Tax planning & managerial decisions

                                      UNIT  -  5

 Tax planning with reference to specific managerial  decisions -     Own/ lease, Make or buy decisions, shut down / continue,


1)   Tax planning in respect of own or lease :   

    A lease of property is a transfer of the right to enjoy the such property, made at a certain time, in consideration of a price payable periodically to the transferor by the transferee.
      In other words, leasing is an arrangement that provides a person with use & control over an asset, for a price payable periodically, without having a title of ownership. In the case of a lease agreement, the owner of the asset is called the lessor & the user is called the lessee.
       When a person needs an asset for his business purpose, he has to decide whether the asset should be purchased/taken on lease. While taking this decision he should keep in mind the following factors :

1. Cash position
2. Depreciation
3. Obsolescence risk
4. Residual value
5. Profit margin
6. Consider PAT

1.  Cash Position  :   

(a) When a person has sufficient cash / he can borrow funds at a reasonable rate of interest to purchase an asset / can acquire the asset, under hire purchase/installment system, he may decide to buy it.

(b) The cost of own asset is not deductible in computing the income, but the interest on borrowed funds/under-hire purchase/installment system is deductible in computing income.

(c) If he neither has sufficient cash nor he can borrow due to stringent(strict) credit control, he has to take the asset on lease.

(d) The lease rent is deductible in computing the income.

2. Depreciation : 
(a)  When the asset is purchased/acquired under the hire purchased/acquired hire purchase/installment system, the depreciation is allowed in computing income.

(b) When the asset is taken on lease the depreciation is not allowed to the lessee, because he is not the owner of the asset, but it is allowed to the lessor. Non- availability of depreciation to the lessee will increase his tax liability. 
          If the asset is such on which depreciation is not allowed, for example, land, the increase/ decrease in the value of the asset in the future must be considered. If the asset is such that an increase in value is expected, it may be purchased otherwise it may be taken on lease.

3. Obsolescence risk:   When a plant or machinery is purchased & becomes obsolete earlier than its expected working life, it has to be replaced. The replacement cost can be met partly out of depreciation fund & partly by arranging further cash.
             In the case of a lease, the asset will be replaced by the lessor. However, the lessor will also keep in mind the risk of obsolescence & increase the lease rent to offset such a loss.

4. Residual value:    When a person purchases an asset, he has full rights to the value of the asset at the end of any given period. In the case of an asset with a larger residual value, it is better to purchase it rather than take it on lease.

5. Profit  margin : 

(a)  When the profit margin is low, it is better to purchase the asset. If the asset has been purchased by borrowed funds the cash outflow would be equal to loan installment, interest payment& slightly higher tax.

(b)  In the case of leasing the lease rent would be equal to part of the cost of the asset to the lessor, interest on investment & profit to the lessor.

(c)  The cash outflow will be equal to lease rent less nominal tax saving.

(d)  In the case of a lease, the profit of the lessor will be the loss to the lessee.

6. Consider profit after tax  : 

(a) It is an important consideration in tax planning.
(b) The assessee should follow such a method for obtaining an asset that reduces his tax liability & the profits after tax are greater.
(c) For this purpose some people suggest that own funds should not be used in the purchase of an asset because interest on own funds is not deductible in computing the income.
(d) Whereas, interest on borrowed funds is deductible.

Advantages of acquiring capital assets on lease:

1. Alternative Use of Funds:

A lease agreement makes available an asset to use without making any huge investments. The firm is obliged to make periodic rental payments only. Thus, the firm may make alternative use of the funds saved due to the lease agreement.

2. Beneficial for Small Firms:

As small firms do suffer from a paucity of funds, they can acquire assets on a lease agreement. Thus, leasing becomes a boon especially for small firms to use the most required and costly assets and, thus immensely benefited.

3. Flexibility and Convenience: The lease agreement can be tailor-made with respect to the lease period and lease rentals according to the convenience and requirements of all lessees.

4. Free from Restrictive Covenants:

While lending financial institutions impose several restrictive covenants on the borrowers like management, debt-equity norms, dividend declaration, etc. But, there are no such restrictions while financing through a lease agreement. That is the way a lease agreement arranges cheaper and faster credit to the borrower, i.e. lessee.

5. Tax Shielding:

When a tax-paying lessor enters into a lease agreement, he generally passes a part of the tax benefit to the lessee also by charging lower rental rates. As a result of this, the real cost of the assets to the lessee works out to be lower than what it would have been if he were the owner of the asset.

6. Improvement in Liquidity: Leasing enables the lessee to improve their liquidity position by adopting the sale and leaseback technique.

   Theoretically, thus, leasing has been accepted as a better alternative to financing business operations because of the benefits it offers to the parties involved in the transaction.

Disadvantages:

However, leasing is not an unmixed blessing also. That is, leasing suffers from some disadvantages also.

Some of the important disadvantages of leasing agreements are listed as follows:

1. Leasing deprives of ownership of the asset.

2. In the case of default in the payments of lease rents, the leased assets are deprived, thus, causing a great inconvenience to the lessee.

3. No protection is allowed against the lessee against the supplier’s warranties. In other words, the lessee is not entitled to any protection in case the supplier of the leased asset commits a breach of warranties.

Conclusion:  As far as possible the asset should be purchased & not taken on a lease because the cost of use of the purchase is less than the cost of lease rent.

     However, where the assessee is suffering from a liquidity crunch & cannot invest in an asset nor can avail substantial credit from the suppliers/money lenders, he should take an asset on lease.