Taxation 15

Centre for Management of Technology and Entrepreneurship

Department of Chemical Engineering and Applied

ChemistryUniversity of Toronto

Course: CHE349 File: CHE349/Taxation15

Copyright: Joseph C. Paradi1996-2004

Taxation

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Note that Tax avoidance is NOT the same as tax evasion!

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Corporations and Tax There are essentially two types of corporations, public

and private. There are rigorous definitions of what each of these are, but for our purposes, these will do:

Public companies have shares that have been distributed to the public, have more than 50 shareholders - a subsidiary is also a public company for taxation purposes

Private companies are Canadian resident firms incorporated under Federal or provincial laws, called CCPCs (Canadian Controlled Private Corporations).

There are about 400,000 companies registered in Canada, most of them are private and very small.

There are taxes other than income taxes but we will not deal here with these (GST, excise, PST)

4Course: CHE349


Introduction to Taxation In Canada, both the Federal and Provincial Governments

levy taxes on Corporations. The tax treatment can have a significant impact on a

proposed project. Tax considerations are a vital component of the

investment decision making process. A new investment effects the firm's cash flow both ways,

out for the investment and in from sales or savings. If an investment makes a net profit, it will be taxed. Since taxes reduce the returns from an investment, they

are treated as a form of disbursement. Taxes paid represent a real cost of doing business

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Some Tax Effects Since taxes affect cash flows, it is necessary to perform

economic analysis on an after-tax basis Income taxes affect investment decisions because they

reduce the capital available for investment – they take a portion of the firm’s earnings

First, calculate the effects of taxes before doing any discounted cash flow calculations

Both depreciation (capital cost allowance) and other tax incentives are important

In Canada corporate tax rates are generally 35-60% of net income.

Taxes such as property taxes, employment related taxes, taxes on emission or other production related items are simply treated as expenses

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Corporate Taxation CCPCs enjoy a 21% reduction from the top tax rate for

income not exceeding $150,000 per year up to an aggregate amount of $750,000. There are some other restrictions here also.

Tax losses can be carried forward to offset future earnings, but they are lost after 7 years.

Corporations can re-file tax returns after the fact to create or use tax losses already incurred.

CCA does not have to be taken in any year, so these credits can be held for future years indefinitely.

The tax authorities have a section of the law "General Avoidance Provision" (GAP) which allows them to negate any transaction that was done solely for tax purposes.

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Tax Incentives Accelerated Capital cost Allowances are

sometimes offered by Government when they want to provide companies a reason to invest in productive equipment now, rather than sometime in the future.

Investment tax credit is another way to provide incentive to Canadian companies to make new capital spending plans: acquisition of new buildings and new equipment regional incentive (to locate in low growth areas)

The goods must be acquired for the designated activity and be unused when acquired. The Income Tax Act specifies the rules.

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R&D Tax Incentives The Scientific Research and Experimental

Development SR&ED Program provides tax incentives to Canadian businesses that conduct SR&ED in Canada.

It is intended to encourage businesses - particularly SMEs - to conduct SR&ED that will lead to new, improved, or technologically advanced products or processes.

The SR&ED provides a tax rebate on the average of the last three year’s of eligible R&D expenditures, 20% to a large corporation, more to a small corporation.

Claims are subject to audit by both accountants and technical experts.

The SR&ED rebate must be considered in Engineering Economy because it alters the First Costs incurred in certain projects done by the company (R&D related).

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Taxable Income Calculations Taxable income is basically, all income, less allowable

expenses. Allowable expenses include:

cost of goods manufactured labour costs any operating costs used to earn an income administration costs external experts, consultants etc. (some exceptions) capital cost allowances certain tax credits interest

Non allowable expenses include: club memberships 50% of entertainment costs

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Tax Effects on Financing Interest payments are tax deductible, so the leverage is

on a before tax basis. This concept will effect the way one finances a project:

equity (after tax money) debt (interest is tax deductible) lease rent

There are specific rules that govern leases because there are different types and therefore different accounting and tax treatments

We do not have the time to deal with these in detail But it should be noted that the firm's profit levels may

dictate how things are financed.

