Asset Capitalization Process and Tax Credits – An illustrative example of a Manufacturing Environment

A tax incentive for Canadian manufacturers is accelerated depreciation of manufacturing assets and corporations can maximize via a true valuation of its capital asset. In this sequel we quantitatively highlight how accurate asset capitalization involves your engineer and accountant.

Example

Consider a fictional Canadian corporation, ABC with the following simplified expense. Over two year period, ABC had manufacturing equipment acquisition totalling $500K. Yr1: $200K, and Yr2: $300K. At end of year 2, ABC will have up to $200K of CCA balance (tax equivalent of depreciation). Based on management discretion, this amount can be applied towards reducing tax payables arising from taxable income.

Is there an issue? Unsure of the asset reporting, prior to year 2 filing, ABCs accountant decided along with an engineer to conduct a walk-through of ABC facility and discovered $300K was reported in year 2 was solely based on invoice amount of equipment purchase!

In year 2, ABC recorded costs worth $100K as below:

Companies like ABC have internal accounting system that report costs based on an input – often an invoice item that relates to equipment such as in this case. This does not replace human intervention required to consider complex engineering or associated costs. Additionally, in a busy shop floor, errors and omissions of such kind is not unusual.

The accountant decided the following actions:

• Use engineering assistance to review and identify all direct and indirect costs required to bring the equipment for operational and economical use;
• Ensure new added costs can be associated as a long term expense towards an asset;
• Collect engineering documentation that substantiated the new cost at $400K in year 2 and reversed the expenses (operational to capital) appropriately.

The action items resulted in increase of $50K in to the CCA balance for Year 2! Further this ensured accurate balance sheet reporting of assets.

Summary remarks:

• Capitalization process involves engineers and their input towards an important assertion: identifying associated costs that are essential for the asset to become economically useful;
• Based on your establishment, there are additional refundable tax credits. For example, if you are a Quebec establishment, an inclusion of $100K could mean refundable tax credits anywhere from $10K to $50K (depending on the geographical region of operation). There is a decrease in this valuation following Quebec June 2014 budget announcement, but the main concept is materially intact;
• If you are eligible to receive tax credits, the asset purchased has to be new and considered to be “qualified new property” as per Federal Income Tax Act. However, if you purchased an old or a refurbished asset, it can be considered for refundable tax credits as long as its new purpose is distinctly different from the original old asset. Otherwise, your capitalization process will be based on the fair market value of acquisition and addition of all costs required to make the asset useful.

An interesting outcome can be SR&ED process and additional tax credits. If so, your asset capitalization has to consider careful cost segregation, and even potential recapture. This analysis can be involved.

ABOUT THE AUTHOR

ALLAN MADAN

CPA, CA

Allan Madan is a CPA, CA and the founder of Madan Chartered Accountant Professional Corporation. Allan provides valuable tax planning, accounting and income tax preparation services in the Greater Toronto Area.

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