Henrietta
Aguirre, CGA, is the newly hired director of corporate taxation for Mesa
Incorporated, which is a publicly traded corporation. Aguirre's first job with
Mesa was to review the company's accounting practices for future income taxes.
In doing her review, she noted differences between tax and book depreciation
methods that permitted Mesa to recognize a sizeable future tax liability on its
balance sheet. As a result, Mesa did not have to report current income tax
expenses. Aguirre also discovered that Mesa had an explicit policy of selling
off plant and equipment assets before they reversed in the future tax liability
account. This policy, together with the rapid expansion of Mesa's capital asset
base, allowed Mesa to defer all income taxes payable for several years, at the
same time as it reported positive earnings and an increasing EPS. Aguirre
checked with the legal department and found the policy to be legal, but she is
uncomfortable with the ethics of it.
Instructions
(a)
Why would Mesa have an explicit policy of selling assets before they reversed
in the future tax liability account?
(b)
What are the ethical implications of Mesa's deferral of income taxes?
(c)
Who could be harmed by Mesa's ability to defer income taxes payable for several
years, despite positive earnings?
(d)
In a situation such as this, what might be Aguirre's professional
responsibilities?
(a) Accelerated
depreciation, such as the double declining balance method used for income tax
purposes, allows a company to deduct substantial capital cost allowance early
in the asset’s life. Yearly CCA declines
to a point where the accelerated CCA amount is lower than the depreciation
expense computed under the straight-line method. The reversing point occurs
when the accelerated CCA matches the straight-line rate. Some companies are motivated to sell assets
prior to this point to maximize the CCA benefit provided in terms of income
taxes. The selloff might result in less
recaptured CCA being reported and taxed at ordinary income tax rates. In addition, as long as the company is
growing, the company may receive a prolonged deferral of income taxes.
(b)
The deferral of
income taxes means that, due to temporary differences caused by the difference
in financial accounting principles and tax laws, a company will be able to
defer paying its income taxes until future periods. The practice of selling-off
assets before they reverse means that the company may pay a lesser amount of
taxes to the government.
(c)
Shareholders would be harmed by Mesa’s income tax
practice. In order to maintain this policy, and using the mechanism described
in (a) above, the company has to systematically acquire new assets at a cost
higher than the previously disposed assets. To repurchase assets at a lower
cost would trigger recaptured CCA in several cases. This means that management
is probably embarking on a short-term policy of improving its financial picture
at the cost of a damaging cash management policy, or it is indebting itself.
One would also have to question whether there is a legitimate need for these
new assets. This would be demonstrated by a decrease in the effectiveness of
their use of assets in declining return-of-assets or asset-turnover ratios.
(d)
As a CGA,
Henrietta is obligated to uphold objectivity and integrity in the practice of
financial reporting. If she thinks that this practice is unethical, then she
needs to communicate her concerns to the highest levels of management within
Mesa, including members of the Board and/or the Audit Committee. However, it
would appear here that Mesa is simply trying to minimize its income taxes,
which should not be considered unethical.
Current tax legislation permits
taxpayers to arrange their affairs in order to pay the minimum amount of
tax—when it is done within tax rules. However, transactions whose sole purpose
is to avoid paying income taxes and have no bona fide business purpose can be
caught under GAAR (General anti-avoidance rules). These transactions, if
caught, could be recharacterized by Canada Revenue Agency.
