs.3000 per day. The corporate Tax rate is 25%. Assume 360 days in a year.

Required: Suggest which alternative is preferable.

Solution:

Working notes:

Profit per day = Rs.8000

Loss per day = Rs.3000

Fund rising period from shares = 75 days

Fund rising period from debentures = 30 days

Fund rising period from bank loan = 10 days

Fund rising period from private money lender = 4 days

1. Calculation of profit

Alt 1: Net profit earning days/non operating days

Capital collection through equity capital = 75 days

Add Extension period = 20 days

= 95 days

\ No. of profit earning days = 360–95 = 265 days

\ Expected profit = 265×8000 = Rs.2120000

Alt 2: Capital collection through equity capital = 75 days

Capital collection through debenture capital = 30 days

No. of profit earning days = 360–95 = 265 days

\ Expected profit = 265×8000 = Rs.2120000

Alt 3: Capital collection period of equity = 75 days

Capital collection period of debenture = 30 days

Capital collection period of Bank loan = 10 days

No. of profit earning days = 360–95 = 265 days

\ Expected profit = 265×8000 = Rs.2120000

Alt 4: Capital collection period of Bank loan = 10 days

Capital collection period of private loan = 4 days

Net profit earning days/non operating days = Capital collection period of Bank loan + Extension period = 10+20 = 30 days

\ Profit earning days = 360–30 = 330 days

\ Expected profit = 330×8000 = Rs.2640000

2. Calculation of interest

Alt 1: Equity capital = Nil

Alt 2: 7% debenture

interest = (750000 ×

Alt 3: Interest = (750000 × = Rs.105687

Alt 4: Interest = (750000 × = Rs.277083

In case of two or more capital in the structure, collection period of the capital having higher period is needed to consider for interest calculation.

3. Calculation of Flotation cost

Alt 1: (2% of 1500000) = Rs.30000

Alt 2: (2% of 1500000) = Rs.30000

Alt 3: (2% of 1050000 + 1% of 450000) = Rs.25500

Alt 4: (1% of 750000) = Rs.7500

4. Current losses

Alt 1: 360–285 days = 95 days

\ Loss = 95×3000 = Rs.285000

Alt 2: Loss = 95×Rs.3000 = Rs.285000

Alt 3: Loss = 95×Rs.3000 = Rs.285000

Alt 4: Loss (360–330) = 30 days × Rs.3000 = Rs.90000

Calculation of earning after tax (EAT) at different structure available

Particulars	ALT–1	ALT–2	ALT–3	ALT–4
Profit before interest, tax and other expenses	2120000	2120000	2120000	2640000
Less: Expenses Interest on loan	–	41562	105687	277083
Flotation cost	30000	30000	5500	7500
Losses	285000	285000	285000	90000
Total Expenses	315000	356562	416187	374583
Earning before tax	1805000	1763438	1703813	2265417
Less Tax @ 25%	451250	440860	425953	566354
Earning after Tax (EAT)	1353750	1322578	1277860	16990 63

From the above analysis, the 4^th 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

Income Slab (Rs.)	Cumulative income (Rs.)	Tax Rate (percentage)	Tax Amount (Rs.)	Effective Tax Rate
First Rs.100000	100000	–	–	–
Next Rs.75000	175000	15%	Rs.11250	6.43
Above Rs.175000	–	25%	–	–

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

Income Slab (Rs.)	Cumulative income (Rs.)	Tax Rate (percentage)	Tax Amount (Rs.)	Effective Tax Rate
First Rs.160000	160000	1%	1600	1%
Next Rs.100000	260000	15%	15000	5.77
Above 260,000	–	25%	–	–

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

Income Amount (Rs.)	Tax as per Fy 2062/63	Tax as per Fy 2067/68	Difference Tax saving	Relief (in%)
160000	9000	1600	7400	82.22
260000	32500	15000	17500	53.85

Source: Self computation based on Table 1 and table 2

Note: Col.2 and Col.3 are calculated from tax rate applicable to F.y.2062/63 and 2067/68 after deducting exemption limit of Rs.100000 and 160000 respectively.

