DEPRECIATION AND INCOME TAX

Transcription

1 Dr. Hassan, Y DEPRECIATIO AD ICOME TAX General Depreciation is a decrease in worth Production equipment gradually becomes less valuable though wear Instead of charging the full purchase price of a new asset as a one-time expense, the outlay is spread over the life of the asset Depreciation charges are not actual cash flows True decrease in market value may not correspond to allowable deductions Purpose of Depreciation Accounting: Recover capital invested in production assets Calculate realistic cost of production Calculate realistic operating expenses Causes of Declining Value: Physical Depreciation Functional Depreciation Technological Depreciation Depletion of resources Monetary Depreciation Canadian Vocabulary of Depreciation Accounting: According to Revenue Canada, corporations and individuals engaged in professional activities can claim depreciation on assets that are used in earning income Business calculate depreciation for reporting the state of finances to their shareholders and for submitting income tax to Revenue Canada Businesses are allowed to deduct part of the capital cost of specified depreciable property from income earned during the year This depreciation deduction is called capital cost allowance (CCA) CCA is applied to the undepreciated capital cost (UCC) The PW of the sum of tax savings due to CCA is called CCA Tax Shield Depreciation Methods: Symbols used: P = purchase price of asset

2 Dr. Hassan, Y S = salvage value = useful life of asset n = number of years of use DC = annual charge for depreciation BV = book value on accounting records Straight line method: DC = P S = constant n BV( n) = P ( P S) P = $7,000 = 5 years n = 3 years S = $1,000 BV(3) =? BV P S 0 Declining Balance Method: BV(n) = P * (1 Depreciation rate) n DC(n) = BV(n 1) * (Depreciation rate) For the previous example (P = $7,000, S = $1,000, n = 3, = 5) find the book value after 3 years given a depreciation rate of 40% Another form for the declining balance method is: R DC( n) = [ BV( n 1)] R may be determined by the analyst based on a positive salvage value as: S R = 1 P 1/ If R > 1, the declining balance method will produced higher depreciation charge than the straight-line (SL) in the first year The depreciation charge will decrease every year as the book value of the previous year decreases A more common approach for the depreciation rate is to be independent of the salvage value The double-declining-balance (DDB) method results when the depreciation rate = 2/ An accelerated depreciation can be achieved by switching from DDB to SL in the late years of the asset s life

3 Dr. Hassan, Y An asset has P = $7,000, S = 0, and = 5. Determine an accelerated depreciation schedule in which BV(5)=0 Capital Cost Allowance (CAA): Used to calculate tax-deductible depreciation expenses for income tax purposes Based on straight line and declining-balance methods Various rates determined by government for various classes of assets (Tables 9.2 and 9.3) CCA rates are different from rates used for accounting purposes: UCC(m) BV(m) UCC(m) = undepreciated capital cost at end of year m BV(m) = book value at end of year m CAA rates are applied to the undepreciated capital cost (UCC) of all assets in a certain class Available for Use Rule An individual or business cannot claim the depreciation expense until the property is ready for use Half-Year Rule Modification in the Canadian tax regulations Effective on ovember 12, 1981 Objective is to prevent individuals or businesses who could purchase a property before their year-end from receiving a full year depreciation expense Regardless of when the asset was put in service, the corporation gets only one-half of the normally allowable depreciation Purchase price of equipment = $700 million, CCA rate = 20%. Find the depreciation for years 1 to 3 and book value at the end of year 3. UCC Calculations: Property is assigned the proper class number UCC at beginning of year is entered Add capital cost of new assets purchased during the year Make the necessary adjustments that increase or decrease the total capital cost Subtract proceeds from assets disposed of during the year ( 0). If the business disposed of property for more than its capital cost, use the capital cost only and the excess is treated as capital gain Apply CCA rate to calculate allowable CCA for tax purposes

