Taxes

• Tax Forms
• Tax Rates
• Tax Implications on Depreciable Assets

1
Business and Business Income
A business is an activity that you intend to carry on for
profit and there is evidence to support that intention.
 a profession;
 a calling;
 a trade;
 a manufacture;
 an undertaking of any kind; and
 an adventure or concern in the nature of trade

2
 Business Organizations

1. Sole proprietorships

2. Partnerships

3. Corporations

3
 Business Organization

 Sole Proprietorships
 Just you, taxed on T1
 May need registration of name and/or licence
 Partnerships
 You and your friends,
 Default is shared liability, dissolve upon death of any partner
 May use a partnership agreements to change default
 Corporations (Provincial and Federal)
 A “fictitious person” under the law
 May provide tax and liability advantages
 Doesn’t legally dissolve when owners die
 Must have Shareholders, Directors, and Officers
 May want a Shareholder’s Agreement

4
Comparisons of Forms of Business
Organizations

Number Sales Profits

Sole proprietorships
Partnerships
Corporations
5
 Sole Proprietorships

 Advantages  Disadvantages
 Easy and inexpensive to  Unlimited liability
form  Difficulty in raising capital
 Owner’s right to all  Limited managerial
profits expertise
 Direct control of the  Difficulty finding qualified
business employees
 Freedom from  Personal time
government regulation commitment
 No special taxation  Unstable business life
 Ease of dissolution  Owner absorbs all loses

6
Partnership
 A partnership is two or more persons carrying on a
business with a view to making a profit.
 A partnership relationship is consensual and
contractual.
 A written agreement between the partners is not
necessary to show that a partnership relationship
exists.
 A court looks for the substance of the relationship
between parties to determine if it is a partnership.

7
 Partnerships

General Partnerships Limited Partnerships

 Partners co-own assets  Controlled by one or
and share profits more general partners
 Each partner is who have unlimited
individually liable for all liability
debts and contracts of  Partner’s liability is limited
the partnership to their investment
 Do not participate in the
firm’s operations

8
 Partnerships

 Advantages  Disadvantages
 Ease of formation  Unlimited liability for
 Availability of capital general partners
 Diversity of skills and  Potential for conflict
expertise between partners
 Flexibility  Sharing of profits
 No special taxes  Difficulty in leaving or
 Relative freedom from ending a partnership
government control

9
Limited Partnerships
 A Limited Partnership is a partnership in which some of
the partners limit their liability to the amount of their
capital contribution
 Must have at least one “general partner”

10
Limited Liability Partnerships

 Many provinces have enacted laws concerning the

establishment of Limited Liability Partnerships.

 A Limited Liability Partnership is a partnership in

which a non-negligent partner is not personally
liable for the debts, obligations, and losses caused
by the negligence of another partner committed
during the course of the partnership business.

 Limited partner should ensure that their name is

not used in the name of the partnership.
11
 Corporation:
a legal entity with an existence and life
separate from its owners, who therefore are
not personally liable for its debts; it can own
property, enter into contracts, sue and be
sued, and engage in business operations

12
 The Incorporation Process
1. Select the company’s name
2. Write and file the articles of incorporation
3. Pay fees and taxes
4. Hold organization meeting
5. Adopt bylaws, elect directors, and pass operating
resolutions

13
 Types of Corporations
 Private Corporation
 A corporation that does not trade publicly and, therefore, is
not listed on a stock exchange.
 The number of shareholders is no more than 50
 The public is not invited to share in its securities

 Public Corporation
A corporation that has the right to issue shares to
the general public and is listed on a stock exchange.

14
 Corporations

 Advantages  Disadvantages
 limited liability  double taxation of profits
 easy of transfer  cost and complexity of
ownership formation
 unlimited life-span  more government
 ability to attract financing regulations and
 ability to attract potential restrictions
employees

15
The Nature of a Corporation
 A corporation is a legal person; that is, a person in the
eyes of the law.

 A legal person is an entity recognized by law as having

rights and duties of its own.

 Salomon v. Salomon & Co. Ltd. Upheld that a corporation

was a distinct and separate entity.

