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Sign the attendance sheet Switch off your cell phone Get ready for a quiz Principles of Taxation
Oksana Alexandrovna Korneo, MBA
Office #307, Dostyk Building
Based on Principles of Taxation for Business and Investment Planning by Sally M. Jones
Principles Property Acquisitions
and Cost Recovery
and Deductible Expense or
In present value terms,
the tax savings are usually maximized (and the after-tax cost is
minimized) if the expenditure is deductible in the current tax year.
The present value of the tax savings decreases if the firm must
capitalize the expenditure and postpone its deduction until some
future year. For tax accounting purposes,
capitalization means that an expenditure is recorded as an asset on
the balance sheet rather than as a current expense. Deductible Expense or
Absent any restrictions, firms would deduct every business
expenditure in the current year. However, a basic premise of the federal income tax is that
no expenditure is deductible unless a specific provision of the
Internal Revenue Code authorizes the deduction. Deductible Expense or
If the expenditure results in the creation or enhancement of a
distinct asset with a useful life substantially beyond the current
year, the expenditure must be capitalized.
year Even if the expenditure does not result in a new asset or enhance an
existing asset, the expenditure must be capitalized if it results in a
significant long-term benefit to the firm.
significant Moreover, if the tax treatment of an expenditure is uncertain,
capitalization is the norm while deductibility is the exception
capitalization This year, Corporation M raised $1 million of new capital by issuing
preferred stock to a group of private investors.
The corporation incurred $40.000 of legal and other professional fees in
connection with this transaction. Corporation M's marginal tax rate is 35
percent. Compare the after-tax cash flows under two different assumptions
concerning the tax treatment of the $40,000 expenditure.
Current Reduction Capitalized Cost
Proceeds of stock issue
Tax savings ($40,000 deduction X 35%)
After-tax cash flow $1,000,000 $1,000,000 (40,000) (40,000) 14,000
$ 974,000 0
$ 960,000 Expenses related to raising capital or reorganizing a firm's capital structure
are for the betterment of the firm's operation for the duration of its existence
and are not deductible.
not Repairs and Cleanup Costs
Repair and mainte-nance costs that are regular and recurring in
nature and do not materially add to either the value or the useful life
of an asset are deductible.
are In contrast, expenditures that substantially increase the value or
useful life of an asset are nondeductible capital improvements.
are Similarly, the expense of adapting an existing asset to a new or
different use must be capitalized as part of the cost of the asset.
capitalized Out of concern for earthquake safety, the city of San Francisco required
the Fairmont Hotel to either remove or replace the con-crete parapets and
cornices that had decorated the hotel's exterior since 1907.
The hotel spent $3 million to replace the old parapets and cornices with
replicas made of light-weight fiber glass. The Fairmont Hotel deducted the
expenditure as a repair.
The IRS concluded that the expenditure was a capital improvement to the
building and disallowed the deduction. In court, the Fairmont's owners
argued that the $3 million expenditure was necessary to maintain the
classical арреаrancе of the building and to preserve its identity as a
"grand hotel of the world." Moreover, the expenditure Was no t voluntary
bat was respired by city ordinance.
In spite of these arguments, the court agreed with the IRS that the
expenditure materially prolonged the life and increased the value of the
Fairmont Hotel and was not deductible. Environmental Cleanup Costs
Many firms, either voluntarily or because of government mandate,
are spending millions of dollars to clean up pollutants, toxic
wastes, and other dangerous substances unleashed on the
environment as industrial by-products.
These firms argue that these cleanup costs should be currently
deductible, while the IRS maintains that many such costs must be
capitalized. Environmental Cleanup Costs
MM replaced the asbestos insulation in all its manufacturing equipment
with non-hazardous insulation and deducted the replacement expense.
The company justified the deduction because the replacement was made
to protect the health of Its employees and did not improve the operating
efficiency or increase the value of the equipment. Furthermore, the
replacement expend remedied a historic problem and was not related to
the generation of future business income.
Upon audit, the revenue agent concluded that the asbestos replacement
did, in fact, result in a long-term benefit to Company NM by permanently
improving the work environment Therefore, the IRS required the company
to capitalize the replacement expense to the cost of the reinsulated
equipment. Environmental Cleanup Costs
Congress enacted a provision allowing firms to elect to deduct
(rather than capitalize) expenditures incurred to abate or control
hazardous substances at targeted contamination sites,
commonly described as "brown-fields.“
This provision should encourage firms to undertake
environmental remediation of these sites by reducing the aftertax cost of the remediation. Current Deductions of Capital
Expenditures as Subsidies
The tax law contains special rules permitting firms to claim deductions for
expenditures that clearly should be charged to a capital account. These
preferential rules reduce the firm's after-tax cost of the expenditure and
thereby represent an indirect federal subsidy.
