Lecture 11: Depreciation and Taxes

Depreciation

Referring to the diagram cash.eps from the last lecture, note that a company can deduct operating costs from operating revenues before calculating what taxes it owes. There is a particular kind of operating cost that needs to be handled carefully, and that is the operating cost associated with equipment lasting longer than a year.

For example, in calculating the operating costs for a photocopy shop, the paper that needs to be purchased every week is clearly an operating cost. But the shop may also need to buy a new photocopier every five years. How is this cost handled?

A prudent manager will set some money aside each year in a sinking fund , so that this account will accumulate enough money to replace the asset when its economic life comes to an end. Canadian tax law allows the company to deduct part of the machine's cost from its pre-tax cash flow every year, whether or not the company has actually set up a sinking fund. In general, the allowable annual deduction will not be equal to the annual contribution to the sinking fund, but will be fixed by the income tax laws.

We need to make a distinction here between the depreciation rate the company uses in its internal accounting, and the depreciation rate it uses in filling out its tax returns. These two rates may be the same, but it is also possible that the company chooses to use a different rate for its own calculations. For example, the depreciation rate stipulated by the tax laws is a function only of time, whereas a company might want to figure into its internal depreciation rate the amount of use that an asset suffers.

Depreciation for Internal Accounting

Four engineering graduates set up a company to provide consulting services to local industry. Using $125,500 of their own money, and a borrowed $30,000, they acquire four state-of-the-art workstations and associated CAD/CAM software. This gives them a competitive advantage, and they are able to bring in enough to pay themselves comfortable salaries and to pay off the loan. However, after five years their equipment is obsolete and they no longer have the capital needed to replace it.

To avoid being taken by surprise, the graduates should have kept accounts showing the value of their equipment declining each year. The annual decline need not correspond to the tax laws; its only purpose is to accurately represent to the graduates the value of their company, and to alert them to the erosion in its value.

The potential causes for depreciation of an asset include physical depreciation, or wearing out; functional depreciation, as when the function an asset provides becomes inadequate or unneeded; technological depreciation, as in the above example, where other means of performing the same function better or more cheaply become available; depletion, as in the consumption of a non-renewable natural resource; and monetary depreciation, that is, the need to set aside additional money to replace an asset because inflation has pushed up the price of a replacement. Internal accounting should accurately reflect these effects.

Canadian Tax Law on Depreciation

In Canada, there is only one allowable depreciation expense, known as the capital cost allowance (CCA). The law specifies a small number of classes of asset, and a CCA rate for each class. In filling in the tax return, each class must be accounted for separately, as follows:

Start with the undepreciated capital cost of all assets in that class at the beginning of the year.
Subtract the proceeds from the sale of any assets in that class that you've disposed of during the year.
Add the total allowable cost of asset additions during the year. (This is only 50% of the cost of the assets you've actually purchased during the year; the other 50% is shifted forwards to next year.)
Subtract any government assistance payments or investment tax credits. The resulting figure is the undepreciated capital cost (UCC) to be used in tax calculations.
Apply the appropriate CCA rate. (To find the appropriate rate, check with the most recent publications of Revenue Canada, or consult a tax lawyer.)

Applying the CCA

There are two methods of calculating depreciation allowance in common use. Canadian tax law uses one method for some classes, the second method for others.

Method 1: Straight-Line Depreciation

This is the simplest method, and the most widely used for internal accounting. Canadian tax law applies it to asset classes 13, 14, 24 and 29.

In internal accounting, an asset with a physical life of N years depreciates annually by

D = (P-S)/N

every year, where P is the initial cost and S is the salvage price.

The value of the asset as it appears in the company's books is therefore

BV = P - (P-S)n/N

For tax purposes, the salvage price is taken to be zero.

Method 2: Declining Balance Depreciation

This method reduces the value of the asset by a constant factor every year. Canadian tax law applies it to asset classes 3, 6, 7, 8 and 10. Specifically, the book value of the asset in any given year is

BV_n = P(1 - depreciation rate)ⁿ

and the depreciation cost in that year is

DC_n = BV_n-1 (depreciation rate)

Note that this method never leads to a book value of zero, so it may overstate the value of an asset towards the end of its life.

Tax Rates

The corporate tax with which we will be chiefly concerned is corporate income tax. Like individual income tax, this is paid to both the federal and provincial governments. The federal rate is 46%, reducible by 21% for small businesses, and the provincial rates vary from province to province. In B.C., the current provincial tax is 16%, reduced to 8% for small businesses.

In calculating the cost of acquiring capital from various sources, it is worth noting that interest payments are deducted from the company's pre-tax cash flow, while dividend payments come out of the company's after-tax cash flow. Similarly, if you are the majority stockholder in your own company, you may wish to consider the tax advantages of paying yourself a high salary out of pre-tax cash flow versus paying yourself a large dividend out of after-tax cash flow.

If there are significantly different tax consequences for different investment strategies, the strategies should be compared by an after-tax analysis, rather than a pre-tax analysis of the kind we have been using up to this point. We will discuss this in greater detail in the next lecture.

John Jones
Thursday January 27 2008