CPA Mock Evaluation Tax Elective Module Page 1

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1 CPA Mock Evaluation Tax Elective Module Page 1 ELECTIVE (TAXATION)- Elective examinations will be 3 hours in length. Candidates will be given 4 hours to complete the examination, providing an extra hour to formulate their responses. The intention is to reduce the time constraint. The examinations will be made up of a mix of objective-format and medium to large -sized, moderately complex cases. The split and length may vary across the Electives to adapt to learning outcomes required. Elective examinations will use larger and more complex cases than those used for Core 1 and Core 2, requiring a minimum of 60 and a maximum of 120 minutes to complete. The assessment of professional skill will continue in a multi-competency environment, always building on prior learnings but greater than 50% of assessment opportunities will be related to the Elective area being examined. Elective cases will require candidates to simulate the roles they will play in real life, and therefore access will be provided to the reference tools they would use, where practical to do so. The Board of Examiners will use preloaded forms like tax returns, and provide access to the Tax Act and other tax information, etc. for questions where possible in the Taxation Elective. MANDRAKE CONSTRUCTION LTD. Suggested time: 80 minutes (represents the time judged necessary to complete the question) (HITS COMPETENCIES IN TAXATION and FINANCE) It is September 17, 2015, and you, CPA, have just completed a meeting with Robert and Wendy Mandrake, the owners of Mandrake Construction Ltd. (MCL) and its sister company, Rena Holdings Ltd. (RHL). MCL was incorporated in 1992 by Robert and Wendy and has been financially successful over the years. RHL was incorporated in 2000 to own the property from which MCL operates. Now in their mid-fifties, the Mandrakes are considering retirement and have approached your firm, Partner & Partner, for advice. Extracts from MCL s financial statements for the past three years are included in Appendix I. You have compiled information from your files concerning MCL and RHL (see Appendix II). The Mandrakes have two children, Ben (34 years old) and Elaine (29 years old). Ben is a schoolteacher. He is not currently involved in the business and is not interested in any future involvement. Elaine has become progressively more involved with the operations of MCL since she completed her university degree in a commerce program five years ago. Robert and Wendy have decided the time has come to pass control of the company to the next generation and are transferring their ownership of the business to Elaine. Although Robert is willing to allow Elaine to run the day-to-day operations, he is concerned that she may find herself in over her head, and he would like to be able to take control if the need arises. He views such an arrangement as being especially crucial as the value of their business is the main component of the Mandrakes net worth. Robert estimates their retirement plans will call for annual cash needs before taxes of $100,000 per year. They have provided you with a listing of their other assets in Appendix III.

2 CPA Mock Evaluation Tax Elective Module Page 2 As Robert and Wendy have thought about transferring the business to Elaine, they have realized that they need to consider how all of their assets will ultimately be distributed to their children. It is their intention that each child will receive an equal share of their assets Elaine would receive the business and Ben would receive the other assets. Robert and Wendy recognize that Elaine has made a real contribution to the growth of the business in the past three years. As a result, they wish to transfer the company at a discounted price, effectively giving her half of the growth in the value of the business between July 2012 and June 30, The family has already agreed that the value of MCL as at June 30, 2012, was $3.1 million. As any future growth in value from June 30, 2015, will be entirely the result of Elaine s efforts, the Mandrakes are comfortable with her benefiting from such increases in value. A valuation was also completed for RHL. As at June 30, 2013, the value of RHL was $2.2 million. The family has agreed that this value has not changed significantly since that time. On your return to the office, Jake Partner, the partner in charge of the Mandrake engagement, asks you to prepare a preliminary recommendation on how the Mandrake s assets can be equally split between their children according to their wishes. He reminds you that where choices exist, the Mandrakes would prefer the alternative that minimizes their costs, and especially their taxes. Finally, if you encounter any other concerns with the corporate or personal tax situation of the Mandrakes and their corporations, Jake has asked you to address those as well.

