TAX PLANNING WITH REFERENCE

TO MANAGERIAL DECISIONS
 Purchase of asset
The leasing and purchase decision is taken only when it is
finalized that a particular asset is to be acquired. The factors
which determine effective tax saving in relation to purchase
of asset are as follows
Basis Purchase Lease
Cash position Sufficient or can borrow funds Neither sufficient cash nor can
at a reasonable rate of borrow due to stringent credit
interest
Deduction The cost of own asset is not The lease rent is deductible
deductible but the interest on
borrowed funds is deductible
Depreciation Allowed as deduction Not allowed to the lessee
Residual value Large Small
Cash outflow Loan installment + interest Lease rent
It is an important consideration in tax planning that assessee should follow such
as method for obtaining an asset which reduces his tax liability and the profits
after tax are greater.
 CASE STUDY
An assessee who carries on a business, acquires a plant
and machinery costing Rs 1,00,00. this plant and
machinery is utilized for the business of the company till
year ten when it is discarded and sold at the depreciated
price. In this case the taxpayer can claim depreciation for
year one to year ten under section 32. Effective tax
benefit depend upon maximum marginal rate of tax. For
this purpose, it is assumed that the maximum marginal
rate of tax is 33.99 percent. Tax saving are discounted at
the rate of 10 per cent to find out the present worth/
value. This case study is based on two plans, namely, (i)
when owned funds are invested and (ii) when 75 percent
cost of plant is financed by deposit taken from public
 Result
- When own funds are invested in plant and machinery- Present
tax savings on account of deductions available under different
circumstances, when own funds are invested in plant and
machinery. One can finance 18.84 per cent of investment in plant
and machinery by tax savings.

- When borrowed funds are invested in plant and machinery –

Data regarding the extent of tax saving when Rs75,000 is
borrowed form public by accepting deposit at the rate of 9 percent
per annum to finance the investment of Rs 1,00,000 in plant and
machinery. While interest is paid annually , principal is repaid in
year ten.

• one can finance 23.17 per cent of investment by tax savings.

Therefore, purchase out of own funds is better
 Tax savings under the scheme of depreciation at 15 per cent
(Tax rate : 33.99 per cent )

Year Amount of depreciation Tax saving on Present worth of

(investment : depreciation tax savings
Rs. 1,00,000) (discount rate :
10 per cent )
Rs Rs Rs.
Year one 15,000 5,099 4,635
Year two 12,750 4,333 3,579
Year three 10,838 3,684 2,767
Year four 9,212 3,131 2,138
Year five 7,830 2,661 1,652
Year six 6,656 2,262 1,275
Year seven 5,687 1,922 986
Year eight 4,809 1,635 763
Year nine 4,087 1,389 589
Year ten 3,474 1,181 456
18,840
 Present value of differential outflows on purchase of plant and machinery
with borrowed funds ( Amount of investment :
Rs 1,00,000 amount borrowed : Rs 75,000)
Year Interest at the Own investment Present value of total Present value of total outflow on
rate of 9 and principal repaid outflow on principal and principal and interest net of tax
per cent interest (discount rate : 10 (discount rate :
per cent 10 per cent ) Tax
Rate 33:99 per cent

(1) (2) (3) (4) (5)

Rs Rs Rs Rs
Year zero - 25,000 25,000 25,000
Year one 6,750 - 6,136 4,050
Year two 6,750 - 5,576 3,681
Year three 6,750 - 5,069 3,346
Year four 6,750 - 4,610 3,043
Year five 6,750 - 4,192 2,767
Year six 6,750 - 3,807 2,513
Year seven 6,750 - 3,463 2,286
Year eight 6,750 - 3,152 2,081
Year nine 6,750 - 2,862 1,889
Year ten 6,750 75,000 31,556 30,670
Total 67,500 1,00,000 95,423 81,326
Note :-
1.Present worth of Rs 6,750: Rs2,606+ Present worth of Rs 75,000: Rs 28,950
2.66.01% of column (4)
3.66.01% of Rs 2,606 + Rs 28,950
 Contribution of deduction under section 32 when borrowed
funds are invested in plant and machinery
(Tax rate : 33.99 per cent

