ACCT226 Chapter 3 Problem 7 PDF

Preview

Summary

ACCT226 Chapter 3 Problem 7...

Description

Fred Ethridge is a valued employee of a large Canadian company. He is in the process of negotiating a new compensation package for the coming year. As he is looking to purchase a new residence, one of the alternatives that is being considered is an interest free loan that would be used to purchase this property. Fred needs $350,000 to comfortably finance this purchase. As he has an excellent credit rating, the Royal Bank is prepared to extend the $350,000 on a 5 year, closed mortgage at a rate of 4.75 percent. The company has indicated that they will extend a $350,000, 5 year, interest free loan in lieu of a raise. The Company’s accounting department will calculate the after tax cost of providing the loan and his employer will offer Fred the alternative of additional salary that has the same after tax cost to the Company. The Company is subject to tax at a combined federal/provincial rate of 29 percent. When funds are available, the Company has alternative investment opportunities that earn a pre-tax rate of 10 percent. Because of Fred’s current high salary, any additional compensation will be taxed at a combined federal/provincial rate of 49 percent. Assume that the prescribed rate for the current year is 2 percent.

Required:

A. Determine the tax consequences to Fred and the cost to the Company, in terms of lost after-tax earnings, of providing Fred with a $350,000 interest free loan for the first year of the loan.

B. Determine the amount of additional salary that could be provided to Fred for the same after tax cost to the Company that you calculated in Part A.

C. Which alternative would you recommend that Fred accept? Explain your conclusion.

Part A The first year tax consequences for Fred would be that he would be assessed a taxable benefit on the loan of $7,000 [(2%)($350,000)] for the current year. This would result in an increase in his Tax Payable of $3,430 [(49%)($7,000)]. The cost of the loan to the company for the first year would be calculated as follows:

Lost Earnings On Funds Loaned [(10%)($350,000)]

$35,000

Corporate Taxes On Imputed Earnings (At 29 Percent)

( 10,150)

Net Cost To Company - Loan

$24,850

This will result in Fred having the use of $350,000 at a tax cost to himself of $3,430 and an annual cost of $24,850 to the Company.

Part B If instead of giving Fred the $350,000, the Company pays him the potentially lost annual earnings of $35,000, the after tax cost to the Company will be the same, as shown in the following calculation:

Additional Salary

$35,000

Savings In Corporate Taxes (At 29 Percent)

( 10,150)

Net Cost To Company - Additional Salary

$24,850

Part C Fred can borrow on a loan at a rate of interest of 4.75 percent. This means that the annual interest payments on $350,000 would amount to $16,625 [(4.75%)($350,000)]. If he receives the additional salary, his after tax income would be as follows:

Additional Salary

$35,000

Tax Payable (At 49 Percent)

( 17,150)

Net Increase In Cash

$ 17,850

Fred should accept the additional salary of $35,000 per year as it results in an annual cash inflow of $1,225 ($35,000 - $17,150 - $16,625) after paying the tax and the mortgage interest. This compares to a cash outflow of $3,430 if the company extends the loan to Fred....