3 CPA Mock Evaluation Tax Elective Module Page 3 APPENDIX I MANDRAKE CONSTRUCTION LTD EXTRACTS FROM UNAUDITED BALANCE SHEET as at June 30 (in thousands of dollars) Assets Cash $ 10 $ 5 $ 7 Accounts receivable 1,679 1,672 1,664 Due from RHL 1,682 1,788 1,882 Capital assets 3,127 2,953 2,741 $ 6,498 $ 6,418 $ 6,294 Liabilities Accounts payable $ 1,480 $ 1,446 $ 1,420 Bank debt 1,000 1,150 1,400 Bonuses payable Shareholders loans 972 1,271 1,510 4,404 4,740 5,039 Shareholders equity Share capital Retained earnings 2,092 1,676 1,253 2,094 1,678 1,255 $ 6,498 $ 6,418 $ 6,294

4 CPA Mock Evaluation Tax Elective Module Page 4 APPENDIX I (continued) MANDRAKE CONSTRUCTION LTD EXTRACTS FROM UNAUDITED INCOME STATEMENT for the years ended June 30 (in thousands of dollars) Revenue $ 17,275 $ 16,875 $ 16,450 Cost of goods sold 14,335 14,012 13,684 Gross profit 2,940 2,863 2,766 Administrative and office expenses Office expenses Office salaries Rent Amortization Management remuneration ,449 2,364 2,241 Income before income taxes Income taxes Net income $ 416 $ 423 $ 435

5 CPA Mock Evaluation Tax Elective Module Page 5 APPENDIX II NOTES ON FINANCIAL INFORMATION 1. MCL and RHL record amortization of capital assets in an amount equal to the maximum capital cost allowance claims available for income tax purposes. Therefore, for income tax purposes, the net book value of non-depreciable assets on the financial statements is equal to their adjusted cost base, and the net book value of depreciable assets is equal to the undepreciated capital cost. 2. MCL has considerable long-term debt as well as a line of credit that fluctuates throughout the year with the seasonality of the construction business. The line of credit bears interest at a rate of prime plus 1.5% and is secured by a floating charge on receivables and capital assets. The prime rate is currently 3.5%. Most of the capital assets are pledged as security for the longer-term loans. Several years ago, the bankers requested personal guarantees from Robert and Wendy. To avoid this requirement, the line of credit was guaranteed by RHL, a guarantee that still exists. The potential transfer of ownership to Elaine has been discussed with the company s bankers. The bank is willing to maintain the terms of its existing line of credit agreement with MCL. The bank is not willing to accept a personal guarantee from Elaine as collateral because she has a substantial mortgage and few assets. 3. Elaine is anxious to expand MCL s line of credit to take advantage of greater opportunities in construction. She has requested a $1 million increase in the limit on the present line of credit. The bank has stated that such an increase in the line of credit would require a debt-to-equity ratio that does not exceed 1.5 to 1. The bank is willing to consider advances from shareholders to be equity provided that the advances are subordinated to the bank s claim. 4. Bonuses are reflected on the income statement as Management Remuneration. Historically, the bonuses have been paid in the ratio of 75% to Robert and 25% to Wendy. Since fiscal 2012, Robert has allocated a portion of the year-end bonuses from MCL to Elaine in recognition of her efforts in managing the business. In 2013, her total remuneration was $100,000, rising to $150,000 in Until 2009, Robert had two full-time managers, each of whom was paid $5,000 monthly, plus a bonus equal to 10% of income after controllable overhead expenses. When one manager died suddenly and the second left the company to go into business on his own, Robert, who had been in semi-retirement, returned to manage the business full-time until Elaine graduated in While Robert believes equivalent managers could have been found on the same terms, he did not wish to hire short-term management since Elaine had expressed an interest in taking over the family business.

6 CPA Mock Evaluation Tax Elective Module Page 6 APPENDIX II (continued) NOTES ON FINANCIAL INFORMATION 5. MCL originally issued 100,000 common shares for $0.01 per share, 75,000 owned by Robert and 25,000 by Wendy. In December 2011, Robert and Wendy exchanged all their common shares for 100,000 new preferred shares having a redemption value of $31 per share, which may be redeemed on demand by the holder. These shares bear no dividends. Robert and Wendy subscribed for 30 and 10 common shares respectively, at a price of $25 per share. The valuation of MCL, prepared by your firm, was based on a discount rate of 20%, determined as the prime rate (then 7%) plus a 13% premium for the risk of the investment. 6. MCL was sued in 2014 by a rival construction firm. The suit was eventually dismissed, but in 2014 MCL incurred approximately $20,000 in legal fees over and above the costs that the rival was required to pay. This is the only major legal action ever brought against MCL. 7. Rent is paid by MCL to RHL, which owns the building from which the business operates. The fair market value rent would be $18,000 per month on an arm s-length basis. 8. MCL has generally had a good history of collecting its receivables, as it performs work primarily for large institutions and various levels of government. As a result MCL has few, if any, bad debts. In May 2013, one of its customers went into receivership while owing $200,000 to MCL. It was anticipated that the creditors would recover 76 cents on the dollar, and an allowance for $48,000 was recorded on the 2013 financial statements. The creditors eventually recovered 82 cents on the dollar, and a recovery of $12,000 was recorded on the 2014 financial statements. 9. The combined (federal and provincial) effective tax rate for the Mandrakes is approximately 50%. 10. RHL has 100 issued shares, with a paid-up capital value of $10 per share, 75 to Robert and 25 to Wendy. 11. In 2011, RHL completed repayment of the mortgage obtained to construct the building. Excess cash that has accumulated in the company has been used to invest in shares of blue chip corporations. These shares have an aggregate cost of $265,000 at June 30, 2015, but are trading at a value of $345, Neither Robert nor Wendy has used their lifetime capital gains deduction at all.

