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Unformatted text preview: CNAPTC 1.2 7 laxes fl9 Personal Income Taxes and Corporate
Income Taxes Compared pjfl vicoine tases and colporate iicutne uxe
FIìee are cubumiaI dffeieiice
Most duJt ii.c familiir with dic rouunc of filing incumc tax returns. For most pcopk, thc
proccdurc is rithcr simpic: An cmploycr provides ì stnmcnt rcpordng thc person ncomc
incarne tax aIrcidy pd, and othcr Jr1ounts for the prcvious )rcr. thcse amounts are assem1kd ou the tax trrn Mid hire Used cak-ulue ihe iotiI tax owed or the arnourt of refujiti.
rUht: u returu ts then ubrniueti to the iproriate govennnent tx ageiicy fur rocessirig.
Corporate taxes are inílir in corne ways, but the re are several substantial thftereiicec.
Onc main Jiffcrcnce has to 10 with the tax racc. Pcrsonal rncomc txcs usually exhibit a
progrc:s5i'c tZX YItC mcning that people who earn more arc charged a Iargcr percentage oíthcir incomc.. For exampic. ifa perso&s tax.ibk incxnnc is rcry Io' he or shc might
flot pt' auy income taxcs. At a moderate iricorne in indviJuaI rrngti t he epectud to
25 percent ofhis or lier income s income tax. A very-high-income indivdua1 in some
cowitríes might pay SD percent or more of his or her income in income tax. Although
thc cact ratc of taxation changes from ycìr to year. and varies from country to councr
individuiI income taxes in developed countrics arc almost always progressive.
En contrs, corporac tixcs are typically Icvicd according to a proportíonl or
tx. iliLs nietns that cororatioris pv he saine tax rate, regardless of their iiicorne level.
Agún, races c-iì change over time atid between couiicries, but the r.ue will he the sgiie
whcthcr a company makes a small profit or i vcry large profit. The main cxccption is
that most councrics git-c smaller compatiics favourthlc ta rcatmcnc to encourage ncw
businesses. I lowever, once the business is oEa certain size, the t:n ritc is constant.
.&I1()thCT difference betweerk personal iticonie IIx ami coqiurite iucorne tX lia' to (IO
with itr the LI-x IS calculiatetl_ l'he income Used to LletercnIc Ilie taxes ail iIl(Iiviilu;l pays
reduced by deductions or tax credits, wllteh are real or nominal cocts that
or are taxed at a reduced race. For cirnp1c, cxccss medical epcnscs, tuition kcs antI
pcnsion plan concriburions arc gcncrailv all considcrcd eligible dcducaons along with
a subtstandal 'basic personal amount." 'thus an individuaPs utaabIe income" cin be qrnte 3
hit tess i-fian his or her actual meome.
A cororaiìoti's Laxes are calculated in quae a different mariner. Net liicorne br tax
purposes is calculated by subtracting expenses, which are either real costs associated
with performing the corporation1s business or a portion oí the capital epciisc for an
from gross income. ConscqucntI; a company that m3Lcs lio prott (income iess
epcnscs) may pay no income taxes.
aJILI corporale taxes differ in c(irnplexit
In arcìcu1ar, a comparivs
taxes will uualTy be complicated by iues concerning capital expenses. trhiclì are purchasts of asseL ci sígníficaiit ralue. Suth assets have a strong effect on the income taxes
paid by a company but how they are created for tax purposes is complex. lhis is usually
not an issue oconcern to indisduaIs.
to asset1 7.3 Corporate Tax Rates
In this diajaer. we are concerned only with coriorate taxes, and in particular tIle impact
ofcorporate income taxes on the viabdicy oían engmeermg project. Thble 7.1 compares
corporate taxes among several couinries, hut the actual tax rate applied in any circunistance can lic fairly complicated and can depend on the suc of the firm, whether it is a PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor 240 CIIAPTIII ? Tucet Table 7.1 Corporate Tax Rates Around \rgentina \ucr1ia
India 34% Isracl 36.1%
Francc te World frcLrnct South Afrtca
Unitcd Staccs 25%
3t)-44J% 12.5% 31%
29% 15-5% location, and a varicty <Áotber ficcors. Comparing the ux nates in ulfferent countries s difficult. For example, come countries provide a ful! range of healthcare cervicec from their tax revenues, while others do uoc. Cercaiti health-care cot may
be, msccad! a significant cxpensc for a compan In come countries thc tocal curportc
tu is a combination offrderal tix and statc or provincial tar. 1c races cliangc ovcr ümc.
