Capital Budgeting on Karideph

[Griet van Vliet]

With the Talz having signed a tax treaty with the Karideph tax authorities, it was easier, but by no means easy, for the new clients that did business in both Talz space and on Karideph to get their taxes in order. The first client of the day was a Talz advertising executive that, although a Talz resident for tax purposes, works for a Karideph-based employer and is taxed as such. Divorced from her former husband three years ago (and she suspects Kari taxes have something to do with the divorce) she has custody of both kids, one 17 years old, and the oldest has 18. The divorce decree is to provide that the client claims the children as dependents for both Talz and Kari taxes. (The distinction needs to be made between alimony and child support for tax purposes: Talz tax alimony received in the hands of the payee, and is tax-deductible for the payor, but Kari don't, and both races consider child support payments to be non-taxable to the payee and non-deductible for the payor). What's obvious here is that the client holds head-of-household status for Kari taxes (Talz tribes sometimes have a HH filing status but there is no unified standard at the federal level).

 

[Griet van Vliet]

"Wait! About divorcing, please pay attention to the divorce date! I know that getting divorced for fiscal or financial reasons is a thing among both Talz and Kari, but the Karideph Revenue Code undertook major changes before the tax treaty was ratified" the Kari colleague told Griet.

"What does the KRC reform have to say about divorcing?"

"The divorce was finalized three years ago also so the alimony is treated the same as you would in Talz-land"

The number of items that the KRC has changed is just staggering. Alimony is 16,000 and, since the client spent 6,500 for supporting the younger child, and the ex-husband spent 5,500 the support test for dependency is met. Also, since the inheritance is well below the estate tax threshold, the 625,000 inheritance from her late mother, killed on Sisio, is not subject to it, no more than the proceeds from her mother's life insurance. She also sold the shares that gave rise to the eligible dividends for 22,000, and bought for 24,000 from her cousin at the time. The other items that goes into the AGI (the adjusted gross income, which is the Kari equivalent to the NITP in Talz tax) and/or the NITP are as follows:

Salary 80,000
Interest income from GICs 2,500
Groceries won from a Karideph raffle 750 (non-taxable for Talz taxes)
Qualified dividend income 1,800 (taxed as a long-term capital gain on Karideph; 2,484 in eligible dividends for Talz taxes)
Capital gain 3,500 (half of which is taxable in Talz-land)
Alimony 16,000
Interest income from municipal school bonds Nil (but the interest of 3,750 fully taxable in Talz-land)
Income from a partnership 5,300

AGI: 109,850/NITP: 112,534

 

[Griet van Vliet]

For Talz taxes, the following items are either treated at a different stage of the tax return or not deductible at all. But these were all "from-AGI" items, and normally itemizing was the way to go since the client was a non-resident but because Griet felt it was good to try testing the assertion that itemizing could be worth less than just using the standard deduction of 18,350.

Charitable donations 6,000
Mortgage interest 7,800 (non-deductible for Talz tax purposes)
Local taxes 8,400 (the higher of CST vs clan income taxes, plus property taxes; only the 4,100 in clan taxes are deductible for Talz tax purposes, albeit at a different stage)
Medical expenses Nil (does not exceed 10% of the AGI but, for Talz taxes, 1,998 can be claimed for tax credits since the net declarable amount of 4,300 exceeds 2,302)

Total itemized deductions 22,200

Less: Deduction for QBI: 1,060

Taxable income: 86,590 (Karideph) 112,534 (Talz)

 

[Griet van Vliet]

The Kari part of the story would soon end: the tax to be paid is the following:

Regular tax: (86,590-5,300-52,850)*22% + 6,065 = 12,322
Dividend and capital gains tax: (1,800+3,500)*15% = 795

Total tax payable: 13,117

Less: Child tax credit 1,000
Tax withheld at the source: 9,000
Installment payments: 2,800

Balance owing (Kari) 317

Now came the painful part: Talz tax return.

 

[Griet van Vliet]

The tax credit portion is as follows:

Personal exemption 12,069
Medical expenses 1,998

Tax credit base: 14,067
Tax credit: 2,110

Charitable donation tax credit: 200*15% + 5,800*29% = 1,712

Income tax payable: 16,908.44 + (112,534-95,259)* 26% = 21,399.94

Less: Tax credits 3,822
Less: Dividend tax credits 684*6/11 = 373.09

Net income tax payable 17,204.85

 

[Griet van Vliet]

But these days, most Talz tribes went with the 48% surtax to diminish their bureaucracy, and the FTC would be the lesser of the actual tax paid (16,217), or 1.48 times the basic tax since there is no Talz-sourced income. Therefore the balance owing in Talz-land is:

Combined tax payable: 25,463.18

Less: FTC 16,217

Balance owing: 9,246.18

 

[Griet van Vliet]

Now there was another courier service that was buying a new starship at 48,000 to replace the one lost on Sisio. An independent courier service that wanted a bigger ship and assumes it was the only asset in the CCA class. Griet estimated the FMV of the ship at the end of the 8th year is 20,000, and its RRR is 9%, and its tribe taxes ABI at 40% (which means that it taxes ABI at a much, much higher rate than the "Feds" even if it earned 50,000 or more in passive income). The courier would then consider buying it only if the undiscounted payback period does not exceed 5.6 years.

