FNCE-2005 M2 Solutions to Selected Problems

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Red River College *

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2005

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Accounting

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Apr 3, 2024

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Solution to P 11-1 Part 1 (a) Net income for tax purposes: Profits from operations Head office $1,200,000 Alberta branch 10,000 1,210,000 Dividend income 80,000 Taxable capital gains 70,000 Net income for tax purposes $1,360,000 (b) Taxable income: Net income for tax purposes $1,360,000 Deduct: Net capital losses (limited to capital gains, above) [ITA 111(1)(b)] (70,000) Non-capital losses [ITA 111(1)(a)] (120,000) Dividends [ITA 112(1)] (80,000 ) Taxable income $1,090,000 (c) Federal and provincial taxes: Before calculating the provincial tax liability, it is necessary to determine the allocation of business income to Nova Scotia and Alberta [Reg. 402(3)]. Provincial allocation - Because the Alberta activity is conducted from a permanent establishment in that province, a portion of the taxable income is subject to Alberta provincial tax. The percentage of taxable income allocated to Alberta is 14.36% calculated as follows [Reg 402(3)]: Sales in Alberta $1,300,000 = 14.44% Total sales $9,000,000 Wages in Alberta $200,000 = 14.28% Total wages $1,400,000 Average sales % and wages % 14.44% + 14.28% = 28.72 = 14.36% 2 Taxable Income - Alberta: $1,090,000 x 14.36% = $ 156,525 Taxable Income - Nova Scotia: 100% - 14.36% = 85.64% x $1,090,000 933,475

Total $1,090,000 Federal: Basic rate 38% x $1,090,000 [ITA 123(1)] $414,200 Abatement 10% x $1,090,000 [ITA 124(1)] (109,000 ) 305,200 General tax reduction 13% x $1,090,000 [ITA 123.4] (141,700 ) Federal Tax 163,500 Provincial Nova Scotia 16% x $933,475 149,356 Alberta 12% x $156,525 18,783 Total Tax $331,639 Part 2 Operating the Alberta operation as a branch of the main corporation resulted in two tax benefits:  The arbitrary provincial allocation formula caused $156,525 of taxable income to be taxed in Alberta at the lower provincial rate of 12% (versus 16% in Nova Scotia) when the actual Alberta profit was only $10,000. If a separate corporation had been used, total provincial taxes would increase because only $10,000 of the total taxable income of $1,090,000 would be taxed in Alberta. Therefore, if the Alberta branch had been incorporated from the outset, the taxes for the year would have increased by $5,861 calculated as follows: Provincial profits: Branch $156,525 Corporation (10,000 ) $146,525 Tax cost 16% - 12% = 4% x $146,525 = $5,861 Solution to P 11-5 Part 1 In order to reduce the risk of the $650,000 loss carry-forward from expiring, the company can take a number of discretionary steps that will increase income currently in exchange for deductions at a later time. This action will reduce the loss carry-forward but preserve the discretionary items to reduce income at some future time. Some of or all of the following can be done:

(a) Capital cost allowance : CCA is discretionary and if it is not claimed in the current year, the UCC of the class will be higher allowing greater CCA to be claimed in future years. Based on the current year's financial statement, this could increase income by $40,000. (b) Salary to owner : The sole shareholder of the company receives a salary of $60,000. By not paying this salary to the owner, income can increase by $60,000 annually. This step will also reduce the tax payable by the shareholder. If the shareholder needs funds for personal living expenses, the corporation can repay a portion of the shareholder's loan of $400,000 which results in no tax to the shareholder. The amount of the annual shareholder debt repayment required (to meet the owner's personal needs) is equal to the after-tax salary previously received, which is considerably less than $60,000. As less cash is being paid out of the company, its financial strength is enhanced. (c) Allowance for Doubtful Accounts : The company has claimed a reserve of $310,000 for doubtful accounts receivable. Deducting this reserve is discretionary. The current year's reserve is first added to next year's income and a new reserve is claimed. If no reserve is claimed next year, income will increase by $310,000. A new reserve can be deducted in any future year provided that it is reasonable. (d) Interest on shareholder's loan : The amount owing to the shareholder bears interest at 9% which reduces the corporate income and increases the shareholder's taxable income. This amounts to $36,000 annually ($400,000 x 9%). If the demand loan is renegotiated without interest, corporate income will increase and the shareholder's personal tax cost will decrease. If the shareholder needs the funds for personal reasons, annual repayments of the loan can be made similar to the salary adjustment above. If the current year's tax return has not been filed, some of the above items can be implemented in the current year. The potential adjustments total $446,000 as follows: CCA $ 40,000 Salary to owner 60,000 Reserve for bad debts 310,000 Interest on shareholder loan 36,000 $446,000 Therefore, the potential adjustments are sufficient to use up a large portion of the loss carry-over of $650,000 and preserve the deductions for future years. Solution to P 11-6 In computing federal tax for a public corporation there is no tax benefit to be obtained by claiming the M&P deduction (13) since other income receives the general tax reduction (13%). However, there is a provincial benefit in some provinces, Saskatchewan, being one of them.