For instance, firms may deduct the first $ 15,000 of the annual cost of the
removal of architectural and transportation barriers from buildings or
transportation equipment to make such facilities more accessible to
handicapped or elderly people.
A more significant preference is the allowance of a deduction for research
and experimental expenditure. This deduction is available even if the
research leads to the development of an identifiable asset with an extended
useful life to the firm. Current Deductions of Capital
Expenditures as Subsidies
Under the accrual method, firms match expenses against
revenues in the year the firm incurs the liability for the expense,
regardless of when the expense is paid
CPT Inc. research laboratory spent $3 million in the development of a
chemical process that eliminates cholesterol from dairy products; CPT
applied for and received a patent on the process from the U.S. Patent
The patent gave CPT the exclusive right to exploit the process for
commercial purposes for 17 years. Even though the patent is an
identifiable asset with long-term value, CPT deducted the $3 million cost
of this "self-created asset" as а research and experimental expenditure.
Consequently, CFTs capitalized cost of the' patent is zero. Current Deductions of Capital
Expenditures as Subsidies
Many preferential deductions benefit only certain industries:
• For instance, farmers are allowed to deduct soil and water conservation
expenditures, which include the cost of leveling, grading, and terracing
land, constructing drainage ditches and earthen dams, and planting
windbreaks to inhibit soil erosion.
• Oil and gas producers may deduct intangible drilling and development
costs (IDC) associated with locating and preparing wells for production. Advertising costs are deductible, even though a firm's successful
advertising cam-paign can increase its market share and improve its
competitive position for years to come. Graphic Design
R.J. Reynolds tobacco Company deducted $2,2 million of graphic design
costs related to its cigarette backs and cartons. Graphic design
comprises the verbal information, styles of print, pictures or drawings,
shapes, patterns, and colors displayed on the packs and cartons.
The IRS disallowed the deduction because the design costs created
intangible “brand equity” assets that were distinguishable from the
goodwill created by advertising.
In court, R.J. that its graphic designs fit the textbook definition of
advertising as “any presentation and promotion of ideas, goods, or
services by an identified sponsor, which involves the use of mass
The judge accepted this argument and held that R.J. Reynolds could
deduct the graphic design cost as advertising expenses. Basis, Cost Recovery, and
Basis can be defined as a taxpayer's investment in any asset or property
right—the measure of unrecovered dollars represented by the asset.
An asset's basis plays a key role in the calculation of cash flows because
taxpayers are entitled to recover this basis at no tax cost. This recovery
occurs either through a series of future deductions or when the taxpayer
disposes of the asset.
A deduction for a portion of the capitalized cost of an asset has two
1. the asset's initial tax basis is reduced by the deduction. The reduced
basis is called the asset's adjusted basis.
2. The second consequence is that the deduction generates a tax savings
that reduces the after-tax cost of the asset.
that Firm J pays $5,000 cash for a business asset.
The tax law allows Firm J to deduct the capitalized cost of the asset ratably over five years. In the year of purchase and in each of the four
subsequent years, the firm deducts $1,000 and reduces its basis in the
asset by this deduction.
If the firm has а 35 percent marginal tax rate and uses a 7 percent
discount rate to compute net present value (NPV), what is the after-tax
cost of the asset (NPV of the cash flows)? When a firm acquires an asset through debt financing, the cost basis of the
asset equals its entire cost, not just the firm's equity in the asset. Tax planners refer to the use of borrowed funds to create tax basis as
leverage. The use of leverage can reduce the purchaser's after-tax cost of
Assume that the firm financed the purchase by paying $1,500 from its
bank account and borrowing $3,500 from a commercial lender. Firm J
gave the lender a lien on the asset to secure the debt. Firm J must pay
$315 interest (9 percent) at the beginning of each year and repay the
$3,500 principal amount at the beginning of the fifth year. The annual
interest payments are deductible expenses. Four Basic Methods
of Periodic Cost Recovery
• cost of goods sold,
• amortization, and
• depletion Cost of Goods Sold
Firms maintaining inventories of goods for sale to customers are required
to account for their inventory on the accrual basis
In other words,
firms can't deduct the cost of manufactured or purchased inventory but
must capitalize the cost to an asset account.
must Allocating Costs between Inventory
and Cost of Goods Sold
• Specific identification
• LIFO *** While the LIFO convention can offer substantial tax savings, its
popularity is diminished by the fact that any firm electing LIFO for tax
purposes must also use it to prepare financial statements.