Tax shield perpetuity: Cost*tax rate*CCA rate*(1+discount/2)/(1+discount)(discount+CCA rate) = 48,000*0.4*0.3*1.045/(1.09)(0.39) = 14,160

Net initial investment = 33,840

After-tax annuity: 4,800*5.53482 = 26,567

Salvage value: 10,037

Tax shield reversal present value: 4,800*0.4*0.3*0.50187/0.39 = (741)

Recapture tax bill: 10,037*15,200/20,000*40% = (3,051)

NPV: -1,028

 

[Griet van Vliet]

One of the courier's clients reported a cost of goods sold of 640,000, is considering a machine worth 165,000, and its RRR is 12%. It would increase its capacity by 10k units, to 30k units. Same tribe, same CCA class percentage, the sales price is 50/unit, whereas the COGS is 32/unit. 13.44 being a variable labor cost, but the new COGS then becomes 27.97/unit for the first two years (out of 5). So the new fixed costs of 45,000/year must be factored in also.

Initial investment: 165,000

Tax shield from the new machine is 44,617, and the old machine has no salvage value

Total initial investment: (120,383)

Annual cash flow 1 (savings+extra fixed costs): (4.03*20,000-45,000)*0.6 = 21,360* 3.60478 = 76,998
Annual cash flow 2 (new units for the last 3 years): 50,617
Salvage value: 14,175
Tax shield reversal (with UCC being 48,105 at the end of the fourth year): (7,793)
Terminal loss: 23,105*0.4*0.567 = 5,240

NPV = 18,875 so the client should make the investment

 

[Griet van Vliet]

There came the next client of the day. Operating an unincorporated business, a Kari sole proprietor that has, this time around, no ties to Talz worlds, came to Griet because the client feels that non-Kari accountants are more likely to remain independent. Luckily, there was no cross-jurisdiction question of CCA: as much as Kari qualifying dividends are typically eligible in Talz-land under the terms of the treaty, and vice-versa, depreciable assets were another story: CCA on Karideph was further compounded by... Section 179, which allows for immediate expensing for capital assets put in service, she thought, realizing it was a single person, and whose main source of income is its sole proprietorship. The client may as well be getting an income statement for free...

Writers Anonymous​

Income Statement (partial)​

For the year ended...​

​

Sales revenue 85,000
Rent expense 16,500
Utilities 7,900
Supplies 1,800
Insurance 5,000
Travel 2,300
Meals 1,200 (can only deduct 1/2 for taxes)

Operating income 50,300 (tax-basis 50,900)

 

[Griet van Vliet]

"If you take the S179 deduction, then your UCC will be nil for future years. Or that's how I understand S179 as applied to this situation. You didn't take any depreciation expense because you weren't able to determine the useful life of the capital assets"

The Talz equivalent to Karideph's Section 179 is much more restrictive as to assets but much less restrictive as to value: Class 53 can now be expensed in full (up to the value of the tax-basis EBITDA) the year Class 53 assets are put in service, and the same now holds for Class 12 assets because of the AII which essentially converts the half-year rule to the 1.5-year rule. Here, because the assets are office furniture and fixtures worth 21,000 on January 10 and computer equipment worth 12,400 put in service on July 28, neither asset exceeds the 500,000 per-asset, and the put-in-service limit of 2.55 million is not yet reached, the full amount may be expensed. However, she prepares a second set of CCA calculations should the KRS deem the assets ineligible for S179, and the year-end UCCs that result. If S179 eligibility is, in fact, confirmed, the final revenue item is interest income of 4,000, so the preliminary AGI would then be 21,500. And yet there was the FICA for self-employed to take into account, which was the lesser of 14.13% of net earnings from self-employment up to 137,737 or 19,462, here it was 2,473, of which half was deductible for AGI, or 1,237. The real AGI was 20,263.