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If the manufacturing business is operated as a division of Vertex, the M & P profits will be $1,542,375 as follows: [Reg. 5200 – 5202] Business profits: Manufacturing operations $ 240,000 NDI existing operations 4,730,000 4,970,000 Less interest on bonds (130,000 ) Adjusted business income $4,840,000 Manufacturing capital (MC) Cost of depreciable manufacturing property Building (80% x $300,000) $240,000 Manufacturing equipment 600,000 $840,000 MC - $840,000 x 10% x 100/85 $98,824 Total capital (TC) Owned assets: Building acquired $ 300,000 Manufacturing equipment 600,000 Cost of VDI's existing depreciable assets 1,890,000 2,790,000 Leased assets - rent of trucks 80,000 TC - ($2,790,000 x 10%) + $80,000 $359,000 Manufacturing labour (ML) Direct labour $320,000 ML - $320,000 x 100/75 $426,667 Total labour (TL) Direct labour - manufacturing $ 320,000 Administrative salaries 630,000 Warehouse and sales salaries 340,000 TL $1,290,000

M & P Profits: MC + ML -------------- x ABI TC + TL $98,824 + $426,667 ------------------------------ x $4,840,000 = $1,542,375 $359,000 + 1,290,000 The Saskatchewan provincial tax reduction – 2% x $1,542,375 = $30,848 If the manufacturing plant is structured as a separate corporation, the maximum M & P profits could not exceed $240,000 (the profits for the corporation). The maximum Saskatchewan tax reduction would be $4,800 (2% x $240,000). Therefore, the division structure increases the provincial M&P tax reduction by $26,048 ($30,848 - $4,800). Assuming profit levels are maintained, this is an annual amount. Dividend Refund - Private company (A) + (B) + (C) (A) Lessor of: (i) 38 1/3% x eligible dividends paid 3,833 (ii) Eligible RDTOH balance 5,750 3,833 Plus (B) Lessor of: (i) 38 1/3% x non-eligible dividends paid 28,748 (ii) Non-eligible RDTOH balance 6,000 6,000 Plus (C) Lessor of: (i) 38 1/3% x non-eligible dividends paid 28,748 less: Non-eligible RDTOH balance (6,000) 22,748 and (ii) Eligible RDTOH balance 5,750 less: Dividend refund for eligible dividends (3,833) 1,917 1,917 11,750

Dividend Refund - Private company (A) + (B) + (C) (A) Lessor of: (i) 38 1/3% x eligible dividends paid 3,833 (ii) Eligible RDTOH balance 5,750 3,833 Plus (B) Lessor of: (i) 38 1/3% x non-eligible dividends paid 28,748 (ii) Non-eligible RDTOH balance 6,000 6,000 Plus (C) Lessor of: (i) 38 1/3% x non-eligible dividends paid 28,748 less: Non-eligible RDTOH balance (6,000) 22,748 and (ii) Eligible RDTOH balance 5,750 less: Dividend refund for eligible dividends (3,833) 1,917 1,917 11,750