Table–4 : Extra tax charged after deflating income and deflated value of tax based on overall consumer prices 2062/63 = Rs.152.5

Money income (Rs.)	Tax amount on Money income as per 2067/68 prices	Deflated tax calculated from col.2 based on CPI= Rs.152.5	Deflated income calculated from col.1 based on CPI=Rs.152.5	Tax on deflated income as per 2062/63	Differe-nce on col.3–5	Extra pay off tax in col.6/col.3
160000	1600	1049	104918	737.7	311.3	29.68
260000	15000	9836	170492	10573.8	(737.8)	(7.50)

Source: Self computation from table 3

Note: Col.5 is calculated from the tax rate applicable to F.y.2062/63 after deducting exemption limit of Rs.100000.

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 (Rs.)	Cumulative income (Rs.)	Tax Rate	Tax Amount	Effective Tax Rate
152500	152500	–	–	–
100000	252500	10%	10000	3.96
200000	452500	15%	30000	6.63
Above 452500	–	25%	–	–

Source: Self proposed

The proposed tax rate structure will satisfy the double objective of economic growth and social justice, since individual tax payers in lower class will have adequate post tax disposable income with them to satisfy the demand for basic needs and enjoys better standard of living. This will encourage the process of economic development by increasing demand for such goods and will save the economy, from declining danger of recession on account of lack of demand due to fall in purchasing power of money. The problem of industrial sickness will also get some reprieve where it is on account of falling demand. Individuals falling in different income slabs will have a will to earn more on account of moderate progression in tax rates. The proposed tax rate structure will bring about a better compliance by most of the tax payers because incentive for tax evasion will come down essentially. People in higher income category will also have adequate encouragement to go in for savings and investments even after satisfying with the needs of comforts in their lives. The cost of income tax administration will come down conformably due to fall in the number of tax payers by rising of exemption limit. They will have more time and energy left to perceive cases for tax evasion.

It will be interesting to analyze the impact of our proposals an average rate of tax. The series of average tax rate in 2062-63 ranged from 6.43 percent. Our proposed tax rate structure will have an average tax rate ranging from 3.96 percent to 6.63 percent. We have proposed relief to lower income group (upto 252500) tax payers in term of average rate of tax because they have been burdened disproportionately high income tax when inflation adjusted figures are considered. High income tax of this group of tax payers has led to huge tax evasion also. There is some justification for raising upper limit of tax rate from 10 percent to 25 percent on income over Rs.260000. Because higher income categories people have enjoyed under tax relief when we consider the impact of inflation. They have capacity to pay more tax. Therefore, tax rate structure will become more just, equitable, growth oriented and less inclined to tax evasion. Assuming that income exceeding Rs.260000 appears to have higher incidence of taxation. It is evident from the fact, money income of Rs.260000 equals to Rs.170492 at 2062-63 prices. Since an income of Rs.260000 of 2062-63 equals to Rs.396500 at 2067-68 prices. Higher income tax should not be imposed on individuals with an annual income of 260000 instead it is suggested that Rs.452500 and above income should be selected for such tax. It is evidenced from the above that current tax rate structure benefits more to the rich people rather than lower income group in the country. Tax paying capacity should be issued after making an objective study of inflation impact. Therefore, the existing tax policy is recommended to change at earliest.

Any tax policy should be conductive to the economic development, equity and social justice. Progressive tax policy is widely regarded as a means to reduce the poverty from the society. It is therefore, a country like Nepal should have progressive tax policy otherwise, it is no doubt that the increased gap between haves and have nots will further widened in our society.

8.3. Tax planning in the form of tax depreciation

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.