7 CPA Mock Evaluation Tax Elective Module Page 7 APPENDIX III ROBERT AND WENDY MANDRAKE LIST OF PERSONAL ASSETS (Prepared by Wendy Mandrake) as at September 15, 2015 Personal residence (Note 1) $ 450,000 Rental property (Note 2) $ 575,000 Cash and term deposits (Note 3) $ 50,000 RRSPs - Robert (Note 4) $ 225,000 RRSPs - Wendy (Note 4) $ 250,000 Yacht (Note 5) $ 95,000 Antiques (Note 6) $ 230,000 Life insurance (Note 7) $??? Debts: Nil Notes: 1. Registered in our joint names (as all our residences have been); cost $250,000 in Registered in our joint names. Purchased for $350,000 in We lived in the house until the end of Converted to rental use when we bought the new house. (Your files show the property was appraised at $300,000 at that time, and that an election was filed to avoid any deemed disposition on conversion to rental usage. No CCA has been claimed on the property since.) 3. Currently earning an average of 3½%. Owned equally by each of us. 4. Over the years, Rob and I have each contributed (and deducted) $125,000 to our RRSPs, but my investments have done a bit better. 5. Cost $225,000 in 2008 I told Rob that boat would be a money pit! 6. My collection of antique watches and clocks has a total cost of $195,000. My hobby actually makes a profit unlike some people s I could mention! 7. I wasn t sure which value to use both Robert and I have a $50,000 whole life policy. The cash surrender value on each policy is currently $5,000.

8 CPA Mock Evaluation Tax Elective Module Page 8 MARKING GUIDE MANDRAKE For the Elective, candidates are expected to assume the role of someone working in a Taxation role. In this particular case, candidates would be expected to draw upon their prior knowledge in Finance (restricted to a Core level since not identified within Tax Elective competencies), and the Elective level Taxation competencies in responding to the required in a competent fashion. REPORT TO ROBERT AND WENDY MANDRAKE Assessment Opportunity #1 The candidate assesses the estate planning opportunities The candidate demonstrates competence in Taxation CPA Competency Map: Analyzes estate-planning opportunities for individuals (Core Level C; moves to Level B in taxation elective) Introduction As requested, we have prepared our preliminary recommendations on how your assets could be equally split between your two children, Ben and Elaine. Where choices exist, we have selected the distribution alternative that results in the lowest overall tax cost. In arriving at our preliminary recommendations we have followed your specific wishes, which we understand are as follows: You must have sufficient cash available to finance your retirement plans. You estimated that your annual cash needs before taxes will be $100,000. As partial remuneration for Elaine s efforts since joining MCL in July 2012, one-half of the growth over that time in MCL s fair market value (FMV) should be gifted to her. Elaine alone will receive the benefits of any growth in the FMV of MCL after June 30, Ben and Elaine will each receive one-half of the FMV of your estate after all income taxes are paid and after Elaine receives her gift.