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Part 2 The sale of shares of the corporation will result in an acquisition of control. If the loss carry-over of $650,000 exists at that time, its use will become restricted. The loss can then be deducted only against profits from the company's jewelry retailing business or a similar business. Therefore, the unused losses are more valuable to a purchaser corporation that is already in a similar line of business. Such a purchaser could take steps to combine their profitable similar operations with the acquired losses of Hope Enterprises Ltd. Therefore, the president should seek out such buyers as they would be prepared to pay a higher price for the shares because of their special ability to generate tax savings from the acquired loss carry-over. Solution to P 13-10 1. Net income per financial statement $528,000 Add (deduct) Charitable donations 5,000 Gain on sale of securities (40,000) Taxable capital gain on securities (1/2 of $40,000) 20,000 Net income for tax purposes 513,000 Donations (5,000) Canadian dividends (8,000 ) Taxable income $500,000 For purposes of calculating the small business deduction, the active business income is $470,000 as follows: Net income for tax purposes $513,000 Less - dividends (8,000) - taxable capital gain (20,000) - interest income (15,000 ) $470,000 Calculation of tax (assuming a provincial rate of 4% for eligible small business income and 12% on other) Federal 38% of $500,000 [ITA 123(1)] $190,000 Less: abatement (10% of $500,000) [ITA 124(1)] (50,000 ) 140,000 Refundable tax - 10 ⅔% x lesser of: [ITA 123.3] Aggregate investment income $35,000 (interest $15,000 + TCG $20,000) TI ($500,000) minus income subject - SBD amount $370,000) to the small business deduction ($470,000) $30,000 10 ⅔% x $30,000 3,200

Small business deduction (19% x $470,000) [ITA 125(1)] (89,300) General rate reduction 13% ($500,000 - $470,000 - $30,000) $$$$ $35,000$35$35,000) (0) 53,900 Provincial 4% $470,000 $18,800 12% 10% 30,000 3,600 22,400 $500,000 $ 76,300 Fully refundable part IV tax on Dividends $8,000 x 38⅓% [ITA 186(1)] $3,067

2. The expected additional profits for next year from the new contract will increase the corporation's active business income from $470,000 to $650,000. This is $150,000 in excess of the annual small business deduction limit of $500,000 [ITA 125(2)]. This excess will not be subject to the small business deduction and will also not receive the lower provincial tax rate of 4%. The income will be subject to the following tax rates: 1 st $500,000 (business income up to $500,000) 13% [38% - 10% - 19% + 4% provincial] Next $150,000 of business income 27% [38% - 10% – 13% + 12% (provincial)] The additional income over the small business deduction limit will be subject to some double taxation if dividends are declared in the future or if the shares of the corporation are sold resulting in a taxable capital gain. 3. As a result of the current year's estimate of income and the projected profits for next year, two events will cause increased tax costs. First of all, the current year's business income is $470,000 and, therefore, does not use $30,000 of potential small business deduction income ($500,000 - $470,000) while next year the business income will be in excess of $500,000 and the excess will be taxed at the higher rate. Secondly, income in the second year over $500,000 is subject to some double taxation if distributed as a dividend in the future. In order to use up the full small business deduction this year (knowing that next year's income is over the limit), the corporation can take steps to recognize more taxable income in the current year and reduce the taxable income the following year. One item in particular is evident. The financial statement indicates a reserve for doubtful accounts of $22,000. This reserve does not have to be claimed, which will increase profits by a further $22,000 this year and reduce profits by a corresponding reduction the following year [ITA 20(1)(l)]. This means that $22,000 of income will be taxed this year at the low rate rather than next year at 27%. It is not known if the owner/manager has taken her salary in the current year. If possible, she should reduce or eliminate her salary for the remaining part of the fiscal year and extract her required funds by either a dividend or a temporary loan. To the extent that next year's profits still exceed $500,000, the company should consider paying Carol an additional salary or bonus which shifts the corporate income directly to Carol to be taxed only once rather than twice if it was taxed in the corporation and later distributed as a dividend. This avoids the potential for double taxation. This should be done if Carol needs additional funds. However, if she does not need additional funds it may not be prudent to pay additional salaries on these amounts as the salary is taxed at 45% and avoids immediate corporate tax of only 27%. Thus, there is a significant deferral while the after-corporate-tax income remains in the corporation. She must consider when additional funds may be needed and take into account the time value of money.