Depreciation allowance is that portion of total original cost of an asset which is allocated as expense to a particular year. It aims at distributing the total cost/other basic value of tangible capital asset less salvage value, if any, over the estimated useful working life of the asset in a systematic and rational manner.¹

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

Similarly, there is a practice to fix depreciation for each asset separately or to fix rates for a pool of assets. Under pooled system, all assets of a similar nature are put in a group and treated as a single asset for the purpose of depreciation. According to the schedule 2 of the income tax Act, assets are classified into two major groups, tangible assets and intangible assets. The tangible assets are further classified into four blocks (i.e. A, B, C and D). Each block includes assets of similar classes. The blocks and classes are given below:

Table:– 1

Classification, pooling and rates of depreciation assets

Block	Details of Assets	Rate of depreciation
"A"	Buildings, structures and similar works of a permanent nature	5%
"B"	Computers, data handling equipment, fixtures, office furniture and office equipment	25%
"C"	Automobiles, buses and minibuses	20%
"D"	Construction and earth moving equipments, unabsorbed pollution control cost and Research and development costs and any tangible assets not included in above blocks (eg. plant and machinery)	15%
"E"	Intangible assets (patent, copy rights, trade marks, software etc., which are not included in block 'D' assets	Cost divided by life

The depreciation amount per year is determined by applying the following formula based on pooled system.

Depreciation Amount = Rate of Depreciation × Depreciation Base

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

The portion for which depreciation is not allowed for the year is called unabsorbed portion of the addition during the year. Formulas given by section 2(5) of schedule 2 of the Act for calculation of the absorbed and unabsorbed portions of addition during the year, are as follows:

Table–2

Particulars	Absorbed portion	Unabsorbed portion
Assets purchased or used up to the end of month of Poush of the year	total (100%)	Zero
Assets purchased or used from Magh 1 to the end of Chaitra of the year	2/3 of total	1/3 of total
Assets purchased or used from Baishak 1 to the end of Ashad of the year	1/3 of total	2/3 of total

The provision of income tax (amendment) Rules 1992 in respect of granting depreciation necessitates the segregation of industrial items of plant and machinery. Further, it also provides that if the cost of a component of plant and machinery is less than Rs.2000, the same be depreciated fully (100%) in the year of purchase of such component, such a provision aims at encouraging new capital formation in the capital cost.

Nepal has been granting depreciation allowance for various assets such as buildings, plant and machinery, furnitures and vehicles from very beginning. It has been adopting itemized system of depreciation. Under this system, depreciable assets are listed in the depreciation table–1 and the rates of depreciation are given for each asset separately. Initially, depreciation provisions were not included in Income Tax Act but it was a part of Business profits and Salaries Tax Regulations 1960. Under these regulations, following depreciation rates were prescribed on the following assets. Similarly, depreciation provisions were included in the Income Tax Act 1963. The method of depreciation proposed by the Act was straight line method and depreciation rate allowed were 10% for plant and machinery, 6% for building, 5% for furniture and 15% for vehicles (as shown in table–3). In 1974, Income Tax Act 1974 was introduced and depreciation rates were changed.

Table–3

A Comparison of depreciation rates in between 1960 and 1963

Types of Assets	Depreciation Rates in 1960	Depreciation Rates in 1963
1. Buildings	4% for industrial use and 2% for business use	6% where machines are installed and 3% for the use of business insurance and agency
2. Machinery	7 percent	10 percent
3. Furniture	5 percent	5 percent
4. Other materials	upto 6 percent	–
5. Motors, Lorries, Trucks and other vehicles	–	15 percent

