capitalized expenditures
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Capitalized Expenditures. Expenditures which create an asset whose useful life extends beyond the current taxable year must be capitalized Examples: equipment, buildings, land, patents Exceptions: R & D costs, advertising costs - PowerPoint PPT PresentationTRANSCRIPT
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Capitalized Expenditures
Expenditures which create an asset whose useful life extends beyond the current taxable year must be capitalized Examples: equipment, buildings, land, patents Exceptions: R & D costs, advertising costs
Note: Capitalize means to treat a cost as an asset rather than a current expense In tax lingo, a capital asset is a certain type of
asset, with a narrower definition than a capitalized expenditure
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Cost Recovery of Capitalized Expenditures
When is the cost of a capitalized expenditure ‘recovered’ for tax purposes? Over time? When the asset is sold? Other?
How is the cost of a capitalized expenditure recovered for tax purposes? Permissible cost recovery methods? Treatment of unrecovered cost on sale?
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Types of Property
Define the following and provide examples of each: Tangible property Intangible property Real property Personal property
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Initial Tax Basis of Business Assets
General rule: initial tax basis equals purchase price: Cash paid + debt assumed or incurred + FMV of
other property or services given up Other purchase-related costs also included in
initial tax basis: Sales tax Freight Installation charges
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Adjustments to Tax Basis of Tangible Business Assets
Must capitalize the costs of additional expenditures which materially increase the value or extend the useful life of the asset Repairs vs. capital improvements Which of the following costs must be capitalized?
Environmental cleanup/asbestos removal New roof on building Landscaping costs Interior remodeling (carpet, partitions, etc.) Paint
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Adjustments to Tax Basis continued
Adjusted tax basis = Initial tax basis + capital improvements - depreciation/amortization/ depletion allowed or allowable
Adjusted tax basis represents the taxpayer’s unrecovered cost of the asset
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Tax Depreciation under MACRS
WARNING: MACRS rules have changed significantly several times since enacted in 1981. Depreciation is determined by the rules in effect for the year in which an asset is placed in service.
The following discussion pertains to rules in effect for assets placed in service since 1993.
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MACRS
Ten recovery periods Specified by type of property Usually shorter than useful life for GAAP
Conventions for year placed in service and year of disposition Mid-year convention for 3- through 20-year
property Midquarter convention if > 40% of depreciable
personalty acquisitions occur during final quarter Mid-month convention for >20-year property
Tax depreciation ignores salvage value
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MACRS Depreciation Methods
200% DB for 3- through 10-year property 150% DB for 15- and 20-year property Straight-line for >20-year property IRS tables provide percentages
Table percentages are applied to the asset’s initial tax basis (not adjusted tax basis) to determine each year’s depreciation amount
Mid-year and mid-month conventions for year of acquisition are built into tables
For year of disposition (if before end of recovery life) table percentages must be adjusted
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Tax Basis of Intangible Assets
Costs of self-created intangibles must be capitalized and amortized over time period for which economic benefits expected
Many purchased intangibles subject to IRC. Sec. 197 Amortized on straight-line basis over 15 years Examples: Goodwill, covenant-not-to-compete,
customer-based and workforce intangibles
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Start-up and Organization Costs
Start-up Costs: Pre-operational costs and costing of investigating either the creation or acquisition of a business
Organization Costs: legal, accounting, filing and registration costs related to formation of a new corporation or partnership
Taxpayer may elect to amortize these costs over 60 months, beginning in the first month of operation of an active business
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Mineral Rights
Costs of acquiring mining or drilling rights must be capitalized and are subject to depletion as mineral is removed Cost = Adjusted Basis * Current production in units
Depletion Estimated total units of production
Percentage Depletion = Gross Income * Statutory Rate
Greater of cost or percentage depletion for taxable year is deductible (property-by-property)
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Current Deductions of Capital Expenditures
Sec. 179 (Limited Expensing) Election – NEW LAW CHANGES $100,000 (2003-2006) of tangible personal property costs
deductible in year of acquisition Phased out for taxpayers with annual property expenditures > $400,000 Currently deductible amount limited to taxable business income before
this deduction Post-Sept. 11 additional first year depreciation
Applies to tangible personal property, computer software and leasehold improvements
30% of cost deductible in year of acquisition for acquisitions after 9/11/01 and before 5/6/03
50% of cost deductible in year of acquisition for acquisitions after 5/5/03 and before 1/1/05 (NEW LAW CHANGE)
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Current Deductions of Capital Expenditures continued
Costs of removal of barriers to handicapped access ($15,000 annual maximum)
Soil and water conservation expenditures by farmers
Research and experimentation costs Advertising Costs of environmental remediation at targeted
contamination sites Intangible Drilling Costs
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Tax Incentives Example: Oil and Gas Drilling and Development
Independent oil and gas companies receive two important tax incentives: Current deduction for intangible drilling costs Percentage depletion (15% of gross revenue)
Why are these favorable tax breaks offered? Without them, the riskiness of oil and gas exploration would deter many companies from investing in this activity
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Example 1: Oil and Gas Incentives Assume drilling costs of $100,000 for a well
expected to produce 2,500 barrels of oil annually for 5 years. Current oil prices are $18 per barrel, and expected operating costs for the well are $6 per barrel. Assume a marginal tax rate for the independent producer of 34%, and a 7% discount rate.