9 CPA Mock Evaluation Tax Elective Module Page 9 Overall recommendation We have estimated the current FMV of MCL since a figure was not supplied to us. Otherwise, our preliminary recommendation is based on the FMV of your assets that you provided to us. The FMV for each of the assets currently held, and the specific assets that you ultimately hold at your time of death, will likely change. As a result, you should review the specific asset split periodically. Our preliminary recommendations on how to distribute your assets to Ben and Elaine are as follows: Elaine Ben Personal residence $ $ 450,000 Rental property 575,000 Yacht 95,000 Antiques 230,000 Shares of RHL 2,200,000 Estate taxes - cash shortfall (see Appendix III) (339,000) (339,000) Shares of MCL (4,810 less 645 given to her) 4,165,000 Shareholder loans in MCL, less marketable securities (to balance) 16, ,000 $ 3,842,000 $ 3,842,000 The primary difficulty in determining a potential asset split is that the FMV of MCL constitutes more than one-half of the value of your total estate. As a result, Elaine will somehow have to compensate Ben for this difference. At this point, we have compensated Ben for this difference by allocating to him a larger portion of the shareholder loan. As funds become available in MCL, the company could repay Ben on a tax free basis. Other alternatives do exist: Ben could, for example, accept a promissory note from Elaine or he could be issued preferred shares in MCL. Although we can minimize Ben s involvement in MCL, we cannot completely eliminate it and still meet your objective of an equal division of assets. If shares are ultimately granted to Ben, you may want to consider appointing an independent trustee to look after his interest, especially if his involvement in MCL is likely to cause friction between Ben and Elaine. You should also consider whether either of your children desires any specific asset. We recommend that you discuss your plans, and the potential asset distribution, with your children now to avoid disputes between them later. In addition, you should seek legal advice to assist you in drafting your wills.

10 CPA Mock Evaluation Tax Elective Module Page 10 The remainder of this report explains how we arrived at our preliminary recommendations and considers related issues (the method to be used for transferring MCL, and retirement income planning, and a cash shortfall created at the time of your death). Assessment Opportunity #2 The candidate estimates the FMV of MCL and the Mandrake estate. The candidate demonstrates competence in Finance CPA Map-Finance (Core level): Develops or evaluates financial proposals and financing plans (Core- Level B) Evaluates the entity s investment portfolio(core-level B) Applies appropriate methods to estimate the value of a business (Core-Level B) Valuation of MCL An estimate had to be completed for the current FMV of MCL as at June 30, 2015, before an asset distribution could be determined. The family has already agreed that the FMV of MCL at June 30, 2012, was $3.1 million. In order to estimate the current FMV, we have calculated the net present value of MCL s expected future earnings. In making this calculation, we assumed that MCL s future earnings will be similar to its past performance, normalized for unusual and non-recurring items. As shown in Appendix I, we estimate the current FMV of MCL to be $4.81 million. Calculation of personal net worth To calculate the value of your entire estate, we must determine the after-tax value of all the assets you currently own. For income tax purposes, a person is deemed to dispose of his or her assets at their FMV at the time of death. Any inherent gains thus become taxable at that time. Based on the current FMV of the assets that you identified, your estate would be worth approximately $7.7 million after all taxes were paid, as shown in Appendix II. This is the amount that would be split between your two children. As mentioned above, the value of MCL is greater than one-half of the value of the estate.

11 CPA Mock Evaluation Tax Elective Module Page 11 Assessment Opportunity #3 The candidate evaluates the tax planning opportunities. The candidate demonstrates competence in Taxation CPA Map (Taxation Elective): advises on tax consequences or specific tax-planning opportunities for shareholders and their closely held corporations (Core Level C; moves to Level A in taxation elective) advises on specific tax-planning opportunities for individuals (Core Level C; moves to Level B in taxation elective) Transfer of business You stated that you wanted to transfer the business to Elaine. For now, I have assumed that the business does not include RHL. Even though RHL s real estate is used by MCL, the two entities can be allocated to different children. We have allocated this company to Ben. MCL could rent a facility elsewhere while RHL could rent the property to arm s-length parties, or Ben could sell RHL. More importantly, the value of RHL does not depend on the management of MCL, but instead varies with real estate values. In order to distribute the assets equally, I have assumed that Elaine does not have to inherit the ownership of RHL. You expressed a desire to transfer the business to Elaine at a discounted price. For tax purposes, the transfer of any asset to your child is deemed to take place at the FMV of the asset. Therefore, gifting any portion of MCL to Elaine would require you to pay income taxes on the difference between the FMV of the gift and your related adjusted cost base. Clearly, a method of transferring these shares on a tax-deferred basis should be sought. One way to defer the tax would be to defer the gift to Elaine and account for it in the distribution of the estate s assets. In 2011, you exchanged your common shares of MCL for preferred shares that had a redemption value of $3.1 million, the FMV of MCL. The common shares had a nominal value because the full value of the corporation was represented by preferred shares. Once again, in order to transfer the business to Elaine, you could exchange the outstanding common shares that you hold for retractable, voting, preferred shares which have an aggregate redemption value of approximately $1.71 million. This exchange would take place with no immediate tax cost to you. Elaine could then subscribe for common shares at a nominal value. The preferred share attributes listed above would enable you to step in and take control at any time if necessary. Another alternative would be to use a section 85 holding company freeze. You could incorporate a new entity, Mandrake Holdings Inc. (MHI), with Elaine as the common shareholder. You could then each transfer your common shares of MCL to MHI in exchange for preferred shares redeemable and retractable for $1.71 million, the current value of them. Electing under section 85 will defer the taxes on this transaction, and you could elect at an amount higher than cost to use up some of your lifetime capital gains deduction. MHI would now control MCL, and any future growth in its value would belong to Elaine.

