Capital Cost Allowance

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Capital Cost Allowance

• Business 2039

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CCA

• Capital Cost Allowance (CCA) is the
  depreciation method used by taxpayers in Canada
  when reporting business income to CRA Canada
  Revenue Agency for tax purposes.

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Importance of CCA to Financial Decisions

• Taxation issues must be explicitly addressed in
  each financial decision you make.
• Since CCA affects the net income from a business
  (and especially affects net cash flow), knowledge
  of the CCA system is essential for all business
  decision-makers.

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CCA gives rise to a Tax Shield Benefit to the
Company

• CCA is a non-cash deduction from income that
  would otherwise be subject to income taxation.
• As a result of the CCA deduction, taxable income
  is reduced.
• This results in a savings in tax payable.
• The tax shield benefits is equal to T(CCA)
• t corporate tax rate
• CCA the dollar amount of CCA claimed
• A firm with a 40 corporate tax rate and a 2,000
  CCA deduction will save 800 in taxes.

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ExampleConsider two firms that report 10,000
in earnings before CCA and taxes, face a 40 tax
rate. One firm has no CCA to claim, the other
can claim 2,000 in CCA

• Company A Company B
• Earnings Before CCA Tax 10,000 10,000
• CCA 2,000 0
• Taxable Income 8,000 10,000
• Taxes _at_ 40 3,200 4,000
• Net Income 4,800 6,000
• Add back non-cash expense 2,000 0
• Cash flow from Operations 6,800 6,000

Note that company A is better off by 800 because
of the 2,000 non-cash deduction of CCA. That is
the amount of taxes saved. If you look at net
income, Company A appears to be worse off,
however, that is only an accounting illusion!!
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CCA vs. Accounting Depreciation

• CCA
• like assets are grouped into pools or classes
• the CCA rate used in each asset class is setout
  in the regulations to the Income Tax Act and may
  or may not reflect economic wastage of the asset
• no estimate of useful life or of salvage value
• as long as the firm remains in existence, and
  assets remain in the pool, residual UCC values
  will remain in the pool.

• Accounting Depreciation
• choose the method that will best represent the
  economic wastage of the asset (declining balance,
  sum-of-the-years digits, straight-line, etc.)
• individual assets are depreciated
• estimate of useful life and salvage value is
  included

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CCA Rules

• 1/2 of the regular CCA rate for the class applies
  to the net additions to the pool for that year.
• CCA cannot be used to create a tax loss.

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CCA Over Time - A Simple ExampleAssume you
acquire a depreciable asset with a cost base of
100,000 and there are no other assets in this
pool. The CCA rate for the pool is 10. Note
you are allowed only 1/2 the regular CCA rate on
the net additions to the pool in the year of
acquisition.
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CCA Tax Shield Over Time(Assume a corporate Tax
Rate T of 40)
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Tax Shield Over Time(A Graphical Representation)
Asymptotic Curve
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Observations

• In the foregoing you can now readily see
• CCA provides large tax shields in the early years
  of the assets life
• residual values remain in the pool long after the
  asset was acquiredthis means that the firm will
  never fully recoup the original cost of the asset
  as the firms asset base ages, cash flows
  generated from CCA will not enable the firm to
  replace the original asset.
• If a firm were to pay out all of its earnings in
  the form of dividends, there would not be
  sufficient cash flow left to replenish the asset
  base that is wearing out eventually the firm
  would go out of business its physical assets
  would be worthless and UCC would remain on its
  books!

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Disposition of Assets and CCA

• A taxable capital gain would occur if the firm
  sold a depreciable asset for greater than its
  original cost.
• Capital Gain Original Cost Base - Salvage Value

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Disposition of Assets and CCA

• If the salvage value of the asset exceeds the UCC
  of the pool there is a recapture of depreciation
• recaptured depreciation is subject to tax
• Recaptured Depreciation UCCpool - Salvage
  Value

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Disposition of Assets and CCA

• When the last physical asset in the pool is sold
  and not replaced, the pool will be closed out.
• If there is a positive balance remaining in the
  pool after disposition, that balance is called a
  terminal loss and is deductible from income in
  that year.it is a non-cash deduction just like
  CCA.