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Some Important Issues The calculation of taxable income seems simple but

there are many hidden complexities as we will see laterTaxable income =gross income - eligible deductions/expenses

The purchase of a fixed asset is not an eligible expense at the time of purchase, however, the depreciation of the asset over its useful life is an expense (that is subtracted from gross income when calculating taxable income). However, depreciation is not a cash flow.

A firm may finance projects through equity (owner’s $) or debt financing (e.g., bonds, loans). The interest portion of each payment on the loan is tax deductible (may be subtracted from gross income when calculating taxable income)

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Mechanics of Tax Calculations Taxable income must be determined before any tax

rate can be applied. Taxable Income = Gross Income – Allowable

Deductions Taxes to be paid = taxable income * tax rate

Taxable IncomeInterest

Capital Cost Allowance

(Depreciation)

Operating costs

Allowable Deductions

Gross Income

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MARR - Before and After Tax MARR so far assumed to be Before Tax MARR although

this was not made explicit. So we must set MARR high enough to account for taxes

otherwise, we will make significantly less money. But if we actually account for taxes in the calculations,

then MARR should be adjusted accordingly. Typically, we don't consider taxes because the overall

effect on the firm is usually not known until the final accounting and reporting takes place.

If we do want to adjust MARR, then:MARRAT MARRBT * (1 - t)

Where t is the corporate tax rate (21%, 50%, etc.)

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Depreciation - Tax Treatment As we seen before, Depreciation is the process of

allocating and charging the cost of the usefulness of an asset to the period of time that benefits from its use

It is the conversion of the cost of the asset into expense Companies usually keep 2 sets of books; one for their

own purposes and one for tax purposes, we will concentrate on the latter where depreciation is more related to tax laws than actual deterioration of the asset

Depreciation reduces the before-tax income (although it is NOT a cash flow), it is an expense in a particular period. The cash flow occurs when you initially purchase the asset.

But, depreciation is an important issue because it reduces the cash flow to Government - more is kept.

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An Example The facts in a profitable company:

Tax rate is 40% Investment tax credit (ITC) 30% SR&ED tax credit 20% Company invests an extra $125,000 in eligible investment (for

both ITC and SR&ED) What is the net after tax cost of this extra investment? Notes:

Investment tax credits are “refunds” from the Government on the cost of the investment.

SR&ED credits are based on the total investment. If there were no tax issues and the company just paid tax Tax = $125,000 * 0.40 = $50,000 But now tax = 0.4(125K-(125K*(0.3+0.2))) = 25,000

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More on Taxes and Depreciation There are a couple of basic unfairness in how

Government treats Depreciation for tax purposes: you spend the cash now and they give you relief later, time value

of money is on their side inflation is not allowed anywhere, so you pay more when you

replace the equipment the Government allowed to be written off Since net income is taxed

companies want to depreciate assets as quickly as possible to lower taxable income and defer or lower taxes

Government has the opposite view To limit the depreciation amount that companies use for

tax purposes, the Canadian government establishes a maximum level of capital cost expense (depreciation) which a company can claim each year. This is referred to as the firm’s Capital Cost Allowance (CCA).

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Capital Cost Allowance The CCA specifies the amount and timing of

depreciation that must be used. In Canada, only the Declining Balance method is

allowed for depreciation of fixed assets. Straight-line can be used for a couple of other items (e.g., patents, copyrights).

Assets are grouped in classes by CCA Asset Class and each class has a CCA rate. All assets in a class are grouped together and depreciation expenses are based on the total remaining undepreciated capital cost (UCC) of all assets in that class.

The 50% Rule or ‘Half-year Convention’. For most asset classes, this rule limits the maximum CCA of new assets acquired during the year to 50% of what it would otherwise be.

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More on CCADeclining balance method never depreciates the entire amount unless you dispose of the asset. At that point, all of the remaining amount is written off against taxes that year.