12 CPA Mock Evaluation Tax Elective Module Page 12 In either situation, Elaine will be able to use the lifetime capital gains deduction on her shares on eventual sale, provided the shares continue to meet the definition of qualified small business corporation shares. To maximize the tax benefit, I recommend using the section 85 holding company freeze, as this will provide you with a higher adjusted cost base on your shares. Care should be taken to ensure that Robert continues to have ultimate control over MCL (by attaching votes to his preferred shares), as he currently has control over RHL. RHL is benefitting from having its income deemed to be active business income, since it is associated with MCL which is using RHL s property in its active business. RHL s rental income would otherwise be aggregate investment income and subject to a much higher tax rate. Any future restructuring (including an eventual transfer of RHL to Ben) will need to consider the impact of RHL s income reverting to aggregate investment income should it ever become not associated with MCL. As you know, a valuation is not precise. In case Canada Revenue Agency (CRA) disputes the FMV value, a price adjustment clause should be included in any share exchange agreement. This clause will allow an adjustment to the preferred share redemption amount if CRA is successful in asserting a different share value, which would otherwise yield a one-sided adjustment and double taxation. A lawyer should be hired to prepare these documents to ensure the appropriate steps are taken. Elaine s desire for an increased line of credit impairs your ability to withdraw funds (loans or preferred shares). Elaine s expansion plan should be reviewed to determine whether you are comfortable with the risk to your future retirement income. If you agree to subordinate loans, there should be an agreed plan for Elaine to accumulate equity. Assessment Opportunity #4 The candidate assesses cash needs vs sources of cash available. The candidate demonstrates competence in Finance CPA Mapping Finance: Prepares, analyzes, or evaluates operational plans, budgets, and forecasts (Core-Level A) Retirement plans At this point in time, we cannot determine whether your current income-producing assets will yield enough cash flows during your retirement. However, your current cash-generating investments appear to be inadequate to fund your cash needs. Your income-producing assets would include the following: Income from your rental property would be available, assuming that the property generates a positive cash flow. The income derived from your investments, as well as the capital, could be utilized. Your RRSPs could provide you with funds for your retirement needs. However, you should delay withdrawing RRSPs due to tax deferrals available. Consider paying yourselves a retiring allowance from MCL. A maximum of $2,000 per year employed before 1996 plus an additional $1,500 before 1989 could be paid to each of the

13 CPA Mock Evaluation Tax Elective Module Page 13 Mandrakes and transferred to an RRSP on a tax deferred basis. The loans currently payable to you by MCL could be repaid. Interest could also be paid to you on any unpaid balances. A lawyer should be involved in any restructuring to the debt to ensure the interest is tax deductible. The preferred shares that you currently hold in MCL could be redeemed, or dividends could be paid on them. However, current debt covenants may prevent their redemption. Canada pension plan payments may also be available, given you have both been earning employment income for several years. Based on your current income level, old age security payments would have to be repaid in the form of taxes when you file your personal income tax returns, due to your high level of income. However, if your retirement incomes are as low as you expect ($100,000 combined, assumed to be $50,000 each), you will likely have access to the OAS in the long term, as well. A more detailed analysis of your cash flow needs should also be performed to assess the amount of cash actually needed to cover your expenses ($100,000 is significantly lower than the $500,000 of compensation you currently earn, though you will likely not be putting money aside for retirement as you are currently doing). Cash shortfall at date of death Appendix III calculates the potential cash shortfall that would result if your estate had only the current amount of cash and other liquid assets to fund the resulting tax liability. Income taxes on the deemed disposition of your assets at your date of death would total approximately $1.6 million, while the estate would have just $1.0 million in cash and other liquid assets. This shortfall is obviously significant, and plans should be made for how to finance it. Otherwise, other estate assets, including MCL, may have to be sold. Some preliminary ideas on how to fund this shortfall are as follows: Purchase insurance You could purchase additional insurance to fund the shortfall. However, the premiums for this policy will increase the amount of cash you require to fund your retirement needs. Defer tax payment CRA will allow the estate to pay the tax liability over ten years. This does not solve the problem of where the funds will come from: it merely delays payment. In addition, CRA will charge the estate interest, which will not be tax deductible. However, this interest rate is currently 5%, which is comparable to your bank s rate. Beneficiaries pay The estate s beneficiaries could fund this liability; however, given the current facts, they are unlikely to have the cash funds available. Sell other assets Some of the other assets held by the estate could be sold. However, this might take time given the nature of the assets held. Borrow the funds The estate could borrow the funds and use the real estate assets as collateral. The interest payable on any loans would not be deductible for tax purposes.