and thcre arc sometimes hor-tcrni tax rcdlicnon5 or inccntwCs (see Ckse-Up 7I) for
companies in sl)ecIìc iidutrie. Rather iban locucluig wi ilie irnIicaiions olsuch uIiïerencec, our concern here is wdi che basic approach used in deternuirng the impact of
taxcs on a proicct. For spcciI tax rules, it is bcs o chcck with the approprîatc tax
agency or a tax specialist.
in the past
lt is aiso .uto.ih noting thac: tax rules can changc cuduknl» For
3(_} years .1 icre jtare Ieen fundanicuital dun gts in the cororate tax ru1e
in CanaLla and
other countries. These changes can aiitl have had a significant impact on inveUneiics Tu ade
by companies. Lesc-signilicant new rulec are ititroduced every yeardue to changes in techiOlo% current cconomic conditions, or policical factors. In particular thcrc arc usually
opportunicics for small technoIokal companies co take advantage of benckial tax rules.
as detailed in Cl0SC-1.J 7.2.. rnnuiacturcr. i cxampic1 Inetives I- - I Governments sometimes uy co iiitluence corporate hehaviour through the use. ot in«nzáves. These inccntivcs include grants to certain types of projcct; for cxample, prQjett$
unckrtaken in particular g«graphic areas, or nriectc provkli ng m iI ovnuent t( crtin
Oilier incentives take the kwnt of ta relief. For example, ieverI cuuntries allow poilutioiì equipnieni to be folk cpenscd in the rer of purchase. Tue ibility to depreciate
poIliiori equIpment qiickly
it a more desirible investmeiic for a company and a
li,cncficial iflvtsrmcnt br society as a whoic.
ì'he Cct Iorin of incentivc% changes from year co year as gnvernmcnts change and
a rIte pliticl iritresb of r.00kty clunge. In rnat compuriies there is n individual or
kparunent Lh1L keeps ir.ck of poible programs alkuing cirnipany protects.
Incentives must be considercd when assessing the viahiliiiy ot project Grant meenIj%res provide additional cash How to dic project that
n bc taken into account like any
ckmcnt- Ta inccnovcs may lic morc di1icuh to ascss since somcimcs
for ccimI1c. IlleV u-sc othcr tC)IThS of de1rcdatùrn or mîy rccult in diftcrent tax races ditrein prt ()ÍtIte pro ¡ecL PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor CW*PTC Sriiall Company 7 laxes ?41 lax Rules d'rntiges arc gwen w sinì1ler compinic. ucb tediniciIIy oriented
..ridiig their own
firm rather than working for a ti-g'er company. The purpoe ut these incentives is to give
i strong motPv(ion to inco.rportc a new company and providc morc aftcr-u incomc for
retnvesunent and ext)an!ion.
¡n Canada, die crnall bursess deduction applies tu small Canadian-controlled
private corpora orl arid rcduccs ihc ellcctivc tax rate for a small Canadian company tu
llfl-up. This iiiav ti i o xrticuLir intere;t to engiiieerc incerest«1 iii Li less than 20 percenc U die Spreidsliect Savvy fiawre will Fucus on che ue ufExcel charts and Ñn'matiing (iatrcs USC(Ul in the pnparation o(cnginecring reporis. Spread4ieet soFtware i.. in
tool nr prcparing charts ta cumma nze the rcsailts rif n ccoriumk anaiysi. Creating charts with
Eççl is qraiInarward. Pral,llv thc nwist commonly uscd is the X-V scatter) chart, lt pIot a
sei-jcs ol V values a Ñnçtiun uf corrjin Jng X values. The atter chart below wjs ci-eaeç4 Ivotii
the Chipicr $ Sprcadshcct Sawy tahlc
in Clupters 7 antI RcpLwrmenl Analysis 50000
000 4 40000
35 000 30!'!'