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4. If Carol sells 30% of her common shares to the senior manager, she will incur a taxable capital gain of $185,000 [$400,000 - (30% x $100,000) = $370,000 x 1/2]. As she has never sold any capital property before, she will be able to shelter the capital gain from tax by the capital gains deduction, if the corporation is a qualified small business corporation (QSBC) [ITA 110.6]. Sufficient information is not provided to determine this, but the income statement shows interest income of $15,000 from bonds and $8,000 of dividends from shares of public corporations. This means that the corporation has some non- business assets. One of the tests to qualify as a QSBC is that all or substantially all of the corporation's assets must be used in an active business at the time of sale. Generally, CRA has interpreted substantially all to mean 90%. The amount of the capital gain that would be taxable is either $185,000 or nil depending on the corporation’s status. During the current year, the corporation earned a capital gain of $40,000 ($20,000 taxable). The non-taxable portion of this gain ($20,000) can be paid out to Carol as a tax- free capital dividend [ITA 83(2)]. This should be done before the share sale, as the payment of the tax-free dividend will reduce the value of all the shares by $20,000 of which $6,000 (30%) applies to the shares that will be sold. This reduces the capital gain on the proposed sale by $6,000 which, although it is a small amount, still reduces the tax on the sale or reduces the amount of the capital gains deduction that will be used up. There are a number of elective options and reorganization techniques that can be used to transfer 30% of the shares to the manager. However, these techniques are not reviewed until Chapters 14 and 19 and in most cases defer taxes but do not necessarily minimize the tax. This section of the problem can be re-examined after reviewing Chapters 14 & 19. Solution to P 13-11 Federal income tax payable Part I tax payable 21,100 Part IV tax payable 5,200 Dividend refund (7,666) 18,634 The computations are below.

Active business income 170,000 Interest income from bonds 10,000 Taxable capital gain 14,000 Eligible dividends from public companies 12,000 Non-eligible dividends from PQ Ltd 6,000 Net income for tax purposes $212,000 Dividends from Canadian corporations (18,000) Donations (4,000) Non-capital losses (5,000) Taxable income $185,000 Active business income Net income for tax purposes 212,000 Less: dividends received (18,000) Less: taxable capital gains (14,000) Less: interest (10,000) Active business income 170,000 Interest from overdue accounts receivable pertains to the active business. Aggregate investment income Taxable capital gains 14,000 Interest 10,000 24,000

Part I tax Basic federal tax - 38% 70,300 Abatement - 10% (18,500) 51,800 Small business deduction - 19% x least of (i) ABI 170,000 (ii) TI 185,000 (iii) Business limit ($500,000 - $320,000) 180,000 170,000 (32,300) Refundable tax on investment income 10 2/3% times the least of: AII 24,000 TI - income subject to SBD 15,000 15,000 1,600 General tax reduction - 13% of Taxable income 185,000 Less: Income subject to SBD (170,000) Less: AII (24,000) (9,000) - PART I TAX 21,100 Part IV Tax Dividends from non-connected corporations 38 1/3% x $12,000 eligible dividend 4,600 Dividends from connected corporations (PQ Ltd.) 60% x $1,000 non-eligible dividend 600 5,200 There is no reduction to the business limit resulting from the 2021 adjusted aggregate investment income of $30,000 since the amount is under $50,000. The reduction reflected above is due to the amount utilized by PQ, an associated corporation. Cinder and PQ are associated since PQ is controlled by Cinder.

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Non-eligible RDTOH Balance at end of previous year 2,000 Less: Dividend refund for preceding year - Add: Part IV tax on non-eligible dividends 600 Add: refundable Part I tax - least of: (i) 30 2/3% x AII 7,361 (ii) 30 2/3% (TI - income subject to SBD) 4,600 (iii) Part I tax 21,100 4,600 7,200 Eligible RDTOH Balance at end of previous year - Less: Dividend refund for preceding year - Add: Part IV tax on eligible dividends 4,600 4,600 Dividend Refund (i) Lessor of: (a) 38 1/3% x eligible dividends paid 3,833 (b) Eligible RDTOH balance 4,600 3,833 Plus (ii) Lessor of: (a) 38 1/3% x non-eligible dividends paid 3,833 (b) Non-eligible RDTOH balance 7,200 3,833 7,666