14 CPA Mock Evaluation Tax Elective Module Page 14 Assessment Opportunity #5 The candidate assesses other taxation concerns for the corporate group. The candidate demonstrates competence in Taxation CPA Mapping Taxation: Determines taxes payable for a corporation in routine situations (Core Level B; moves to Level A in taxation elective) Advises on tax consequences or specific tax-planning opportunities for shareholders and their closely held corporations (Core Level C; moves to Level A in taxation elective) Other tax issues In addition to the above concerns, I have identified several issues with MCL s corporate taxes and with the corporate structure. Management remuneration Management remuneration must be paid within 180 days of the end of the taxation year in order to be deductible by the corporation. The bonuses payable account has increased each year since 2013, and is now well in excess of the total remuneration for even one year. This suggests that not only have prior years bonuses not been paid, but at least a portion of the current year s bonus is not being paid. The portions unpaid by 180 days after the end of each taxation year need to be added back to MCL s net income for tax purposes on its corporate tax returns. Going forward, this bonuses payable account should be paid out over time as the amount has grown quite substantially. Rent paid by MCL to RHL MCL is currently paying rent to RHL in excess of its fair market value. In order to be deductible, the expense must be reasonable in the circumstances (section 67). Given the situation, it is unlikely that MCL would reasonably agree to pay more than fair market value for its rent if this were to a third party. Accordingly, the rent paid in excess of the fair market value will be denied as a deduction. Going forward, I recommend that the rent be adjusted to the rate that would be paid between third parties. This will reduce the cash outflows to RHL from MCL, but as discussed below, this could prove to be advantageous anyway.

15 CPA Mock Evaluation Tax Elective Module Page 15 Bonus policy It appears that MCL is paying bonuses to its shareholders as a form of compensation. While many of these appear to be unpaid, at least a portion is being paid each year, which is taxable to the shareholders immediately when received. It is possible, depending on the specifics of the situation and the tax rates in your jurisdiction, that paying dividends would be advantageous from a tax perspective. There are also other forms of removing cash from the corporation, such as repayment of debt, which could yield lower tax results, given relatively low corporate tax rates. A more detailed analysis will need to be performed to ensure the minimum amount of taxes are paid. QSBC share status While we do not know the value of RHL s building, we know the corporation is worth $2.2 million and has no mortgage debt. RHL does owe $1.682 million to MCL, which implies total assets of $3.882 million (assuming no further liabilities, which should be confirmed). This implies the building is worth $3.537 million, since the blue-chip stocks are worth $345,000. The building will qualify as an active business asset for the QSBC shares test as it is used in the active business of an associated corporate, MCL. Therefore, since it comprises just over 91% of the fair market value of RHL s assets, RHL s shares will likely qualify. If any future sales (or restructuring) are to occur of RHL s shares, the sellers will be able to claim the lifetime capital gains deduction against gains. However, the balance is still very close to the 90% threshold so care should be taken to minimize the amount of non-qualifying assets in the corporation. Since MCL has very little cash, and is not even paying out its bonuses as required, RHL should liquidate these investments and repay part of its debt to MCL. This will purify RHL s shares in case of future sale. 50% of any gains earned on the sale of the investments will be added to RHL s capital dividend account (CDA), so this should be paid out to the shareholders before any amounts are paid to MCL. MCL s shares will qualify as QSBC shares (which is why we have applied the lifetime capital gains deduction against the gain, above). MCL is a CCPC and has been owned by the Mandrakes for more than 24 months. Its assets are all used in its active business, with the exception of the indebtedness from RHL. As a connected corporation that is, itself, a small business corporation, RHL s indebtedness is counted towards MCL s asset tests, and therefore 100% of MCL s assets qualify. MCL s shares are, therefore, QSBC shares.