Since equipment of the same type is placed in the asset class (pool) and the class is depreciated as a whole, if you keep buying and disposing of assets you cannot write off the last part until the last piece of the class/pool is disposed of.

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Examples of CCA ClassesDescription Class %

Bridges, Canals, Culverts, Dams 1 4Electrical generating equipment, pipelines 2 6Frame, log, corrugated metal buildings 6 10Canoes, rowboats, small craft 7 15General prop. furniture, fixtures, equipment 8 20Autos, trailers, Computers, terminals 10 30Books, chinaware, software, uniforms, linen 12 100Leasehold improvements 13 formulaDies, tools, instruments cost<$200 22 100Patents, licences, rights 44 25

Remember the rule that you can only depreciate 50% of the First Cost in the first year of acquisition.

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Example of CCA Application A company purchased a $1,000,000 piece of

equipment. The CCA rate for the equipment is 20%. The company’s tax rate is 50%. Note the 1/2 rate in the first year (see text pp319).

Year Base UCC CCA Remaining UCC

Tax Savings due to CCA

1 100,000 10,000 90,000 5,000 2 90,000 18,000 72,000 9,000 3 72,000 14,400 57,600 7,200 4 57,600 11,520 46,080 5,760

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The "Half-Year" rule Purchase:

add only 1/2 of the purchase cost to the asset base UCC (Undepreciated Capital Cost) amount (pool) in the first year of purchase.

After calculating the CCA, add the other half to the base UCC. Disposition:

subtract the full amount received for a disposition of an asset from the base UCC Amount for its class

Purchase and Disposition in the same year First, subtract the total dispositions from the total acquisitions.

If the remainder is positive, treat it as a purchase. If it negative it is a disposition.

Note that if you scrap an asset but there are still items left in the UCC base for that class, the disposition = 0

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Recaptured Depreciation This is not only a tax issue, of course. When

depreciable assets are sold, there can be a gain, loss or break even on the transaction.

Loss on sale - sold it for less than Book Value Gain on Sale - sold for more than Book Value No gain or loss - sold for Book Value Capital Gain - sold for more than First Cost (this is not

a common occurrence, except in real estate, antiques and collectibles). But this may arise from investments in market securities where the cost may well be much lower than the sales price.

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Depletion Allowance The tax rules recognise that certain businesses

engaged in the non-renewable natural resources sector actually use up their reserves of minerals, oil, gas etc.

There is a depletion allowance against the costs incurred for exploration and development.

There is also a principle here of the asset depreciating because the reserves are depleted by selling them.

As these rules are very complex and are subject to change regularly, we do not have the time to go into details here, so engage experts when needed.

Unfortunately, tax planning in many cases determine what companies do, rather than market sources.

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Depletion Allowance Example B.C. Forest Products negotiated the rights to cut timber on a

privately held forest for $700,000. It was estimated that 350 million board feet (MBF) of lumber can be harvested. (a) Determine the Depletion amount (depreciation) after 2 years of cutting

is the first year they cut 15 million board feet and the second year 22 million

Depletion rate/MBF = $700,000 / 350 = $2,000 / MBF Total Depletion = 15 * 2,000 + 22 * 2,000 = $74,000 (b) But after the two years, they reestimated the total recoverable board

feet of lumber and decided that they can really get 450 MBF from the time they started cutting. Calculate the cost of depletion per MBF for year 3 and onward.

New Depletion rate = (700,000 - 74,000) / (450 - 37) = 626,000 / 413 = $1,516

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Capital Cost Tax Factor (CCTF) The complexities of our tax laws requires some careful

work on depreciation when tax returns are filed We can simplify the calculation by using the CCTF. It is

a value that summarizes the effect of the future benefit of tax savings due to CCA and allows us to take these benefits into account when calculating the PW of an asset.

This is the same principle as the other factors used in Engineering Economy, just a nice short-cut.

Care is required when using the CCTF because there are differences in timing due to the "Half-Year" rule.