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Example 1 continued
Without special tax incentives to promote exploration, drilling costs would be capitalized and depleted, using cost depletion, over the productive life of the well. Annual gross revenue $45,000
Annual operating costs 15,000Annual depletion 20,000Net taxable income 10,000Annual tax cost 3,400Annual after-tax cash flow 26,600
PV of 5 year after-tax returns $109,065Rate of Return on investment 9%
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Example 1 continued By allowing immediate expensing of drilling costs,
the return on this investment increases significantly. Annual gross revenue $45,000
Annual operating costs 15,000Annual depletion 0Net taxable income 30,000Annual tax cost 10,200Annual after-tax cash flow 19,800
PV of 5 year after-tax returns $81,184Tax benefit in year 1 from drilling cost deduction
34,000Total NPV $115,184
Rate of Return on investment 15%
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Example 1 continued By also allowing percentage depletion of 15% of
annual gross revenue, the return on this investment more than doubles from the non- tax-favored return. Annual gross revenue $45,000
Annual operating costs 15,000Annual depletion 6,750Net taxable income 23,250Annual tax cost 7,905Annual after-tax cash flow 22,095
PV of 5 year after-tax returns $90,594Tax benefit in year 1 from drilling cost deduction 34,000Total NPV $124,594
Rate of Return on investment 25%
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Incorporating Cost Recovery into NPV Analysis
Initial cost of asset results in cash outflow If acquired with debt, cash outflows occur for debt
principal and interest payments Tax savings generated by interest expense represents a
cash inflow
Depreciation expense is not a cash outflow Tax savings generated by depreciation expense
represents a cash inflow
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Accounting for Inventories
Must use accrual method - only cost of goods sold (COGS) is deductible
Two issues in determining COGS: Product versus period costs (which costs are
inventoriable) Manufacturers and large retailers/wholesalers must
determine inventory cost (product cost) for tax purposes using uniform capitalization rules, which are NOT consistent with GAAP
Allocation of costs to goods on hand versus goods sold (cost flow assumptions): Specific identification, FIFO, LIFO LIFO conformity requirement
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Tax Implications of Asset Acquisitions: Planning Issues
The after-tax cost of an asset acquisition increases as the recovery life (period of time over which the asset’s cost may be deducted for tax purposes) increases
Leveraged financing of asset purchases, where the cost of the asset is financed over a period longer than the recovery period, can decrease the after-tax cost of an acquisition
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Planning Issues continued
Another alternative: Lease vs. purchase Tax treatment of leases:
Generally, annual lease payments are deductible Up-front payments to acquire a lease must be
capitalized and amortized over lease term Some leases may be treated as purchases for tax
purposes, depending on facts
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Update to Book/Tax Difference List
Temporary Differences
• Differences in inventoriable costs under Unicap rules
• Differences between book and tax depreciation/ amortization/depletion
• Sec. 179 (immediate expensing) deduction
• Intangible drilling costs (full cost method for GAAP)
•Deductible R&D costs
Permanent Differences
• Percentage depletion in excess of investment