16 CPA Mock Evaluation Tax Elective Module Page 16 Conclusion In combination, these issues all point to the need for a cash management strategy for MCL and RHL. This will only become more important after restructuring to include Elaine in the business. The following steps should be taken to improve the cash flow and minimize taxes for the corporations: Immediately revise the rental agreement to reduce the amount of rent paid to RHL. This will preserve more cash inside of MCL. Liquidate RHL s investments, pay out a capital dividend to the maximum extent possible, and use the remaining cash to repay a portion of RHL s debt to MCL. Perform a more detailed analysis of management compensation for the Mandrakes, including an assessment of whether they should be paying salaries, dividends, or neither. Given the amount owing to them, it is possible the Mandrakes could benefit from simply having MCL continue to pay off the remaining payables (total of $1.6 million owing to them). Use excess cash in MCL to pay off the bonuses payable (which will be immediately taxable to the Mandrakes, but will ensure that MCL can actually deduct the amounts it has accrued) as well as the shareholders loans (repayment of which will not be taxable to the Mandrakes at all). Going forward, any excess cash in RHL (as a result of rent received from MCL) should be used to pay down its debt to MCL, and then MCL should use it to continue to pay down the amounts it owes to its shareholders.

17 CPA Mock Evaluation Tax Elective Module Page 17 APPENDIX I MANDRAKE CONSTRUCTION LTD. ESTIMATED CURRENT FMV (in thousands of dollars) Income before income taxes (Note 1) $ 491 $ 499 $ 525 Adjustments required to normalize income Salary and wages adjustment (Note 2) Add: Management remuneration expenses Less: Salary paid to two managers (120) (120) (120) Bonus paid on profits (354) (336) (322) Legal fees related to lawsuit (Note 3) 20 Bad debt expense (12) 48 Rent expense (Note 4) Add: Rent expensed Less: Fair market value rent (216) (216) (216) Normalized income Less: income 25% (Note 5) Weighting factor (Note 6) ,641 $ 990 $ 468 Total income for three-year period ($1, ) $ 3,099 Average income per year ( 6 years) $ 516 Discount rate (Note 7) 16½ % Estimated value of business ($516,000 16½%) $ 3.13 million Add: redundant assets, due from RHL (Note 8) $ 1.68 million Estimated value of business $ 4.81 million

18 CPA Mock Evaluation Tax Elective Module Page 18 APPENDIX I (continued) MANDRAKE CONSTRUCTION LTD. ESTIMATED VALUE OF BUSINESS Notes: 1. Net income Amortization of capital assets using income tax rates does not necessarily reflect the salvage value of the remaining assets. Additional information is required to recalculate (normalize) the amortization expense. 2. Salary and wages Currently, MCL declares an annual bonus to compensate its owners. We must adjust this bonus to reflect salaries that would be paid to arm s-length managers. We have used the amount paid to the two full-time managers who worked for MCL on the assumption that this represents an arm s-length salary. Two managers would be required, and each would be paid $5,000 per month plus a bonus equal to 10% of net income before income taxes and other items beyond their control (remuneration and amortization). 3. Legal fees Legal fees related to the 2014 lawsuit were considered to be an unusual expense and unlikely to recur. Therefore, this amount was added back to income. 4. Rent expense Rent expense has been adjusted to reflect the fair market value rate of $18,000 per month. 5. Tax rate with income in excess of the small business deduction limit, a portion will be taxed at the lower rate ( %, depending on the province) with the remainder taxed at the higher rate (26-31%). Assumed approximate rate of 25% overall. 6. Average earnings In order to calculate the average amount of earnings that MCL could expect, we have averaged the past three years earnings, assuming that the most current years more closely approximate the annual earnings which can be expected. 7. Discount rate The discount rate used was calculated as 16½%. This reflects a 3½% prime rate plus a 13% risk factor. The risk premium is consistent with that used in the prior valuation, and reduced for the lower risk-free rate (the one paid on Robert and Wendy s term deposits). 8. Due from RHL The amount due from RHL was considered to be a redundant asset, not used in normal business operations. As a result, this amount should be added to the value of MCL.