(5) 25 (MIRi 20 Iii;.! i 5 000
o 3 i 4 L'.. -s- Salar Iuc --- Operating and mintenanie costs
fr Lue in \cars. Salvage Value,
To beitin. highlight xlls R3D$ containing the titles and data
Operating anti Maintenance CLs. Select Insert Irwn the riliixjn. and then X-Y(ccauer)as th
desired chart type. Ofthc options, thc clurt alxwe shows 'srraìght mcc and markcr.' By default.
the chart will be inserted as an 0bject intii thc current worksheet. }y tlicking anywhere on th
chart. the riIbim will indiçatc three çhrt editing uptions I)CsiII1 I .ayout anj Formai. inder
Dcsi-n, the layout and saylc of an cxisting chart ian he changcJ. as well a its location- Under th
I.ayout tab iin the nbbmi. the lacauun of the legend was chand to below the chan, and the font
wschangcd to enlarge it (i-oui ts dthoht aluc. Also undcr I.avuut. the grîdhineswcreajiiisted ti
and I PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor 242 CHAPTIII ? Tucet hiw both honzunul arid vcnìcal grid1inc! for the mar
adJeI. a; well as both horíiontal and rnciÎ ¿is Iabe1.
rai. on tI1IC auic mar1cr. FinaIly a charE t1c ws
hcsc options all appear under the Layout rî1iiìfl. Thc lwmLring afrhc X and V axes was aIuchangcd. Whcn thc chart w-as firsi nudc, thc mticimum Y va!uc displaycd was 60 0(X), and far tlic X axis it ws 8)- Iioveiing ovir ithcr uf
or rile AXLS Ic1 and righr-ctickini, scvcral cdiiing ripiions bccomc ava2tablc. ith thc (nnr option
fur the Y acä, the dedmal points were removed and the funt suc cnlargcd to I 2pt ,riaI) md lEahcized. Under furtnat aiis, the maximum vahic di%played was %ct to 5O 000. Similar changes were
o 4 and thc Ioi ic chngii tu i 2pt ÑI, itahmade to the X ci'i.., with the ma.iuiiwii luc
to be a fact an1 eWectwc toal for cuninìanzìn
. artd commuiiic.itint recuits from an 1.4 I Before- and After-Tax Txcs havc cmomk anaIvcic. MARR significant effect ori cngiincering decixion making so much so chat they
cannot 1)C ignored. In this tct, so
it seems as though no spectiv tix ciIculitions hwc
been donc. In fact, they hare bccn implicitly incorporated into the computation5
iIrough the wie ()fI lieIure-ux MARR. iIlougtk we Iia not called it ucb.
rIìe basic logic i a follows. Suiec taxes have the effect of redudtìg proñts asoctned
with a project we need to make cure chat we sec an appropnate .\IARR for project accept3IJi1k) If we do not cxplicitly account for che impcc of cacc in thc project cash (1ows then
WC fleed (t) Set !1ARR high enough to recognic thit taxes Will fleed to be paid. 1'his is
the br/ire-t.íi.r \IARR. If. ou the other hand, the impact of taxes i explicitly cc()uI1tec1 nr
t1owi ola roect (i.e, rtduce the ca,h flows I,y
tx rate), then the MARR
uced for the proiect chould bue lower, since che cas-h flows already taLe into account the
paymcnc o caces. This is thc IftLSt.7?X 1ARR.
lui íict, we caut expreM iui approximate re1aiionchtp
ì lar1 1 ch (7.1)
ARR1artx X (1 - t)
where t is the corporate t rate. The tir'i,r_r4ix \1ARR means tIit the %1\RR has been
chosen high enough tu provide an accepiable r.Ìte of return williout explicitly cousiLlering
bixes. liii other words, since aU profiLs are axed at hie ra te hie l!ejoîr-tdx \1ARR bac to
MARRTIU t, include enoug1 returns to meet the afkr sax i-1ARR and,
addition, provide the amount
to be paid in taxes. As we can sce front tbc ibovc equacion, the after-tax MARR will gcncrally be: lower than the bcforc-tax !-1ARR. %trc will sec latcr in this chapter how thc
relationship giren in this equation is a simpIificition hut a reasonable approximation o1 the
effect of taxes. In pracuce, the beÑre- rn LI after-tax 1ARRs are often chosen iudependenny and are not directly related by this equauon. Generally s-peaLtng, if a MARK is
t.iven rjchout seciIvtn whether t is on a before- or after-tax hasic-, it can be assumed co
bc i before-tax i\IARR.