Source:– Income Tax Rules

Since 1982, depreciation provisions have been prescribed in the Income Tax rules, depreciation rates prescribed in 1982 were revised in 1992 under this system, and all assets were listed separately under 5 main groups (i.e. buildings, means of transportation, furniture and office equipment, plant and machinery and others which were further divided into 30 sub–groups. There were 7 rates of depreciation ranging from 5 percent to 50 percent (5, 7, 10, 15, 20, 25 and 50 percent). Under the provision of income tax rules 1982, a new industrial company can claim a benefit of tax holiday period. One can claim depreciation on the written down value of the assets, one of the conditions for the grant of the declining method of depreciation is that the fixed asset should be owned by the company and that the same be used for the business purposes. Under the Industrial Enterprises Act 1992, one third additional rate of depreciation can be charged for manufacturing industry, export business and public infrastructure entities. Non-industrial companies are not entitled to an additional depreciation at the rate of 1/3 of normal depreciation. Similarly an additional 25 percent depreciation over the normal rates were allowed on godowns and sheds only but the furniture of hotels, lodges, restaurants, cinema halls, theaters etc. were not entitled to additional facilities as per Industrial Enterprises Act. There was a provision for allowing as deduction at the rate of 40 percent of new additional fixed assets acquired on capacity expansion upto 25 percent or more of the existing capacity. It might be written off either in one lump sum or in equal installments in 3 years (section 15 (J) of Industrial Enterprises Act 1992). Such initial depreciation was also applied to a deduction of upto 50% from the taxable income for the investments of an industry on process or equipment with an objective of controlling pollution. Such remission could be deducted on a lump sum or in equal installments in 3 years according to section 15 (k) of the industrial Enterprises Act.

Nepal exercised various rates of depreciation system prescribed by various income taxes related Acts and rules. After the introduction in 1962, it was changed in 1974, 1981, 1982, 1992 and 2002. After each reform, the company used to claim that depreciation on provision brought was more generous than earlier one.

Additional depreciation for special industry

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

Block of Assets	Normal Rate of Depreciation	Additional Depreciation ( of normal rate)
'A' Class	5%	6.67%
'B' Class	25%	33.33%
'C' Class	20%	26.67%
'D' Class	15%	20%

Source:– Industrial Enterprises Act/Income Tax rules

Depreciation is allowed on a block of assets concept as shown in above table. All assets of a similar nature are classified under a single block and any additions/deletions are made directly in the Block.

Tax Depreciation

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 account³. 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%

Rate of depreciation	Accumulation of depreciation excluding interest at the end of 10 years (as % cost)	Year in which accumulation reaches 100% (end of year)	Accumulation at the end of 10 years (as % of cost)
33.3	98.2	4	177
26.7	95.5	5	167
20.0	89.3	6	151

Table 5.1.A

Funds in Hand on Account of Depreciation (33.33%) and interest (16%) with Tax Rate of 30%

Year End	Book value (cost less depreciation)	Depreciation during the year	Cumulative Depreciation	Interest accrued (Total)	Cumulative interest	Total funds in hands (Depreciation+Interest)
Initial position	1000	–	–	–	–	–
1	667	333	333	–	–	333.00
2	445	222	555	37.30	37.30	592.30
3	296	148	703	62.16	99.46	802.46
4	197	99	802	78.74	178.20	980.20
5	131	66	868	89.82	268.02	1136.02
6	87	44	912	97.22	365.24	1277.24
7	58	29	941	102.14	467.38	1408.38
8	39	19	960	105.39	572.77	1532.77
9	26	13	973	107.52	680.29	1653.29
10	17	9	982	108.98	789.27	1771.27

Source: Self computed

Table: 5.1.B

Fund in Hand on Account of depreciation (26.67%) and interest (16%) with Tax Rate of 30%

Year End	Book value (cost less depreciation)	Depreciation during the year	Cumulative Depreciation	Interest accrued (Total)	Cumulative interest	Total funds in hands (Depreciation+Interest)
Initial position	1000	–	–	–	–	–
1	733	266.7	266.7	–	–	266.7
2	538	195.6	462.3	29.87	29.87	492.17
3	394	143.4	605.7	51.78	81.65	687.35
4	289	105.3	711.0	67.84	149.49	860.49
5	212	77.0	788.0	79.63	229.12	1017.12
6	155	56.5	844.5	88.26	317.38	1161.88
7	114	41.5	886.0	94.58	411.96	1297.96
8	84	30.3	916.3	99.23	511.19	1427.49
9	62	22.3	938.6	102.63	613.82	1552.42
10	46	16.4	955.0	105.13	718.95	1673.95

Source:– Self computed

Table:– 5.1.C

Fund in Hand on Account of Depreciation (20%) and Interest (16%) with Tax Rate of 30%