 

[Griet van Vliet]

"There are two options if the KRS deems the choice of S179 inappropriate: either use the regular CCA calculation, MACRS as they call it, or straight-line CCA, while taking into consideration the half-year or the mid-quarter conventions"

Here MACRS, or modified accelerated cost recovery system, refers to the method, while CCA is the line item on the business income schedule. Unlike in Talz-land, even unprofitable businesses must reduce the year-end UCCs by the allowable amounts, even though they can't take it. The only reason why would someone want to use straight-line over MACRS, and not to use Section 179 deductions, is if the business is unprofitable to begin with, but expects to return to profitability at a later date. Also, because under Karideph rules, there is no carry-back of tax losses, there is no such thing as a current tax benefit either, since current tax benefits arise from loss carrybacks. Because the mid-quarter convention is used if more than 40% of the value of the assets placed in service was bought in the last three months, in which case the assets are deemed to be put in service for CCA purposes in the middle of the quarter they were bought in.

If using straight-line CCA: 21,000*1/2*1/7 = 1,500 for the furniture, 12,400*1/2*1/5 = 1,240 for the computer equipment and then the AGI would be 48,475 (FICA being 3,685). The resulting year-end UCC balances would be 19,500 for the furniture and 11,160 for the computer equipment.

If using MACRS: 21,000*1/2*1/7*2 = 3,000 for the furniture, 12,400*1/2*1/5*2 = 2,480 for the computer equipment and then the AGI would be 45,928 (FICA being 3,492). The resulting year-end UCC balances would be 18,000 for the furniture and 9,920 for the computer equipment.

Itemized deductions:

State income tax 2,950
Mortgage interest 6,000
Property taxes on home 2,500
Charitable donation 1,200

Total itemized deductions 12,650

And the taxable income, prior to the QBD, becomes: If S179 is allowed: 7,613/If S179 is not allowed and straight-line CCA is used: 35,825/If S179 is not allowed and MACRS is used: 33,278

QBD: 1,523/7,165/6,656

Taxable income: 6,090/28,660/26,622

Income tax payable: 609/3,162.20/2,917.64

Less: Installment payments 3,000

Refund/balance owing: 2,391 refund/162.20 balance owing/82.34 refund

 

[Griet van Vliet]

What's the deal with these clients? What kind of clients am I getting if I keep getting clients that are Talz residents for tax purposes but work for Karideph-based employers that treat their payrolls as if they were Karideph residents? Griet thought, while the next client of the day was a sales manager that needed two separate calculations for work space in the home: one for Karideph taxes, and the other for Talz taxes, because there are items that are deductible only for Karideph taxation and not under Talz taxation. Also, under the Kari-Talz tax treaty, 401(k) contributions can be deducted as one would a RPP contribution, and also count towards the RRSP limit as a result. Because somehow the employer deemed the entire 401(k) contribution to be borne out of the employee's pocket, even though Talz employers would only have half of the cost borne from the employee's paycheck for a RPP. That is, the client may not even have any room left for RRSP contributions... The client was handed a T2200.

Salary 83,000
Treasure trove 5,000 (non-taxable for Talz purposes)
Less: 401(k) contributions 11,000

And there remained the entire question of how to go around treating the employment expenses.

 

[Griet van Vliet]

There were three major categories of employment expenses to consider: spacecraft, work space in the home and travel expenses. The spacecraft was used 70% for business and 30% for personal use, and incurred the following deductible expenses:

Fuel 3,100
Insurance 2,900
License plate dues 240
Repairs and maintenance 1,200

Pre-CCA expenses: 7,440
Deductible portion: 5,208

The hard part: calculating CCA for both jurisdictions. The original cost of buying the spacecraft two years ago was 37,000, before the accelerated investment incentive kicked in on Talz worlds. In both cases, UCC proration is necessary to reflect business vs personal use, and is a Class 10.1 asset at 30% in Talz-land.

Opening UCC: 15,411 for Talz purposes
CCA taken: 3,050 on Karideph, 4,623 for Talz purposes
Ending UCC: 10,788 for Talz purposes

Total spacecraft expenses: 7,943 on Karideph, 10,431 for Talz purposes

 

[Griet van Vliet]

Work space in the home. 20% of the space was used for home office, so 20% of the joint costs are to be allocated to the home office.

Rent: 18,000
Utilities: 4,000
Insurance: 1,600

Total joint costs: 23,600
Deductible portion: 4,720

Carpet for the office space: 1,200

Total expenses: 5,920

 

[Griet van Vliet]

Travel expenses: double-edged sword here. One component relates to "domestic" travel and the other to go to far-flung locations. The domestic portion is the following:

Lodging: 3,200
Meals: 2,800 (only 50% is deductible for Talz taxes)
Public transportation fares: 4,100
Taxis: 300
Business gifts: 540 ($25 each plus $5 incidental so the full amount is allowed)
Continuing education: 400 (for which no T2202A was issued)
Professional journals: 140

Domestic expenses: 10,080 (Talz) 11,480 (Kari)

Far-flung expenses (deductible portion):