III Saskatchewan Gold Mines (SGM) has been selecting projects for inves-inient on the
basis of a before-tax %tARR of U perccnc. Sherri feels that some good projcc havc
been missed becausc che cffcccs of taxation on che projects have not bccn examined in
enough detail, so shc proposed reviewing the projects on an after-tax basis. 'Iut would
l)e a good choice 01 after-tax MARR for her rcview SGAI pays 45 percent corporate
taxes. PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor CNAPTC 7 laxes ?41 Akiinugli the iisue oÍe1ecüng n after-tax \1ARR is Iilet to h more cornplkated,
recorub1e choice for Sherri would be to uce Equation (7.1) s wy of caIcu1crng an
after-tax MARR for her review. lins gwec MAR R.kILcru = 0.12 X (I - 0.45) = Q.06 = 6.6% A reasonable choice for after-tax ÏtIARR would he 6.6 percera. \lRR biOW when to use the aftcr-tix
ind when to use a beforetax MARR. In geTler.al, f yOU are d()it an aproxitnate calculation without taking taxes
fltI) account exptictly, then you shouiI use a before-tax ALARR. Thus, aU tile examples
in this book up co this point were appropriately done usiig a belore-tax MARR, boosted
to account for the fact that profits would be taxed. I Iowever when con skiering taxes
explicitly im calculations, the after-tax MARR should be used. There is no need to
increase the deci5ion thrcshold when the proììts that arc lost ro taxes arc dreaJy taken
lt is import;ult CO into account. 1.5 The Effect of Taxation on Cash Flows
There is a cet of
sh flows chat arises whenever an iiwescment is made. Consider the
following example. Ebcon Corp. is considering purdiasing a small LICVICC Used to test printed circuit boards
that has a first cost of $4 DoD. The tester is expected co reduce labour costs and
improve the defect detection rate so as to bring about savings of $23 0(X) per year.
Additional operating costs arc cxpectcd to lic $73(X per year. The salvage value of the
tester wiH be $5000 in Ave years. lhe corporate tax rate is = 42 percent and th aftertax AlRR is I 2 pertcnt. lucre are thrc .
e U key cash how cicments in this example. First cost: chc $45 000 investment. This is a negative cash flow made at unie zero.
Net annual savmgs: the S23 00() per year savings less the $7300 additional operating
costs for a net$15 700 positive cash flow at the end ofeach ofyears one w five.
Salvage value: the $5000 residual value oldie tester at the end of its service life in five
years. Fach of thcsc cash flow elements is affected by taxcs and in different ways.
En this section we will explore the influence of coqx,ratc ncs on the
tsh flows for
diìs inveslinent untier sirn1,1i1ed tax rules that are ilot
common in Canada. 1he actual
rules of clic Canadian tax c'stern are quite complicated. probably the most complicated n
the world arid are better dealt wali after the basic prirxcip1 have been established. 1.5.1 The Effect of Taxes ori First Cost Companies are taxed on net profits. which are revenues less expenses. Consequeral)
when an expense is incurred, less tax is pad. From this perspective, although the tester in
PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor 244 CHAPTIII ? Tucet Fxmpk hJ cost of $45 OOO ¡f thic Arst cost couid be rcccgni7cd as n
icnrnedift t:xi)ui, ikert would 1c a t;ix aving ufS45 000 x 0.42 - $18 900. }liwever
the itx henefic. ;we usu.iIk Cliuiult(1 ;u Lue eiiti uÍ tx yeir. .kcsurnìnR that the tecter wt
purched at the beginning uf the year, and the tax saviìg accrue at the end of thn
samc year, thcn thc prcscnt worth ol the lirsi coc of thc tester wuId QnIy be
$18 900(P/F12%,1) = $45 000 + SIS 900(0.89286)
Ilowrver, by tax nues, capital purchases such as production equipment cannot U5Ually be FuIt c6irned ai an expence iii hie year in which Lite purcIie occurred. The logic
is tased on the idea ofdepreciauon. Acec retain value over unie. Their loss in va1ue ac
oppoced to their coc. trht tax ruTes generally reconize as an eligible expense.