Year End	Book value (cost less depreciation)	Depreciation during the year	Cumulative Depreciation	Interest accrued (Total)	Cumulative interest	Total funds in hands (Depreciation+Interest)
Initial position	1000	–	–	–	–	–
1	800.0	200.0	200.0	–	–	200.00
2	640.0	160.0	360.0	22.4	22.40	382.40
3	512.0	128.0	488.0	40.32	62.72	550.72
4	409.6	102.4	590.4	54.66	117.38	707.78
5	327.7	81.9	672.3	66.12	183.50	855.80
6	262.2	65.5	737.8	75.30	258.80	996.60
7	209.8	52.4	790.2	82.64	341.44	1131.64
8	167.8	42.0	832.2	88.50	429.94	1262.14
9	134.2	33.6	865.8	93.20	523.14	1388.94
10	107.4	26.8	892.6	96.97	620.11	1512.71

Source:– Self computed

However, the recovery of capital costs has to be spread over a number of years during which the value of those assets gradually depreciates through wear and tear and absolescence. Traditionally, the basis of calculating depreciation under the Income Tax Act has been the original or historical cost of the asset. However, historical cost basis of depreciation does not provide sufficient funds for replacement of assets particularly under inflationary conditions. If prices remain stable, the total accumulated depreciation will enable to recover the cost of assets by the end of useful life of the assets.

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% respectively after adding to normal rate of depreciation.

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 6^th 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

The economic development of any country depends to a large extent on investment in the industrial sector. Industrial investment, in its turn, depends upon the ability and willingness of the investors to invest. The willingness to invest depends upon the after tax profitability of investment, while the ability to invest depends upon the availability of internal and external funds.

Tax incentive is becoming an integral part of the tax system for accelerating the pace of industrialization in most of the developing countries. The incentive to invest arises from the relaxation in normal taxation rules which curtail the tax burden and thus increase the profitability of a particular investment activity. Tax incentives involve cost in the form of loss of revenue to the government but at the same time, it results in increase in industrial savings and investments.

The necessity of offering tax incentives is felt basically for two reasons: stretching the scope of tax beyond its revenue objective to achieve certain socio-economic ends and to mitigate the adverse impact of high taxation on industrial savings and investment activities. Heller and Kaufman(1) had observed that "incentive legislation in a highly taxed developing nation is viewed as a political and quid pro quo for necessary but otherwise politically unattainable reforms and administrative changes". It is generally felt that tax incentives are valuable as an indirect stimulus to invest insofar as they enhance the investment climate of the country. Wanchoo committee had also observed that tax incentives seek to modulate the tax structure to suit the needs of the time by providing differential tax treatment to various types of incomes by inducing chanelisation of saving of the community into selected sectors of the investment. They facilitate achievement of certain basic social and economic objectives." (2)

A Comparison of Tax incentives:

A variety of incentive laws prevail in different countries influenced by their economic and political climate. However, a common feature of these incentive legislations is that the incentive either takes the form of an exemption, including, inter–alia, tax–holiday or deduction by way of investment credit or allowance, accelerated depreciation, etc. According to an UN study (3), in countries like Philippines, Mexico, etc, the incentive is mainly in the form of tax–holiday. The investment allowance is operated actively by Turkey, India, Morocco, Zambia, Korea, Tanzania, Ceylon, etc. A combination of tax–holiday with investment and other allowances is also common in many countries including India, Nepal, Israel, Ghana, Jamaica, Trinidad and Peurti Rico. The UN study further observed that incentive programmes in most of the countries studied were not applied on a selective basis in relation to the contribution of the industries to the economy as well as to specific targets like employment creation and thus have been found costly to the government.