19 CPA Mock Evaluation Tax Elective Module Page 19 APPENDIX II ROBERT AND WENDY MANDRAKE PERSONAL NET WORTH - AFTER TAXES (in thousands of dollars) Real estate (Note 1) Personal residence $ 450 Rental property 575 Income taxes (Note 1) (30) $ 995 RRSP withdrawal RRSPs - Robert 225 RRSPs - Wendy 250 Less: Income taxes on deregistration (50%) (237) 238 Shares of MCL Shares of MCL, Appendix I 4,810 Less: tax on MCL shares (Note 2) (802) 4,008 Less: Elaine s share (Note 3) (645) 3,363 Shares of RHL Shares of RHL (Note 4) 2,200 Less: tax on RHL shares (550) 1,650 Antiques Antiques 230 Less: income taxes (Note 5) (9) 221 Other assets Cash and term deposits 50 Yacht (Note 6) 95 Life insurance (Note 7) 100 Shareholder loans (Note 8) 972 Estimated personal net worth $ 7,684

20 CPA Mock Evaluation Tax Elective Module Page 20 APPENDIX II (continued) ROBERT AND WENDY MANDRAKE PERSONAL NET WORTH Notes: 1. The principal residence deduction must be allocated between the personal residence and the rental property. The calculation is as follows: Personal residence Rental property Total estimated gain $ 200,000 $ 225,000 Number of years owned Average gain per year 20,000 15,000 Years allocated 9 years ('07 to 15) 6 years ( 01 to 06) Capital gain - residence = $200,000 - ($200,000 x (9+1)/10) =NIL - rental property = $225,000 - ($225,000) x (6+1)/15) =$120,000 Taxable capital gain (1/2) = $60,000 Tax at 50% combined rate = $30, For income tax purposes, your combined shareholdings in MCL have an adjusted cost base of $2,000 (the amount paid for the new common shares, plus $1,000 ACB from the original shares exchanged for preferred shares in 2011; the ACB is retained in such transactions). Therefore, the capital gain that will result on your MCL shareholdings will be approximately $4.808 million, with a taxable capital gain of $2.404 million. One quarter of this, or $601,000, is Wendy s, and the remainder, $1,803,000, is Robert s. Assuming they have not used their lifetime capital gains deductions by the time of disposition (that is, that they do not use a holding company estate freeze to transfer the shares to Elaine before death), they can apply this against these gains. Each will have $400,000 available (2014 amount), leaving them with $201,000 and $1,403,000 of taxable capital gains, respectively. This will yield taxes of $802, The share value has increased by $1.71 million, before taxes, since Elaine became involved in the corporation s management. You intend to transfer half of the after-tax increase in value to Elaine. The income tax that would result on the $1.71 million capital gain would be approximately $420,000. As a result, the after-tax gain over the past three years is $1,290,000, half of which accrues to Elaine ($645,000).

21 CPA Mock Evaluation Tax Elective Module Page 21 APPENDIX II (continued) ROBERT AND WENDY MANDRAKE PERSONAL NET WORTH 4. The value of RHL is unchanged from its 2013 value of $2.2 million. The gain on these shares, and the related tax, is as follows: Total value $ 2,200,000 Less: paid-up capital - ACB 1,000 Capital gain 2,199,000 Taxable capital gain (1/2) 1,099,500 Tax at 50% $ 549, The increase in the value of your antiques ($35,000) will be a capital gain. The income tax on the gain will be $8,750 ($35,000 x 50% x 50%). As these are listed personal property (LPP), a more detailed analysis will be necessary to ensure the minimum adjusted cost base of $1,000 per item is applied, and that LPP losses are only applied against LPP gains. 6. The yacht has decreased in value. Yachts are considered personal use property, and losses are not deductible for income tax purposes. 7. The death benefit received from a life insurance policy is not taxable. 8. Shareholder loans can be repaid by the company on a tax-free basis.

22 CPA Mock Evaluation Tax Elective Module Page 22 APPENDIX III POTENTIAL CASH SHORTFALL ON ESTATE TAXES Cash required by estate Income tax on assets (see Appendix II) Real estate $ 30,000 RRSP 237,000 MCL shares 802,000 RHL shares 550,000 Antiques 9,000 1,628,000 Less: Cash readily available to fund liability Cash and term deposits 50,000 RRSPs 475,000 Life insurance 100,000 Available from RHL (Note 1) 325,000 Cash shortfall $ 678,000 Note 1: Most of the assets held by MCL and RHL are used in the businesses and are not readily convertible to cash. However, the marketable securities in RHL could be sold, yielding approximately $325,000 ($345,000 less tax of $20,000) of after-tax cash proceeds. This could then be used to repay the debt payable to MCL. MCL could then pay the cash to your estate as a partial repayment of the shareholder loan account. Alternatively, RHL could pay capital dividends directly to the Mandrakes to the extent the gain creates a positive balance in the capital dividend account.