Given a choice, a finii would want to write off (i.e., depreciate) n investment is
quickly as paissibic. Sncc deprcc:ation is considered an cpcnsc and offsets revenue the
earlier the epemsr is recogni7cd. thc earher the ta savings wilT accrue. Sinoe money
earlier in LiTTle worth more iIuui the iarne arnourn oImoney later in time, there Lc good
reason tu deprecvate cptal assets as quwkly as a1luwhIe. This effect of reductiig taxec
can be coiiciderable.
Although companies would of course, like to rcducc taxes by writing off their aecc
as quickly as possibIe. there arc also undesirable cfÑ,cts of doing this. For one thing, it
tnay lead to accounting dcwurnentc that are riot represcuiLicive of a 1km actual financial
if valuable c1,ital acsets are aigned-for tax reacons-tc) have
value, tl'us may underrepresent the true value of che compaiìy ac
a whole. It may also creatc an opporninicy for inefficient business dccision-s. From thc
perspective of thc government imposing the taxes, it can lead to companies improperly
ecpIoiting the tix rules.
To couuter these undesirable effects, tax utlioritie have carefully tielined tue
derecìaiion tnethods the Permit for wie iii coinuiing taxes. The ennkted inediods
for claiming depreciation expenses may not reiiec the true deprecinioii of an ascet,
they are rulc-oriented rather than truly attempting to recognize thc diminishment iii
value of an assec. Conscqucntly, chc dcprcciation charge is rcfcrrcd to by a difkrcnt
name-the ipit4 c aioz'ai:tr-to recognize that the book value implied by the taxaiicrn-related depreciation charges does not riececsari1 reprecent a good eciimate of the
asset market value. however, there is usually a fair correspondence between capital cost
allowance auJ depreciation, and many firms do not distingu1sh henveen them in caic-ulations for their financial ctatcmen. Lt is chcrcforc reaconablc to thmk of theni as being
the same thing for most purposes.
7.2(A) a Irst 45 ljx ruTes for Fbcon Corp. (see Example 7!(A)) speci that the capital allowance For thc
ieLtt he calculited as straight-line dcrecation over die life uf the tester. ''ha is the
pre,ent worth oldie testers first cost?
This seems like an odd qucstion but it rcuks from the 1ct that in a taxed company;
iRe first cost irnrnetliaely
rise to future tax savings. This exanipte is criterit wiili
one of the depreciation methodologies occasionally permitted as au investment mcencive
As i1tutratetI in Figure 7.1, the first cost of$45 (J0() gives rise to h.eiiefii in the form
of an annuity of 45 000 x 0.42/5
$3780. In a sense, the presence of taxes transforms
the $45 ()00 purchasc into a more complcx s'ct of cash flows consisting of not only che
first cost but also a subscanúal annuity.
Lfl PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor CIUPTC Figure 7.1 The Beneficial Effects of a First Cost (for Example
760 tax 5axlngs per 7 laxes ?45 72) wii hie present worth of the fIrst yost is then:
- -45 000 + 37H0(P/AJ2%,5) = -45 001) + 3781)(3.bO+8)
The present worth of the zecter lìr cos is ibouc -$3 I 400. -31 400 Note that this result is rnore coct1 for Fbcon by aLmut $3 400 - $2 000 = $3400
il Ehcou could
the eu1tre Lester in the ear of purctiae. This difference s
the preseni worth uf the
Uxes that the government tecCivCs uy not .dhwing
Fbcon co count che tester as an expense m the year that it .traç purchased. ¡he Effect 1.5.2 I exne lilark of Taxes on Savinas .'ilthough iii a taxed business environment the first cost is reduced, this is balanced by
the fact that the savings from the investinent are also reduced. An uiiilerivirig assurnplion is iliac any inve-_Stukent decision Ls made in a pnfitah1e company for which ibis ttecision is a relatively siuill part of the overall husuiess. Consequently, if any rnoiìey is
savcd those savings increase thc profits of che finii. And since profits arc taxed at the tax
rate, the net savings arc reduced proportionah1} present worth of the annual ncc savings created by the tester?
hlie approach used i to reduce the net annual savings ci the teste...
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