Because of this, any reduction in taxable income attributable to LIFO is
mirrored by a reduction in accounting income and earnings per share
reported to the firm's investors Depreciation / Amortization
KZ TAX CODE
main assets, investments to immovable property, intangible and biological
assets which are accounted for in the accounting balance sheet of the taxpayer
in accordance with the IFRS and the requirements of the legislation of the
Republic of Kazakhstan and intended for the use in the activity aimed at
earning income. … assets with service life over one year …
assets Depreciation / Amortization
KZ TAX CODE
NOT Fixed Assets (extracts):
• museum valuables;
• monuments of architecture and arts;
• facilities of public use; motor roads, pavements, boulevards, public
• assets under constructions;
• items related to films archives. KZ TAX CODE
Accounting for fixed assets shall be carried out by groups:
No. No. of group Description of fixed assets 1. I Buildings, facilities,
except for oil, gas wells and conveyor facilities 2. II Machines and equipment,
except for machines and equipment for oil and gas
production, and also computers and equipment for
information processing 3. III Computers and equipment for information processing 4. IV Fixed assets not included into other groups, including
oil, gas wells, transmission facilities, machines and
equipment for oil and gas production Depreciation / Amortization
KZ TAX CODE
Beginning Balance (New Tax period) =
minus Depreciation (previous period)
minus Adjustments (previous period) Ending Balance =
plus (minus) Adjustments Depreciation / Amortization
KZ TAX CODE
Receipt of Fixed Assets
the historic value of fixed assets shall comprise costs incurred by the
taxpayer from the date of putting such fixed asset into operation:
• costs of purchase of a fixed assets,
• costs of its manufacture,
• costs of construction,
• costs of assembly and installation, as well as other costs increasing
its value Depreciation / Amortization
KZ TAX CODE
No No. of group
. Description of fixed assets Max rate of
ion (%) 1. I Buildings, structures, except for oil, gas wells and
transmission facilities 10 2. II Machines and equipment, except for machines and
equipment for oil and gas production, and also
computers and equipment for information
processing 25 3. III Computers and
processing information 40 4. IV Fixed assets not included into other groups,
including oil, gas wells, transmission facilities,
machines and equipment for oil and gas
production 15 equipment for Amortization of Intangible
As a general rule,
amortization is permitted only if the intangible asset has a determinable life
CPT Inc. patented a chemical process that eliminates cholesterol from diary
Hanover Inc., a manufacturer of frozen foods, wanted to use the process to
develop a new line of healthy ice cream, Thus, Hanover purchased the patent
from CPT for $ 10 million. At date of purchase, the patent had a remaining
legal life of 157 months. Hanover must capitalize the cost of the patent and
can amortize the cost at the rate of $63,694 per month ($10 million /157
months). Amortization of Intangible
A firm's cost basis in an intangible asset with an indeterminable life is
not amortizable but can be recovered only when the firm disposes of the
This year, Firm FG purchased 16,000 shares of common stock in ABC
Inc. The firm also bought a 10 percent interest in the KLM Partnership.
Firm FG must capitalize the cost of both these intangible equity
interests. Because the interests represent a permanent investment Firm
FG cannot recover the capitalized cost through amortization. Amortization
Organizational and Start-Up Costs
Organizational costs - legal and accounting fees attributable to the
formation of a partnership or corporation and any filing or registration fees
required under state or local law .
Start-up expenditures - include both the up-front costs of investigating the
creation or purchase of a business and the routine expenses incurred
during the preparation phase of a business. This preparation phase ends
only when the business has matured to the point that it can generate
Tax law allows newly formed entities to elect to amortize their organizational
costs and start-up costs over a 60-month period.
The capitalization requirement for start-up expenditures does not apply to
the expansion costs of an existing business.
Organizational and Start-Up Costs
Mr. Dugan and Mrs. Huffman go into partnership to operate a day care center.