It is necessary that one should keep in view the value of tax incentives which are generally deducted from the base of corporate tax. Thus, the base for corporate income would depend on the commercial profits plus partially and completely dis-allowed expenses minus tax concessions or incentives. Tax incentives which have commonly been offered from time to time in different countries may be justified on the ground of relationship between reduction in the tax burden and increase in investment. These incentives are; investment allowance, investment tax credit, development rebate, depreciation allowance, extra–shift allowance, initial depreciation allowance, tax holiday, liberal carry back or carry forward of losses, investment grants, deduction of interest payment to domestic or foreign creditors, deduction in respect of dividend, promotion to tourist facilities or hotels, development of backward regions, rehabilitation of industries, permitting share holders or creditors to off–set against their own taxes, the losses suffered by their corporations or debtors and a host of expert and other incentives. These tax incentives have always been an important part of corporate tax system, because it is an important instrument in accelerating the pace of economic growth through mobilizing savings and investment, and its type, size and magnitude varies according to the needs and aspirations of the people of different countries.

In order to provide greater coverage of tax incentives, the alternative use of fiscal concessions in the form of tax credit is also enjoyed by companies, which make their tax liabilities lower. Fiscal facilities were differentiated with production activities of the company in respect of violating the conditions of horizontal equity of the fiscal system. In Germany, until 1989, tax credits were allowed for investments in the mining sector for the production of energy, scientific research, anti–pollution activities and in favour of small and medium companies. Except companies established in specific areas, fiscal incentives were removed in Germany starting from 1990. In the United States, tax credits were introduced between 1981 and 1982, but the Tax Reform Act abolished them in 1986. In Japan, tax credits were allowed to companies for the purchase of goods expected for energy savings or goods with a high technological content. In France, tax credits were allowed for deduction from corporate taxable income in respect of expenses incurred on scientific research. In Ireland, manufacturing companies operating in the domestic market or abroad are subject to a soft tax rate of 10%. In the case of Belgium, Denmark and Greece, the use of fiscal incentives is mostly limited to developing industries in under-developed and less developed areas.

We shall now briefly discuss some important incentives which are commonly found in different countries.

Tax Holiday Provision:

Tax holiday is the holiday from Tax for a certain period of time. If any industry has received a 5 year tax holiday period from the government, the holiday will start from the year in which the industry commences its commercial production. This is a kind of tax incentives provided under the income tax act that avoids some of the disadvantages of investment allowances.

The investment allowances may be favoured by existing companies, whereas tax holiday is mainly concerned with new companies in the industrial sector. Such a relief on tax is applicable on profits earned from new investment and it will automatically terminate after the holiday period. This incentive does not decrease the effective management function but increases profitability of investment of the company. The profit will be subject to the normal rates of taxation after the expiry of tax holiday period. Tax holiday attracts short–run investment in industries with quick return.

Tax holiday is one of the most popular of all the tax incentives. It is allowed in a large number of countries. For instance, tax holiday is available in Afganistan, Bangladesh, Barbadas, Ecuador, Fiji Island, Ghana, India, Indonesia, Ivory Coast, Jamaica, Malaysia, Nigeria, Pakistan, Peru, Senegal, Seria Leone, Singapore, Sudan, Surinam, Mauritius, Srilanka, Nepal, etc.

Tax holiday in most of these countries is based on the factors of prospective development like reinvestment of undistributed profits by companies, engaged in priory industries, export–oriented or labour–intensive technology or location in the interior of the country. Nepal has also followed the example of these countries. The tax holiday is granted to newly established industries giving consideration such as level of capital investment, number of people employed, nature of product (for basic needs or national priority industries) and the contents of local raw materials under section 15 of the Industrial Enterprises Act 1992, the range of tax holiday period is from 5 to 14 years depending on the above noted criteria.

Beneficiaries from tax holiday

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.

Tax holiday of 10 years from commencement of its operation is available to industries established at Himali or Hilly Economic zone (S.11.3(ka)). After expiry of the 10^th year, taxable income of the industry shall be subject to income tax at a rate of 50% of the rate applicable to the industry as per schedule of the income tax act.

Finance Act 2063 has introduced a new subsection (3ka) to section 11 states that any industry established at any notified specific economic zone shall avail a tax holiday of 5 years from commencement of its operation. After completion of the 5^th years, taxable income of the industry shall be subject to income tax at a rate of 50% of the rate applicable to the industry as per schedule 1 of the Income Tax Act.