16
 Specialized Forms of Business
Organizations
 Cooperatives
 a legal entity collectively owned by individuals or businesses
with similar interests
 profits distributed to the members in proportion to their
contributions

 Franchises

17
 Franchising:
a business organization in which a franchisor supplies the
product concept to the franchisee, who sells the goods or
services in a certain geographical area

18
 Franchises

 Advantages  Disadvantages
 increased ability for  loss of control for
franchisor to expand franchisor
 recognized name, product  costs of franchising
and operating concept  restricted operating
 management training and freedom for franchisee
assistance for franchisee
 financial assistance for
franchisee

19
RAN
FRANCHISE NAME STARTUP COSTS
K
1 Hampton Hotels $3.7M - 13.52M
2 Subway $85.2K - 260.35K
3 Jiffy Lube Int'l. Inc. $196.5K - 304K
4 7-Eleven Inc. $30.8K - 1.5M
5 Supercuts $103.55K - 196.5K
6 Anytime Fitness $56.3K - 353.9K
7 Servpro $133.05K - 181.45K
8 Denny's Inc. $1.18M - 2.4M
9 McDonald's $1.07M - 1.89M
10
20
Pizza Hut Inc. $295K - 2.15M
21
Some Tax Effects

 Income taxes affect investment decisions because they

take a portion of the firm’s earnings
 Both depreciation (capital cost allowance) and other
tax incentives are important
 Taxes such as property taxes, employment related taxes,
taxes on emission or other production related items
are simply treated as expenses

22
Corporate Taxation
 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.

23
Tax Incentives
 Accelerated Capital cost Allowances provide
companies a reason to invest in 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.

24
 R&D Tax Incentives

 The Scientific Research and Experimental

Development Program provides tax incentives to
Canadian businesses .
 It is intended to encourage 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.

25
 Some Important Issues

Taxable income = gross income - 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)

26
Mechanics of Tax Calculations
 Taxes to be paid = taxable income * tax rate

27
 More on Taxes and Depreciation

 There is a 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
 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
 The Canadian government establishes a maximum level
of capital cost expense (depreciation) which a company
can claim each year, Capital Cost Allowance (CCA).

28
TAX IMPLICATIONS ON DEPRECIABLE ASSETS
EXAMPLE: Dr. M. C.’s Passion
FACTS:
First Cost = $ 80,000, Life =5 years
USED FOR BUSINESS INCOME
Tax Rate = 40%
Investment Interest Rate = 10%

QUESTION: How much he would

save if he invests the tax savings?
[A] Assign 100% depreciation during
1styear.
[B] Use DB-Method d= 30%
29 depreciation for next 5 years.
 TAX IMPLICATIONS ON
DEPRECIABLE ASSETS
METHOD: A First Cost $80,000
YEAR 1 2 3 4 5
Depreciation
Expense $80,000 $0 $0 $0 $0
Tax Rate 40% 40% 40% 40% 40%
TAX SAVINGS $32,000 $0 $0 $0 $0

ACCUMULATED
$32,000 $35,200 $38,720 $42,592 $46,851
TAX SAVINGS
(Invested at 10%)
YEAR 1 2 3 4 5
Depreciation
Expense $24,000 $16,800 $11,760 $8,232 $5,762
Tax Rate 40% 40% 40% 40% 40%
TAX SAVINGS $9,600 $6,720 $4,704 $3,293 $2,305

ACCUMULATED $9,600 $17,280 $23,712 $29,376 $34,619

TAX SAVINGS
(Invested at 10%)
30
CAPITAL
31 COST ALLOWANCE (CCA) SYSTEM
 TAX IMPLICATIONS ON
DEPRECIABLE ASSETS

CAPITAL COST ALLOWANCE (CCA) SYSTEM

 Capital Cost Allowance (CCA) Asset Class

 Capital Cost Allowance (CCA) Rate

32
INCOME STATEMENT & TAX FORMS
INCOME
COST OF GOODS (INCOME)
GROSS INCOME or GROSS PROFIT:
BUSINESS EXPENSE
DEPRECIATION EXPENSE
TOTAL BUSINESS EXPENSES:

NET INCOME (LOSS) = GROSS INCOME - EXPENSES

+ DEPRECIATION EXPENSE
ADJUSTEMENTS
- CAPITAL COST ALLOWANCE(CCA)
TAXABLE NET INCOME (LOSS):
33 TAXES = TAXABLE NET INCOME x TAX RATE
 Specific Tax Rules in Canada
 In Canada, most assets must be depreciated using a more
complex declining-balance method.
 The depreciation rate depends on the type of asset
 Regulations are set out in the in the capital cost
allowance (CCA) system.

