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Unformatted text preview: Before we start Before Sign the attendance sheet Switch off your cell phone Get ready for a quiz Principles of Taxation Principles Instructor: Instructor: Oksana Alexandrovna Korneo, MBA Oksana Office #307, Dostyk Building Based on Principles of Taxation for Business and Investment Planning by Sally M. Jones Based Principles Property Acquisitions and Cost Recovery and Deductible Expense or Capitalized Cost? Capitalized In present value terms, the tax savings are usually maximized (and the after-tax cost is maximized minimized) if the expenditure is deductible in the current tax year. current The present value of the tax savings decreases if the firm must present decreases capitalize the expenditure and postpone its deduction until some capitalize 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 Capitalized Cost? Capitalized 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 no Internal Revenue Code authorizes the deduction. Deductible Expense or Capitalized Cost? Capitalized If the expenditure results in the creation or enhancement of a distinct asset with a useful life substantially beyond the current useful beyond 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 Professional fees 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 Repairs Repair and mainte-nance costs that are regular and recurring in regular recurring nature and do not materially add to either the value or the useful life do of an asset are deductible. are In contrast, expenditures that substantially increase the value or substantially useful life of an asset are nondeductible capital improvements. are Similarly, the expense of adapting an existing asset to a new or adapting to different use must be capitalized as part of the cost of the asset. different 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 Environmental 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 Environmental 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 deduct (rather than capitalize) expenditures incurred to abate or control to hazardous substances at targeted contamination sites, at 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 Expenditures 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 removal 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 and research leads to the development of an identifiable asset with an extended useful life to the firm. Current Deductions of Capital Current Expenditures as Subsidies Expenditures Under the accrual method, firms match expenses against accrual expenses revenues in the year the firm incurs the liability for the expense, incurs 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 Office. 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 Expenditures 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 Graphic 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 media.” The judge accepted this argument and held that R.J. Reynolds could deduct the graphic design cost as advertising expenses. Basis, Cost Recovery, and Cash Flow Cash Basis can be defined as a taxpayer's investment in any asset or property right—the measure of unrecovered dollars represented by the asset. unrecovered represented 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 consequences: consequences: 1. the asset's initial tax basis is reduced by the deduction. The reduced the basis is called the asset's adjusted basis. adjusted 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 leverage the asset. 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, • depreciation, • amortization, and • depletion Cost of Goods Sold Cost Firms maintaining inventories of goods for sale to customers are required are to account for their inventory on the accrual basis accrual In other words, firms can't deduct the cost of manufactured or purchased inventory but can't must capitalize the cost to an asset account. must Allocating Costs between Inventory and Cost of Goods Sold and Basic Methods: • Specific identification • FIFO • 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 Depreciation KZ TAX CODE Fixed Assets: 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 Depreciation KZ TAX CODE NOT Fixed Assets (extracts): • land; • museum valuables; • monuments of architecture and arts; • facilities of public use; motor roads, pavements, boulevards, public squares; • assets under constructions; • items related to films archives. KZ TAX CODE KZ 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 Depreciation KZ TAX CODE Beginning Balance (New Tax period) = Ending Balance minus Depreciation (previous period) minus Adjustments (previous period) Ending Balance = Beginning Balance plus Additions minus Disposals plus (minus) Adjustments Depreciation / Amortization Depreciation 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 Depreciation KZ TAX CODE No No. of group . Description of fixed assets Max rate of depreciat 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 Assets Assets As a general rule, amortization is permitted only if the intangible asset has a determinable life determinable CPT Inc. patented a chemical process that eliminates cholesterol from diary products. 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 Assets Assets 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 not asset 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 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 revenues. 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 does the expansion costs of an existing business. expansion Amortization Organizational and Start-Up Costs Organizational 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 total $3,840. 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 Organizational TresChic Company manufactures and imports perfumes, cosmetics, clothing, and accessories. For many years, TresChic sold its goods only at wholesale. 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 Improvements Improvements 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 leasehold 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 leasehold and depreciated under the normal rules. Leasehold Costs and Improvements Improvements 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 Purchased 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 goodwill patronize the business) • going-concern value (value attributable to the synergism of business going-concern 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 Purchased 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 Depletion 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 must 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 cost based on the following formula: Depletion of Natural Resources Depletion 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 only Current deduction Capitalized to inventory Nondeductible Capitalized to asset account Recovered Through depreciation Recovered through amortization Recovered through depletion Recovered on disposition only ...
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