a. Present worth of total outflow on principal and interest net of tax Rs 81,236
b. Present worth of tax savings on account of deduction under section Rs. 18,840
32 .
c. (b) as % of (a) 23.17
 Lease Vs. Purchase
• With the concept of leasing gaining immense popularity in recent times, any
business management is faced with the choice to purchase assets or to go in for
leasing the asset. One must resolve this issue on economic consideration taking
into account the different tax shield effects. If assets is purchased, the assessee can
claim depreciation. Besides, interest on capital borrowed to finance investment in
plant and machinery can also be claimed as deduction, if however, asset is
obtained on lease, deduction can be claimed in respect of lease rental and lease
management fees.
Case Study:- For this purpose a case study on the following data has been made. A
plant is to be purchased for Rs 1,00,000. The depreciation rate is 15 per cent and
the corporate tax rate 33.99 per cent. The weighted average cost of capital is 10
per cent. The life of machine is 10 years. A loan of Rs 75,000 can be had by
accepting public deposits at the interest rate of 18 per cent for financing the
investment in plant. It is assumed that the public deposit are repaid after 10 years.
On the other hand, the asset can be obtained on lease. The lease rentals are at the
rate of Rs 34,000 per annum for the primary lease period of 5 years . Beyond this
peppercorn rentals of Rs 600 per annum are to be paid. A lease management fee
of Rs 1,000 is payable on inception of the lease. In all, three situations have been
studied :
 Situation 1-
Purchase with own funds-
The following results one can obtain on the basis of date
presented below

Present value of outflow of cash when plant is purchased out of

own funds Rs
Investment in plant and machinery 1,00,000
Tax savings on account of depreciation 18,840
81,160
Outflow of cash
Situation -2 Purchase with borrowed funds
To finance purchase of plant and machinery, a loan ( by way of public
deposits) of Rs 75,000 is obtained at the rate of 9 per cent . While interest
is paid annually, principal is repaid in year ten. The following results one
can obtain on the basis of information presented

Present value of outflow of cash when plant is

purchased out of borrowed funds

Rs
•Present worth of total outflow on principal and interest net of tax 81,326
•Present worth of tax savings on account of deduction under section 18,840
32 62,486
•Outflow of cash ( net of taxes )
 Situation 3- Taking asset on lease
Table presents data when plant is obtained on lease from own funds
Present value of differential cash outflow on leasing with own funds
Year Lease Lease Tax saving on fee Differentials Present value of
management Rentals and rentals (tax Cash outflow differential cash
fee Rate :33.99 outflow
per cent) (discount rate: 10
per cent
Rs Rs Rs Rs Rs
Year zero 1,000 34,000 11,897 23,103 23,103
Year one - 34,000 11,557 22,443 20,401
Year two - 34,000 11,557 22,443 18,538
Year three - 34,000 11,557 22,443 16,855
Year four - 34,000 11,557 22,443 15,329
Year five - 600 204 396 245
Year six - 600 204 396 223
Year seven - 600 204 396 203
Year eight - 600 204 396 185
Year nine - 600 204 396 168
Year ten - - - - -
Total 95,250
Conclusion :- From the above it would be evident that purchase of plant out own fund is the best alternative
 Make or buy
Many costing or non-costing consideration guide the decision relating
to “ make or buy. Some of these consideration are –(a) utilization of
capacity,(b) inadequacy of funds, (c) latest technology, (d) variable
cost of manufacturing vis-à-vis purchase price (e) dependence upon
supplier (f) labour problem in the factory etc .Following tax
consideration one has to keep in mind:-

1. Establishing a new unit – If the decision to manufacture a part or component

involves setting up a separate industrial unit, then tax incentives available under
section 10A, 10B, 32,80-IA,80-1B and 80-1C one has to keep in mind.