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CRA Form
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Capital Cost Allowance - Depreciation for tax
purposes
Class Rate Assets 1 4 Buildings acquired
after 1987 8 20 Furniture, photocopiers 10 30
Vans, trucks, tractors and computer equipment 13
Straight-line Leasehold improvements 16 40 Ta
xicabs and rental cars 22 50 Pollution control
equipment 43 30 Manufacturing equipment
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CCA Schedule (simple)
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CCA Schedule (simple over time)
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CCA Schedule (simple ½ net additions rule)
The bottomline here is that you are allowed
only half the regular CCA on additions to the
pool in the year of acquisition.
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CCA Schedule (simple ½ net additions rule)
A net addition to the pool is equal to
additions minus disposals.
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CCA Schedule (simple changes over time)
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CCA Schedule (simple changes over time)
Compare this slide with the last onenote that
the CCA in the first year is half as great as in
the last slidebecause there was a net addition
to the pool of 10,000 and no beginning UCC.
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CCA Schedule (Disposals)
When you dispose of assets from the pool
rememberthat you are not allowed ANY CCA on the
asset that has been disposed of even though you
might have used the asset for the greater part of
the fiscal year.
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CCA Schedule changes over time
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CCA Schedule Recapture
If the proceeds on the sale of an asset in the
pool cause the balance in the pool to become
negativethat negative amount is a recapture of
depreciation.
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Recapture of Depreciation

• A recapture is realized on the disposal of an
  asset in a CCA pool where the remaining balance
  in the pool turns negative.essentially this
  arises because the government has allowed you to
  depreciate for tax purposes the equipment at too
  great a rate.
• When you sold the equipmentthe selling price did
  not reflect the depreciated valuethe selling
  price exceeded not only the depreciated value of
  the individual assetbut if other assets remain
  in the pool, the selling price has exceeded the
  depreciated (or UCC) of all of the assets
  remaining in the pool.
• You will have to claim the recapture as income in
  the fiscal year that it was realizedand pay
  income taxes on it.

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CCA Schedule Terminal Loss
If the LAST physical asset in the asset class was
finally sold for 5,000, and 4,250 was left in
the poolthe 4,250 is a terminal loss.
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Terminal Losses are Rare

• These are usually pretty rare in
  practicebecause, generally when old assets are
  worn outthey are replacedand therefore, there
  remain physical assets in the pool.
• Only if a firm is getting out of a line of
  businessand disposing of all of their assets (or
  perhaps deciding to lease them all instead of
  owning them)can you imagine a firm disposing of
  all of the assets in an asset pool.

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Tax Treatment of Terminal Losses

• In essence, a residual value left in the pool
  after the sale of the last physical assetcan
  only occur if the sale value of the assets
  (disposal values) were less than the UCC of the
  assetsthis means that over time, the
  governments CCA rate did not reflect the true
  wastage of the assets.
• Consequently, a terminal loss can be deducted
  from income (just like regular CCA)
• Since a terminal loss is a non-cash deduction
  (like CCA) it will give rise to a tax shield (Tax
  shield terminal loss times the corporate tax
  rate)

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CCA Schedule Capital Gain
You sell an asset for 20,000 that originally
cost you 16,500, you would use the lower of the
two values to record this disposal for CCA
purposes.
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CCA Schedule Capital Gain and a Recapture
You sell an asset for 20,000 that originally
cost you 16,500, you would use the lower of the
two values to record this disposal for CCA
purposes. If the sale causes the UCC to become
negativea recapture of depreciation will also be
triggered by the transaction.
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CCA Schedule template
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Capital Gains and CCA

• If you sell a depreciable asset for more than
  its original costthen the difference is a
  realized capital gain
• Capital Gain Selling Price Original Cost
• 3,500 20,000 - 16,500
• You would use the lower of the Original cost or
  the selling price when recording the asset
  disposal for CCA purposes. (in this case 16,500)

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Finding ending UCC

• You can always do a detailed table to finding
  ending UCC given the assumption of maximum use of
  available CCA in each year
• However, you can also use a formula

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Finding ending CCA using a full CCA Schedule
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CCA and Capital Budgeting

• Since the tax shield on CCA varies over time and
  the stream of tax shield benefits can go on
  forever, it is necessary to develop an equation
  for the tax shield on CCA
• This equation assumes the asset is purchased and
  held forever (there is no salvage value)that the
  maximum CCA is claimed each year