34
 The Capital Cost Allowance System
 May deduct capital expense over period of years by claiming
depreciation expense each year of the useful life
 The depreciation is recorded in two ways:
1. it is recorded in balance sheet as a reduction in the book value
2. it is recorded as a depreciation expense on the income statement
thereby reducing the before-tax income
 because depreciation is considered an expense that offsets
revenue, best to “write off” ASAP
 However, Canadian tax system defines a specific amount of
depreciation called the capital cost allowance (CCA)
 There are “classes” that dictate CCA rates

35
 Capital Cost Allowance System (cont’d)

 The depreciation rate is called Capital Cost Allowance

(CCA).
 The class of asset dictates the actual CCA rate
 i.e. buildings are depreciated more slowly than vehicles
 Typically, Engineering projects fall into class 8, with a 20%
declining balance depreciation rate.
 the remaining value in each pooled account is called the
Undepreciated Capital Cost (UCC).

36
 Undepreciated Capital Cost Allowance and
the Half-Year Rule

 Capital cost of asset is total acquisition cost (incl.

Installation, transportation, legal, accounting, etc)
 As asset is depreciated, company keeps track of UCC
which may differ from market or salvage value
 The Canadian tax system uses the half-year rule - in
the year of purchase and salvage only half the usual
depreciation is applied.
 UCCopening + additions – disposals – CCA = UCCending

37
 The Capital Tax Factor and Capital Salvage
Factor

Assume an asset purchased for $100 000 20% CCA rate

 In the first year, a CCA claim of $10 000 (half-year rule)
 With a tax rate of 50%, saves $5000 in taxes
 Therefore the PW of $100 000 asset is less than $100k
 reduced by PW of tax savings of future years (See Table 8.9, Tax
Savings Due to the CCA (50% Tax Rate) on page 283 in your
textbook.)
 PW of tax savings = $5000(P/F, i ,1) + $9000(P/F, i, 2) +
$7200(P/F, i, 3) + $5760(P/F, I, 4)…
 So PWtax savings reduces the first cost of the investment!

38
 TAX IMPLICATIONS ON
DEPRECIABLE ASSETS
EFFECTS OF HALF-YEAR RULE
CCA = [UCC opening+(12)* NET additions ] x CCA RATE
OR
CCA = [UCC opening- NET disposals ] x CCA RATE

If additions > disposals, then

NET ADDITIONS
If disposals > additions, then
NET DISPOSALS
39
CAPITAL COST ALLOWANCE (CCA) SYSTEM
CCA and UCC calculations

40
TAX IMPLICATIONS ON DEPRECIABLE ASSETS
EXAMPLE: Dr. M. C.’s Decisions

FACTS: Sold old car on December 30th for $

20,000. UCC opening = $5,248
Bought new car on December 31st for
= $ 80,000
USED FOR BUSINESS INCOME
Use CCA class and rate

QUESTION:
How would he calculate UCC and
CCA for the current taxation year?
41
CAPITAL COST ALLOWANCE (CCA) SYSTEM
CCA and UCC calculations

10 5,248 80,000 20,000 65,248 30,000 35,258 30 10,577 54,671

42
 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)

 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

43
 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%.

44
 TAX IMPLICATIONS ON DEPRECIABLE ASSETS
HALF-YEAR RULE: Only one-half of the value
of the depreciable asset bought in the current
year can be used for current year CCA.
CCA = [UCC opening + (12) additions ] x CCA RATE
YEAR 1 2 3 4 5
UCCope ning
$40,000 $68,000 $47,600 $33,320 $23,324
+ (1/2) additions
Depreciation
Expense $12,000 $20,400 $14,280 $9,996 $6,997
Tax Rate 40% 40% 40% 40% 40%
TAX SAVINGS $4,800 $8,160 $5,712 $3,998 $2,799