Cruising fare: 1,800 (must be apportioned between business and leisure time)
Lodging: 2,100
Meals: 1,470 (only 50% is deductible)
Transportation: 350

Total far-flung expenses: 4,985

 

[Griet van Vliet]

These are the remaining items for AGI:

Long-term capital loss: 1,500 (nil for Talz purposes but can be carried forward)
Municipal bond interest: Nil (350 is taxable in Talz-land)
Interest from short-term investments: 400

AGI: 75,900/NITP: 70,750

"For some reason the so-called travel allowance isn't simply a travel allowance for Kari taxes, but remains strictly a travel allowance for Talz taxes. Therefore work space in the home is the only class that is, in fact, deductible for Talz taxes"

Deductions from AGI:

Charitable donations: 5,600
State and local general sales taxes: 3,300
Medical expenses: (7,897+4,500)-7,590 = 4,807

Itemized deductions: 13,707

Taxable income: 62,193 (Karideph)/70,750 (Talz)

Base income tax payable: 9,540.96 (Karideph)/11,884.10 (Talz)

Amounts withheld + installment payments: 9,400

Kari balance owing: 140.96

 

[Griet van Vliet]

Talz tax credits:

Base amount: 12,069
Medical expenses: (7,897+4,500)-3%*70,750 = 10,274.50

Tax credit base: 22,674

Tax credits: 3,351.53

Charitable donations tax credits: 30+(5,400*29%) = 1,596

Federal income tax payable: 6,936.57

Tribal surtax: 3,329.55

Total income tax payable: 10,266.12

Less: FTC 9,540.96 (lesser of total income tax payable, prorated by the fraction of the income from foreign source, and actual paid of 9,540.96)

Talz balance owing: 725.16

 

[Griet van Vliet]

And now one of the clients, a small carpet cleaning outfit, Gore Range Carpet Cleaning, was struggling to understand the costing portion of their business. They were planning on using multiple cost drivers, and they have 4 cost pools to consider: the actual carpet cleaning, job support, travel to jobs, and, of course, the other costs that are not usually allocable as overhead. They used a single-driver fee, 0.2295/square foot. The client's activity cost pools are the following:

Activity/Cost driver/Activity volume
Cleaning carpets/square feet cleaned/1 million
Travel to jobs/Kilometers driven/80,000km
Job support/Number of jobs/1,800 jobs
Other/N/A

The total costs of operating the company for the year is 340,000, and the revenue is 229,500. Poodoo: they are operating at a loss of 110,500, she thought, realizing that maybe there is a going concern issue.

Gore Range Carpet Cleaning​

Income statement​

For the year ended...​

Sales revenue 229,500
Wages 140,000
Cleaning supplies 25,000
Cleaning equipment depreciation 10,000
Vehicle expenses 30,000
Office expenses 60,000
President's compensation 75,000

Net loss 110,500

 

[Griet van Vliet]

The estimates of resource consumption are the following:

Wages: 75% CC/15% TJ/10% Other
Cleaning supplies: 100% CC
Cleaning equipment depreciation: 70% CC/30% Other
Vehicle expenses: 80% TJ/20% Other
Office expenses: 60% JS/40% Other
President's compensation: 30% JS/70% Other

Total costs:

CC: 105,000+25,000+7,000 = 137,000 so 0.1370/sq ft
TJ: 21,000+24,000 = 45,000 so 0.5625/km driven
JS: 36,000+22,500 = 58,500 so 32.50/job
Other: 14,000+3,000+6,000+24,000+52,500 = 99,500

Their latest client, the Lazy Bee Ranch, was a 600 square feet cleaning job, for which they earned 137.70, had 80km in driving distance.

Cleaning carpets: 0.1370*600 = 82.20
Travel to job: 80*0.5625 = 45.00
Job support: 32.50

Gross job cost: 159.70

Gross margin: -22.00

"Using sq ft alone is not the way to go for pricing the services"

 

[Griet van Vliet]

Speaking of the Lazy Bee Ranch, it produces 2 types of products, 25,000 Premium and 5,000 Select, per month, each taking 1 hour of direct labor hour. So a total of 30,000 DLH. 40/unit in raw material in Premium, 30/unit in Select, 12/DLH, and, for a total of 900,000 in OH, 30/DLH, if using traditional costing. So it costs the ranch 82/unit for Premium, and 72/unit for Select.

Now, there needed to get 500 setups for Premium, 1,000 for Select, sharing 300k in machine setup. As for machining, 500,000 to be allocated to 50k MH, and finally, 100k for 2,000 inspections.

So the total costs for Premium comes to: 100,000+300,000+25,000=425,000 or 17/unit, and 475,000 or 95/unit for Select. End result: the unit price is 59/unit for Premium, 137/unit fo Select.