Taxation 15

Department of Chemical Engineering
and Applied Chemistry

University of Toronto
Course: CHE349
File: CHE349/Taxation15
Copyright: Joseph C. Paradi
1996-2004
Centre for Management of Technology and Entrepreneurship
Taxation
#
Course: CHE349 Centre for Management of Technology and Entrepreneurship
1
Note that Tax avoidance is NOT the same as tax evasion!
#
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)
#
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
#
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
firms 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
#
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.
#
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.
#
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 years 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).
#
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.
#
Some Important Issues
The calculation of taxable income seems simple but there are
many hidden complexities as we will see later
Taxable 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 (owners $) 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)
#
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 Income
Interest
Capital Cost
Allowance
(Depreciation)
Operating costs
Allowable
Deductions
Gross
Income
#
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:
MARR
AT
~ MARR
BT
* (1 - t)
Where t is the corporate tax rate (21%, 50%, etc.)
#
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 firms Capital
Cost Allowance (CCA).
#
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.
#
More on CCA
Declining 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.
0
100
200
300
400
500
600
700
800
900
1000
0 1 2 3 4 5 6 7 8 9 10
50%
25%
10%
5%
#
Examples of CCA Classes
Description Class %

Bridges, Canals, Culverts, Dams 1 4
Electrical generating equipment, pipelines 2 6
Frame, log, corrugated metal buildings 6 10
Canoes, rowboats, small craft 7 15
General prop. furniture, fixtures, equipment 8 20
Autos, trailers, Computers, terminals 10 30
Books, chinaware, software, uniforms, linen 12 100
Leasehold improvements 13 formula
Dies, tools, instruments cost<$200 22 100
Patents, licences, rights 44 25
Remember the rule that you can only depreciate 50% of the First Cost in the
first year of acquisition.
#
Example of CCA Application
A company purchased a $1,000,000 piece of equipment.
The CCA rate for the equipment is 20%.
The companys 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 t o 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
#
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
#
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.
#
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.
#
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.
#
Capital Cost Tax Factor
Definitions
1
1
2
1
( )(1 )
old
new
td
CCTF
i d
i
td
CCTF
i d i
=
+
| |
+
|
\ .
=
+ +
Where:
t = taxation rate
d = CCA rate
i = 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.
#
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 CCTF
new
applies.
CCTF
new
=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.
#
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.
#
Components of a Complete PW
Tax Calculation
First Costs - multiply it with the CCTF
NEW
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.
#
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?
PW
FC
= -$10,000(CCTF
new
). Using the formula, we get
CCTF
new
= 0.70424 or PW
FC
= -$7,042
Annual savings are taxed at 50%, so PW of savings is
PW
AS
(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 CCTF
old
.
PW
SV
(salvage value) = $2000(P/F,12%,5)CCTF
old
=$780
PW(after taxes)=PW
FC
+PW
AS
+PW
SV
= $947
#
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 owners 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.
#
After Tax IRR
Tax can effect IRR calculations also:
IRR
after-tax
= IRR
before-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%
IRR
after-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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