ACCUMULATED $4,800 $13,440 $20,496 $26,544 $31,997

TAX SAVINGS
(Invested@10%)
45
TAX IMPLICATIONS ON DEPRECIABLE ASSETS
First Cost $80,000 current year d=30%
YEAR 1 2 3 4 5
UCCopening
$40,000 $68,000 $47,600 $33,320 $23,324
+ (1/2) additions
Depreciation
Expense $12,000 $20,400 $14,280 $9,996 $6,997
Tax Rate 40% 40% 40% 40% 40%
TAX SAVINGS $4,800 $8,160 $5,712 $3,998 $2,799
ACCUMULATED
TAX SAVINGS $4,800 $13,440 $20,496 $26,544 $31,997
(Invested @10%)

Assuming the FIRST COST occurs in the beginning and the

tax savings occur at the end of fiscal year
Present Cost of the car = $80,000 - $4,800 (P/F, i, 1) - $8,160
(P/F, i,2) - $5,712 (P/F, i,3) - $3,998 (P/F, i,4) - $2,799 (P/F, i,5)-
$…*(P/F, i, n)………
PW of an Asset = P * CTF, where, CTF = Capital Tax Factor
46
 CAPITAL COST TAX FACTOR (CCTF)
Assuming CCA rate ‘d’, tax rate ‘t’ and the interest rate ‘i’
remain constant, then CTF would be constant.

Present Worth of an Asset incl. tax effects= P * CTF

Where, CTF is the Capital Tax Factor (new)
CTF = 1- td (1+i/2)
(i+d)(1+i)
Suppose d = 30%, t = 40%, and i = 10%,

CTF = 0.71364
Present Cost of the car = $80,000 * 0.71364 = $ 57,091

This is assuming one would keep the asset indefinitely.

However, when the asset is sold, say for $‘S’ in future, this
47will reduce the tax benefit beyond the time it was sold.
 CAPITAL Salvage FACTOR (CCTF)
Since HALF-YEAR RULE doesn’t apply to disposals, a
different factor must be used
Present Worth (at the time of sale) of Salvage Value
including tax reductions = S * CSF
Where, CSF is the Capital Salvage Factor (using old rule)
CSF = 1- [td/ (i+d)]
Suppose d = 30%, t = 40%, and i = 10%, CSF = 0.7
Suppose, the Salvage value of the car after 5 yrs = $20,000
The Salvage value including taxes = $20,000* 0.7 = $ 14,000
PW of Salvage at the time of Purchase = $14, 000 * (P/F, i, N)
= $14,000/(1+0.1)5 = $8,693
Thus, net Present Cost of the car = $57, 091 - $8,693
= $ 48,398
48
TAX IMPLICATIONS ON DEPRECIABLE ASSETS

Present Worth of an asset

= P * CTF - [S * CSF ]*(P/F, i, N)
If there is additional savings or
expenses due to this asset, say,during
period ‘n’ then the associated present
worth = [A * (1-t)]*(P/F, i, n)

AN IMPORTANT ASSUMPTION IN TAX

CALCULATION IS THAT THE BUSINESS IS
49
MAKING A PROFIT
Capital Tax Factor (CTF)

 We can simplify the calculation by using the CTF.

 It 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 CTF because there
are differences in timing due to the "Half-Year" rule.

50
 Example

 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 CTF applies.
CTF=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

51
Components of a Complete PW Tax
Calculation
 First Costs - multiply it with the CTF 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 CSF to remove the
entire amount in the year of disposal.

52
 Another Example
 A chemical recovery system costs $30,000 and saves
$5280 per year of its 7 year life. The salvage value is
$7500. The after-tax MARR is 9% and taxes are 45%.
What is the net after-tax annual cost of the system?
 CTF = 0.7025 CSF = 0.6897
 AWFC(first cost) = -$30000(A/P,9%,7)CTF
 AWAS(ann. Savings) = $5280(1-t)
 AWSV(salvage value) = $7500(A/F,9%,7)CSF
 AW = -721

53
 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(CTF).
 CTF = 0.70424 or PWFC = -$7,042
 PWAS(ann. Savings) = $4,000(P/A,12%,5)(1-t) = $7,209
 PWSV(salvage value) = $2000(P/F,12%,5)CSF=$780
 PW(after taxes)=PWFC+PWAS+PWSV = $947
54
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

55