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Debt fund taxation: Should Interest on Debt be Taxed?

Created on 09 May 2020

Wraps up in 3 Min

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Updated on 29 Aug 2020

Starting a company is no child’s play. A lot of work goes into making a business module into a successful one. It’s like enjoying your dream holiday after a lot of struggle. But one important component which you will need to plan even before you get on with booking hotels, food or place is secure adequate cash. Similarly, every business needs money. And bringing up adequate capital is a whole new story of hardship. The two options which are attractive in the eyes of an entrepreneur are debt and equity. 

Usually, start-ups go for equity-based capital. Though there is no repayment obligation, the person who capitalizes the company has a legal share in it. Thus, he will affect every decision taken thereon. This is the ultimate reason why numerous firms dread this way of raising capital. And the only way to end this is by buying out the shares you sold initially. This can be a troublesome process and can be expensive too. 

Another important and most sorted way of raising capital is by issuing debt or debt instruments. This works like a loan. The lender will not influence the affairs of the company and the relationship between the two comes to an end as soon as the debt is settled. And you have the liberty to use the money in the way you want. Adding to that, you will be liable to pay regular interest whether or not you have enough profits to be distributed. 

As an entrepreneur, the source of your capital and decisions about it are taken based on the accessibility, availability, various ratios, and nature of business models. 

Perks of debt

Debt has been a popular choice of many owing to the tax benefits attached to it. The tax that is charged on the company is deducted from the interest. For instance, say you borrowed Rs.100 as debt and earned a sum of 100 as profit. Further, you are liable to a 10% interest. Further, you will have to pay another 35% as tax. But this is deducted from interest. Hence, instead of Rs.10, you will have to pay just Rs.6.50 as interest for the debt received. This helps the company to offload some of the debt and tax burdens and ultimately focus on using more money on business operations. 

The cost of equity is also high when compared to debt. Further, in some cases, the parent company lends or provides security or guarantee to its subsidiary entity. Ford Motors is a good example of this. Here the companies can negotiate flexible credit terms and tailor their repayment and interest procedures as per their convenience. The parent company receives the benefit of extra revenue in terms of interest. Investments or debts to subsidiary companies are treated as assets in the books of the parent entity. This enables them to use it as collateral for raising further capital. Apart from that better co-operation, increased credit, easy disinvestment are a few other perks of it.

Especially for a troubled company when there are no options to raise capital this might be a good way. Though there were a lot of restrictions placed on raising capital earlier, a lot of them are eased now.  

Let’s swiftly figure out the answer to the most important question. 

Should government tax debt like they do profits? 

The tax deductibles are to increase the corporate investment activities and to divert a big piece towards the development of the corporate world. It boosts economic growth as well. Hence, treating them as profits will only burden the firms and minimize the working capital leading to lesser and lesser expansion, interest rates, and improvement activities.

An Article By -

Deb P Samaddar

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Deb is a keen learner and eager to learn about the finance world. He is that person who would never stop talking, but my oh my, the words he uses, are not something a normal human would in a regular conversation. While the conversations are well, interesting, the write-ups are faultless. With an increased proclivity towards tech and language, he aims to capitalise on his interests as a content writer at Finology.

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