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Capital Cost Tax Factor Definitions

1

121

( )(1 )

old

new

tdCCTFi d

itdCCTF

i d i

Where:t = taxation rated = CCA ratei = after-tax interest rate

This formula is used for capital asset purchases before November 13, 1981.

This formula is used for capital asset purchases after November 13, 1981.

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Example 8.4 from Text Automobile purchased by a Lestev Corp for $25,000. CCA

rate = 30%, corporate tax rate 43%, after tax MARR = 12%. What is the PW of the first cost of the auto, taking into account the future tax benefits of depreciation?

Auto purchased this year, therefore CCTFnew applies.CCTFnew=1-(0.43)(0.3)(1+0.06)/[(0.12+0.3)(1+0.12)] = 0.709311

The PW of the first cost is:PW = 0.709311($25,000) = $17,733

The tax benefit due to claiming CCA has effectively reduced the cost of the car from $25,000 to $17,733 in terms of PW.

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Tax Calculations Evaluating the economic impact of purchasing a

depreciable asset has three tax associated components: Impact of taxes on the first cost (PW of tax savings essentially

reduces the first cost of the investment since making the investment and depreciating it over time brings tax benefits)

Tax implications of the savings or additional expenses brought about by the asset during its useful life

When an asset is disposed of, you can no longer take advantages of CCA and must terminate the stream of tax savings resulting from depreciating the asset

Although it seems strange that the FC is reduced by tax calculation, it should be kept in mind that these savings are not the only cash flows to be considered.

The profits generated from the investment will be considered as income and we will pay tax on it.

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Components of a Complete PW Tax Calculation First Costs - multiply it with the CCTFNEW to find the after

tax cost. Savings or Expenses - reduce these by the tax rate by

multiplying them by (1 - t ). Note that there is an assumption the company is profitable and the Company is paying taxes on all of the savings.

Salvage Value we apply the OLD CCTF to remove the entire amount in the year of disposal (assuming we did not buy some in that year).

While the tax law says that you need to net purchases and sales, we will treat the two separate transactions individually.

Significant tax advantages are available if planned well.

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Another Example Water bottling company has purchased an automated

bottle capper. SV = $2,000, tax rate = 50%, after-tax MARR = 12%, CCA rate = 20%

What is the after-tax PW of the machine if it costs $10,000 and saves $4,000/year over its 5 year life?

PWFC = -$10,000(CCTFnew). Using the formula, we get CCTFnew = 0.70424 or PWFC = -$7,042

Annual savings are taxed at 50%, so PW of savings is PWAS(ann. Savings) = $4,000(P/A,12%,5)(1-t) = $7,209

Salvage value reduces the UCC and lessens the tax benefit from the original purchase. The after tax benefits are found by applying the CCTFold.

PWSV(salvage value) = $2000(P/F,12%,5)CCTFold=$780 PW(after taxes)=PWFC+PWAS+PWSV = $947

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Effects on the Situation The method of depreciation does not affect the number

of tax dollars paid, but significantly affects the present worth of the taxes paid and the after-tax cash flows

Equity funding uses the owner’s after tax funds. Debt funding uses borrowed money (e.g., bonds) Common method of repaying money is to pay back the

principal plus interest in equal payments. For tax purposes, it is important to know how much of each payment is interest and how much paid to the principal.

Interest on borrowed money is tax deductible (reduce taxable income), whereas the payments on the principal are not. This concept will affect the way a company finances projects.

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After Tax IRR Tax can effect IRR calculations also:

IRRafter-tax = IRRbefore-tax (1 - t) Where: t: income tax rate

An after-tax rate-of-return resulting from a before-tax IRR of 15% and an income tax rate of 35% would be 9.75%

IRRafter-tax= (0.15)(1-0.35) = 0.0975 After-tax Comparison of Proposals can be made using any of the

comparison methods PW, AW, IRR

Determine the tax effects on cash flows. Computational procedures and interpretation of results are the

same as before.

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Taxation 15