2. Sale of plant and machinery- If buying is cheaper than manufacturing and the
assessee decides to “buy” parts/components for a long time , he may like to sell the
existing plant and machinery . Tax implications, as specified by section 50 , one has
to consider for taking the decision.
 Case study
• X Ltd. manufactures electric pumping sets. The company has the option
to either make or buy from the market component Y used in
manufacture of the sets.
• The following details are available :
• The component will be manufactured on new machine costing Rs 1 lakh
with a life of 10 years. Material required cost Rs 2 per kg and wages Re
0.30 per hour. The salary of the foremen employed is Rs 1,500 per
month and other variable overheads include Rs 20,000 for
manufacturing 25,000 components per year. Material requirement is
25,000 kgs and requires 50,000 labour hours.
• The component is available in the market at Rs 4.30 per piece.
• Will it be profitable to make or to buy the component ? Does it make
any difference if the component can be manufactured on an existing
machine ?
Question :- XYZ Ltd needs a components in an assembly operation. It
is contemplating the proposal to either make or buy the aforesaid
component.
1 If the company decides to make the product itself, then if would
need to buy a machine for Rs 8 lakh which would be used for 5
years. Manufacturing costs in each of the five years would be Rs 12
lakh, Rs 14 lakh,Rs16 lakh Rs20 lakh and Rs 25 lakh respectively .
The relevant depreciation rate is 15 per cent. The machine will be
sold for Rs 1 lakh at the beginning of the sixth year.
2. If the company decides to buy the component from a supplier the
component would cost Rs 18 lakh, Rs 20 lakh, Rs 22 lakh, Rs 28 lakh
and Rs 34 lakh respectively in each of the five year.

The relevant discounting rate and tax rate are 14 per cent and
33.99 per cent respectively. Additional depreciation is not
available . Should XYZ Ltd. make the component or buy from
outside ?
 Alternative 1- Make the component
Year Depreciation WDV
Rs Rs
1 1,20,000 6,80,000
2 1,02,000 5,78,000
3 86,700 4,91,300
4 73,695 4,17,605
5 62,641 3,54,964
Computation of short-term capital loss
Rs
Sales consideration 1,00,000
Less :Cost of acquisition 3,54,964
Short term capital loss (-) 2,54,964

Year Manufacturing cost Depreciation Tax saving Cash outflow

from operations
(COFO)
Rs Rs Rs Rs

1 12,00,000 1,20,000 4,48,668 7,51,332

2 14,00,000 1,02,000 5,10,530 8,89,470
3 16,00,000 86,700 5,73,309 10,26,691
4 20,00,000 73,695 7,04,849 12,95,151
5 25,00,000 62,641 8,71,042 16,28,958
 Discounted cash flow analysis o make proposal
Year PVF/A Cash outflow PV
Rs
Investment 0 1 8,00,000 8,00,000
Cash outflow 1 0.877 7,51,332 6,58,918
Cash outflow 2 0.769 8,89,470 6,84,002
Cash outflow 3 0.675 10,26,691 6,93,016
Cash outflow 4 0.592 12,95,151 7,66,729
Cash outflow 5 0.519 16,28,958 8,45,429
Sale of machine 6 0.519 1,00,000 (-)51,900

43,96,194

Alternative 2- Buy the component

Year Purchase cost Tax saving Cash outflow from
operation(COFOP
Rs Rs

1 18,00,000 6,11,820 11,88,180

2 20,00,000 6,79,800 13,20,200
3 22,00,000 7,47,780 14,52,220
4 28,00,000 9,51,720 18,48,280
5 34,00,000 11,55,660 22,44,340
Discounted cash flow analysis of buy proposal
Year PVF/A Cash outflow PV
Rs Rs
Cash outflow 1 0.877 11,88,180 10,42,034
Cash outflow 2 0.769 13,20,200 10,15,234
Cash outflow 3 0.675 14,52,220 9,80,249
Cash outflow 4 0.592 18,48,280 10,94,182
Cash outflow 5 0.519 22,44,340 11,64,812