Dividend declared by any industry established in a notified economic zone is exempted from income tax for the period of 5 years from the commencement of its operation. After expiry of the 5^th year, tax rate applicable on the dividend shall be 50% of the applicable under rate for 3 more years, (under section 3 ka introduced by Finance Act 2064 and 2065). The taxable income of an entity engaged in commercial electricity generation, transmission, or distribution within 2075 Chaitra, is 100 percent tax free for initial 7 year and 50% tax rebate thereafter for 3 years from the date of such commencement of generation, transmission and distribution. Such facilities shall also be applicable for electricity generated from solar, wind and organic materials. In case of these entities which are already having started commercial production of electricity before 1^stShrawan 2066 shall be eligible for facility as existed at the time of licence issued.

Incentives for development of specified areas in comparison to other countries.

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.

Balanced regional development is one of the cherished objectives of economic planning of a country. But in Nepal, there has been no balanced regional development of industries. There are some districts like Kathmandu, Lalitpur, Bhaktapur, Makawanpur, Chitwan, Parsa, Bara, Dhanusha, Sunsari, Morang, Rupandehi and Banke which are industrially developed. These are mostly plain areas connected with Indian border and also equipped with infrastructural facilities. As against this, there are as many as 35 remote and undeveloped districts, which are generally hilly areas located in north–east and north–west region of Nepal. This has resulted in unequal distribution of economic benefits among the people of different regions of the country. With a view of minimizing this gap, Government of Nepal started providing from the year 1975–76, various fiscal and financial incentives to the units located or to be located in industrially backward districts.

An important step by the Government was the extensive industrial survey of Nepal and subsequent classification of all the 75 districts of the country into four regions namely remote areas, undeveloped areas, underdeveloped areas and developed areas (for the details of districts included under each category, please see appendix–1)

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
PBIT (Rs.)	1000000	1100000	1200000	1300000	1400000

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 for one unit of production	@ Rs. 5	@ Re. 1	@ Rs. 1.25
Tax Rebate	Nil	50%	30%

The expected production and sales for the next 5 years are as given:

Years	1	2	3	4	5
Output (units)	120000	130000	140000	150000	160000

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)

Particulars	Year –1	Year–2	Year–3	Year–4	Year–5
Profit before transportation and tax Less transportation cost (raw material only)	1000 (300)	1100 (325)	1200 (350)	1300 (375)	1400 (400)
Earnings before Tax Less Tax @20%	700 140	775 155	850 170	925 185	1000 200
Total EAT (Rs.)	560	620	680	740	800

Total Earning after Tax = Rs.34,00,000/– for next 5 years

Alternative–II (if factory is located at Achham) (Rs. in thousand)

Particulars	Year –1	Year–2	Year–3	Year–4	Year–5
Profit (PBIT) Less transportation cost	1000	1100	1200	1300	1400
Raw material (50%)	(60)	(65)	(70)	(75)	(80)
Finished goods @ Rs.4	(480)	(520)	(560)	(600)	(640)
Earning before tax	460	515	570	625	680
Less tax @ 10%	46	52	57	63	68
Total EAT (Rs.)	414	463	513	562	612

Total Earning after Tax = Rs.2564000/– for next 5 years

Alternative–III (if factory is located at Baglung) (Rs. in thousand)

Particulars	Year –1	Year–2	Year–3	Year–4	Year–5
Profit (PBIT) Less transportation cost	1000	1100	1200	1300	1400
Raw material (50%)	(75)	(8125)	(88)	(94)	(100)
Finished goods @ Rs.3	(360)	(390)	(420)	(450)	(480)
Earning before tax	565	629	692	756	820
Less tax @ 14%	79	88	97	106	115
Total EAT (Rs.)	486	541	595	650	705

Total Earning after Tax = Rs.2977000/– for next 5 years

Decision : Since EAT of Bhaktapur is higher than Baglung and Achham, So as a tax planner, we recommend to locate factory at Bhaktapur.

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.

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