From interest payment deductions to capital gains tax exemptions, this article covers the tax implications of debt and equity financing for businesses in India.
Debt and equity financing are two commonly used methods of financing for businesses. Debt financing involves borrowing money from a lender, while equity financing involves raising funds by issuing shares in the company. Both methods have their advantages and disadvantages, and they also have different tax implications. This article will discuss the tax implication of debt and equity financing in India.
Tax Implications of Debt Financing
Debt financing involves borrowing money from a lender, such as a bank or a financial institution. The borrower has to pay interest on the amount borrowed, and this interest payment is tax-deductible. This means that the borrower can claim a deduction for the interest paid on loan, which reduces the business’s taxable income.
Interest payment on loans taken for business purposes is tax-deductible under Section 36(1)(iii) of the Income Tax Act, 1961. However, certain conditions need to be fulfilled to claim this deduction. For example, the loan should have been taken for business or profession, and the interest should have been paid in the same financial year.
It is important to note that the interest payment on loans taken for personal purposes, such as a home loan or a car loan, is not tax-deductible.
Another important point to remember is that there is a limit on the amount of interest that can be claimed as a deduction. The limit is ₹ 2 lakh for self-occupied property and ₹ 30,000 for loans taken for higher education.
Tax Implications of Equity Financing
Equity financing involves raising funds by issuing shares in the company. When a company issues shares, it receives money from the investors in exchange for ownership in the company. Unlike debt financing, there is no interest payment involved in equity financing. However, there are other tax implications to consider.
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Dividends paid to shareholders are taxable in the hands of the shareholders. Dividend income is taxed at 10% for individuals and Hindu Undivided Families (HUFs) whose total income is above ₹ 10 lakh per annum. For others, the tax rate is 20%. In addition, a surcharge of 12% and a cess of 4% are also applicable.
It is important to note that the company must also pay a dividend distribution tax (DDT) on the dividends declared. The current rate of DDT is 15%. If a company declares a dividend of Rs. 100, it must pay a DDT of ₹ 15, and the shareholder will receive only ₹ 85.
To avoid DDT, some companies may buy back their shares instead of declaring dividends. In a share buyback, the shareholder will receive the buyback price, which is usually higher than the market price, and this amount will be taxed as capital gains.
Capital Gains Tax
When a person sells an asset, such as shares or property, for a profit, the profit is known as a capital gain and is taxable. Capital gains can be short-term or long-term, depending on the asset’s holding period.
In the case of equity financing, if the shares are held for more than 12 months, they are considered long-term capital assets, and the capital gains tax rate is 10% (without indexation). If the shares are held for less than 12 months, they are considered short-term capital assets, and the capital gains tax rate is 15%.
It is important to note that the capital gains tax rate can be reduced by applying indexation. Indexation considers the inflation rate during the holding period and adjusts the acquisition cost accordingly. This reduces the capital gains tax liability.
However, the tax implications are different if the shares are sold on a recognised stock exchange. In the case of the sale of shares on a recognised stock exchange, the long-term capital gains tax is exempt, while the short-term capital gains tax rate is 15%.
Tax Implications of Debt-Equity Mix
Most companies use a combination of debt and equity financing to meet their funding requirements. This is known as the debt-equity mix. The tax implications of this mix depending on the proportion of debt and equity used.
If a company has a high proportion of debt in its capital structure, the interest payment will be high, reducing the company’s taxable income. However, if the company has a high proportion of equity, the dividends paid to the shareholders will be taxable.
To balance the tax implications of debt and equity financing, the government has introduced a concept known as the thin capitalisation rule. Under this rule, the interest paid on excessive debt is not tax-deductible. Excessive debt is defined as debt that exceeds a certain ratio of equity. The current ratio is 2:1, which means that the interest paid on debt that exceeds twice the equity is not tax-deductible.
Conclusion
Debt and equity financing have different tax implications, and businesses need to understand these implications before choosing a method of financing. Debt financing offers tax benefits in the form of interest payment deductions, while equity financing offers tax benefits in the form of exemptions on long-term capital gains.
To make informed decisions, businesses should consult with tax experts and seek professional advice on the tax implications of different financing methods. By doing so, businesses can optimise their financing structure and minimise their tax liabilities.
Vakilsearch can provide expert legal and financial advice to help businesses navigate the tax implications of debt and equity financing in India. Our team of professionals can assist with compliance and optimisation of your financing structure to minimise tax liabilities. Contact us today for personalised solutions.