Decision:-

The above analysis shows that there are considerable savings in making the
component, amounting to Rs 9,00,316 (i.e. Rs 52,96,510-43,96,194). Hence it is
benefited to manufacture the component. More over, XYZ Ltd, will have a short-
term capital loss of Rs 2,54,964 after the end of the fifth year. Assuming that, it
has an equal amount of short- term capital gain also this will result in tax savings
of Rs 86,663 at the current corporate tax rate ( i.e. Rs 2,54,964x33.995).
 Repairs , Replace , Renewal or
Renovation
The main tax consideration which one has to kept in mind is whether
expenditure on repair replace or renewal is deductible as revenue
expenditure under section 30,31 or 37(1) . If the expenditure is
deductible as revenue expenditure under these sections, the cost of
financing such expenditure is reduced to the extent of tax saved. For
instance, if tax rate is 33.66 per cent and a ‘ renewal’ expenditure of
1,00,000 is allowed as deduction under section 30,31, or 37(1) then
effective out of pocket expenditure is Rs 66,340 [ i.e. Rs 1,00,000
minus 33.66 per cent of Rs 1,00,000] . On the hand, if such
expenditure is not allowed as deduction under section 30,31 or 37(1),
then if may be capitalised and on the amount so capitalized
depreciation is available if certain conditions are satisfied .
Case Study :-
XYZ Ltd is considering the purchase of a new machine costing Rs
60,000 with an expected life of 5 years with salvage value of Rs
3,000 in replacement of an old machine purchased 3 years ago for
Rs 30,000 with expected life of 8 years . The present market value of
this old machine is Rs 35,000. because of the purchase of new
machinery, the annual profits before depreciation are expected to
increase by Rs 12,000. The relevant depreciation rate for the
machine is 15 per cent on written down value basis and the tax rate
is 33.99 per cent . Assume the after tax cost of capital (discounting
rate ) to be 14 per cent. Advise the company suitably.
 Assumptions :-
1.It is assumed that the old machine is sold and the new machine is purchased at the
beginning of fourth year of the purchase of old machine
2.There is no other asset in the block
Working note
Computation of the written down value of the old machine(after providing three years
depreciation)

Year Depreciation WDV

Rs Rs
1 4,500 25,500
2 3,825 21,675
3 3,251 18,424

WDV of the old machine ( in the beginning of the fourth year) 18,424
Add: Purchases 60,000
Total 78,424
Less : Sales 35,000
WDV at the beginning of fourth year for old machine ( or first year for new machine ) 43,424
Future years Change in depreciation Change in WDV
Rs Rs
1 25,000x0.15=3,750 21,250
(60,000-35,000) (25,000-3,750)
2 21,250x0.15=3,188 18062
21,250-3,188)
3 18,062x0.15=2,709 15,353
(18,062-2,709)
4 15,353x0.15=2,303 13,050
(15,353-2,303)
5 10,050
Short-term capital loss
(13,050-3,000)

Future years Change in Change in Change in tax Change in cash

profit Depreciation flow
Rs Rs Rs Rs

1 12,000 3,750 2,804 9,196

2 12,000 3,188 2,995 9,005
3 12,000 2,709 3,158 8,842
4 12,000 2,303 3,296 8,704
5 12,000 10,050 662 11,338
 Discounted cash flow analysis of the project
Year PFV/A Cash flow Present Value
Rs. Rs
Net investment 0 1 -25,000 -25,000
Cash inflow from operations 1 0.877 +9,196 +8,065
Cash inflow from operations 2 0.769 +9,005 +6,924
Cash inflow from operations 3 0.675 +8,842 +5,968
Cash inflow from operations 4 0.592 +8,704 +5,152
Cash inflow from operations 5 0.519 +11,338 +5,884
Sale of scarp 6 0.519 +3,000 +1,557

Net present value +8,523

Decision :- Since the net present value on the basis of the above stated
analysis is positive , the old machine should be replaced with the new machine