Their first step is to engage an attorney to draft a partnership agreement; the
entrepreneurs pay $800 to the attorney for her services and another $160 to
register their new partnership with the state. The partners spend the next two
months locating and renting a suitable facility for their center, hiring and
training staff, publicizing the new business, and applying for the operating
license required under local law. Their expenses with respect to these activities
DH Partnership receives its operating license in late August, and the day care
center enrolls its first student on September 3.
How much DH Partnership should capitalized and amortize every month? Amortization
Organizational and Start-Up Costs
TresChic Company manufactures and imports perfumes, cosmetics,
clothing, and accessories. For many years, TresChic sold its goods only
However, three years ago, the company decided to move into the retail
market and opened its first "BeBe Boutique." The success of the first
boutique prompted the company to open 11 more boutiques nation-wide.
The boutiques operate in exactly the same manner, have a standardized
décor and carry the same merchandise, TresChic handles the accounting,
financing, management, purchasing, and advertising for all the boutiques.
Can TresChic capitalize the cost associated with 11 new boutiques? Leasehold Costs and
When a firm rents tangible property for use in its business, it may incur upfront costs to acquire the lease on the property. Such leasehold costs must
be capitalized and amortized over the term of the lease. In contrast, if a firm pays for physical improvements to leased property, the
cost of the leasehold improvements must be capitalized to an asset account
and depreciated under the normal rules. Leasehold Costs and
Early in this year VB Corporation entered into a lease agreement for
commercial office space.
VB’s cost of negotiation the lease was $3,120. The corporation also spent
$28,000 to construct cabinets, bookshelves, and lightning fixtures to
conform the leased space to its needs. The term of the lease is 48 months,
beginning on May 1.
How much should capitalized and amortize? Purchased Intangibles
A firm that purchases an established business enterprise is usually buying
more than just the monetary and tangible operating assets recorded on the
businesses balance sheet. If the lump-sum price exceeds the value of the
monetary and tangible assets, the excess is allocated to the intangible
assets of the business.
Such assets include
• goodwill (value created by the expectancy that customers will continue to
patronize the business)
• going-concern value (value attributable to the synergism of business
assets work-ing in coordination).
For tax purposes, firms recover the cost of purchased intangibles over a 15year period, regardless of the actual length of time during which the firm
expects the intangible to yield any commercial benefit. Purchased Intangibles
On March 9, В V Company (a calendar year taxpayer) paid $2 million to buy a
business enterprise from Mr. Lopez.
The sales contract stated that $1.7 million of the lump-sum price was
attributable to the appraised value of monetary and tangible operating assets.
An additional $100,000 was attributable to the business's trade name, and
$200,000 was attributable to a covenant not to compete. Under this covenant,
Mr. Lopez agreed not to engage in a similar business for the next three years. Refer back to the example in which Hanover Inc. purchased a patent for a
chemical process for use in its manufacturing business.
This year, Crowne Food Inc. purchased Hanover Inc’s entire business
operation. Consequently, Crown Food acquired all Hanover*s tangible
and intangible assets, including the patent At date of purchase, the
patent had a remaining legal life of only eight years (96 months).
But because the patent is included as one of Crown Food's purchased
intangibles, Crown must recover its cost allocated to the patent over a 15year amortization period. Depletion of Natural Resources
Firms engaged in the business of extracting minerals, oil, gas, and other
natural deposits from the earth incur a variety of up-front costs to locate,
acquire, and develop their op-erating mines and wells.
Many of these costs must be capitalized and recovered over the period of
years during which the mine or well is productive.
The method for recovering a firm's investment in an exhaustible natural
resource is called cost depletion. The annual cost depletion deduction is
based on the following formula: Depletion of Natural Resources
Company M, which operates a mining business, spent $500,000 for
geological surveys, mineral rights and excavation costs, all of which were
capitalized as the basis of a new copper mine. At the beginning of the
first year of production the company's engineers estimated that the mine
should produce 80,000 tons of copper ore. During the first year 20,000
tons of ore were extracted and sold. The company's cost depletion
deduction was $125,000.
At the beginning of the second year, the engineers revised their estimate
of the mine's remaining productivity to 65,000 tons; during the second
year, 32,000 tons of copper ore were extracted and sold. The cost
depletion deduction was $184,615. Expenditure Benefit
in current year
to inventory Nondeductible Capitalized
to asset account
disposition only ...
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- Spring '11