Dr. Hassan, Y. – 91.380
1
DEPRECIATION AND INCOME 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
Dr. Hassan, Y. – 91.380
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S = salvage value
N = useful life of asset
n = number of years of use
DC = annual charge for depreciation
BV = book value on accounting records
BV
Straight line method:
DC =
P
P −S
= constant
N
BV (n ) = P −
n
(P − S )
N
S
Example:
P = $7,000
N = 5 years
S = $1,000
BV(3) = ?
n = 3 years
0
N
Declining Balance Method:
BV(n) = P * (1 – Depreciation rate)n
DC(n) = BV(n–1) * (Depreciation rate)
Example:
For the previous example (P = $7,000, S = $1,000, n = 3, N = 5) find the book value after
3 years given a depreciation rate of 40%
•
Another form for the declining balance method is:
DC(n ) =
•
R
[BV (n − 1)]
N
R may be determined by the analyst based on a positive salvage value as:
1/N
 S
R = 1− 
 P
•
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/N
•
An accelerated depreciation can be achieved by switching from DDB to SL in the late years
of the asset’s life
Dr. Hassan, Y. – 91.380
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Example:
An asset has P = $7,000, S = 0, and N = 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 November 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
Example:
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
•
Subtract CCA from UCC(1) to calculate UCC(2) for next year
Example:
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
-
Not 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
Dr. Hassan, Y. – 91.380
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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:
-
Non 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
Example:
end of
UCC
year
account
CCA @
30%
Income Tax
50%
(P/F, 10%, n)
PW of tax
credit
0
1000
1
700
300
150
0.9091
136
2
490
210
105
0.8264
87
3
343
147
73
0.7513
55
4
240
103
52
0.6830
36
5
168
72
36
0.6209
22
6
118
50
25
0.5605
14
7
83
35
18
0.5132
9
8
58
25
13
0.4665
6
9
41
17
8
0.4241
3
10
29
12
6
0.3855
2
∑1-10
971
486
Future
years
29
14
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
370
Dr. Hassan, Y. – 91.380
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d = CCA rate
-
i = discount rate
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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(N–1)=(1–d)N-1→ CCA tax saving (N)=(1–d)N d * t
 1
1− d
(1 − d ) N −1 
CCA tax shield = t d 
+
+
...
+

2
(1 + i )N 
1 + i (1 + i )
At N → ∞: CCA tax shield = [(t d)/(i + d)]
CCTF = 1 – [(t d)/(i + d)]
(No salvage value)
CCTF Value for Depreciable Assets (Declining Balance)
•
Bought before November 13, 1981:
CCTF = 1 – [(t d)/(i + d)]
•
Bought after November 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:
Depreciation:
1
2
…
k
d/2
d
…
d/2
Dr. Hassan, Y. – 91.380
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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:
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Tax shield adjustment applies
-
Tax shield adjustment = (UCC – S) * (tax shield)
Example:
A new testing machine will be purchased at $45,000 in early 1981. 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%
Example:
In the previous, if the machine has a salvage value of $5,000 at the end of its life. What is
PW (after tax)?
Example:
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)?
Example:
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.