4 4 Subtract CCA from UCC(1) to calculate UCC(2) for next year A small engineering consulting office is planning to purchase a new computer workstation for computer-aided design. The cost of the workstation is $6,800. This equipment is Class 10 CCA (declining balance CCA rate = 30%). The company already has $20,000 in Class 10 depreciable property at the beginning of the year. Find the maximum CCA for this firm s Class 10 depreciable property for this year. Tax Concepts: Types of Taxes: 1. Property Taxes: - Charged by local governments on land, buildings, machinery, equipment, and inventory - Function of the appraised asset value and tax rate - ot a significant factor in engineering economics studies 2. Excise Taxes - Imposed on the production of certain products such as alcohol and tobacco - Rarely affect economic comparisons 3. Income Taxes: - Levied on individuals and corporations at higher rates for higher income - They have significant influence on acceptability of various proposals Changing Taxes: Government fiscal policy vs. inflation Methods for altering government receipts - Changing tax rates - Changing CCA requirements - Allowing tax credits Corporate Income Tax: Taxable income = gross income expenses interest on debit CCA Income tax = taxable income * effective tax rate Effective income tax rate = federal tax rate + provincial rate Interest: - Interest paid: deductible - Interest received: taxable

5 Dr. Hassan, Y Small businesses: - Much lower effective tax rates Capital gain/ losses: - Assets can appreciate or depreciate - Capital gain is taxable - Capital loss is deductible Corporate Loss Carryback / Forward: - on capital losses can be carried back to the previous 3 years and/or forwarded to the next 7 years After Tax Economic Comparisons: A tabular approach for modifying the before-tax cash flow to show the effect of tax Assume tax paid at the end of each year end of year UCC account % Income Tax 50% (P/F, 10%, n) PW of tax credit Future years Capital Cost Tax Factor (CCTF) It is the after-tax present value of one dollar investment Consider a depreciable asset (declining balance): - t = tax rate

6 Dr. Hassan, Y d = CCA rate - i = discount rate CCA tax saving (n) = UCC(n 1) * d * t UCC(0) = 1 CCA tax saving (1) = d * t UCC(1) = (1 d) CCA tax saving (2) = (1 d) d * t UCC(2) = (1 d) 2 CCA tax saving (3) = (1 d) 2 d * t.. UCC( 1)=(1 d) -1 CCA tax saving ()=(1 d) d * t 1 1 d CCA tax shield = t d + 1+ i (1+ i) At : CCA tax shield = [(t d)/(i + d)] CCTF = 1 [(t d)/(i + d)] 2 (1 d) (1+ i) (o salvage value) CCTF Value for Depreciable Assets (Declining Balance) Bought before ovember 13, 1981: CCTF = 1 [(t d)/(i + d)] Bought after ovember 13, 1981: - Half-year rule applies CCTF = 1 [(t d)/(i + d)] [(1+0.5 i)/(1 + i)] CCTF Value for Depreciable Assets (Straight-Line) According to Revenue Canada regulations, a number of assets are classified as straight-line class If the half-year rule is not applicable: - Depreciation pattern is: Year: 1 2 k Depreciation: d d d - Years required for full depreciation = k = (100%)/(d%) (rounded to higher number) CCA tax shield = t d (P/A, i, k) CCTF = 1 [t d (P/A, i, k)] If the half-year rule is applicable: - Depreciation pattern is: Year: 1 2 k Depreciation: d/2 d d/2 1

7 Dr. Hassan, Y Years required for full depreciation = k = (100%)/(d%) + 1 (rounded to lower number) CCA tax shield = t (0.5) d [1/(1+i) + 2/(1+i) 2 + k/(1+i) k ] Disposable Tax Effect: The selling price of the asset at the end of its service life is not necessarily dependent on the original purchasing price or the UCC Disposable tax effect at the end of the service life can be calculated as: S > P : - Capital gain tax and CCA recapture apply - Disposable tax effect = (S P) * capital gains tax + (P UCC) * t S < P, S > UCC: - Only CCA recapture applies - Disposable tax effect = (S UCC) * t S < UCC: - Tax shield adjustment applies - Tax shield adjustment = (UCC S) * (tax shield) A new testing machine will be purchased at $45,000 in early The required rate of return is 12% after tax. Useful life of the machine is 5 years with no salvage value. Savings in annual maintenance = $23,000 Operating Costs = $7,300 /yr The machine is in class 8 (20% CCA rate) Effective income tax rate = 42% In the previous, if the machine has a salvage value of $5,000 at the end of its life. What is PW (after tax)? Let the machine in the previous example be in Class 29 (straight-line method). What is PW (After Tax) if the depreciation rate is 50% (S = 0)? A company is considering the purchase of Class 8 (CCA rate = 20%) equipment in 1995 for $30,000. The revenue is estimated to be $15,000/year for 5 years. Expected salvage value is $2,500. Maintenance cost is $1,400 for the first year and is to increase by $200/year. The effective tax rate is 40% and the MARR is 10% (after tax). Find the PW of the investment.